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CHAPTER 3
COST-VOLUME-PROFIT
RELATIONSHIPS

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The Basics of Cost-Volume-Profit (CVP) Analysis

• Contribution Margin
• CVP Relationships in Equation Form
• CVP Relationships in Graphic Form
• Contribution Margin Ratio (CM Ratio)
• Some Applications of CVP Concepts
Change in Fixed Cost and Sales Volume
Change in Variable Costs and Sales Volume
Change in Fixed Cost, Sales Price, and Sales Volume
Change in Variable Cost, Fixed Cost, and Sales Volume
Change in Selling Price
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Contribution Margin

Explain how changes in

activity affect
contribution margin and
net operating income.

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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
For each additional speaker
the company sells during the
month, $100 more in
contribution margin becomes
available to help cover the
fixed expenses.

If a second speaker is
sold, for example, then
the total contribution
margin will increase by
$100 (to a total of $200)
and the company’s loss
will decrease by $100
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Contribution Margin
If enough speakers can be
sold to generate $35,000 in
contribution margin, then all of
the fixed expenses will be
covered and the company will
break even for the month

Once the break-even point has

been reached, net operating
income will increase by the
amount of the unit contribution
margin for each additional unit
sold.

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Contribution Margin
To illustrate, if Acoustic Concepts is currently selling 400
speakers per month and plans to increase sales to 425
speakers per month, the anticipated impact on profits can
be computed as follows:

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Contribution Margin

- 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
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CVP Relationships in Equation Form

For example, we compute the net operating income (profit) at sales of 351
speakers ???

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Contribution Margin Ratio (CM Ratio)

Use the contribution

margin ratio (CM ratio) to
compute changes in
contribution margin and
net operating income
resulting from changes in
sales volume.

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Contribution Margin Ratio (CM Ratio)

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Contribution Margin Ratio (CM Ratio)

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Contribution Margin Ratio (CM Ratio)

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%).
Net operating income will also increase by 40 cents, assuming that
fixed costs are not affected by the increase in sales. Generally, the
effect of a change in sales on the contribution margin is expressed in
equation form as:

Ex: a $30,000 increase in sales during the coming month, the CM

should increase by $12,000
($30,000 increase in sales × CM ratio of 40%).

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Contribution Margin Ratio (CM Ratio)

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Some Applications of CVP Concepts

Show the effects on net

operating income of
changes in variable
costs, fixed costs, selling
price, and volume.

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Some Applications of CVP Concepts

Change in Fixed Cost and Sales Volume

Acoustic Concepts is currently selling 400 speakers per

month at $250 per speaker for total monthly sales of
$100,000. The sales manager feels that a $10,000
increase in the monthly advertising budget would
increase monthly sales by $30,000 to a total of 520
units. Should the advertising budget be increased? The
table on the next page shows the financial impact of the
proposed change in the monthly advertising budget.

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Some Applications of CVP Concepts

Change in Fixed Cost and Sales Volume

Acoustic Concepts is currently selling 400 speakers per

month at $250 per speaker for total monthly sales of
$100,000. The sales manager feels that a $10,000
increase in the monthly advertising budget would
increase monthly sales by $30,000 to a total of 520
units. Should the advertising budget be increased? The
table on the next page shows the financial impact of the
proposed change in the monthly advertising budget.
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Some Applications of CVP Concepts

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Some Applications of CVP Concepts

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Some Applications of CVP Concepts

Change in Variable Costs and Sales Volume

Refer to the original data. Recall that Acoustic Concepts is
currently selling 400 speakers per month. Prem is
considering the use of higher-quality components, which
would increase variable costs (and thereby reduce the
contribution margin) by $10 per speaker. However, the
sales manager predicts that using higher-quality
components would increase sales to 480 speakers per
month.
Should the higher-quality components be used?
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Some Applications of CVP Concepts

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Some Applications of CVP Concepts

Change in Fixed Cost, Sales Price, and Sales Volume

Refer to the original data and recall again that Acoustic
Concepts is currently selling 400 speakers per month.
To increase sales, the sales manager would like to cut
the selling price by $20 per speaker and increase the
advertising budget by $15,000 per month. The sales
manager believes that if these two steps are taken, unit
sales will increase by 50% to 600 speakers per month.
Should the changes be made?

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Some Applications of CVP Concepts

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Some Applications of CVP Concepts

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Some Applications of CVP Concepts

Change in Variable Cost, Fixed Cost, and Sales
Volume
Refer to Acoustic Concepts’ original data. As before, the
company is currently selling 400 speakers per month. The
sales manager would like to pay salespersons a sales
commission of $15 per speaker sold, rather than the flat
salaries that now total $6,000 per month. The sales
manager is confident that the change would increase
monthly sales by 15% to 460 speakers per month. Should
the change be made?

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Some Applications of CVP Concepts

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Some Applications of CVP Concepts

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Some Applications of CVP Concepts

Change in Selling Price Refer to the original data
where Acoustic Concepts is currently selling 400
speakers per month. The company has an opportunity
to make a bulk sale of 150 speakers to a wholesaler if
an acceptable price can be negotiated. This sale would
not disturb the company’s regular sales and would not
affect the company’s total fixed expenses. What price
per speaker should be quoted to the wholesaler if
Acoustic Concepts is seeking a profit of $3,000 on the
bulk sale?

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Target Profit and Break-Even Analysis

Determine the level of

sales needed to achieve
a desired target profit.
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Target Profit Analysis

We can compute the number of units
that must be sold to attain a target
profit using either:
(1) Equation method, or
(2) Formula method.

