Cost-Volume-Profit Relationships

Chapter 5

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
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 5-2

Learning Objective 1

Explain how changes in

activity affect
contribution margin and
net operating income.
 5-3

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.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles) $ 250,000
Less: Variable expenses 150,000
Contribution margin 100,000
Less: Fixed expenses 80,000
Net operating income $ 20,000

Contribution Margin (CM) is the amount remaining from

sales revenue after variable expenses have been deducted.
 5-4

Basics of Cost-Volume-Profit Analysis

Racing Bicycle Company

Contribution Income Statement
For the Month of June
Sales (500 bicycles) $ 250,000
Less: Variable expenses 150,000
Contribution margin 100,000
Less: Fixed expenses 80,000
Net operating income $ 20,000

CM is used first to cover fixed expenses. Any

remaining CM contributes to net operating income.
 5-5

The Contribution Approach

Sales, variable expenses, and contribution margin
can also be expressed on a per unit basis. If Racing
sells an additional bicycle, $200 additional CM will
be generated to cover fixed expenses and profit.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 $ 200
Less: Fixed expenses 80,000
Net operating income $ 20,000
 5-6

The Contribution Approach

Each month, RBC must generate at least
$80,000 in total contribution margin to break-
even (which is the level of sales at which
profit is zero).
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 $ 200
Less: Fixed expenses 80,000
Net operating income $ 20,000
 5-7

The Contribution Approach

If RBC sells 400 units in a month, it will be
operating at the break-even point.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (400 bicycles) $ 200,000 $ 500
Less: Variable expenses 120,000 300
Contribution margin 80,000 $ 200
Less: Fixed expenses 80,000
Net operating income $ -
 5-8

The Contribution Approach

If RBC sells one more bike (401 bikes), net
operating income will increase by $200.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (401 bicycles) $ 200,500 $ 500
Less: Variable expenses 120,300 300
Contribution margin 80,200 $ 200
Less: Fixed expenses 80,000
Net operating income $ 200
 5-9

The Contribution Approach

We do not need to prepare an income statement to
estimate profits at a particular sales volume. Simply
multiply the number of units sold above break-even
by the contribution margin per unit.

If Racing sells
430 bikes, its net
operating income
will be $6,000.
 5-10

CVP Relationships in Equation Form

The contribution format income statement can be
expressed in the following equation:

Profit = (Sales – Variable expenses) – Fixed expenses

Racing Bicycle Company

Contribution Income Statement
For the Month of June
Total Per Unit
Sales (401 bicycles) $ 200,500 $ 500
Less: Variable expenses 120,300 300
Contribution margin 80,200 $ 200
Less: Fixed expenses 80,000
Net operating income $ 200
 5-11

CVP Relationships in Equation Form

This equation can be used to show the profit RBC

earns if it sells 401. Notice, the answer of $200 mirrors
our earlier solution.
Profit = (Sales – Variable expenses) – Fixed expenses

401 units × $500 $80,000

401 units × $300

$200 = ($200,500 – $120,300)

Profit – $80,000
Variable expenses) – Fixed
Fixed expenses
 5-12

CVP Relationships in Equation Form

When a company has only one product we can further

refine this equation as shown on this slide.

Profit = (Sales – Variable expenses) – Fixed expenses

Quantity sold (Q) Quantity sold (Q)

× Selling price per unit (P) × Variable expenses per unit (V)
= Sales (Q × P) = Variable expenses (Q × V)

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

 5-13

CVP Relationships in Equation Form

This equation can also be used to show the $200
profit RBC earns if it sells 401 bikes.

