Cost-Volume-Profit Relationships

Syllabus Chapter 3 [Book Chapter 5]

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Cost-Volume-Profit Analysis
Cost volume profit analysis is a financial modeling method
that evaluates how changes in costs and volume affect a
company’s operating income and net income. It helps
businesses determine the level of sales needed to cover
costs, reach profitability, and plan optimal pricing and
production strategies.
 5-2

Key Assumptions of CVP Analysis

1. Selling price is constant.
2. Costs are linear and can be accurately
divided into variable (constant per unit) and
fixed (constant in total) elements.
3. In multiproduct companies, the sales mix is
constant.
4. In manufacturing companies, inventories do
not change (units produced = units sold).
 5-3

Learning Objective 1

Explain how changes in

activity affect
contribution margin and
net operating income.
 5-4

Basics of Cost-Volume-Profit Analysis

The
/ contribution income statement is helpful to managers
in judging
0 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.
/%
 5-5

Basics of Cost-Volume-Profit Analysis

CM is used first to cover fixed expenses.
Any remaining CM contributes to net operating income.
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
 5-6

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
 5-7

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
 5-8

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 $ -
 5-9

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
 5-10

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 $6000.
 5-11

CVP Relationships in Equation Form

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

Profit $= (Sales
2 –- 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
 5-12

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
2 –- Variable expenses)
? # – Fixed expenses
/%

401 $80,000
7:8
18( units × $500
A
888
401
18( units × $300
A

$200 = ($200,500
Profit $200,50 – $120,300) – $80,000
$80,000
$120,300)
 5-13

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
2 –- Variable expenses)
? # – Fixed expenses
/%
Quantity sold (Q) Quantity sold (Q)
× Selling price p e r unit (P) × Variable expenses per unit (V)
= S a le s ( Q × P ) = Variable expenses (Q × V)

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

 5-14

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
2 –- Variable expenses)
? # – Fixed expenses
/%
Profit = (P × Q – V × Q) – Fixed expenses
77++88
$200
Profit$= 88 22 ×-7&88
($500 -7&88
401 –A A18(18(
$300 × 401) ?– $80,000
? 7088 7088 A
A 18(.
18(. ? 7
 5-15

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$= (P ×2Q -– V A× Q)
B –?Fixed
# Aexpenses
B. ? > / /
Profit$= (P –2 V)- × Q? –#.
Fixed
A expenses
B ? > / /%
Profit$= Unit
C 2CM ×A QB– Fixed? > expenses
/ /%
 5-16

CVP Relationships in Equation Form

Profit$= (P ×2Q -– V A× Q)
B –?Fixed
# Aexpenses
B. ? > / /
Profit$= (P –2 V)- × Q? –#.
Fixed
A expenses
B ? > / /%
Profit$= Unit
C 2CM ×A QB– 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.
 5-17

Learning Objective 2

Prepare and interpret a

cost-volume-profit (CVP)
graph and a profit
graph.
 5-18

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 $ - $ $ 200,000 $ 300,000
100,000
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
 5-19

Preparing the CVP Graph

Dollars

In a CVP graph, unit volume is usually

represented on the horizontal (X)
axis and dollars on the vertical (Y)
axis.
Units
 5-20

Preparing the CVP Graph


Draw a line parallel to
%the volume axis
to represent total fixed
% expenses.

/
Dollars

Units
 5-21

Preparing the CVP Graph


Choose some sales volume, say ,, 400 units, and plot the point representing
118888 Draw a line through the data point
total expenses (fixed and variable). %%
back to where the fixed expenses line intersects the dollar axis.
//%% --$$ // ,, ..

** $$ // / /%
%
Dollars

Units
 5-22

Preparing the CVP Graph


Choose some sales volume, say ,, 400 units, and plot
118the
888point representing%
total sales. Draw a line through
% the data point back to the point of origin.
))

%%
Dollars

Units
 5-23

Preparing the CVP Graph

BBrreeBreak-even
aakk-eevveenpointn ppooiinntt
(44( 000or0u$200,000
(400 units unniitss
t ooin
rr$sales) Profit $Area
$220000,,000000iinn ssaalleess))
Dollars

Loss
3 Area Units
 5-24

Preparing the CVP Graph

Profit $= Unit2CM
C × Q – FixedACosts
B ?

$ 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
 5-25

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
 5-26

Learning Objective 3

Use the contribution

margin ration (CM ratio)
to compute changes in
contribution margin and
net operating income
resulting from changes
in sales volume.
 5-27

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%

Each $1 increase in sales results in a total contribution
margin increase of 40¢.
 5-28

Contribution Margin Ratio (CM Ratio)

The contribution margin ratio at Racing Bicycle
is:

CM per unit $200 = 40%

CM Ratio = SP per unit = $500

The
)" CM ratio can also be calculated
$# by
dividing the
- contribution
- margin
" per unit by
the selling% price per unit.
" # $$ .
.
 5-29

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
Sales $ $
Less: variable expenses 500 Units
200,000 250,000
Contribution margin 120,000
80,000 150,000
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).
 5-30

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
b. 0.758
c. 0.242
d. 4.139
 5-31

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
CM Ratio =
Unit contribution margin
b. 0.758 Unit selling price
c. 0.242 ($1.49 - $0.36)
d. 4.139 =
$1.49

$1.13
= $1.49 = 0.758
 5-32

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
0 @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
 5-33

Learning Objective 4

Show the effects on net

operating income of
changes in variable
costs, fixed costs,
selling price, and
volume.
 5-34

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
 5-35

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?
 5-36

Changes in Fixed Costs and Sales

Volume
$$// ## 99 $$%% ##
$80,000 + $10,000 advertising = $90,000 $
44
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.
 5-37

