Cost-Volume-Profit

Relationships
Chapter 05
Learning Objective 1

Explain how changes in

activity affect
contribution margin and
net operating income.
 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.
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.
 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
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
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 $ -
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
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.
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
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

$80,000
401 units $500
401 units $300

Profit = ($200,500 $120,300) $80,000

$200 = ($200,500 $120,300) $80,000
 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

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

Profit = (($500 401) ($300 401))
$80,000
Profit = $200
 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
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
RBCs $200 profit
if it sells 401
bikes.
Learning Objective 2

Prepare and interpret a

cost-volume-profit (CVP)
graph and a profit graph.
 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
Preparing the CVP Graph
$350,000

$300,000

$250,000

$200,000

$150,000

$100,000
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
Preparing the CVP Graph
$350,000

Draw a line parallel to the volume axis
$300,000
to represent total fixed expenses.
$250,000

$200,000

Fixed expenses
$150,000

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
 Preparing the CVP Graph
$350,000
Choose some sales volume, say 400 units, and plot the point representing
total expenses
$300,000
(fixed and variable). Draw a line through the data point
back to where the fixed expenses line intersects the dollar axis.
$250,000

$200,000

Total expenses
Fixed expenses
$150,000

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
Preparing the CVP Graph
$350,000 Break-even point
(400 units or $200,000 in sales) Profit Area
$300,000

$250,000

$200,000
Sales
Total expenses
$150,000 Fixed expenses

$100,000

$50,000

$0
0 100 200 300 400 500 600
Loss Area Units
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
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
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.
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%

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.
 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).
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. What is the CM Ratio for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139
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
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
Learning Objective 4

Show the effects on net

operating income of
changes in variable
costs, fixed costs,
selling price, and
volume.
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
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?
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.
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)
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?
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.
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?
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.
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?
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.
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?
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
Learning Objective 5

Determine the level of

sales needed to achieve
a desired target profit.
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.
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.
Target Profit Analysis
Suppose RBCs 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
The Formula Method

The formula uses the following equation.

Unit sales to attain Target profit + Fixed expenses

=
the target profit CM per unit
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
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
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
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
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
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
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
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 generated to attain Targetprofits
target profit +ofFixed
$2,500
to attain = expenses
per month. target profit CM ratio
a. $2,550 $2,500 + $1,300
=
b. $5,013 ($1.49 0.36) $1.49
c. $8,458 $3,800
=
d. $10,555 0.758
= $5,013
Learning Objective 6

Determine the break-

even point.
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. Lets 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
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.

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
Break-Even in Unit Sales:
Formula Method
Lets 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
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). Lets use the equation
method to solve this problem.

Profit = CM ratio Sales Fixed expenses

Solve for the unknown Sales.

 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 = $200,000
 Profit = CM ratio Sales Fixed expenses
0 = CM ratio Sales Fixed expenses
Fixed expenses = CM ratio Sales
Fixed expenses ($)= Sales in $
CM ratio

Fixed expenses = Sales in units

CM per unit
Break-Even in Dollar Sales:
Formula Method
Now, lets 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
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
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
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
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 averageBreak-even
of 2,100 cups Fixed
are expenses
sold each
= CMunits?
per Unit
month. What is the break-even sales in
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
Learning Objective 7

Compute the margin of

safety and explain its
significance.
 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

Lets look at Racing Bicycle Company and

determine the margin of safety.
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
The Margin of Safety Percentage
RBCs 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
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, RBCs margin of safety is 100 bikes.

Margin of $50,000
= = 100 bikes
Safety in units $500
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
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
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 organizations cost structure.
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.
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.
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
Operating Leverage
To illustrate, lets 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
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%

Heres the verification!

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.
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
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
Operating Contribution margin
b. 0.45 leverage = Net operating income
c. 0.34
$2,373
d. 2.92 = $1,073 = 2.21
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%
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%
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%
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.

Lets look at an example.

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.
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.
Tutorials

5-13
5-14
5-15
5-17
5-18
5-19A
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.
The Concept of Sales Mix
Sales mix is the relative proportion in which a companys
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.

Lets assume Racing Bicycle Company sells bikes and

carts and that the sales mix between the two products
remains the same.
 Multiproduct Break-Even Analysis
Bikes comprise 45% of RBCs 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
 Multiproduct 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%

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).