Profit = (Sales – Variable expenses) – Fixed expenses

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

$200 = ($500 × 401 – $300 × 401) – $80,000
Profit
 5-14

CVP Relationships in Equation Form

It is often useful to express the simple profit equation in
terms of the unit contribution margin (Unit CM) as follows:
Unit CM = Selling price per unit – Variable expenses per unit
Unit CM = P – V
Profit = (P × Q – V × Q) – Fixed expenses
Profit = (P – V) × Q – Fixed expenses
Profit = Unit CM × Q – Fixed expenses
 5-15

CVP Relationships in Equation Form

Profit = (P × Q – V × Q) – Fixed expenses
Profit = (P – V) × Q – Fixed expenses
Profit = Unit CM × Q – Fixed expenses

Profit = ($500 – $300) × 401 – $80,000

Profit = $200 × 401 – $80,000
This equation
Profit = $80,200 – $80,000 can also be
Profit = $200 used to compute
RBC’s $200 profit
if it sells 401
bikes.
 5-16

Learning Objective 2

Prepare and interpret a

cost-volume-profit (CVP)
graph and a profit graph.
 5-17

CVP Relationships in Graphic Form

The relationships among revenue, cost, profit, and volume
can be expressed graphically by preparing a CVP graph.
Racing Bicycle developed contribution margin income
statements at 0, 200, 400, and 600 units sold. We will
use this information to prepare the CVP graph.

Units Sold
0 200 400 600
Sales $ - $ 100,000 $ 200,000 $ 300,000
Total variable expenses - 60,000 120,000 180,000
Contribution margin - 40,000 80,000 120,000
Fixed expenses 80,000 80,000 80,000 80,000
Net operating income (loss) $ (80,000) $ (40,000) $ - $ 40,000
 5-18

Preparing the CVP Graph

$3,50,000

$3,00,000

$2,50,000

$2,00,000

$1,50,000

$1,00,000
In a CVP graph, unit volume is usually
$50,000
represented on the horizontal (X) axis
and dollars on the vertical (Y) axis.
$0
0 100 200 300 400 500 600

Units
 5-19

Preparing the CVP Graph

$3,50,000

Draw a line parallel to the volume axis
$3,00,000
to represent total fixed expenses.
$2,50,000

$2,00,000

Fixed expenses
$1,50,000

$1,00,000

$50,000

$0
0 100 200 300 400 500 600

Units
 5-20

Preparing the CVP Graph

$3,50,000 
Choose some sales volume, say 400 units, and plot the point representing
total expenses
$3,00,000
(fixed and variable). Draw a line through the data point
back to where the fixed expenses line intersects the dollar axis.
$2,50,000

$2,00,000

Total expenses
Fixed expenses
$1,50,000

$1,00,000

$50,000

$0
0 100 200 300 400 500 600

Units
 5-21

Preparing the CVP Graph

$3,50,000 
Choose some sales volume, say 400 units, and plot the point representing
total sales.
$3,00,000
Draw a line through the data point back to the point of origin.

$2,50,000

$2,00,000
Sales
Total expenses
$1,50,000 Fixed expenses

$1,00,000

$50,000

$0
0 100 200 300 400 500 600

Units
 5-22

Preparing the CVP Graph

$3,50,000 Break-even point
(400 units or $200,000 in sales) Profit Area
$3,00,000

$2,50,000

$2,00,000
Sales
Total expenses
$1,50,000 Fixed expenses

$1,00,000

$50,000

$0
0 100 200 300 400 500 600
Loss Area Units
 5-23

Preparing the CVP Graph

Profit = Unit CM × Q – Fixed Costs

$ 60,000

$ 40,000

$ 20,000
Profit

$0

-$20,000 An even simpler form of

the CVP graph is called
-$40,000
the profit graph.
-$60,000

0 100 200 300 400 500 600

Number of bicycles sold
 5-24

Preparing the CVP Graph

$ 60,000 Break-even point, where

profit is zero, is 400
$ 40,000
units sold.
$ 20,000
Profit

$0

-$20,000

-$40,000

-$60,000

0 100 200 300 400 500 600

Number of bicycles sold
 5-25

Learning Objective 3

Use the contribution

margin ratio (CM ratio) to
compute changes in
contribution margin and
net operating income
resulting from changes in
sales volume.
 5-26

Contribution Margin Ratio (CM Ratio)

The CM ratio is calculated by dividing the total
contribution margin by total sales.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit CM Ratio
Sales (500 bicycles) $ 250,000 $ 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
Less: Fixed expenses 80,000
Net operating income $ 20,000

