Cost-Volume-Profit

Relationships
 LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Explain how changes in activity affect
contribution margin.
2. Compute the contribution margin ratio (CM)
ratio and use it to compute changes in
contribution margin and net income.
3. Show the effects on contribution margin of
changes in variable costs, fixed costs, selling
price and volume.
4. Compute the break-even point by both the
equation method and the contribution margin
method.
 LEARNING OBJECTIVES
After studying this chapter, you should be able to:
5. Prepare a cost-volume-profit (CVP) graph and
explain the significance of each of its
components.
6. Use the CVP formulas to determine the activity
level needed to achieve a desired target profit.
7. Compute the margin of safety and explain its
significance.
 LEARNING OBJECTIVES
After studying this chapter, you should be able to:
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 to net 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.
10. (Appendix 6A) Understand cost-volume-profit
with uncertainty.
The Basics of Cost-Volume-Profit
(CVP) Analysis

WIND BICYCLE CO.

Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bikes) $ 250,000 $ 500
Less: variable expenses 150,000 300
Contribution margin 100,000 $ 200
Less: fixedMargin
Contribution expenses 80,000
(CM) is the amount remaining
Net income
from sales $ 20,000
revenue after variable expenses have been
deducted.
The Basics of Cost-Volume-Profit
(CVP) Analysis

WIND BICYCLE CO.

Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bikes) $ 250,000 $ 500
Less: variable expenses 150,000 300
Contribution margin 100,000 $ 200
Less: fixed expenses 80,000
Net
CMincome $ 20,000
is used to cover fixed expenses.
The Basics of Cost-Volume-Profit
(CVP) Analysis

WIND BICYCLE CO.

Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bikes) $ 250,000 $ 500
Less: variable expenses 150,000 300
Contribution margin 100,000 $ 200
Less: fixed expenses 80,000
Net income $ 20,000
After covering fixed costs, any remaining CM
contributes to income.
The Contribution Approach

For each additional unit Wind sells, $200

more in contribution margin will help to
cover fixed expenses and profit.
The Contribution Approach

Each month Wind must generate at least

$80,000 in total CM to break even.
The Contribution Approach

If Wind sells 400 units in a month, it will be

operating at the break-even point.
The Contribution Approach

If Wind sells one additional unit (401

bikes), net income will increase by $200.
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (401 bikes) $ 200,500 $ 500
Less: variable expenses 120,300 300
Contribution margin 80,200 $ 200
Less: fixed expenses 80,000
Net income $ 200
The Contribution Approach

The break-even point can be defined either as:

The point where total sales revenue equals total
expenses (variable and fixed).
The point where total contribution margin equals
total fixed expenses.
Contribution Margin Ratio

The contribution margin ratio is:

Contribution margin
CM Ratio =
Sales

For Wind Bicycle Co. the ratio is:

$200
= 40%
$500
Contribution Margin Ratio

At Wind, each $1.00 increase in sales

revenue results in a total contribution
margin increase of 40¢.

If sales increase by $50,000, what will be

the increase in total contribution margin?
Contribution Margin Ratio

400
400 Bikes
Bikes 500
500 Bikes
Bikes
Sales
Sales $$200,000
200,000 $$250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net income
income $$ -- $$ 20,000
20,000

A $50,000 increase in sales revenue

Contribution Margin Ratio

400
400 Bikes
Bikes 500
500 Bikes
Bikes
Sales
Sales $$200,000
200,000 $$250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net income
income $$ -- $$ 20,000
20,000

A $50,000 increase in sales revenue

results in a $20,000 increase in CM
or ($50,000 × 40% = $20,000)
Changes in Fixed Costs and Sales
Volume

Wind is currently selling 500 bikes per month.

The company’s sales manager believes that
an increase of $10,000 in the monthly
advertising budget would increase bike sales
to 540 units.

