Cost-Volume-Profit Relationships

Chapter 3

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
 3-2

Learning Objective 3-1

Explain how changes in

activity affect contribution
margin and net operating
income.
 3-3

Basics of Cost-Volume-Profit
Analysis
The contribution income statement is helpful to managers in
judging 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.
 3-4

Basics of Cost-Volume-Profit
Analysis
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

CM is used first to cover fixed expenses. Any remaining CM

contributes to net operating income.
 3-5

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
 3-6

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
 3-7

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 $ -
 3-8

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
 3-9

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 $6,000.
 3-10

CVP Relationships in
Equation Form
The contribution format income statement can be
expressed in the following equation:
Profit = (Sales – 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
 3-11

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 – Variable expenses) – Fixed expenses

401 units × $500 $80,000

401 units × $300

Profit
Profit===($200,500
$200 ($200,500 –––$120,300)
($200,500 Variable
$120,300)expenses)
––$80,000
$80,000–
Fixed
Fixed expenses
 3-12

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 – Variable expenses) – Fixed expenses

Quantity sold (Q) Quantity sold (Q)

× Selling price per unit (P) × Variable expenses per unit (V)
= Sales (Q × P) = Variable expenses (Q × V)

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

 3-13

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 – Variable expenses) – Fixed expenses

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

Profit = ($500 × 401 – $300 × 401) – $80,000
$200
 3-14

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 × Q – V × Q) – Fixed expenses
Profit = (P – V) × Q – Fixed expenses
Profit = Unit CM × Q – Fixed expenses
 3-15

CVP Relationships in
Equation Form
Profit = (P × Q – V × Q) – Fixed expenses
Profit = (P – V) × Q – Fixed expenses
Profit = Unit CM × Q – Fixed expenses
Profit = ($500 – $300) × 401 – $80,000
Profit = $200 × 401 – $80,000
Profit = $80,200 – $80,000
Profit = $200
 3-16

Learning Objective 3-2

Prepare and interpret a cost-

volume-profit (CVP) graph
and a profit graph.
 3-17

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 $ - $ 100,000 $ 200,000 $ 300,000
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
 3-18

Preparing the CVP Graph

$350,000

$300,000

$250,000

$200,000

$150,000

$100,000 In a CVP graph, unit volume is usually

$50,000
represented on the horizontal (X) axis and
dollars on the vertical (Y) axis.
$0
0 100 200 300 400 500 600

Units
 3-19

Preparing the CVP Graph

$350,000

$300,000 Draw a line parallel to the volume
axis to represent total fixed expenses.
$250,000

$200,000

Fixed expenses
$150,000

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
 3-20

Preparing the CVP Graph

$350,000 
Choose some sales volume, say 400 units, and plot the point representing
total$300,000
expenses (fixed and variable). Draw a line through the data point
back to where the fixed expenses line intersects the dollar axis.
$250,000

$200,000

Total expenses
Fixed expenses
$150,000

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
 3-21

Preparing the CVP Graph

$350,000 
Choose some sales volume, say 400 units, and plot the point representing
$300,000
total sales. Draw a line through the data point back to the point of origin.
$250,000

$200,000
Sales
Total expenses
$150,000 Fixed expenses

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
 3-22

Preparing the CVP Graph

$350,000 Break-even point
(400 units or $200,000 in sales) Profit Area
$300,000

$250,000

$200,000
Sales
Total expenses
$150,000 Fixed expenses

$100,000

$50,000

$0
0 100 200 300 400 500 600
Loss Area Units
 3-23

Preparing the CVP Graph

Profit = Unit CM × Q – Fixed Costs

$ 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
 3-24

Preparing the CVP Graph

$ 60,000 Break-even point, where

$ 40,000
profit is zero, is 400
units sold.
$ 20,000
Profit

$0

-$20,000

-$40,000

-$60,000

0 100 200 300 400 500 600

Number of bicycles sold
 3-25

Learning Objective 3-3

Use the contribution margin

ration (CM ratio) to compute
changes in contribution
margin and net operating
income resulting from
changes in sales volume.
 3-26

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%

 3-27

Contribution Margin Ratio

(CM Ratio)
The contribution margin ratio at
Racing Bicycle is:
CM per unit $200
CM Ratio = = = 40%
SP per unit $500

The CM ratio can also be calculated by dividing

the contribution margin per unit by the selling
price per unit.
 3-28

Contribution Margin Ratio

(CM Ratio)
If Racing Bicycle increases sales from 400 to 500 bikes, the
contribution margin will increase by $20,000 ($50,000 ×
40%).Here is the proof:
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

A $50,000 increase in sales revenue results in a $20,000 increase

in CM ($50,000 × 40% = $20,000).
 3-29

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
 3-30

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 Unit contribution margin
CM Ratio =
b. 0.758 Unit selling price
c. 0.242 ($1.49 - $0.36)
=
$1.49
d. 4.139
$1.13
= = 0.758
$1.49
 3-31

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 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
 3-32

Learning Objective 3-4

Show the effect on net

operating income of
changes in variable costs,
fixed costs, selling price, and
volume.
 3-33

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
 3-34

Changes in Fixed Costs and

Sales Volume
 3-35

Changes in Fixed Costs and

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

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.
 3-36

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)
 3-37

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?
 3-38

Change in Variable Costs and

Sales Volume
580 units × $310 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.
 3-39