$100,000 ÷ $250,000 = 40%

 5-27

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.
 5-28

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

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

increase in CM ($50,000 × 40% = $20,000).
 5-29

Quick Check ✓
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
 5-30

Quick Check ✓
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 Unit contribution margin
CM Ratio =
b. 0.758 Unit selling price
c. 0.242 ($1.49 - $0.36)
=
d. 4.139 $1.49
$1.13
= = 0.758
$1.49
 5-31

Contribution Margin Ratio (CM Ratio)

The relationship between profit and the CM ratio
can be expressed using the following equation:

Profit = (CM ratio × Sales) – Fixed expenses

If Racing Bicycle increased its sales volume to 500
bikes, what would management expect profit or net
operating income to be?
Profit = (40% × $250,000) – $80,000
Profit = $100,000 – $80,000
Profit = $20,000
 5-32

Learning Objective 4

Show the effect on net

operating income of
changes in variable
costs, fixed costs, selling
price, and volume.
 5-33

The Variable Expense Ratio

The variable expense ratio is the ratio of variable
expenses to sales. It can be computed by dividing the
total variable expenses by the total sales, or in a single
product analysis, it can be computed by dividing the
variable expenses per unit by the unit selling price.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit CM Ratio
Sales (500 bicycles) $ 250,000 $ 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
Less: Fixed expenses 80,000
Net operating income $ 20,000
 5-34

Changes in Fixed Costs and Sales

Volume

What is the profit impact if Racing Bicycle

can increase unit sales from 500 to 540 by
increasing the monthly advertising budget
by $10,000?
 5-35

Changes in Fixed Costs and Sales

Volume
$80,000 + $10,000 advertising = $90,000

500 units 540 units

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 operating income $ 20,000 $ 18,000

Sales increased by $20,000, but net operating

income decreased by $2,000.
 5-36

Changes in Fixed Costs and Sales

Volume
A shortcut solution using
incremental analysis
Increase in CM (40 units X $200) $ 8,000
Increase in advertising expenses 10,000
Decrease in net operating income $ (2,000)
 5-37

Change in Variable Costs and Sales

Volume
What is the profit impact if Racing
Bicycle can use higher quality raw
materials, thus increasing variable costs
per unit by $10, to generate an increase
in unit sales from 500 to 580?
 5-38

Change in Variable Costs and Sales

Volume
580 units × $310 variable cost/unit = $179,800

500 units 580 units

Sales $ 250,000 $ 290,000
Less: Variable expenses 150,000 179,800
Contribution margin 100,000 110,200
Less: Fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,200

Sales increase by $40,000 and net operating income

increases by $10,200.
 5-39

Change in Fixed Cost, Sales Price,

and Volume
What is the profit impact if RBC: (1) cuts its
selling price $20 per unit, (2) increases its
advertising budget by $15,000 per month,
and (3) increases sales from 500 to 650
units per month?
 5-40

Change in Fixed Cost, Sales Price,

and Volume
650 units × $480 = $312,000

500 units 650 units

Sales $ 250,000 $ 312,000
Less: Variable expenses 150,000 195,000
Contribution margin 100,000 117,000
Less: Fixed expenses 80,000 95,000
Net operating income $ 20,000 $ 22,000

Sales increase by $62,000, fixed costs increase by

$15,000, and net operating income increases by $2,000.
 5-41

Change in Variable Cost, Fixed Cost,

and Sales Volume
What is the profit impact if RBC: (1) pays a
$15 sales commission per bike sold instead
of paying salespersons flat salaries that
currently total $6,000 per month, and (2)
increases unit sales from 500 to 575 bikes?
 5-42

Change in Variable Cost, Fixed Cost,

and Sales Volume
575 units × $315 = $181,125
500 units 575 units
Sales $ 250,000 $ 287,500
Less: Variable expenses 150,000 181,125
Contribution margin 100,000 106,375
Less: Fixed expenses 80,000 74,000
Net operating income $ 20,000 $ 32,375

Sales increase by $37,500, fixed expenses decrease by

$6,000, and net operating income increases by $12,375.
 5-43

Change in Regular Sales Price

If RBC has an opportunity to sell 150
bikes to a wholesaler without disturbing
sales to other customers or fixed
expenses, what price would it quote to
the wholesaler if it wants to increase
monthly profits by $3,000?
 5-44

Change in Regular Sales Price

$ 3,000 ÷ 150 bikes = $ 20 per bike

Variable cost per bike = 300 per bike
Selling price required = $ 320 per bike

150 bikes × $320 per bike = $ 48,000

Total variable costs = 45,000
Increase in net operating income = $ 3,000
 5-45

Learning Objective 5

Determine the level of

sales needed to achieve
a desired target profit.
 5-46

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.
 5-47

Equation Method
Profit = 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.
 5-48

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
 5-49

The Formula Method

The formula uses the following equation.

