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CHAPTER 7
Cost-Volume-Profit Analysis
CHAPTER OVERVIEW
The chapter follows the contribution margin approach introduced in the last chapter, but
quickly moves into break-even computations. Total fixed costs divided by the
contribution margin, referred to as the contribution margin ratio, will yield the break even
point in units or in dollars. When a target profit is added to the fixed costs, the same
computation yields the units or the dollar sales necessary to earn the target profit.
The same CVP formulas that are used to perform CVP analysis for a company with a
single product can be used for a company will multiple products. But, these formulas will
use weighted-average contribution margin of all products. So, each unit’s contribution
margin is weighted by the relative number of units sold. Companies that offer many
products, though, don’t want to know the break-even point in terms of units. Rather, they
focus on the break-even (or target profit volumes) in terms of sales revenue. Therefore,
they need to know the weighted-average contribution margin ratio.
Finally, the chapter reviews common indicators of risk, including the margin of safety
and operating leverage.
LEARNING OBJECTIVES
After studying Chapter 7, your students should be able to:
1. Calculate the unit contribution margin and the contribution margin ratio.
2. Use CVP analysis to find break-even points and target profit volumes.
3. Perform sensitivity analysis in response to changing business conditions.
4. Find break-even and target profit volumes for multiproduct companies.
5. Determine a firm’s margin of safety and operating leverage.
Chapter 7
TEACHING OUTLINE
1. Using Cost-Volume-Profit (CVP) analysis
a. CVP assumptions
i. A change in volume is the only factor that affects costs.
ii. Managers can classify each cost (or the components of mixed
costs) as either variable or fixed. These costs are linear throughout
the relevant range of volume.
iii. Revenues are linear throughout the relevant range of volume.
iv. Inventory levels will not change.
v. The sales mix of products will not change.
b. Unit contribution margin
c. Contribution margin ratio
2. Using CVP analysis to find break-even points and target profit volumes.
a. BE is the point where revenues = expenses and net income is zero
b. The income statement approach
c. The shortcut approach using the unit CM
d. The shortcut approach using the CM ratio
e. Formulas
i. BE point in units = fixed costs / CM per unit
ii. BE point in sales revenue = fixed costs / CM ratio
iii. Target profit volume in units = (fixed costs + target profit) / CM
per unit
iv. Target profit volume in sales revenue = (fixed costs + target profit)
/ CM ratio
5. Multiproduct companies
a. Changing the mix of products offered for sale
b. Find BE in sales units
c. Find BE in sales revenue
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Chapter 7
b. ERP
7. Indicators of risk
a. Margin of safety = excess of actual or expected sales over break-even
sales
i. In units
ii. In sales dollars
iii. In percentage
b. Operating leverage = the relative amount of fixed and variable costs that
make up total costs
i. Characteristics of high operating leverage firms
ii. Characteristics of low operating leverage firms
iii. Operating leverage factor
KEY TOPICS
Make sure students understand cost behaviour from Chapter 6. If they understand cost
behaviour, it makes this chapter much easier to grasp. In particular, remind students about
fixed costs decreasing per unit as more is produced. A good example is the rent cost on
apartment. If one student lives in the apartment, it would cost $800 per month, a fixed
cost per unit/person of $800. If another student moves in, this fixed cost per student is
reduced to $400 per student.
Relevant range is important to explain regarding fixed cost. A good example to illustrate
this concept is the depreciation on a school building. Depreciation is a fixed cost within
the number of classrooms that are available. If enrollment increased dramatically, then
the school would need to purchase another building, thus increasing the fixed cost. The
relevant range would be the number of students that can be served with the number of
available rooms.
Have students work in teams or with a partner to calculate the contribution margin in
Requirement 1 of E7-40B Find break-even and target profit volume. Call on a student
for the answer. Sometimes the contribution margin is expressed as a ratio. Illustrate how
to calculate the contribution margin ratio. This can be used to compare different products
within a company, to compare one year’s information to another, or it can be used to
compare a company to another company.
Remind students to keep track of the labels (units, dollars, etc.) when using the break-
even formulas. Proper attention will ensure that break-even is accurately shown in dollars
or units. Illustrate how to calculate contribution margin. Have students complete
Requirement 1 E7-40B Find break-even and target profit volume.
Show students how to calculate the break-even point and target profit using the
contribution margin shortcut approaches. Emphasize that companies want to do more
than just break even; they want to determine how much must be sold to earn a desired
profit.
Have students complete Requirements 2 and 3 of E7-40B Find break-even and target
profit volume. Students tend to understand that the target income needs to be added to
the fixed costs. However, they often forget that this is no longer “break-even”, but the
sales necessary to achieve the target income.
Remind students that a company may break-even (or take a loss) on some products in
order to sell other products from which the company profit will be earned. When a
company has more than one product, they must consider a sales mix when performing
CVP analysis. Remind students that companies that sell multiple products use formulas
based on the weighted-average contribution margin of all products. So, each unit’s
contribution margin is weighted by the relative number of units sold. Ask students why
stores that sell multiple brands “push” one brand. (Answer: The contribution margin is
larger for that brand. This is sometimes referred to as the profit margin.)
The most powerful tool of CVP analysis is sensitivity analysis. It is the “what if”
technique to determine what the results will be if actual prices or costs change or if an
underlying assumption changes. Have students work in teams to complete E7-41B
Continuation of E7-40B: Changing costs (10 minutes).
Managers need to routinely compute sensitivity analysis and be prepared for additional
changes to occur after their first decision. For example, if a manager lowers the price, the
sales increase is expected to offset the larger amount of sales needed to break even (or
reach desired profit). However, managers also need to be ready to make additional
decisions if the competition reacts and also lowers the price of a comparable product.
Margin of safety can be used to determine the risk of a project. It is the excess of
expected sales over break-even sales. The higher the margin of safety, the less risk
involved in the business venture. It also tells managers how far sales can drop before they
are ‘in trouble’ of incurring a loss.
While CVP analysis relies on certain assumptions, the assumptions are not absolute or
guaranteed. Companies obviously want to sell more than break even. The amount above
break-even (or the target profit) is the margin of safety and hopefully the margin of safety
insures the company will at least break even or attains its target profit.
Operating leverage refers to the relative amount of fixed and variable costs that make up
the total costs of a company. The higher the fixed costs as compared to the variable costs,
the higher the leverage and the higher the company’s risk if sales decrease. High
operating leverage firms are characterized by higher levels of fixed costs and lower levels
of variable costs, and higher contribution margin ratios. So, these firms are more likely to
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Copyright © 2012 Pearson Canada Inc.
Chapter 7
have higher risk and higher potential for rewards. Examples might be hotels, and cruise
lines. Low operating leverage firms, such as merchandising companies, have the opposite
characteristics.
3. Use CVP to find break-even (BE) points and target profit volumes.
a. BE is the point where revenues = expenses and net income is zero
b. BE point in units = fixed costs / CM per unit
c. BE point in sales revenue = fixed costs / CM ratio
d. Target profit volume in units = (fixed costs + target profit) / CM per unit
e. Target profit volume in sales revenue = (fixed costs + target profit) / CM
ratio
4. Sensitivity analysis
a. Changing the sales price
b. Changing variable costs
c. