Equation Approach

Sales revenue – Variable expenses – Fixed expenses = Profit

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Equation Approach
Sales revenue – Variable expenses – Fixed expenses = Profit

Unit Sales Unit Sales

sales × volume variable × volume
price in units expense in units

At the break-even point profit equals zero,

and the sales volume in units is unknown.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Equation Approach
Sales revenue – Variable expenses – Fixed expenses = Profit

($500 × X) – ($300 × X) – $80,000 = $0

($200X) – $80,000 = $0
X = 400 units

At the break-even point profit equals zero,

and the sales volume in units is unknown.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Graphing Cost-Volume-Profit
Relationships
Viewing CVP relationships in a graph gives managers
a perspective that can be obtained in no other way.
Consider the following information for Curl, Inc.:
Income
Income Income
Income Income
Income
300
300units
units 400
400units
units 500
500units
units
Sales
Sales $$ 150,000
150,000 $$ 200,000
200,000 $$250,000
250,000
Less:
Less: variable
variableexpenses
expenses 90,000
90,000 120,000
120,000 150,000
150,000
Contribution
Contributionmargin
margin $$ 60,000
60,000 $$ 80,000
80,000 $$100,000
100,000
Less:
Less: fixed
fixedexpenses
expenses 80,000
80,000 80,000
80,000 80,000
80,000
Net
Net income
income(loss)
(loss) $$ (20,000)
(20,000) $$ -- $$ 20,000
20,000

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Cost-Volume-Profit Graph
450,000

400,000

350,000

300,000
Sales in Dollars

250,000

200,000

150,000 Fixed expenses

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Irwin/McGraw-Hill Units Sold © The McGraw-Hill Companies, Inc., 19

 Cost-Volume-Profit Graph
450,000

400,000

350,000

300,000
Sales in Dollars

250,000
Total expenses
200,000

150,000

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Irwin/McGraw-Hill Units Sold © The McGraw-Hill Companies, Inc., 19

 Cost-Volume-Profit Graph
450,000

400,000 Total sales

350,000

300,000
Sales in Dollars

250,000

200,000

150,000

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Irwin/McGraw-Hill Units Sold © The McGraw-Hill Companies, Inc., 19

 Cost-Volume-Profit Graph
450,000

400,000 Break-even
350,000 point
300,000
Sales in Dollars

250,000

200,000

150,000

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Irwin/McGraw-Hill Units Sold © The McGraw-Hill Companies, Inc., 19

 Cost-Volume-Profit Graph
450,000

400,000

350,000
r ea
300,000
f it a
Pro
Sales in Dollars

250,000

200,000

150,000

100,000 r ea
ssa
50,000 Lo
-
- 100 200 300 400 500 600 700 800

Irwin/McGraw-Hill Units Sold © The McGraw-Hill Companies, Inc., 19

 Profit-Volume Graph
$100,000
Some managers
$80,000
like the profit-volume
$60,000 graph because it focuses
$40,000 on profits and volume.
$20,000
Profit

$-
$- $50 $100 $150 $200 $250 $300 $350 $400
$(20,000)

$(40,000)

$(60,000)

$(80,000)

$(100,000) 1 2 3 4 5 6 7 8
Units sold (00s)
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19
 Profit-Volume Graph
$100,000

$80,000
Break-even
$60,000 point
$40,000

$20,000
Profit

$-
$- $50 $100 $150 $200 $250 $300 $350 $400
$(20,000)

$(40,000)

$(60,000)

$(80,000)

$(100,000) 1 2 3 4 5 6 7 8
Units sold (00s)
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19
 Profit-Volume Graph
$100,000

$80,000

$60,000

$40,000

$20,000
Profit

$-
$- $50 $100 $150 $200 $250 $300 $350 $400
$(20,000)

$(40,000)

$(60,000)
Sales revenue
$(80,000)

$(100,000) 1 2 3 4 5 6 7 8
Units sold (00s)
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19
 Profit-Volume Graph
$100,000

$80,000
Profit line
$60,000

$40,000

$20,000
Profit

$-
$- $50 $100 $150 $200 $250 $300 $350 $400
$(20,000)

$(40,000)

$(60,000)

$(80,000)