Unit sales to attain Target profit + Fixed expenses

=
the target profit CM per unit
 5-50

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
 5-51

Target Profit Analysis

We can also compute the target profit in terms of
sales dollars using either the equation method or
the formula method.

Equation OR Formula
Method Method
 5-52

Equation Method
Profit = CM ratio × Sales – Fixed expenses
Our goal is to solve for the unknown “Sales,” which
represents the dollar amount of sales that must be
sold to attain the target profit.
Suppose RBC management wants to know the
sales volume that must be generated to earn a
target profit of $100,000.
$100,000 = 40% × Sales – $80,000
40% × Sales = $100,000 + $80,000
Sales = ($100,000 + $80,000) ÷ 40%
Sales = $450,000
 5-53

Formula Method
We can calculate the dollar sales needed to
attain a target profit (net operating profit) of
$100,000 at Racing Bicycle.

Dollar sales to attain Target profit + Fixed expenses

=
the target profit CM ratio

$100,000 + $80,000
Dollar sales =
40%
Dollar sales = $450,000
 5-54

Quick Check ✓
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. Use the formula method to
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
 5-55

Quick Check ✓
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 Unit salesfixed expense per month is $1,300.
average Target profit + Fixed expenses
to attain
Use the formula method= to determineUnithowCM
many cups of
target
coffee would profit
have to be sold to attain target profits of
$2,500 per month. $2,500 + $1,300
= $1.49 - $0.36
a. 3,363 cups
b. 2,212 cups $3,800
=
c. 1,150 cups $1.13
d. 4,200 cups = 3,363 cups
 5-56

Quick Check ✓
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. Use the formula method to
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
 5-57

Quick Check ✓
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.
Use the formula method
Sales $ to determine the sales dollars
that must be to
generated to Targettarget
attain profitprofits
+ Fixed ofexpenses
$2,500
attain =
CM ratio
per month. target profit
a. $2,550 $2,500 + $1,300
= ($1.49 – 0.36) ÷ $1.49
b. $5,013
c. $8,458 $3,800
=
d. $10,555 0.758
= $5,013
 5-58

Learning Objective 6

Determine the break-

even point.
 5-59

Break-even Analysis
The equation and formula methods can be used to
determine the unit sales and dollar sales needed to
achieve a target profit of zero. Let’s use the RBC
information to complete the break-even analysis.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit CM Ratio
Sales (500 bicycles) $ 250,000 $ 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
Less: Fixed expenses 80,000
Net operating income $ 20,000
 5-60

Break-even in Unit Sales:

Equation Method
Profits = Unit CM × Q – Fixed expenses
Suppose RBC wants to know how many
bikes must be sold to break-even
(earn a target profit of $0).

$0 = $200 × Q + $80,000

Profits are zero at the break-even point.

 5-61

Break-even in Unit Sales:

Equation Method
Profits = Unit CM × Q – Fixed expenses
$0 = $200 × Q + $80,000

$200 × Q = $80,000

Q = 400 bikes
 5-62

Break-even in Unit Sales:

Formula Method
Let’s apply the formula method to solve for
the break-even point.

Unit sales to Fixed expenses

=
break even CM per unit

$80,000
Unit sales =
$200
Unit sales = 400
 5-63

Break-even in Dollar Sales:

Equation Method
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 = CM ratio × Sales – Fixed expenses

Solve for the unknown “Sales.”