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Target Profit and Break-Even Analysis

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Target Profit and Break-Even Analysis

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Target Profit and Break-Even Analysis

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Break-Even Analysis

Determine the break-even point

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Break-even Analysis
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Break-even Analysis

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The Margin of Safety

Compute the margin of

safety and explain its
significance.

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The Margin of Safety in Dollars

The margin of safety in dollars is the excess
of budgeted (or actual) sales over the
break-even volume of sales.
Margin of safety in dollars = Total sales - Break-even sales
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The Margin of Safety in Dollars

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CVP Considerations in Choosing a Cost Structure

Cost structure refers to the relative

proportion of fixed and variable costs in an
organization.

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CVP Considerations in Choosing a Cost Structure

Cost Structure and Profit Stability
Which cost structure is better—high variable
costs and low fixed costs, or the opposite?

Which farm has the better cost structure?

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CVP Considerations in Choosing a Cost Structure

Cost Structure and Profit Stability

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CVP Considerations in Choosing a Cost Structure

Cost Structure and Profit Stability
Which cost structure is better—high variable
costs and low fixed costs, or the opposite?

Which farm has the better cost structure?

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CVP Considerations in Choosing a Cost Structure

Cost Structure and Profit Stability

If sales are expected to exceed $100,000 in the future, then

Sterling Farm probably has the better cost structure. The
reason is that its CM ratio is higher, and its profits will therefore
increase more rapidly as sales increase
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CVP Considerations in Choosing a Cost Structure

Assume that each farm experiences a 10% increase in sales without
any increase in fixed costs. The new income statements would be:

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CVP Considerations in Choosing a Cost Structure

What if sales drop below $100,000? What are the farms’ break-even
points? What are their margins of safety?

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Cost Structure and Profit Stability

Cost structure refers to the relative proportion

of fixed and variable costs in an organization.
Managers often have some latitude in
determining their organization’s cost structure.
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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 fixed
will be higher in good years cost structure is that income
compared to companies will be lower in bad years
with lower proportion of compared to companies
fixed costs. 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

Compute the degree of

operating leverage at a
particular level of sales
and explain how it can
be used to predict
changes in net operating
income.

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Operating Leverage
Operating leverage is a measure of how sensitive
net operating income is to percentage changes
in sales. It is a measure, at any given level of
sales, of how a percentage change in sales
volume will affect profits.
Degree of Contribution margin
operating leverage = Net operating income
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Operating Leverage
Operating leverage can be illustrated by returning to the data
for the two blueberry farms.
We previously showed that a 10% increase in sales (from
$100,000 to $110,000 in each farm) results in a 70%
increase in the net operating income of Sterling Farm (from
$10,000 to $17,000) and only a 40% increase in the net
operating income of Bogside Farm (from $10,000 to
$14,000).
Thus, for a 10% increase in sales, Sterling Farm experiences
a much greater percentage increase in profits than does
Bogside Farm. Therefore, Sterling Farm has greater
operating leverage than Bogside Farm.

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Operating Leverage

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Operating Leverage
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Structuring Sales Commissions

Companies generally compensate salespeople
by paying them either a commission based on
sales or a salary plus a sales commission.
Commissions based on sales dollars can lead to
lower profits in a company.

Let’s look at an example.

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Structuring Sales Commissions

Pipeline Unlimited produces two types of surfboards,
the XR7 and the Turbo. The XR7 sells for $100 and
generates a contribution margin per unit of $25. The
Turbo sells for $150 and earns a contribution margin
per unit of $18.

The sales force at Pipeline Unlimited is

compensated based on sales commissions.

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Structuring Sales Commissions

If you were on the sales force at Pipeline, you would
push hard to sell the Turbo even though the XR7
earns a higher contribution margin per unit.

To eliminate this type of conflict, commissions can

be based on contribution margin rather than on
selling price alone.
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Compute the break—even

point for a multiproduct
company and explain the
effects of shifts in the sales
mix on contribution margin
and the break-even point.

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The Concept of Sales Mix

• Sales mix is the relative proportion in which a
company’s products are sold.
• Different products have different selling prices,
cost structures, and contribution margins.
• When a company sells more than one product,
break-even analysis becomes more complex
as the following example illustrates.

Let’s assume Racing Bicycle Company sells

bikes and carts and that the sales mix between
the two products remains the same.

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Multi-Product Break-Even Analysis

Bikes comprise 45% of RBC’s total sales revenue and the
carts comprise the remaining 55%. RBC provides the
following information:
Bicycle Carts Total
Sales $ 250,000 100% $ 300,000 100% $ 550,000 100.0%
Variable expenses 150,000 60% 135,000 45% 285,000 51.8%
Contribution margin 100,000 40.0% 165,000 55% 265,000 48.2%
Fixed expenses 170,000
Net operating income $ 95,000

Sales mix $ 250,000 45% $ 300,000 55% $ 550,000 100%

$265,000 = 48.2% (rounded)

$550,000
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Multi-Product Break-Even Analysis

Dollar sales to Fixed expenses
=
break even CM ratio

Dollar sales to $170,000 = $352,697

=
break even 48.2%

Bicycle Carts Total

Sales $ 158,714 100% $ 193,983 100% $ 352,697 100.0%
Variable expenses 95,228 60% 87,293 45% 182,521 51.8%
Contribution margin 63,485 40% 106,691 55% 170,176 48.2%
Fixed expenses 170,000
Net operating income Rounding error $ 176

Sales mix $ 158,714 45% $ 193,983 55% $ 352,697 100.0%

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Key Assumptions of CVP Analysis

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