CHAPTER 5

Cost-Volume-Profit Relationships
 5-2

Cost-Volume-Profit Analysis
What is Cost-Volume-Profit (CVP) Analysis?

• Cost-volume-profit (CVP) analysis is a decision-making

tool that helps managers understand how several
factors influence profits, including:

• Sales price
• Sales volume
• Unit variable costs
• Total fixed costs
• Product mix

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 5-3

Cost-Volume-Profit Analysis
Why use CVP?

• It is a relatively simple tool or model.

• It highlights how managerial decisions over key
production and pricing decisions affect cost and
volume and, therefore, profitability.
• It can highlight key profitability benchmarks and
what the cost and/or volume levels need to be to
reach these benchmarks.

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 5-4

Cost-Volume-Profit Analysis
Key assumptions used in CVP analysis:

• Sales price is constant

• The price of the product will not change as volume sold changes

• Costs are linear (i.e., y = a + bX)

• Variable costs are constant per unit produced
• Fixed costs are constant over the entire relevant range

• Product mix is constant (in multi-product firms)

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 5-5

CVP Relationships in Graphical Form

We can graph our revenue and expense lines to plot them on a graph.

Our expense line:

• Total Expenses = Fixed Expenses + VC/unit * Units Sold
• Y = a + bQ

Our revenue line:

• Total Revenues = Price/unit * Units Sold
• Y = P*Q
• Note: The intercept will be zero because it would be a very odd
situation if we have positive or negative revenues with zero sales!

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 5-6

CVP Relationships in Graphical Form

Example:

Our expense line:

• Y = a + bQ
• Total Expense = $35,000 + ($150/unit)(# of units)

Our revenue line:

• Y = PQ
• Total Revenue = ($250/unit)(# of units)

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 5-7

CVP Relationships in Graphical Form

Revenue Line:
Y = $250/unit(# units)

Expense Line:
Y = $35,000+$150/unit(# units)

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 5-8

Understanding the Impact of Sales Price

What happens if we
change sales price?

Slope of the
revenue line
changes

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 5-9

Understanding the Impact of Sales Volume

What happens if we
change sales volume?

Where we are on
the original lines
changes

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 5-10

Understanding the Impact of Unit Variable Costs

What happens if we
change unit variable
costs?

Slope of the
expense line
changes

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 5-11

Understanding the Impact of Fixed Expenses

What happens if we
change fixed expenses?

The Y-intercept of
the expense line
changes

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 5-12

Cost Classification in Cost-Volume-Profit Analysis

We use cost behavior to classify costs in CVP Analysis

• Variable costs are combined and modeled as a group in CVP

• Fixed costs are presented and analyzed jointly, but discretely from
variables costs

Because we focus on classifying costs by behavior, CVP Analysis and

the Contribution Format Income Statement go hand-in-hand.

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 5-13

Review of Contribution Format Income Statement

1. Always start with Sales

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 5-14

Review of Contribution Format Income Statement

2. Costs classified by behavior

(variable vs. fixed)

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 5-15

Review of Contribution Format Income Statement

3. Sales – Variables expenses = Contribution margin

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 5-16

Review of Contribution Format Income Statement

4. Contribution margin – Fixed expenses = Net Op. Income

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 5-17

Review of Contribution Format Income Statement

5. Sales, variable expenses, and contribution margin

can be shown per unit.

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 5-18

Review of Contribution Format Income Statement

Calculating the Contribution Margin Ratio (total):

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 $40,000

𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = = = 0.40
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 $100,000

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 5-19

Review of Contribution Format Income Statement

Calculating the Contribution Margin Ratio (per unit):

𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝐶𝐶𝐶𝐶 $100

𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = = = 0.40
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 $250

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 5-20

Review of Contribution Format Income Statement

Calculating the Variable Expense Ratio (per unit):

𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 $60,000

𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = = = 0.60
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 $100,000

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 5-21

Review of Contribution Format Income Statement

Note:
CM ratio = 1 – Var. Exp. Ratio

Calculating the Variable Expense Ratio (per unit):

𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑉𝑉𝑉𝑉𝑉𝑉. 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 $150

𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = = = 0.60
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 $250

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 5-22

Quick Check 1
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is $1.49
and the average variable expense per cup is $0.36. The
average fixed expense per month is $1,300. An average of
2,100 cups are sold each month. What is the CM Ratio for
Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139

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 5-23

Quick Check 1a
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is $0.36.
The average fixed expense per month is $1,300. An
average of 2,100 cups are sold each month. What is the
CM Ratio for Coffee Klatch? Unit contribution margin
CM Ratio =
a. 1.319 Unit selling price
b. 0.758 ($1.49 - $0.36)
=
c. 0.242 $1.49
d. 4.139 $1.13
= = 0.758
$1.49
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 5-24

Practice Problem #1
Smooth-Eaze is a smoothie retailer open for breakfast and lunch. The
average selling price of a smoothie is $5.50 and the average variable
expense per cup is $3.00. The average fixed expense per month is
$1,200. An average of 3,500 smoothies are sold each month.
What is the CM Ratio for Smooth-Eaze?
 5-25

