Managerial Accounting

Seventh Edition

Chapter 7
Cost-Volume-Profit Analysis

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Learning Objectives
7.1 Calculate the unit contribution margin and the contribution
margin ratio
7.2 Use CV P analysis to find the volume needed to break
even or earn a target profit
7.3 Use CV P analysis to measure the impact of changing
business conditions
7.4 Use CV P analysis at multiproduct companies
7.5 Determine a firm’s margin of safety, operating leverage,
and most profitable cost structure
7.6 Describe scenario analysis and its uses in cost-volume-
profit analysis
7.7 Apply Excel by using the what-if analysis tool to model
profitability changes
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Learning Objective 1
Calculate the unit contribution margin and the contribution
margin ratio

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Cost-Volume-Profit Analysis
• Powerful tool that helps managers make decisions
• Expresses relationship among costs, volume, and the
company’s profit
• Determine sales volume needed to break even or earn a
target profit

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Components of C V P Analysis

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CV P Assumptions
1. Sales price remains constant throughout the relevant
range of volume.
2. Managers can classify each cost as either variable or
fixed.
3. Inventory levels will not change.
4. The product mix offered for sale remains constant.

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The Unit Contribution Margin
• Contribution margin: excess of sales revenue over
variable expenses.
• Unit contribution margin: excess of the selling price per
unit over the variable cost per unit.
• All variable costs (product and period) must be included
when calculating the unit contribution margin.

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Unit Contribution Margin Example—
Kay’s Posters (1 of 3)
Kay has an online poster business. She currently sells each
poster for $35, while each poster has a variable cost of $21.
Kay has monthly fixed costs of $7,000. Her relevant range is
0 to 2,000 and she is currently selling 550 posters.

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Unit Contribution Margin Example—
Kay’s Posters (2 of 3)

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Unit Contribution Margin Example—
Kay’s Posters (3 of 3)

• Kay earns $14 every time she sells a poster that can be
used to:
– Pay fixed expenses
– Earn a profit

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Contribution Margin Ratio
• Ratio of contribution margin to sales revenue
• Unit contribution margin  Sales price per unit
• Contribution margin  Sales revenue
• Kay’s calculations:
$14 / $35 40%
$7,700 / $19,250 40%

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Learning Objective 2
Use CV P analysis to find the volume needed to break even
or earn a target profit

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Breakeven Point
• The sales level at which operating income is zero
• Total revenues = Total expenses
• Sales below breakeven point  loss
• Sales above breakeven point  profit
• Three ways to calculate:
– The income statement approach
– The shortcut approach using unit contribution margin
– The shortcut approach using contribution margin ratio

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Breakeven Point—The Income
Statement Approach

Example: Find Kay’s breakeven point:

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Breakeven Point—Using the Unit
Contribution Margin

Fixedexpenses + Operatingincome
Shortcut formula: Sales in units =
Contributionmarginper unit

Example: Kay’s breakeven point

$7,000 + $0
Sales in units=
$14
= 500posters

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Breakeven Point—Using the
Contribution Margin Ratio
Shortcut formula:

Fixed expenses + Operating income

Sales in dollars =
Contribution margin ratio

Example: Kay’s breakeven point

$7,000 + $0
Sales in dollars= = $17,500
40%

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Target Profit—Unit Contribution
Margin
How many posters does Kay need to sell to earn $4,900
profit?

Fixed expenses + Operating income

Sales in units =
Contribution margin per unit
$7,000 +$4,900
=
$14
$11,900
=
$14
= 850posters

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Target Profit—Unit Contribution
Margin Ratio
How much sales revenue does Kay need to generate to earn
$4,900 profit?

Fixed expenses + Operating income

Sales in dollars =
Contribution margin ratio
$7,000 + $4,900
=
40%
$11,900
=
40%
= $29,750

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Target Profit—Income Statement
Approach
How many posters does Kay need to sell to earn $4,900
profit?

