Chapter

5
Cost-Volume-Profit
Relationships
 LEARNING OBJECTIVES
After studying this chapter, we should be able to:
1. Explain how changes in activity affect
contribution margin.
2. Compute the contribution margin ratio (CM)
ratio and use it to compute changes in
contribution margin and net income.
3. Show the effects on contribution margin of
changes in variable costs, fixed costs, selling
price and volume.
4. Compute the break-even point by both the
equation method and the contribution margin
method.
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 LEARNING OBJECTIVES
After studying this chapter, we should be able to:
5. Prepare a cost-volume-profit (CVP) graph and
explain the significance of each of its
components.
6. Use the CVP formulas to determine the
activity level needed to achieve a desired
target profit.
7. Compute and understand the margin of
safety and degree of operating leverage
along with their significance.

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 Cost-Volume-Profit (CVP)
CVP is a powerful tool that helps managers understand
relationships among cost, volume, and profit.
CVP analysis focuses on how profit are affected by the following
five factors:
Selling Prices
Sales Volume
Unit Variable Costs
Total Fixed Costs
Mix of Product Sold

As CVP analysis helps managers understand how profit is

affected by the above five factors, this is a vital tool in many
business decisions, i.e., what products and services to offer, what
prices to charge, what marketing strategy to use, what cost
structure to maintain, etc.
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 Contribution Margin (CM)
CM is the amount remaining from sales revenue after variable
expenses have been deducted.
This is the amount available to cover fixed expenses and then to
provide profits for the product. That means, CM is used first to
cover fixed expenses, and then whatever remains goes toward
profits.
If the CM margin is not enough to cover fixed expenses, then a
loss occurs for the period.

Contribution Margin (CM) = Sales Revenue – Variable Costs

Per Unit CM= Selling Price – Per Unit Variable Costs

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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
NCMet inicos umseedto cover fixe$
20ex,000
dCM is penses.
used to cover fixed expenses.

© McGraw-Hill Ryerson Limited., 2018

 The Contribution Approach

For each additional unit Wind Bicycle sells, $200

more in contribution margin will help to cover fixed
expenses and profit.

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

© McGraw-Hill Ryerson Limited., 2018

The Contribution Approach

Each month Wind must generate at least

$80,000 in total CM to break even.

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

© McGraw-Hill Ryerson Limited., 2018

The Contribution Approach

If Wind sells 400 units in a month, it will be

operating at the break-even point.
WIND BICYCLE CO.
Contribution IncomeStatement
For the Month of June
Total Per Unit
Sales (400 bikes) $200,000 $ 500
Less: variable expenses 120,000 300
Contribution margin 80,000 $ 200
Less: fixed expenses 80,000
Net income $ 0

© McGraw-Hill Ryerson Limited., 2018

The Contribution Approach

If Wind sells one additional unit (401

bikes), net income will increase by $200.
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (401 bikes) $200,500 $ 500
Less: variable expenses 120,300 300
Contribution margin 80,200 $ 200
Less: fixed expenses 80,000
Net income $ 200

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 The Break-Even Point
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.
Once the break-even point has been reached, the net
operating income will increase by the amount of Unit
CM for each additional unit sold.

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 Contribution Margin Ratio
The contribution margin as percentage (%) of sales is referred
to as the contribution margin ration (CM ratio).
CM ratio can also be determined as the ration between unit
contribution margin and per unit selling price.
CM ratio can be used in CVP calculations.
The CM ratio shows how the contribution margin will be
affected by a change in total sales.
CM ratio of 40% OR 0.40 means that for each dollar increase in
sales, total CM will increase by 40 cents and net operating income
will also increase by 40 cents, assuming that fixed costs are not
affected by the increase in sales.
Generally, the effect of a change in sales on the contribution
margin is expressed in equation as follows:
Change in CM = CM ratio * Change in Sales
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 Profit and CM Ratio
The relation between profit and the CM ratio can be
expressed using the following equation:
Profit = (CM Ratio * Sales) – Total Fixed Expenses
This approach will often be quicker and easier than
constructing contribution format income statement.
The CM ratio is particularly valuable in situations where the
dollar sales of one product must be traded off against the
dollar sales of another product.
In this situation, products that yield the greatest amount of
contribution margin per dollar of sales (CM ratio) should be
emphasized.