 Should we authorize the requested increase

in the advertising budget?
Changes in Fixed Costs and Sales
Volume
$80,000
$80,000++$10,000
$10,000 advertising
advertising== $90,000
$90,000
Current Sales Projected Sales
(500 bikes) (540 bikes)
Sales $ 250,000 $ 270,000
Less: variable expenses 150,000 162,000
Contribution margin 100,000 108,000
Less: fixed expenses 80,000 90,000
Net income $ 20,000 $ 18,000

Sales
Salesincreased
increasedby
by$20,000,
$20,000, but
but net
net
income
income decreased
decreased by
by$2,000
$2,000..
Changes in Fixed Costs and Sales
Volume

The Shortcut Solution

Increase in CM (40 units X $200) $ 8,000

Increase in advertising expenses 10,000
Decrease in net income $ (2,000)
APPLICATIONS OF CVP

Consider the following basic data:

Per unit Percent
Sales Price $250 100
Less: Variable cost 150 60
Contribution margin 100 40
Fixed costs total $35,000
APPLICATIONS

• Current sales are $100,000. Sales

manager feels $10,000 increase in sales
budget will provide $30,000 increase in
sales. Should the budget be changed?
YES
Incremental CM approach:
$30,000 x 40% CM ratio 12,000
Additional advertising expense 10,000
Increase in net income 2,000
APPLICATIONS
• Management is considering increasing quality
of speakers at an additional cost of $10 per
speaker. Plan to sell 80 more units. Should
management increase quality?
YES
Expected total CM
= (480 speakers x$90) $43,200
Present total CM
= (400 speakers x$100) 40,000
Increase in total contribution margin 3,200
(and net income)
APPLICATIONS
• Management advises that if selling price
dropped $20 per speaker and advertising
increased by $15,000/month, sales would
increase 50%. Good idea?
Expected total CM NO
= (400x150%x$80) $48,000
Present total CM (400x$100) 40,000
Incremental CM 8,000
Additional advertising cost 15,000
Reduction in net income (7,000)
APPLICATIONS

• A plan to switch sales people from flat

salary ($6,000 per month) to a sales
commission of $15 per speaker could
increase sales by 15%. Good idea? YES
Expected total CM (400x115%x$85) $39,100
Current total CM (400x$100) 40,000
Decrease in total CM (900)
Salaries avoided if commission paid 6,000
Increase in net income $5,100
APPLICATIONS

• A wholesaler is willing to buy 150 speakers if

we will give him a discount off our price. The
sale will not disturb regular sales and will not
change fixed costs. We want to make $3,000
on this sale. What price should we quote?
Variable cost per speaker $150
Desired profit on order (3,000/150) 20
Quoted price per speaker $170
Break-Even Analysis

Break-even analysis can be approached in

two ways:
Equation method
Contribution margin method.
Equation Method

Profits = Sales – (Variable expenses + Fixed expenses)

OR

Sales = Variable expenses + Fixed expenses + Profits

At the break-even point

profits equal zero.
Equation Method

Here is the information from Wind Bicycle Co.:

Total
Total Per
PerUnit
Unit Percent
Percent
Sales
Sales(500
(500bikes)
bikes) $$250,000
250,000 $$ 500
500 100%
100%
Less:
Less:variable
variableexpenses
expenses 150,000
150,000 300
300 60%
60%
Contribution
Contributionmargin
margin $$100,000
100,000 $$ 200
200 40%
40%
Less:
Less:fixed
fixedexpenses
expenses 80,000
80,000
Net
Netincome
income $$ 20,000
20,000
 Equation Method


We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $0

Where:
Q = Number of bikes sold
$500 = Unit sales price
$300 = Unit variable expenses
$80,000 = Total fixed expenses
 Equation Method


We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $0

$200Q = $80,000

Q = 400 bikes
Equation Method


We can also use the following equation to
compute the break-even point in sales dollars.
Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + $80,000 + $0
Where:
X = Total sales dollars
0.60 = Variable expenses as a
percentage of sales
$80,000 = Total fixed expenses
Equation Method


We can also use the following equation to
compute the break-even point in sales dollars.
Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + $80,000 + $0

0.40X = $80,000

X = $200,000
Contribution Margin Method

The contribution margin method is a

variation of the equation method.

Break-even point Fixed expenses

=
in units sold Unit contribution margin

Break-even point in Fixed expenses

total sales dollars = CM ratio
CVP Relationships in Graphic Form

Viewing CVP relationships in a graph gives managers a

perspective that can be obtained in no other way.
Consider the following information for Wind Co.:

Income
Income Income
Income Income
Income
300
300 units
units 400
400 units
units 500
500 units
units
Sales
Sales $$ 150,000
150,000 $$ 200,000
200,000 $$250,000
250,000
Less:
Less: variable
variable expenses
expenses 90,000
90,000 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin $$ 60,000
60,000 $$ 80,000
80,000 $$100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000 80,000
80,000
Net
Net income
income (loss)
(loss) $$ (20,000)
(20,000) $$ -- $$ 20,000
20,000
CVP Graph