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)
 5-38

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?
 5-39

Change in Variable Costs and Sales

Volume
// units ×:: $310
580 $$++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.
!!
 5-40

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?
 5-41

Change in Fixed Cost, Sales Price,

and Volume
,, units ×:: $480
650 $$--/=
/44 $$++
$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 95,000
80,000
Net operating income $ 20,000 $ 22,000

!! $62,000,
Sales increase by $$,,""## fixed
##costs
** increase by
$15,000, and net operating income increases by $2,000.
$$%% ## ##
 5-42

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?
 5-43

Change in Variable Cost, Fixed Cost,

and Sales Volume
7 : $$++%% 44
5757 units ×: $315 = $181,125%
$$%%//
500units 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 $ $ 32,375
20,000
Sales
SaSalleincrease
essiinnccby
rree$37,500,
aasseebbfixed
yy $$expenses
3377,,55000decrease
0,,fiifxxeedby
d
eexxppeand
$6,000, ennnet
sseeoperating
ss ddeeccincome
rreeaassincreases
eebbyy by $12,375.
 5-44

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?
 5-45

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
 5-46

Learning Objective 5

Determine the break-

even point.
 5-47

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
 5-48

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
 5-49

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
 5-50

Break-even in Unit Sales:

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

Unit sales to Fixed

=
break expenses CM
even per unit

$80,000
Unit sales =
$200
Unit sales = 400
 5-51

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.”
 5-52

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
 5-53

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
 5-54

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. 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
 5-55

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 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
 5-56

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. 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
 5-57

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. Theaverage fixed expense per month is
$1,300. An avera ge Break-even
of 2,100 cups Fixed
are soldexpenses
each
= CM per Unit
month. What is th e 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
 5-58

Learning Objective 6

Determine the level of

sales needed to achieve
a desired target profit.
 5-59

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.
 5-60

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.
 5-61

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 = $200 × Q – $80,000
$100,000
$200 × Q = $100,000 – $80,000

Q = ($100,000 + $80,000) ÷
$200 Q = 900
 5-62

The Formula Method

The formula uses the following equation.

Unit sales to attain = Target profit + Fixed expenses

the target profit CM per unit
 5-63

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
 5-64

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
*Formul
Method
a
Method
 5-65

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 +
 5-66

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
 5-67

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. 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
 5-68

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 Unit salesfixed expense per month is $1,300.
average Target profit + Fixed expenses
to attain
Use the formula method= to determine Unit
how CMmany cups
of ould have to be sold to attain target profits of
coffee w target profit
$2,500 p er month. $2,500 + $1,300
= $1.49 - $0.36
a. 3,363cups
b. 2,212 $3,800
=
c. 1,150 cups $1.13
d. 4,200 = 3,363 cups
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. 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
 5-70

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
 5-71

Learning Objective 7

Compute the margin of

safety and explain its
significance.
 5-72

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
- 5 sales

Let’s look at Racing Bicycle Company and

determine the margin of safety.
 5-73

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
 5-74

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
 5-75

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.
 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
c. 1,150 cups
d. 2,100 cups
 5-77

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 pe
r p is $0.36. The average fixed expense per month i
cu Margin
$1,300. An of safety =
average = 2,100
of Total
2,100sales
cups––are
cups Break-even
1,150 cups
sold sales
each
smonth. What is the margin
= 950 cups
of safety expressed in
cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
 5-78

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.
 5-79

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.
 5-80

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.
 5-81

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
 5-82

Operating Leverage
To illustrate, let’s revisit the contribution income statement
for RBC.

Actual sales
500 Bikes
Sales $ 250,000
Less: variable e x p e n s e s 150,000
Contribution m a r g i n 100,000
Less: fi xed e x p e n s e s 80,000
Net i ncom e $ 20,000

Degree of
$100,000
= $20,000 = 5
Operating
Leverage
 5-83

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 × 5
leverage Percent increase 50%
in profits

Here’s the verification!

 5-84

Operating Leverage

10%3 increase in sales from

$250,000
- to $275,000
- 5. . .

.%. . results
% % in a 50% increase in
income' from $20,000' to- $30,000.
-
 5-85

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
 5-86

Quick Check 
Coffee Klatch is an es presso stand in a Actual sales
2,100 cups
downtown office buildi ng. The average selling $ 3,129
Sales
price of a cup of coffe eLess:
is $1.49 and
Variable the average756
expenses
variable expense per cup is $0.36.
Contribution The average2,373
margin
fixed expense per mo Less:
nth is $1,300.
Fixed expensesAn average1,300
of 2,100 cups are soldNet each month.
operating What is$the
income
operating leverage? 1,073

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
 5-87

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.
If4 sales increase by 20%, by how( much
& 7$ should
(
net
# operating income increase?
a. 30.0% #
b. 20.0%
c. 22.1% )
!
d. 44.2% 7
& 7
&&
 5-88

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.
If4 sales increase by 20%, by how( much & 7$ 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% 7
Percent increase in profit 44.20%
&
d. 44.2% 7
&&
 5-89

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%
 5-90

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.

 5-91

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.
 5-92

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.
 5-93

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.
 5-94

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.
 5-95

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
Sales $ 250,000 Total$
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
 5-96

Multi-Product Break-Even Analysis

Dollar sales to
=
Fixed

expenses break even

Dollar sales CM
to ratio $170,000
= = $352,697
break even 48.2%

Bicycle Carts Total

Sales $ 100% $ 193,983 100% $ 100.0%
158,714 352,697
Variable expenses 95,228 87,293 182,521 51.8%
Fixed expenses 60% 45%
Contribution margin 63,485 40% 106,691 55% 170,000
170,176 48.2%
Net operating income Rounding error
$
Sales mix $ 158,714 45% $ 193,983 100.0%
176
 5-97

End of Chapter 5