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Contribution Margin Ratio

The contribution margin ratio is:

CM Ratio = Contribution margin

Sales

For Wind Bicycle Co. the ratio is:

$200 = 40%
$500

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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?

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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

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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
or ($50,000 × 40% = $20,000)

© McGraw-Hill Ryerson Limited., 2018

 Variable Expense Ratio
The variable expense ratio is the ratio of variable expenses
to sales.
It can be computed by diving the total variable expenses by
the total sales, or in a single product analysis, it can be
computed by dividing the per unit variable expenses by the
unit selling price.
Variable expense ratio = Variable expense/Sales
CM ratio = Contribution margin/Sales
CM ratio = (Sales – Variable expenses)/Sales
CM ratio = 1 – Variable expense ratio
In the Wind Bicycle Co. problem, variable expense ratio is
0.60 ($300/$500).

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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?

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Changes in Fixed Costs and Sales
Volume
$80,000
$80,000 ++$10,000
$10,000 advertising
advertising==$90,000
$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
Salesincreased
increased by
by$20,000,
$20,000, but
but
net
netincome
incomedecreased
decreased by
by$2,000.
$2,000.

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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)

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APPLICATIONS OF CVP

Consider the following basic data:

Per unit Percent
Sales Price $250 100
Less: Variable cost 150 60
Contribution margin 100 40
Fixed costs total $35,000

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APPLICATIONS

 Current sales are $100,000. Sales

manager feels $10,000 increase in sales
budget will provide $30,000 increase in
sales. Should the budget be changed?
YES
Incremental CM approach:
$30,000 x 40% CM ratio 12,000
Additional advertising expense 10,000
Increase in net income 2,000

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APPLICATIONS
 Management is considering increasing
quality of speakers at an additional cost of
$10 per speaker. Plan to sell 80 more units.
Should management increase quality?
YES
Expected total CM
= (480 speakers x$90) $43,200
Present total CM
= (400 speakers x$100) 40,000
Increase in total contribution margin 3,200
(and net income)

© McGraw-Hill Ryerson Limited., 2018

APPLICATIONS
 Management advises that if selling price
dropped $20 per speaker and
advertising increased by $15,000/month,
sales would increase 50%. Good idea?
Expected total CM NO
= (400x150%x$80) $48,000
Present total CM (400x$100) 40,000
Incremental CM 8,000
Additional advertising cost 15,000
Reduction in net income (7,000)
© McGraw-Hill Ryerson Limited., 2018
APPLICATIONS
 A plan to switch sales people from flat
salary ($6,000 per month) to a sales
commission of $15 per speaker could
increase sales by 15%. Good idea? YES
Expected total CM (400x115%x$85) $39,100
Current total CM (400x$100) 40,000
Decrease in total CM (900)
Salaries avoided if commission paid 6,000
Increase in net income $5,100
© McGraw-Hill Ryerson Limited., 2018
APPLICATIONS

 A wholesaler is willing to buy 150 speakers

if we will give him a discount off our price.
The sale will not disturb regular sales and
will not change fixed costs. We want to
make $3,000 on this sale. What price
should we quote?
Variable cost per speaker $150
Desired profit on order (3,000/150) 20
Quoted price per speaker $170

© McGraw-Hill Ryerson Limited., 2018

Break-Even Analysis

Break-even analysis can be approached in

two ways:
 E q u a t i o n method
 C o n t r i b u t i o n margin method.

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Equation Method

Profits = Sales – (Variable expenses + Fixed expenses)

OR

Sales = Variable expenses + Fixed expenses + Profits

At the break-even point

profits equal zero.