$(100,000) 1 2 3 4 5 6 7 8
Units sold (00s)
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19
 Profit-Volume Graph
$100,000

$80,000

$60,000

r ea
if t a
$40,000

$20,000 r o
P
Profit

$-
$- $50 $100 $150 $200 $250 $300 $350 $400
$(20,000)

r ea
$(40,000)
s a
os
$(60,000) L
$(80,000)

$(100,000) 1 2 3 4 5 6 7 8
Units sold (00s)
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19
 Target Net Profit
We can determine the number of
surfboards that Curl must sell to earn a
profit of $100,000 using the contribution-
margin approach.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Contribution-Margin Approach
We can determine the number of
surfboards that Curl must sell to earn a
profit of $100,000 using the contribution-
margin approach.

Fixed expenses + Target profit Units sold to earn

=
Unit contribution margin the target profit

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Contribution-Margin Approach
We can determine the number of
surfboards that Curl must sell to earn a
profit of $100,000 using the contribution-
margin approach.

Fixed expenses + Target profit Units sold to earn

=
Unit contribution margin the target profit

$80,000 + $100,000
= 900 surfboards
$200
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19
 Equation Approach
Sales revenue – Variable expenses – Fixed expenses = Profit

($500 × X) – ($300 × X) – $80,000 = $100,000

($200X) = $180,00

X = 900 units

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Applying CVP Analysis
Safety Margin

The difference between budgeted sales

revenue and break-even sales revenue.
The amount by which sales can drop
before losses begin to be incurred.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Safety Margin
Curl, Inc. has a break-even point of $200,000. If
actual sales are $250,000, the safety margin is
$50,000 or 100 surfboards.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Changes in Fixed Costs

Curl
Curl is
is currently
currently selling
selling 500
500 surfboards
surfboards per
per
month.
month.

The
The owner
owner believes
believes that
that an
an increase
increase of
of $10,000
$10,000
in
in the
the monthly
monthly advertising
advertising budget,
budget, would
would
increase
increase bike
bike sales
sales to
to 540
540 units.
units.

 Should
Should we
we authorize
authorize the
the requested
requested increase
increase in
in
the
the advertising
advertising budget?
budget?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Changes in Fixed Costs
Current
Current Proposed
Proposed
Sales
Sales Sales
Sales
(500
(500 Boards)
Boards) (540
(540 Boards)
Boards)
Sales
Sales $$ 250,000
250,000 $$ 270,000
270,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin $$ 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000
Net
Net income
income $$ 20,000
20,000

540
540units
units×× $500
$500per
perunit
unit == $270,000
$270,000

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Changes in Fixed Costs
Current
Current Proposed
Proposed
Sales
Sales Sales
Sales
(500
(500 Boards)
Boards) (540
(540 Boards)
Boards)
Sales
Sales $$ 250,000
250,000 $$ 270,000
270,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000 162,000
162,000
Contribution
Contribution margin
margin $$ 100,000
100,000 $$ 108,000
108,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 90,000
90,000
Net
Net income
income $$ 20,000
20,000 $$ 18,000
18,000

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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Changes in Fixed Costs
Current
Current Proposed
Proposed
Sales will increase
Sales will increase byby Sales Sales
Sales Sales
$20,000, but net income
$20,000, but net income (500 (500 Boards)
Boards) (540
(540 Boards)
Boards)
will
will decrease by $2,000.
decrease by $2,000.
Sales $$ 250,000 $$ 270,000
Sales 250,000 270,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000 162,000
162,000
Contribution
Contribution margin
margin $$ 100,000
100,000 $$ 108,000
108,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 90,000
90,000
Net
Net income
income $$ 20,000
20,000 $$ 18,000
18,000

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Changes in Unit Contribution Margin
Because of increases in cost of raw materials,
Curl’s variable cost per unit has increased
from $300 to $310 per surfboard. With no
change in selling price per unit, what will be
the new break-even point?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Changes in Unit Contribution Margin
Because of increases in cost of raw materials,
Curl’s variable cost per unit has increased
from $300 to $310 per surfboard. With no
change in selling price per unit, what will be
the new break-even point?
($500 × X) – ($310 × X) – $80,000 = $0

X = 422 units (rounded up)

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Predicting Profit Given Expected
Volume

{ }
Fixed expenses
Given: Unit contribution margin Find: {required sales volume}
Target net profit

{ }
Fixed expenses
Given: Unit contribution margin Find: {expected profit}
Expected sales volume

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Predicting Profit Given Expected
Volume
In the coming year, Curl’s owner expects to sell
525 surfboards. The unit contribution margin is
expected to be $190, and fixed costs are
expected to increase to $90,000.