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Graphing CV P Relationships
• Step 1: Choose a sales volume. Plot the point for total sales
revenue at that volume. Draw the sales revenue line from
the origin through the point.
• Step 2: Draw the fixed expense line; a horizontal line that
intersects the y-axis.
• Step 3: Draw the total expense line. Sum of variable plus
fixed expenses.
• Step 4: Identify the breakeven point. Where sales revenue
intersects total expense.
• Step 5: Mark the operating income and operating loss
areas.

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CV P Graph

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Learning Objective 3
Use CV P analysis to measure the impact of changing
business conditions

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Sensitivity Analysis
• Prepare for increasing costs, pricing pressures, and other
changing business conditions
• “What-if” technique
– What if sales price changes?
– What if costs change?
– What if the sales mix changes?
• Use CV P to conduct sensitivity analysis

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Changing the Sales Price and Volume
• Breakeven point changes
• Unit contribution margin changes

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Changing Variable Costs
• Breakeven point changes
• Unit contribution margin changes
– Higher variable costs have the same effect as lower
selling prices—reduce unit contribution margin

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Changing Fixed Costs
• Changes breakeven point
• Does NOT change unit contribution margin

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Sustainability and CV P
• Reducing costs and helping the environment
• Example: decreasing use of plastic reduces variable costs
• Decreasing variable costs makes it easier to reach a target
profit

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Learning Objective 4
Use CV P analysis at multiproduct companies

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Changing Sales Mix
• Sales mix: combination of products that make up total
sales
• All else equal, company earns more operating income by
selling high-contribution margin products
• Weighted-average contribution margin: weights each
contribution margin by the relative number of units sold

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Multiproduct Company: Breakeven in
Sales Units (1 of 2)

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Multiproduct Company: Breakeven in
Sales Units (2 of 2)
Fixed expenses + Operating income
Sales in total units =
Weighted-average contribution margin per unit
$7,000 +$0
=
$20
= 350posters

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Multiproduct Company: Breakeven in
Sales Revenue (1 of 2)

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Multiproduct Company: Breakeven in
Sales Revenue (2 of 2)
Fixedexpenses + Operatingincome
Salesin dollars =
Weighted-averagecontributionmarginratio
$7,000 + $0
=
41.56%
= $16,844 (rounded)

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Learning Objective 5
Determine a firm’s margin of safety, operating leverage, and
most profitable cost structure

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Common Risk Indicators
• Risk depends on many factors
– General health of economy
– Industry of operation
– Current volume of sales
– Fixed and variable costs
• Margin of safety
• Operating leverage

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Margin of Safety (1 of 2)
• Excess of actual or expected sales over breakeven sales
• Drop in sales the company can absorb without incurring a
loss
• Higher margin of safety—less risky

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Margin of Safety (2 of 2)
Assume Kay generally sells 950 posters a month.
Margin of safety in units = Expected (or actual) sales in units  Breakeven sales in units
 950 posters  500 posters
= 450 posters

Margin of safety in units = Expected (or actual) sales in units  Breakeven sales in unit
 (950 posters $35)  (500 posters $35)
= $33,250  $17,500
 $15,750

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Margin of Safety—As a Percentage
In units:
Margin of safety in units
Margin of safety as a percentage 
Expected (or actual) sales in units
450 posters

950 posters
= 47.4% (rounded)

In dollars:
Margin of safety in dollars
Margin of safety as a percentage 
Expected (or actual) sales in dollars
$15,750

$33,250
= 47.4% (rounded)

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Operating Leverage and Operating
Leverage Factor (1 of 2)
• Relative amount of fixed and variable costs that make up
total costs
• Operating Leverage Factor: how responsive a company’s
operating income is to changes in volume
– At a given level of sales:
Contribution Margin / Operating Income
– Greater the operating leverage factor, greater impact a
change in sales volume has on operating income

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Operating Leverage and Operating
Leverage Factor (2 of 2)
• Indicates the percentage change in operating income that will occur
from a 1% change in volume
• Lowest possible value is 1
• Example: Assume Kay sells 950 posters per month
– Contribution margin 950 x $14  $13,300
– Less: Fixed expenses 7,000
– Operating income $ 6,300
$13,300
• Operating leverage factor = 2.11
$6,300

• If Kay’s volume changes by 1%, her operating income will change by

2.11% (1% 2.11).