 5-64

Break-even in Dollar Sales:

Equation Method
Profit = CM ratio × Sales – Fixed expenses
$ 0 = 40% × Sales – $80,000

40% × Sales = $80,000

Sales = $80,000 ÷ 40%

Sales = $200,000
 5-65

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
 5-66

Quick Check ✓
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
 5-67

Quick Check ✓
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
=
0.758
d. $3,129
= $1,715
 5-68

Quick Check ✓
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
 5-69

Quick Check ✓
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 Break-even
of 2,100 cups Fixed
are soldexpenses
each
= CM per Unit
month. What is the break-even sales in units?
a. 872 cups $1,300
=
$1.49/cup - $0.36/cup
b. 3,611 cups
c. 1,200 cups $1,300
=
$1.13/cup
d. 1,150 cups
= 1,150 cups
 5-70

Learning Objective 7

Compute the margin of

safety and explain its
significance.
 5-71

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

Let’s look at Racing Bicycle Company and

determine the margin of safety.
 5-72

The Margin of Safety in Dollars

If we assume that RBC has actual sales of
$250,000, given that we have already
determined the break-even sales to be
$200,000, the margin of safety is $50,000 as
shown.
Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000
 5-73

The Margin of Safety Percentage

RBC’s margin of safety can be expressed
as 20% of sales.
($50,000 ÷ $250,000)
Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000
 5-74

The Margin of Safety

The margin of safety can be expressed in terms of
the number of units sold. The margin of safety at
RBC is $50,000, and each bike sells for $500;
hence, RBC’s margin of safety is 100 bikes.

Margin of $50,000
= = 100 bikes
Safety in units $500
 5-75

Quick Check ✓
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
 5-76

Quick Check ✓
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
Margin of safety = Total sales – Break-even sales
c. 1,150 cups
= 2,100 cups – 1,150 cups
d. 2,100 cups = 950 cups
 5-77

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.
 5-78

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.
 5-79

Learning Objective 8

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.
 5-80

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
 5-81

Operating Leverage
To illustrate, let’s revisit the contribution income statement
for RBC.
Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income $ 20,000

Degree of
Operating $100,000
= $20,000 = 5
Leverage
 5-82

Operating Leverage
With an operating leverage of 5, if RBC
increases its sales by 10%, net operating
income would increase by 50%.

Percent increase in sales 10%

Degree of operating leverage × 5
Percent increase in profits 50%

Here’s the verification!

 5-83

Operating Leverage
Actual sales Increased
(500) sales (550)
Sales $ 250,000 $ 275,000
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
Less fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,000

10% increase in sales from

$250,000 to $275,000 . . .

. . . results in a 50% increase in

income from $20,000 to $30,000.
 5-84

Quick Check ✓
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
 5-85

Quick Check ✓
Coffee Klatch is an espresso stand in a Actual sales
2,100 cups
downtown office building. The average selling
Sales $ 3,129
price of a cup of coffeeLess:
is $1.49 and the average756
Variable expenses
variable expense per cup is $0.36.
Contribution The average2,373
margin
fixed expense per month isFixed
Less: $1,300. An average1,300
expenses
of 2,100 cups are soldNeteach month.
operating What is$the1,073
income
operating leverage?
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
 5-86

Quick Check ✓
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%
 5-87

Quick Check ✓
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%
Percent increase in sales 20.0%
b. 20.0%
× Degree of operating leverage 2.21
c. 22.1% Percent increase in profit 44.20%
d. 44.2%
 5-88

Verify Increase in Profit

Actual Increased
sales sales
2,100 cups 2,520 cups
Sales $ 3,129 $ 3,755
Less: Variable expenses 756 907
Contribution margin 2,373 2,848
Less: Fixed expenses 1,300 1,300
Net operating income $ 1,073 $ 1,548
% change in sales 20.0%
% change in net operating income 44.2%
 5-89

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.

 5-90

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.
 5-91

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.
 5-92

Learning Objective 9

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.
 5-93

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.
 5-94

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
 5-95

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 $ - 100% 100% $ 3,52,697 100.0%
Variable expenses - 60% - 45% - 51.8%
Contribution margin - 40% - 55% 48.2%
Fixed expenses 1,70,000
Net operating income Rounding error

Sales mix $ 1,58,714 45% $ 1,93,983 55% $ 3,52,697 100.0%

 5-96

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%

 5-97

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).
 5-98

EXERCISE: Wheeler Corporation’s most recent income statement follows:

Required:
Prepare a new contribution format income statement under each of the
following conditions (consider each case independently):
1. The sales volume increases by 50 units. NOI $ 8,400
2. The sales volume declines by 50 units. NOI $ 7,600
3. The sales volume is 7,000 units. NOI $ 0
 5-99

EXERCISE: Liman Corporation has a single product whose selling

price is $140 and whose variable expense is $60 per unit. The company’s
monthly fixed expense is $40,000.

