Cost-Volume-Profit

Relationships
 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

Contribution Margin (CM) is the amount remaining from sales revenue after variable
expenses have been deducted.
CM goes to cover fixed expenses.
After covering fixed costs, any remaining CM contributes to income
 The Contribution Approach
Consider the following information developed by the accountant at Wind Bicycle Co.:

Total Per Unit Percent

Sales (500 bikes) $250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000

For each additional unit Wind sells, $200 more in contribution margin will help to cover fixed expenses and profit.
Each month Wind must generate at least $80,000 in total CM to break even.
 The Contribution Approach
WIND BICYCLE CO.
Contribution Income Statement If Wind sells 400 units in a
For the Month of June month, it will be operating
Total Per Unit
Sales (400 bikes) $ 200,000 $ 500
at the break-even point.
Less: variable expenses 120,000 300
Contribution margin 80,000 $ 200
Less: fixed expenses 80,000
Net income $ 0

WIND BICYCLE CO.

Contribution Income Statement
For the Month of June
Total Per Unit If Wind sells one additional
Sales (401 bikes) $ 200,500 $ 500
Less: variable expenses 120,300 300 unit (401 bikes), net income
Contribution margin 80,200 $ 200 will increase by $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 Bikes 500 Bikes
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 income $ - $ 20,000

A $50,000 increase in sales revenue

 Contribution Margin Ratio

400 Bikes 500 Bikes

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 income $ - $ 20,000

A $50,000 increase in sales revenue

results in a $20,000 increase in CM.
($50,000 × 40% = $20,000)
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. 2,100 cups are sold each
month on average. What is the CM Ratio for Coffee Klatch?

cm
CM Ratio =
p
(p - v)
=
p
($1.49 - $0.36)
=
$1.49
($1.13)
= = 0.758
$1.49
 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 + $10,000 advertising = $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 increased by $20,000, but net

income decreased by $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)
 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 Per Unit Percent

Sales (500 bikes) $250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000
 Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

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

Where:
Q = Number of bikes sold
$200Q = $80,000
$500 = Unit sales price
$300 = Unit variable expenses Q = 400 bikes
$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 X = 0.60X + $80,000 + $0

Where: 0.40X = $80,000

X = Total sales dollars
X = $200,000
0.60 = Variable expenses as a
percentage of sales

$80,000 = Total fixed expenses

 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
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. 2,100 cups are sold each month on average. What is the break-
even sales in units? F
Breakeven q =
a. 872 cups cm
b. 3,611 cups $1,300
=
c. 1,200 cups $1.49 - $0.36
d. 1,150 cups $1,300
=
$1.13
= 1,150
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. 2,100 cups are sold each month on average. What is the break-
even sales in dollars?
a. $1,300 F
Breakeven Sales =
b. $1,715 CM Ratio
c. $1,788 $1,300
d. $3,129 =
0.758
= $1,715
 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
 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. How many cups
of coffee would have to be sold to attain target profits of $2,500 per month?
a. 3,363 cups F + Target profit
b. 2,212 cups q to attain target =
c. 1,150 cups cm
d. 4,200 cups $1,300 + $2,500
=
$1.49 - $0.36
$3,800
=
$1.13
= 3,363
 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
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 income $ - $ 20,000
The Margin of Safety
The margin of safety can be expressed as 20
percent 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 income $ - $ 20,000
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. 2,100 cups are
sold each month on average. What is the margin of safety?
a. 3,250 cups
b. 950 cups Margin of safety = Total sales - Breakeven sales
c. 1,150 cups
d. 2,100 cups = 2,100 cups - 1,150 cups
= 950 cups
or
Margin of safety 950 cups
= = 45%
percentage 2,100 cups
 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

Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000 $100,000 = 5
Contribution margin 100,000 $20,000
Less: fixed expenses 80,000
Net income $ 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!

 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 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.