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**htm Chapter 6 Cost-Volume-Profit Relationships Learning Objectives
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1. Explain how changes in activity affect contribution margin and net operating income. 2. Prepare and interpret a cost-volume-profit (CVP) graph. 3. Use the contribution margin ratio (CM ratio) to compute changes in contribution margin and net operating income resulting from changes in sales volume. 4. Show the effects on contribution margin of changes in variable costs, fixed costs, selling price, and volume. 5. Compute the break-even point in unit sales and sales dollars. 6. Determine the level of sales needed to achieve a desired target profit. 7. Compute the margin of safety and explain its significance. 8. Compute the degree of operating leverage at a particular level of sales, and explain how the degree of operating leverage can be used to predict changes in net operating income. 9. Compute the break-even point for a multiple product company and explain the effects of shifts in the sales mix on contribution margin and the break-even point.

Chapter Overview

A. The Basics of Cost-Volume-Profit (CVP) Analysis. Cost-volume-profit (CVP) analysis is a key step in many decisions. CVP analysis involves specifying a model of the relations among the prices of products, the volume or level of activity, unit variable costs, total fixed costs, and the sales mix. This model is used to predict the impact on profits of changes in those parameters. 1. Contribution Margin. Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. It contributes towards covering fixed costs and then towards

C. The total profit (or loss) is the vertical difference between the total revenue and total expense lines. The format of this statement can be expressed in equation form as: Profits = Sales . the unit contribution margin is simply multiplied by the change in unit sales.profit. The unit contribution margin can be used to predict changes in total contribution margin as a result of changes in the unit sales of a product. the total revenue line is drawn. B. Break-even analysis is a special case of target profit analysis in which the target profit is zero. which is a convenient way to express activity in multi-product firms. the change in total contribution margin falls directly to the bottom line as a change in profits. CVP analysis can be used to estimate the effect on profit of a change in any one (or any combination) of these parameters. Target profit analysis is concerned with estimating the level of sales required to attain a specified target profit. CVP Relationships in Graphic Form. Assuming no change in fixed costs. The basic CVP graph is drawn with dollars on the vertical axis and unit sales on the horizontal axis. D.Variable expenses . It shows how the contribution margin is affected by a given dollar change in total sales. The break-even occurs at the point where the total revenue and total expenses lines cross. This is because the contribution margin ratio is denominated in sales dollars. CVP analysis is typically used to estimate the impact on profits of changes in selling price. The contribution margin (CM) ratio is the ratio of the contribution margin to total sales. particularly when a company has many products. Total fixed expense is drawn first and then variable expense is added to the fixed expense to draw the total expense line. Contribution Margin Ratio. CVP graphs can be used to gain insight into the behavior of expenses and profits. A variety of examples of applications of CVP are provided in the text. 2. Some Applications of CVP Concepts. 3. The above equation can be expressed in terms of unit sales as follows: Price x Unit sales = Unit variable cost x Unit sales + Fixed expenses + Profits Unit contribution margin x Unit sales = Fixed expenses + Profits . Unit Contribution Margin. variable cost per unit. sales volume. To do this. Basic CVP equations. The contribution margin ratio is often easier to work with than the unit contribution margin.Fixed expenses In CVP analysis this equation is commonly rearranged and expressed as: Sales = Variable expenses + Fixed expenses + Profits a. Both the equation and contribution (formula) methods of break-even and target profit analysis are based on the contribution approach to the income statement. 1. and total fixed costs. Finally. Break-Even Analysis and Target Profit Analysis.

The two methods are logically equivalent. Then solve for the sales.Unit sales = b. The Contribution Method²Solving for the Break-Even Unit Sales. The break-even point is the level of sales at which profit is zero. This is a short-cut method that jumps directly to the solution.Variable expense ratio = 1 - = =Contributionmargin/Sales =Contributionmarginratio 2. 3. This method involves following the steps in section (1b) above. a. It can also be defined as the point where total sales equals total expenses or as the point where total contribution margin equals total fixed expenses. Set profits equal to zero in the formula. b. Substitute the selling price. Break-even point using the equation method. The Equation Method²Solving for the Break-Even Unit Sales. Substitute the variable expense ratio and fixed expenses in the first equation and set profits equal to zero. . bypassing the intermediate algebraic steps. This method involves following the steps in section (1a) above. unit variable cost and fixed expense in the first equation and set profits equal to zero. Break-even point using the contribution method. Then solve for the unit sales.Variable expense ratio) x Sales = Fixed expenses + Profits Contribution margin ratio* x Sales = Fixed expenses + Profits Sales = * 1 . The basic equation can also be expressed in terms of sales dollars using the variable expense ratio: Sales = Variable expense ratio x Sales + Fixed expenses + Profits (1 . This method involves using the final formula for unit sales in section (1a) above. The Equation Method²Solving for the Break-Even Sales in Dollars. a. Break-even analysis can be approached either by the equation method or by the contribution margin method.

Operating leverage is a measure of how sensitive net operating income is to a given percentage change in sales. This method involves using the final formula for sales in section (1b) above.Break-even unit sales = = b. G. 1. It is the amount by which sales can drop before losses begin to be incurred. Set profits equal to zero in the formula. Cost structure refers to the relative proportion of fixed and variable costs in an organization. Margin of Safety. The Contribution Method²Solving for the Break-Even Sales in Dollars. Operating Leverage. Either the equation method or the contribution margin method can be used to find the number of units that must be sold to attain a target profit. The degree of operating leverage at a given level of sales is computed as follows: . Break-even sales = = 4. Understanding a company¶s cost structure is important for decision-making as well as for analysis of performance. the formulas are: Unit sales to attain target profits = Dollar sales to attain target profits = Note that these formulas are the same as the break-even formulas if the target profit is zero. The margin of safety can be computed in terms of dollars: Margin of safety in dollars = Total sales ± Break-even sales or in percentage form: Margin of safety percentage = F. In the case of the contribution margin method. Cost Structure. Target profit analysis.Degree of operating leverage. The margin of safety is the excess of budgeted (or actual) sales over the breakeven volume of sales. E.

