ACCOUNTING STUDIES CHAPTER 1

Cost-Volume-Profit Relationships

 These calculations can be verified as follows:

 To summarize, if sales are zero, the company’s loss would equal its fixed expenses.

 Each unit that is sold reduces the loss by the amount of the unit contribution
margin.
o Once the break-even point has been reached, each additional unit sold increases the
company’s profit by the amount of the unit contribution margin.

 CVP Relationships in Equation Form:

- The contribution format income statement can be expressed in equation form as
follows:

Profit = (Sales − Variable expenses) − Fixed expenses

 For brevity, we use the term profit to stand for net operating income in equations.

 When a company has only a single product, as at Acoustic Concepts, we can further
refine the equation as follows:

o Sales = Selling price per unit × Quantity sold = P × Q

o Variable expenses = Variable expenses per unit × Quantity sold = V × Q

Profit = (P × Q − V × Q) − Fixed expenses

Mr. Amir Rabie

1
ACCOUNTING STUDIES CHAPTER 1

 We can do all of the calculations of the previous section using this simple equation.

 For example, earlier we computed that the net operating income (profit) at sales of
351 speakers would be $100. We can arrive at the same conclusion using the above
equation as follows:
Profit = (P × Q − V × Q) − Fixed expenses
Profit = ($250 × 351 − $150 × 351) − $35,000
= ($250 − $150) × 351 − $35,000 = ($100) × 351 − $35,000
= $35,100 − $35,000
= $100
 It is often useful to express the simple profit equation in terms of the unit
contribution margin (Unit CM) as follows:

o Unit CM = Selling price per unit − Variable expenses per unit = P − V

o Profit = (P × Q − V × Q) − Fixed expenses
o Profit = (P − V) × Q − Fixed expenses

Profit = Unit CM × Q − Fixed expenses

 We could also have used this equation to determine the profit at sales of 351
speakers as follows:
Profit = Unit CM × Q − Fixed expenses
= $100 × 351 − $35,000
= $35,100 − $35,000 = $100

 Contribution Margin Ratio (CM Ratio) and the Variable Expense Ratio:
- As a first step in defining these two terms, we have added a column to Acoustic
Concepts’ contribution format income statement that expresses sales, variable
expenses, and contribution margin as a percentage of sales:

Mr. Amir Rabie

2
ACCOUNTING STUDIES CHAPTER 1

 The contribution margin as a percentage of sales is referred to as the contribution

margin ratio (CM ratio).This ratio is computed as follows:

contribution margin
CM ratio = sales

- For Acoustic Concepts, the computations are:

Total contribution margin
CM ratio = Total sales = $40,000
$100,000
= 40%
 In a company such as Acoustic Concepts that has only one product, the CM ratio
can also be computed on a per unit basis as follows:

Unit contribution margin

CM ratio = Unit selling price = $$250
100
= 40%
 Similarly, the variable expenses as a percentage of sales is referred to as the variable
expense ratio. This ratio is computed as follows:

Variable expenses
Variable expense ratio = sales

- For Acoustic Concepts, the computations are:

Total variable expenses
Variable expense ratio = Total sales = $$100,000
60 0,000
= 600%
 Because Acoustic Concepts has only one product, the variable expense ratio can also
be computed on a per unit basis as follows:

Variable expense per unit

Variable expense ratio = Unit selling price = $$ 15 0
25 0
= 60%
 Applications of the Contribution Margin Ratio:

Mr. Amir Rabie

3
ACCOUNTING STUDIES CHAPTER 1

The CM ratio shows how the Contribution margin will be affected by a change in
total sales. Acoustic Concepts’ CM-ratio of 40% means that for each dollar increase
in sales, total contribution margin will increase by 40 cents ($1 sales × CM ratio of
40%).

Change in contribution margin = CM ratio × Change in sales

 For example, if Acoustic Concepts plans a $30,000 increase in sales during the
coming month, the contribution margin should increase by $12,000 ($30,000
increase in sales × CM ratio of 40%). As we noted above, net operating income also
will increase by $12,000. if fixed costs do not change. This is verified by the following
table:

Change in profit = CM ratio × Change in sales − Change in fixed expenses

 For example, at sales of $130,000, the profit is expected to be $17,000 as shown
below:
Profit = CM ratio × Sales – Fixed expenses
= 0.40 × $130,000 – $35,000
= $52,000 – $35,000
= $17,000
 Break-Even Analysis:
3
Fixed expenses
Unit sales to break even =
Unit CM
 Break-Even in Dollar Sales :
4
Fixed expenses
Dollar sales to break even =
CM ratio

Mr. Amir Rabie

4
ACCOUNTING STUDIES CHAPTER 1

 Target Profit Analysis:

Target profit + Fixed expenses
Unit sales to attain the target profit = Unit CM

 Target Profit Analysis in Terms of Dollar Sales:

Target profit + Fixed expenses
Dollar sales to attain the target profit = Unit CM

 Multiple choice questions:-

1. Sensabaugh Inc., a company that produces and sells a single product, has provided
its contribution format income statement for January.

If the company sells 1,600 units, its total contribution margin should be closest to:
A. $22,200
B. $28,800
C. $4,800
D. $32,400
Ans: A
2. Gaudy Inc. produces and sells a single product. The company has provided its
contribution format income statement for May.

If the company sells 4,300 units, its net operating income should be closest to:
A. $7,700
B. $25,513
C. $26,700
D. $19,500
Ans: D

Mr. Amir Rabie

5
ACCOUNTING STUDIES CHAPTER 1

3. The contribution margin ratio is 25% for Grain Company and the break-even point
in sales is $200,000. To obtain a target net operating income of $60,000, sales would
have to be:
A. $260,000
B. $440,000
C. $280,000
D. $240,000
Ans: B
4. The contribution margin ratio is 30% for the Honeyville Company and the break-
even point in sales is $150,000. If the company's target net operating income is $60,000,
sales would have to be:
A. $200,000
B. $350,000
C. $250,000
D. $210,000
Ans: B
5. Street Company's fixed expenses total $150,000, its variable expense ratio is 60% and
its variable expenses are $4.50 per unit. Based on this information, the break-even
point in units is:
A. 50,000 units
B. 37,500 units
C. 33,333 units
D. 100,000 units
Ans: A
12. Cindy, Inc. sells a product for $10 per unit. The variable expenses are $6 per unit,
and the fixed expenses total $35,000 per period. By how much will net operating income
change if sales are expected to increase by $40,000?
A. $16,000 increase
B. $5,000 increase
C. $24,000 increase
D. $11,000 decrease
Ans: A

Mr. Amir Rabie

6