CVP Relationships in Equation Form

Profit = Sales – Variable Costs – Fixed Costs
• Sales = Selling price per unit * Quantity sold
• Variable Costs = Variable expenses per unit * Quantity sold

Profit = (P*Q – V*Q) – Fixed Expenses

Profit = Q(P – V) – Fixed Expenses

Unit contribution margin = Selling price per unit – Variable expenses per unit

Profit = Q * Unit CM – Fixed Expenses

 5-26

Practice Problem #2

What is the profit impact if Acoustic can increase unit sales from 400 to
520 by increasing the monthly advertising budget by $10,000?
 5-27

Practice Problem #3
A Company provides the following data:
• Sales: 3,000 units
• Sales price: $70/unit
• Variable cost: $50/unit
• Fixed cost: $25,000
If the sales volume decreases by 25%, the variable cost per unit
increases by 15%, and all other factors remain constant, what is the
impact to net operating income?
 5-28

Concept: Break-Even Point

Break-even point:
• The level of sales at which profit is zero
• Break-even sales can be expressed in dollars or in units sold
• Recall:

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 − 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 − 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

• Thus, for break-even:

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 − 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 − 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 = 0

 5-29

Break-Even Point Calculations

Break-even point in unit sales:
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑡𝑡𝑡𝑡 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 =
𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝐶𝐶𝐶𝐶

$35,000
𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑡𝑡𝑡𝑡 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 = = 350 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
$100

Break-even point in dollar sales:

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑡𝑡𝑡𝑡 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 =
𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅

$35,000
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑡𝑡𝑡𝑡 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 = = $87,500
0.40
 5-30

Quick Check 2
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is
$0.36. The average fixed expense per month is $1,300.
An average of 2,100 cups are sold each month. What is
the break-even sales dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129

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 5-31

Quick Check 2a
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. An average of 2,100 cups are sold each
month. What is the break-even sales dollars?
a. $1,300 Break-even Fixed expenses
=
b. $1,715 sales CM Ratio
c. $1,788 = $1,300
d. $3,129 0.758
= $1,715

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 5-32

Quick Check 3
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is $1.49
and the average variable expense per cup is $0.36. The
average fixed expense per month is $1,300. An average of
2,100 cups are sold each month. What is the break-even
sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups

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 5-33

Quick Check 3a
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is
$0.36. The average fixed expense perFixed
month is $1,300.
expenses
An average of 2,100 cupsBreak-even
are sold eachCMmonth. What is
per Unit
the break-even sales in units? $1,300
a. 872 cups =
$1.49/cup - $0.36/cup
b. 3,611 cups $1,300
c. 1,200 cups =
$1.13/cup
d. 1,150 cups
= 1,150 cups

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 5-34

Practice Problem #4
Frog Inc. produces springs. During the period:
• Sales price per unit: $210.00
• Variable expenses per unit: $98.70
• Fixed expenses for the period: $357,273
The break-even point in units sold is…
 5-35

Practice Problem #5
Giraffe Corp. produces and sells ladders. During the period:
• Sales price per unit: $200
• Variable expenses per unit: $78
• Fixed expenses for the period: $396,500
The break-even point in monthly sales is…
 5-36

Practice Problem #6
Coyote Company sells a single product for $20 per unit. If variable
expenses are 60% of sales and fixed expenses total $9,600, the break-
even point (in dollar sales) will be:
 5-37

Concept: Target Profit Analysis

Target Profit Analysis: what sales value is needed to achieve a target profit.
• The concept is the same as break-even analysis, but our profit is no
longer zero. Rather, we replace this with what profit we are targeting.

Units sales to attain the Target profit + Fixed expenses

==
target profit (Q) Unit CM

Dollar sales to attain Target profit + Fixed expenses

=
the target profit (Sales) CM Ratio
 5-38

Quick Check 4
Coffee Klatch is an espresso stand in a downtown office building.
The average selling price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average fixed expense per
month is $1,300. Determine how many cups of coffee would have
to be sold to attain target profits of $2,500 per month.
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups

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 5-39

Quick Check 4a
Coffee Klatch is an espresso stand in a downtown office building.
The average selling price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average fixed expense per
month is $1,300.Unit
Determine
sales how many cups of coffee would have
Target
to be sold to attain target profits of profit
$2,500 + Fixed expenses
per month.
to attain =
a. 3,363 cups Unit CM
target profit
b. 2,212 cups
$2,500 + $1,300
c. 1,150 cups = $1.49 - $0.36
d. 4,200 cups
$3,800
=
$1.13
= 3,363 cups
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 5-40

Quick Check 5
Coffee Klatch is an espresso stand in a downtown office building.
The average selling price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average fixed expense per
month is $1,300. Determine the sales dollars that must be
generated to attain target profits of $2,500 per month.
a. $2,550
b. $5,013
c. $8,458
d. $10,555

