Cost-Volume-Profit Relationships

Chapter 05

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 5-2

Basics of Cost-Volume-Profit Analysis

The contribution income statement is helpful to managers
in judging the impact on profits of changes in selling price,
cost, or volume. The emphasis is on cost behavior.

Contribution Margin (CM) is the amount remaining from

sales revenue after variable expenses have been deducted.
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Contribution Margin Ratio (CM Ratio)

The CM ratio is calculated by dividing the total
contribution margin by total sales.

$100,000 ÷ $250,000 = 40%

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Contribution Margin Ratio (CM Ratio)

The contribution margin ratio at Racing Bicycle
is:
CM per unit $200
CM Ratio = = = 40%
SP per unit $500

The CM ratio can also be calculated by

dividing the contribution margin per unit by
the selling price per unit.
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Contribution Margin Ratio (CM Ratio)

If Racing Bicycle increases sales from 400 to 500 bikes ($50,000),
contribution margin will increase by $20,000 ($50,000 × 40%).
Here is the proof:

A $50,000 increase in sales revenue results in a $20,000

increase in CM ($50,000 × 40% = $20,000).
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Target Profit Analysis

Equation Method :
Profit = Contribution Margin – Fixed expenses
= (Unit CM × Q) – Fixed expenses

Our goal is to solve for the unknown “Q” which

represents the quantity of units that must be sold
to attain the target profit.
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Target Profit Analysis

Suppose RBC’s management wants to know
how many bikes must be sold to earn a target
profit of $100,000.

Profit = Unit CM × Q – Fixed expenses

$100,000 = $200 × Q – $80,000
$200 × Q = $100,000 – $80,000
Q = ($100,000 + $80,000) ÷ $200
Q = 900
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The Formula Method

The formula uses the following equation.

Unit sales to attain Target profit + Fixed expenses

=
the target profit CM per unit
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Target Profit Analysis in Terms of

Unit Sales
Suppose Racing Bicycle Company wants to
know how many bikes must be sold to
earn a profit of $100,000.

Unit sales to attain Target profit + Fixed expenses

=
the target profit CM per unit

$100,000 + $80,000
Unit sales =
$200
Unit sales = 900
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Break-even in Dollar Sales

Suppose Racing Bicycle wants to compute

the sales dollars required to break-even (earn
a target profit of $0). Let’s use the equation
method to solve this problem.

Profit = Contribution Margin – Fixed expenses

= CM ratio × Sales – Fixed expenses

Solve for the unknown “Sales.”

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Break-even in Dollar Sales

Profit = CM ratio × Sales – Fixed expenses

$ 0 = 40% × Sales – $80,000

40% × Sales = $80,000

Sales = $80,000 ÷ 40%

Sales = $200,000
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Break-even in Dollar Sales:

Formula Method
Now, let’s use the formula method to calculate the
dollar sales at the break-even point.

Dollar sales to Fixed expenses

=
break even CM ratio

$80,000
Dollar sales =
40%
Dollar sales = $200,000
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The Margin of Safety

The margin of safety is the excess of budgeted
or actual sales dollars over the break-even
volume of sales dollars

• Margin of safety in dollars = Total budgeted (or

actual) sales – (Break-even sales)

• Margin of safety in percentage =

Margin of safety in dollars : Total budgeted (or
actual) sales in dollars
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The calculation of margin of safety :

Sales (at the current volume of 400 speakers) (a) . . $100,000

• Sales (at the current volume of 400 speakers) (a) . . . . . . . $100,000
Break-even sales (at 350 speakers) . . . . . . . . . . . . . .
• Break-even sales (at 350 speakers) . . . . . . . . . . . . . . . . .
87,500

Margin of safety in dollars (b) . . . . . . . . . . . . . . . . . . . $ 12,500

Margin of safety percentage, (b) : (a) . . . . . . . . . . . . 12.5%
 5-15

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
cost structure is that income A disadvantage of a high
will be higher in good years fixed
compared to companies cost structure is that income
with lower proportion of will be lower in bad years
fixed costs. 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.
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Operating Leverage
Operating leverage is a measure of how sensitive net
operating income is to a given percentage change in
dollar sales. Operating leverage acts as a multiplier. If
operating leverage is high, a small percentage increase
in sales can produce a much larger percentage increase
in net operating income

Degree of operating Contribution margin

leverage = Net operating income

Percentage change in Degree of operating Percentage change

Net operating income = leverage x change in sales
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Key Assumptions of CVP Analysis

❶ Selling price is constant.
❷ Costs are linear and can be accurately
divided into variable (constant per unit) and
fixed (constant in total) elements.
❸ In multiproduct companies, the sales mix is
constant.
❹ In manufacturing companies, inventories do
not change (units produced = units sold).
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End of Chapter 05