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Characteristics of High Operating
Leverage Firms
• High operating leverage companies have the following:
– Higher fixed costs and lower variable costs
– Higher contribution margin ratios
• For high operating leverage companies, changes in
volume significantly affect operating income, so they face
the following:
– Higher risk
– Higher potential for reward
Examples include golf courses, hotels, airlines, and theme
parks.

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Characteristics of Low Operating
Leverage Firms
• Low operating leverage companies have the following:
– Higher variable costs and lower fixed costs
– Lower contribution margin ratios
• For low operating leverage companies, changes in volume
do NOT have as significant an effect on operating income,
so they face the following:
– Lower risk
– Lower potential for reward
Examples include merchandising companies and fast-food
restaurants.

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Choosing a Cost Structure
• Indifference point: Point at which a company is indifferent
between two options because they result in the same total
cost.
• Example: Kay has two leasing options

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Learning Objective 6
Describe scenario analysis and its uses in cost-volume-profit
analysis

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Scenario Analysis (1 of 2)
• The process of experimenting with different scenarios to
see what would happen to company profits under those
conditions
– Base case
– Best case
– Worst case
• Often done with spreadsheet software
– Microsoft Excel
– Apple Numbers
– Google Sheets
– Specialty software tools

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Scenario Analysis (2 of 2)
• Kay Martin posters example

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Learning Objective 7
Apply Excel by using the what-if analysis tool to model
profitability changes

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How Can Managers Use Data
Analytics to Analyze Cost, Volume,
and Profit? (1 of 3)
• Kay’s poster business example:
– Each poster sells for $35 and has a variable cost of $21
– Kay has $7,000 of fixed costs per month, typically sells 950
posters per month, and would like to earn at least $4,900 of
operating income per month.

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How Can Managers Use Data
Analytics to Analyze Cost, Volume,
and Profit? (2 of 3)

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How Can Managers Use Data
Analytics to Analyze Cost, Volume,
and Profit? (3 of 3)
• Kay’s poster business example

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How to Use the “What-If” Analysis to
Create a Data Table (1 of 4)
1. Create a profit calculation. Use formulas to calculate the
contribution margin per unit, total contribution margin, and
operating income.
2. In a new cell, indicate the cell address of the outcome you
would like to see in the data table. This cell becomes the
upper left corner cell of the data table.

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How to Use the “What-If” Analysis to
Create a Data Table (2 of 4)
3. Going across the row of the corner cell (row 2 in our
example), list possible sales prices. Format as currency.
4. Going down the column of the corner cell (column E in our
example), list possible volumes.

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How to Use the “What-If” Analysis to
Create a Data Table (3 of 4)
5. Use the cursor to select the entire data table. Click on the
Data tab on the ribbon. Click on the What-If Analysis icon
drop-down arrow. Then choose Data Table.

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How to Use the “What-If” Analysis to
Create a Data Table (4 of 4)
6. A dialog box will open. Use the cursor to select the cell
containing the input variable listed along the row. In our
example, the input variable for the row is sales price, which is
shown in cell B1 of the profit calculation. Next, use the cursor
to select the cell containing the input variable listed down the
column. In our example, the input variable for the column is
volume, which is shown in cell B4 of the profit calculation.
Excel automatically adds dollar signs ($B$1 and $B$4) to make
the cell reference absolute. Then click O K.

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How to Use Conditional Formatting to
Shade Specific Cells (1 of 2)
1. Select the entire data table with the cursor, not including
the column headings.
2. On the Home tab, choose the Conditional Formatting icon,
then Highlight Cell rules, and then Greater than...

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How to Use Conditional Formatting to
Shade Specific Cells (2 of 2)
3. A dialog box will open. Rather than typing in the target profit ($4,900),
reference the cell where the target profit is located (=B10) by
selecting it with the cursor. Excel will automatically add dollar signs to
create an absolute reference (=$B$10), thereby shading any value in
the data table greater than the value in cell B10. Then choose the
desired color for shading the cells. Click ok.
4. The shading will now update anytime the variable cost, fixed cost, or
target profit is changed in the original profit calculation shown in
Exhibit 7.22.

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