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 5-41

Quick Check 5a
Coffee Klatch is an espresso stand in a downtown office building.
The average selling price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average fixed expense per
month is $1,300. Determine the sales dollars that must be
Sales
generated to attain $ profitsTarget
target profit
of $2,500 per+month.
Fixed expenses
to attain = CM ratio
a. $2,550
target profit
b. $5,013
$2,500 + $1,300
c. $8,458 = ($1.49 – 0.36) ÷ $1.49
d. $10,555
$3,800
=
0.758
= $5,013

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 5-42

Practice Problem #7
Lone Wolf International Corporation's only product sells for $230.00 per
unit and its variable expense is $80.50. The company's monthly fixed
expense is $821,635 per month. The unit sales to attain the company's
monthly target profit of $35,000 is closest to:
 5-43

Practice Problem #8
Elephant Technologies produces and sells a single product whose
contribution margin ratio is 63%. The company's monthly fixed expense is
$46,050 and the company's monthly target profit is $19,000. The dollar
sales to attain that target profit is closest to:
 5-44

Other Concepts: Margin of Safety

The margin of safety is the excess of budgeted or actual sales
dollars over the break-even volume of sales dollars.
• It is the amount by which sales can drop before losses are
incurred.

Margin of safety in
dollars
= =total budget or actual sales – break even sales

Margin of safety percentage Margin of safety in dollars

= Total budgeted or actual sales
 5-45

Quick Check 6
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is $1.49 and
the average variable expense per cup is $0.36. The average fixed
expense per month is $1,300. An average of 2,100 cups are sold
each month. What is the margin of safety expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups

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 5-46

Quick Check 6a
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is $1.49 and
the average variable expense per cup is $0.36. The average fixed
expense per month is $1,300. An average of 2,100 cups are sold
each month. What is the margin of safety expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
Margin of safety = Total sales – Break-even sales
= 2,100 cups – 1,150 cups
= 950 cups

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further distribution permitted without the prior written consent of McGraw-Hill Education.
 5-47

Other Concepts: Cost Structure

• Cost structure refers to the relative proportion of
fixed and variable costs in an organization.
• Managers often have some flexibility in
determining their organization’s cost structure.
 5-48

Cost Structure and Profit Stability

There are advantages and disadvantages to high
fixed cost (or low variable cost) and low fixed cost
(or high variable cost) structures.

An advantage of a high fixed A disadvantage of a high fixed

cost structure is that income
will be higher in good years
compared to companies
with lower proportion of
fixed costs.
cost structure is that income
will be lower in bad years
compared to companies
with lower proportion of
fixed costs.

Companies with low fixed cost structures enjoy greater

stability in income across good and bad years.
 5-49

Degree of Operating Leverage

Operating leverage is a measure of how sensitive net operating
income is to percentage changes in sales.
• That is, at any given level of sales, of how a percentage
change in sales volume will affect profits.

Degree of Operating Contribution Margin

=
Leverage Net Operating Income

$40,000
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑜𝑜𝑜𝑜 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 = =8
$5,000
 5-50

Degree of Operating Leverage

With an operating leverage of 8, if Acoustic Concepts increases

its sales by 10%, net operating income would increase by 80%.

Percent increase in sales 10%

Degree of operating leverage x 8

Percent increase in NOI 80%

Here’s the verification!

 5-51

Degree of Operating Leverage

Original Increased
Sales $100,000 $110,000
Variable Expenses $60,000 $66,000
Contribution Margin $40,000 $44,000
Fixed Expenses $35,000 $35,000
Net Op. Income $5,000 $9,000

10% increase in sales from

$100,000 to $110,000 . . .

. . . results in an 80% increase in

income from $5,000 to $9,000.
 5-52

Quick Check 7
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. An average of 2,100 cups are sold each month.
What is the operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92

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 5-53

Quick Check 7a
Actual sales
Coffee Klatch is an espresso stand in a downtown 2,100 cups
office building. The average selling price of a cup$ of 3,129
Sales
coffee is $1.49 and the average variableexpenses
Less: Variable expense per 756
cup is $0.36. The averageContribution
fixed expense per month is2,373
margin
$1,300. An average of 2,100Less:cups are
Fixed sold each month.
expenses 1,300
What is the operating leverage?
Net operating income $ 1,073
a. 2.21
b. 0.45 Operating Contribution margin
c. 0.34 leverage = Net operating income
d. 2.92 $2,373
= $1,073 = 2.21

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further distribution permitted without the prior written consent of McGraw-Hill Education.
 5-54

Quick Check 8
At Coffee Klatch the average selling price of a cup of
coffee is $1.49, the average variable expense per cup
is $0.36, the average fixed expense per month is
$1,300, and an average of 2,100 cups are sold each
month.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%

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further distribution permitted without the prior written consent of McGraw-Hill Education.
 5-55

Quick Check 8a
At Coffee Klatch the average selling price of a cup of
coffee is $1.49, the average variable expense per cup
is $0.36, the average fixed expense per month is
$1,300, and an average of 2,100 cups are sold each
month.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0% Percent increase in sales 20.0%

c. 22.1% × Degree of operating leverage 2.21

Percent increase in profit 44.20%
d. 44.2%

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further distribution permitted without the prior written consent of McGraw-Hill Education.