Cost-Volume-Profit Relationships

Chapter 5

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 © 2015 by McGraw-Hill Education. All rights reserved.
 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

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.
 5-4

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
 5-5

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
 5-6

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 $ -
 5-7

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
 5-8

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¢.
 5-9

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
 5-10

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
 5-11

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.
 5-12

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
 5-13

The Formula Method

The formula uses the following equation.

Unit sales to attain Target profit + Fixed expenses

=
the target profit CM per unit
 5-14

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
 5-15

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
Break-even
sales
sales Actual
Actual sales
sales
400
400 units
units 500
500 units
units
Sales
Sales $$ 200,000
200,000 $$ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net operating
operating income
income $$ -- $$ 20,000
20,000
 5-16

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
 5-17

Basic CVP Equations

Contribution Margin =
Total Revenue - Total Variable Costs

Contribution Margin per unit =

Selling price/unit – Variable cost/unit

Operating Income =
Contribution margin - Fixed costs

Contribution Margin Ratio (or Percentage) =

Contribution Margin / Revenue
 5-18

Cost-Volume-Profit Equation and

Contribution Margin Methods
 5-19

Cost-Volume-Profit
 5-20

CVP and Income Taxes

After-tax profit (Net Income) can be calculated by:
Net Income = Operating Income * (1-Tax
Rate)

Net income can be converted to operating income

for use in the CVP equation
Operating Income = Net Income

(1-Tax Rate)
 5-21

Margin of Safety – An Indicator of Risk

• The margin of safety (MOS) measures the
distance between budgeted sales and
breakeven (BE) sales:
• MOS = Budgeted Sales - BE Sales
• The MOS ratio removes the firm’s size from the
output and expresses itself in the form of a
percentage:
• MOS Ratio = MOS / Budgeted Sales