How much profit can we expect to earn?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Predicting Profit Given Expected
Volume
In the coming year, Curl’s owner expects to sell
525 surfboards. The unit contribution margin is
expected to be $190, and fixed costs are
expected to increase to $90,000.
Total contribution - Fixed cost = Profit

($190 × 525) – $90,000 = X

X = $99,750 – $90,000
X = $9,750 profit
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19
 CVP Analysis with Multiple
Products
For a company with more than one product,
sales mix is the relative combination in which
a company’s products are sold.
Different products have different selling prices,
cost structures, and contribution margins.

Let’s assume Curl sells surfboards and

sailboards and see how we deal with
break-even analysis.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 CVP Analysis with Multiple
Products
Curl provides us with the following information:
Unit Unit Number
Selling Variable Contribution of
Description Price Cost Margin Boards
Surfboards $ 500 $ 300 $ 200 500
Sailboards 1,000 450 550 300
Total sold 800

Number % of
Description of Boards Total
Surfboards 500 62.5% (500 ÷ 800)
Sailboards 300 37.5% (300 ÷ 800)
Total sold 800 100.0%

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 CVP Analysis with Multiple
Products
Weighted-average unit contribution margin
Contribution Weighted
Description Margin % of Total Contribution
Surfboards $ 200 62.5% $ 125.00
Sailboards 550 37.5% 206.25
Weighted-average contribution margin $ 331.25

$200 × 62.5%

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 CVP Analysis with Multiple
Products
Break-even point
Break-even Fixed expenses
=
point Weighted-average unit contribution margin

Break-even $170,000
=
point $331.25

Break-even
= 514 combined unit sales (rounded up)
point

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 CVP Analysis with Multiple
Products
Break-even point
Break-even
= 514 combined unit sales
point
Breakeven % of Individual
Description Sales Total Sales
Surfboards 514 62.5% 321
Sailboards 514 37.5% 193
Total units 514

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Assumptions Underlying
CVP Analysis
 Selling price is constant throughout
the entire relevant range.
 Costs are linear over the relevant
range.
 In multiproduct companies, the sales
mix is constant.
 In manufacturing firms, inventories
do not change (units produced =
units sold).

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Cost Structure and Operating
Leverage
The cost structure of an organization is the
relative proportion of its fixed and variable
costs.
Operating leverage is . . .
 the extent to which an organization uses fixed
costs in its cost structure.
 greatest in companies that have a high proportion

of fixed costs in relation to variable costs.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Measuring Operating Leverage
Operating leverage Contribution margin
=
factor Net income
Actual
Actual sales
sales
500
500 Board
Board
Sales
Sales $$ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin $$ 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000
Net
Net income
income $$ 20,000
20,000

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Measuring Operating Leverage
Operating leverage Contribution margin
=
factor Net income
Actual
Actual sales
sales
500
500 Board
Board
Sales
Sales $$ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin $$ 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000
Net
Net income
income $$ 20,000
20,000

$100,000
= 5
$20,000
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19
 Measuring Operating Leverage
A measure of how a percentage change in
sales will affect profits.

If Curl increases its sales by 10%, what

will be the percentage increase in net
income?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 Measuring Operating Leverage
A measure of how a percentage change in
sales will affect profits.

Percent
Percent increase
increase in
in sales
sales 10%
10%
Operating
Operating leverage
leverage factor
factor ×× 55
Percent
Percent increase
increase in
in profits
profits 50%
50%

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19

 CVP Analysis, Activity-Based Costing,
and Advanced Manufacturing Systems
An activity-based costing system can
provide a much more complete picture of
cost-volume-profit relationships and thus
provide better information to managers.
Break-even = Fixed costs
point Unit contribution margin

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 19