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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

© McGraw-Hill Ryerson Limited., 2018

Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

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

Where:
Q = Number of bikes sold
$500 = Unit sales price
$300 = Unit variable expenses
$80,000 = Total fixed expenses

© McGraw-Hill Ryerson Limited., 2018

Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

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

$200Q = $80,000

Q = 400 bikes

© McGraw-Hill Ryerson Limited., 2018

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
Where:
X = Total sales dollars
0.60 = Variable expenses as a
percentage of sales
$80,000 = Total fixed expenses

© McGraw-Hill Ryerson Limited., 2018

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

0.40X = $80,000

X = $200,000

© McGraw-Hill Ryerson Limited., 2018

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

© McGraw-Hill Ryerson Limited., 2018

 CVP Relationships in Graphic Form
Viewing CVP relationships in a graph gives managers a
perspective that can be obtained in no other way.
Consider the following information for Wind Co.:

Income Income Income

300 units 400 units 500
units
Sales $ 150,000 $ 200,000 $250,000
Less: variable expenses 90,000 120,000 150,000
Contribution margin $ 60,000 $ 80,000 $100,000
Less: fixed expenses 80,000 80,000 80,000
Net income(loss) $ (20,000) $ - $ 20,000

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CVP Graph
400,000

350,000

300,000

250,000 Total Expenses

Dollars

200,000

150,000 Fixed expenses

100,000

50,000

-
100

200

300

400

500

600

700

800
-

Units

© McGraw-Hill Ryerson Limited., 2018

CVP Graph
400,000

350,000

300,000
Total Sales
250,000
Dollars

200,000

150,000

100,000

50,000

-
100

200

300

400

500

600

700

800
-

Units
© McGraw-Hill Ryerson Limited., 2018
CVP Graph
400,000

350,000

300,000

250,000
Dollars

200,000
Break-even point
150,000

100,000

50,000

-
100

200

300

400

500

600

700

800
-

Units

© McGraw-Hill Ryerson Limited., 2018

 Target Profit Analysis
Target profit analysis and break-even analysis are used to
answer the questions such as how much would have to be sold to
make a certain amount of profit (target profit) or how much
would have to be sold to avoid incurring a loss.
Target profit analysis is one of the key uses of CVP analysis. In
this analysis, sales volume is estimated to achieve a target profit.
Target Profit in Terms of Sales Quantity:
Target Profit = (Unit CM * Required Quantity) – Fixed Expense
Unit Sales to Attain the Target Profit = (Target Profit + Fixed
Expenses) / Unit CM
Target Profit in Terms of Sales Dollars:
Target Profit = (CM Ration * Sales Dollars) – Fixed Expense
Sales Dollars to Attain the Target Profit = (Target Profit + Fixed
Expenses) / CM Ratio
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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.

© McGraw-Hill Ryerson Limited., 2018

The CVP Equation
Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $100,000

$200Q = $180,000

Q = 900 bikes

© McGraw-Hill Ryerson Limited., 2018

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

© McGraw-Hill Ryerson Limited., 2018

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.
The higher the margin of safety, the lower the
risk of not breaking-even and incurring a loss.

Margin of safety = Total sales - Break-even sales

Margin of Safety Percentage = Margin of safety in

dollars/Total Budgeted (or Actual) Sales in
Dollars
Let’s calculate the margin of safety for Wind.

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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
400 units sales 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

© McGraw-Hill Ryerson Limited., 2018

The Margin of Safety

The margin of safety can be expressed as

20 percent of sales.
($50,000 ÷ $250,000)
Break-even
sales Actual
400 units sales 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

© McGraw-Hill Ryerson Limited., 2018

 Operating Leverage
 A measure of how sensitive net income is to percentage
changes in sales.
 It acts as a multiplier.
 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

A firm with a high proportion of fixed costs will have high

degree of operating leverage.
It is greatest at sales levels near break-even and decreases as
sales and profit rise.

© McGraw-Hill Ryerson Limited., 2018

Operating Leverage
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

$100,000 = 5
$20,000

© McGraw-Hill Ryerson Limited., 2018

 Operating Leverage
The degree of operating leverage can be used to quickly
estimate what impact various % sales will have on profits,
without necessity of preparing detailed income statement.
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!

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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 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.
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End of Chapter 5
We made
it!

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Sample Problem

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Solutions

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