´ Issues in Accounting Education. at the break-even point the degree of operating leverage is infinite since the denominator of the ratio is zero. the degree of operating leverage should be used with some caution and should be recomputed for each level of starting sales. however. 31xx-229. for example. To verify this. the degree of operating leverage provides a quick way to predict the percentage effect on profits of a given percentage increase in sales. It is difficult. Richard Lord.2. points out that the relation between operating leverage and the cost structure of the company is contingent. say that if two single- . 4.Degree of operating leverage is not constant. Fall 1995.The math underlying the degree of operating leverage. The degree of operating leverage is not constant as the level of sales changes. We can. to infer the relative proportions of fixed and variable costs in the cost structures of any two companies just by comparing their operating leverages. consider the following: = = = = = = = Percentage change in net operating income Thus. Operating leverage and cost structure. The higher the degree of operating leverage. 3. For example. the larger the increase in net operating income. assuming there is no change in fixed expenses. providing that fixed expenses are not affected and the other assumptions of CVP analysis are valid. The degree of operating leverage can be used to estimate how a given percentage change in sales volume will affect net income at a given level of sales. Therefore. ³Interpreting and Measuring Operating Leverage. pp.

product companies have the same profit. the same unit sales. changes in the sales mix can cause variations in a company¶s profits. the break-even level of sales dollars can be computed using the overall contribution margin (CM) ratio. then the company with the higher operating leverage will have a higher proportion of fixed costs in its cost structure. and the same total expenses. the same unit sales. Thus. Structuring Sales Commissions. the break-even point in a multi-product company is dependent on the sales mix. All of the statements in the text about operating leverage and cost structure assume that the companies being compared are identical except for the proportions of fixed and variable costs in their cost structures. 1. The contribution margin ratio of this basket can be easily computed by dividing the total contribution margin of all products by total sales. it is usually assumed that the sales mix will not change. For a multi-product company the formulas for break-even sales dollars and the sales required to attain a target profit are: . it is assumed that the company has only one product that consists of a basket of its various products in a specified proportion. In CVP analysis. Students may have a tendency to overlook the importance of this section due to its brevity. In essence. Under this assumption. Use of the overall CM ratio. You may want to discuss with your students how salespeople are ordinarily compensated (salary plus commissions based on sales) and how this can lead to dysfunctional behavior. we cannot safely make this inference about their cost structure. Overall CM ratio = 2. and the same total expenses. The overall contribution margin ratio can be used in CVP analysis exactly like the contribution margin ratio for a single product company. would a company make more money if its salespeople steered customers toward Model A or Model B as described below? Model A Price Variable cost Unit CM $100 75 $ 25 Model B $150 130 $ 20 Which model will salespeople push hardest if they are paid a commission of 10% of sales revenue? I. Most companies have a number of products with differing contribution margins. H. As a result. the same selling price. the same selling price. For example. Sales Mix. If they do not have the same profit. Sales mix is the relative proportions in which a company¶s products are sold.Constant sales mix assumption.

CVP analysis can easily accommodate more realistic assumptions. then the overall contribution margin ratio will change. inventories do not change. this assumption becomes tenuous. the results of CVP analysis should be viewed with more caution in multi-product companies than in single product companies. However. Selling price is constant. if the effects of a decision on fixed costs can be estimated. 3. A number of examples and problems in the text show how to use CVP analysis when fixed costs are affected. Costs are linear and can be accurately divided into variable and fixed elements.Break-even sales = Sales to achieve target profits = Note that these formulas are really the same as for the single product case. J. The assumption is that the selling price of a product will not change as the unit volume changes. 4. A number of examples and problems in the text show how to use CVP analysis to investigate situations in which prices are changed. The constant sales mix assumption allows us to use the same simple formulas. then changes in the sales mix can have a big impact on the overall contribution margin ratio and hence on the results of CVP analysis. It is assumed that everything the company produces is sold in the same period. If the proportions in which products are sold change. Violations of this assumption result in discrepancies between financial accounting net operating income and the profits calculated using the contribution approach. However. . then a more refined CVP analysis can be performed in which the individual contribution margins of products are computed. this can be explicitly taken into account in CVP analysis. In order to increase volume it is often necessary to drop the price. violations of this assumption will not be important. 1. 2. It is assumed that the variable element is constant per unit and the fixed element is constant in total. It also implies that the fixed costs are really fixed. The sales mix is constant in multi-product companies. Nevertheless. Since the sales mix is not in reality constant. if unit contribution margins differ a great deal. Simple CVP analysis relies on simplifying assumptions. Changes in sales mix. the CVP analysis can often be easily modified to make it more realistic. In manufacturing companies. This topic is covered in detail in the chapter on variable costing. This is not wholly realistic since unit sales and the selling price are usually inversely related. Assumptions in CVP Analysis. However. If a manager can predict how the sales mix will change. If unit contribution margins are fairly uniform across products. When volume changes dramatically. if a manager knows that one of the assumptions is violated. This implies that operating conditions are stable. 3. This assumption is invoked so as to use the simple break-even and target profit formulas in multi-product companies.

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