400,000

350,000

300,000

250,000 Total Expenses

Dollars

200,000

150,000 Fixed expenses

100,000

50,000

-
400

500
100

200

300

600

700

800
-

Units
CVP Graph

400,000

350,000

300,000
Total Sales
250,000
Dollars

200,000

150,000

100,000

50,000

-
400

500
100

200

300

600

700

800
-

Units
CVP Graph

400,000

350,000
rea
it A
300,000 o f
Pr
250,000
Dollars

200,000
Break-even point
150,000

100,000
rea
A
50,000 o ss
L
-
400

500
100

200

300

600

700

800
-

Units
Target Profit Analysis

Suppose Wind Co. wants to know how

many bikes must be sold to earn a profit of
$100,000.

We can use our CVP formula to determine

the sales volume needed to achieve a
target net profit figure.
The CVP Equation

Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $100,000

$200Q = $180,000

Q = 900 bikes
The Contribution Margin Approach

We can determine the number of bikes that

must be sold to earn a profit of $100,000
using the contribution margin approach.
Units sold to attain Fixed expenses + Target profit
=
the target profit Unit contribution margin

$80,000 + $100,000
= 900 bikes
$200
The Margin of Safety

Excess of budgeted (or actual) sales over

the break-even volume of sales. The
amount by which sales can drop before
losses begin to be incurred.
Margin of safety = Total sales - Break-even sales

Let’s calculate the margin of safety for Wind.

The Margin of Safety

Wind has a break-even point of $200,000. If

actual sales are $250,000, the margin of
safety is $50,000 or 100 bikes.
Break-even
Break-even
sales
sales Actual
Actual sales
sales
400
400 units
units 500
500 units
units
Sales
Sales $$ 200,000
200,000 $$ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net income
income $$ -- $$ 20,000
20,000
The Margin of Safety

The margin of safety can be expressed as

20 percent of sales.
($50,000 ÷ $250,000)
Break-even
Break-even
sales
sales Actual
Actual sales
sales
400
400 units
units 500
500 units
units
Sales
Sales $$ 200,000
200,000 $$ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net income
income $$ -- $$ 20,000
20,000
Operating Leverage

• A measure of how sensitive net income is to

percentage changes in sales.
• With high leverage, a small percentage
increase in sales can produce a much larger
percentage increase in net income.
Degree of Contribution margin
operating leverage = Net income
Operating Leverage

Actual
Actual sales
sales
500
500 Bikes
Bikes
Sales
Sales $$ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000
Net
Net income
income $$ 20,000
20,000

$100,000 = 5
$20,000
Operating Leverage

With a measure of operating leverage of 5,

if Wind increases its sales by 10%, net
income would increase by 50%.
Percent increase in sales 10%
Degree of operating leverage × 5
Percent increase in profits 50%

Here’s the proof!

Operating Leverage

10% increase in sales from

$250,000 to $275,000 . . .
. . . results in a 50% increase in
income from $20,000 to $30,000.
The Concept of Sales Mix

• Sales mix is the relative proportions in

which a company’s products are sold.
• Different products have different selling
prices, cost structures, and contribution
margins.

Let’s assume Wind sells bikes and carts and

see how we deal with break-even analysis.
 The Concept of Sales Mix

Wind Bicycle Co. provides us with the following

information:
Bikes Carts Total
Sales $ 250,000 100% $ 300,000 100% $ 550,000 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin $ 100,000 40% $ 165,000 55% 265,000 48%
Fixed exp. $265,000 170,000
Net income = 48% (rounded) $ 95,000
$550,000

Break-even point in sales dollars:

$170,000 = $354,167 (rounded)
0.48
Assumptions of CVP Analysis

 Selling price is constant throughout

the entire relevant range.
 Costs are linear throughout the
entire relevant range.
 In multi-product companies, the
sales mix is constant.
 In manufacturing companies,
inventories do not change (units
produced = units sold).
Cost-Volume-Profit
with uncertainty
CVP with uncertainty

• Use a decision tree to simplify

calculations
• The decision tree is used to calculate
profits under various alternatives
• A second decision tree can be used to
calculate the probabilities of the various
scenarios to further determine a
reasonable estimate of profit
• A computer can be used to save time
End of Presentation

We made
it!