Required:
1. Using the equation method, solve for the unit sales that are
required to earn a target profit of $6,000. 575 units

2. Using the formula method, solve for the dollar sales that are
required to earn a target profit of $8,000. 600 units
EXERCISE: Pringle Company distributes a single product. The company’s
5-100

sales and expenses for a recent month follow:.

1. 12,500 units, $500,000
2. $1,50,000
3. 14,000 units
4. $100,000, 16.7%
5. $ 24,000

Required:
1. What is the monthly break-even point in units sold and in sales dollars?
2. Without resorting to computations, what is the total contribution margin at
the break-even point?
3. How many units would have to be sold each month to earn a target profit of
$18,000?
4. Refer to the original data. Compute the company’s margin of safety in both
dollar and percentage terms.
5. What is the company’s CM ratio? If monthly sales increase by $80,000 and
there is no change in fixed expenses, by how much would you expect
monthly net operating income to increase?
 5-101
EXERCISE: Data for Herron Corporation are shown below:

Fixed expenses are $75,000 per month and the company is selling 3,000
units per month.
Required:
1. The marketing manager believes that an $8,000 increase in the monthly
advertising budget would increase monthly sales by $15,000. Should
the advertising budget be increased? NOI $ (2000)
2. Refer to the original data. Management is considering using higher-
quality components that would increase the variable cost by $3 per unit.
The marketing manager believes that the higher-quality product would
increase sales by 15% per month. Should the higher-quality components
be used?. Change in Contribution $ 3,150
EXERCISE: Reveen Products sells camping equipment. One of5-102the
company’s products, a camp lantern, sells for $90 per unit. Variable
expenses are $63 per lantern, and fixed expenses associated with the
lantern total $135,000 per month.
Required:
1. Compute the company’s break-even point in number of lanterns and in total
sales dollars.
2. If the variable expenses per lantern increase as a percentage of the selling
price, will it result in a higher or a lower break-even point? Why? (Assume
that the fixed expenses remain unchanged.)
3. At present, the company is selling 8,000 lanterns per month. The sales
manager is convinced that a 10% reduction in the selling price will result in
a 25% increase in the number of lanterns sold each month. Prepare two
contribution format income statements, one under present operating
conditions, and one as operations would appear after the proposed
changes. Show both total and per unit data on your statements.
4. Refer to the data in (3) above. How many lanterns would have to be sold at
the new selling price to yield a minimum net operating income of $72,000
per month?
1. 5,000 lanterns, $4,50,000 2. $1,50,000 3. NOI $45,000 4. 11,500 lanterns
EXERCISE: Okabee Enterprises is the distributor for 5-103
two
products, Model A100 and Model B900. Monthly sales and the
contribution margin ratios for the two products follow:

Required:
1. Prepare a contribution format income statement for the
company as a whole.
2. Compute the break-even point for the company based on the
current sales mix. FC= 598500
3. If sales increase by $50,000 per month, by how much would
you expect net operating income to increase? What are your
assumptions?
1. NOI $31,500 2. $9,50,000 3. $31,500
EXERCISE: Superior Door Company sells Prehung doors to home
5-104

builders. The doors are sold for $60 each. Variable costs are $42
per door, and fixed costs total $450,000 per year. The company
is currently selling 30,000 doors per year.

Required:
1. Prepare a contribution format income statement for the
company at the present level of sales and compute the degree
of operating leverage. 1. OL = 6
2. Management is confident that the company can sell 37,500
doors next year (an increase of 7,500 doors, or 25%, over
current sales). Compute the following:
a) The expected percentage increase in net operating income
for next year. a. 150%
b) The expected net operating income for next year. (Do not
prepare an income statement; use the degree of operating
leverage to compute your answer.) b. $2,25,000