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?
 3-40

Change in Fixed Cost, Sales Price,

and Volume
650 units × $480 = $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 80,000 95,000
Net operating income $ 20,000 $ 22,000

Sales increase by $62,000, fixed costs increase by $15,000,

and net operating income increases by $2,000.
 Change in Variable Cost, Fixed
3-41

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?
 3-42

Change in Variable Cost, Fixed

Cost,and Sales Volume
575 units × $315 = $181,125
500 units 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 $ 20,000 $ 32,375

Sales increase by $37,500, fixed expenses decrease by

$6,000, and net operating income increases by $12,375.
 3-43

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?
 3-44

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
 3-45

Learning Objective 3-5

Determine the level of sales

needed to achieve a desired
target profit.
 3-46

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.
 3-47

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.
 3-48

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
$100,000 = $200 × Q – $80,000
$200 × Q = $100,000 – $80,000
Q = ($100,000 + $80,000) ÷ $200
Q = 900
 3-49

The Formula Method

The formula uses the following equation.

Unit sales to attain Target profit + Fixed expenses

=
the target profit CM per unit
 3-50

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
 3-51

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 Formula
Method Method
 3-52

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 + $80,000) ÷ 40%
Sales = $450,000
 3-53

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
 3-54

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. 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
 3-55

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 fixedUnit sales per month is $1,300. Use the formula
expense Target profit + Fixed expenses
to attain how= many cups of coffee would have
method to determine Unit CM
to be sold totarget
attainprofit
target profits of $2,500 per month.
a. 3,363 cups $2,500 + $1,300
= $1.49 - $0.36
b. 2,212 cups
c. 1,150 cups $3,800
=
$1.13
d. 4,200 cups
= 3,363 cups
 3-56

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. 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
 3-57

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. The average fixed expense per month is
$1,300. UseSalesthe formula
$ method to determine the
Target profit + Fixed expenses
sales dollarstothat
attain
must =be generated CMto attain
ratio target
target profit
profits of $2,500 per month.
a. $2,550 $2,500 + $1,300
= ($1.49 – 0.36) ÷ $1.49
b. $5,013
c. $8,458 $3,800
=
d. $10,555 0.758
= $5,013
 3-58

Learning Objective 3-6

Determine the break-even

point.
 3-59

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
 3-60

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

Profits are zero at the break-even point.

 3-61

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
 3-62

Break-even in Unit Sales:

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

Unit sales to Fixed expenses

=
break even CM per unit

$80,000
Unit sales =
$200
Unit sales = 400
 3-63

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.”

 3-64

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
 3-65

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
 3-66

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
 3-67

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. 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
 3-68

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 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
 3-69

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. An average ofBreak-even
2,100 cups areFixed
soldexpenses
each
=
month. What is the break-even sales inCM per Unit
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
 3-70

Learning Objective 3-7

Compute the margin of

safety and explain its
significance.
 3-71

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 sales

Let’s look at Racing Bicycle Company and

determine the margin of safety.
 3-72

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
 3-73

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
 3-74

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.

Margin of $50,000
= = 100 bikes
Safety in units $500
 3-75

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
 3-76

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
Margin of safety = Total sales – Break-even sales
d. 2,100 cups
= 2,100 cups – 1,150 cups
= 950 cups
 3-77

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.
 3-78

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.
 3-79

Learning Objective 3-8

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.
 3-80

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
 3-81

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

Degree of
Operating $100,000
= $20,000 = 5
Leverage
 3-82

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 leverage × 5
Percent increase in profits 50%

Here’s the verification!

 3-83

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 operating 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.
 3-84

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
 3-85

Quick Check 
Coffee Klatch is an espresso stand in a downtown Actual sales
office building. The average selling price of a cup
2,100of
cups
coffee is $1.49 and the average
Sales variable expense
$ 3,129
Less: Variable
per cup is $0.36. The average expensesper
fixed expense 756
Contribution
month is $1,300. An average margin
of 2,100 cups are sold2,373
each month. What is theLess: Fixed expenses
operating leverage? 1,300
Net operating income $ 1,073
a. 2.21
b. 0.45
c. 0.34
d. 2.92 Operating Contribution margin
leverage = Net operating income
$2,373
= $1,073 = 2.21
 3-86

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.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%
 3-87

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.
If sales increase by 20%, by how much 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% Percent increase in profit 44.20%
d. 44.2%
 3-88

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%
 3-89

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.

 3-90

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.
 3-91

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.
 3-92

Learning Objective 3-9

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.
 3-93

The Concept of Sales Mix

The term sales mix refers to the relative

proportions in which a company’s products are
sold. Since different products have different
selling prices, variable costs, and contribution
margins, when a company sells more than one
product, break-even analysis becomes more
complex. Let’s look at an example.
 3-94

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 Total

Sales $ 250,000 100% $ 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
 3-95

Multi-Product Break-Even Analysis

Dollar sales to Fixed expenses
=
break even CM ratio

Dollar sales to $170,000

= = $352,697
break even 48.2%

Bicycle Carts Total

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

Sales mix $ 158,714 45% $ 193,983 55% $ 352,697 100.0%

 3-96

Key Assumptions of CVP Analysis

 Selling price is constant.
 Costs are linear and can be accurately divided
into variable (constant per unit) and fixed
(constant in total) elements.
 In multiproduct companies, the sales mix is
constant.
 In manufacturing companies, inventories do
not change (units produced = units sold).
 3-97

End of Chapter 3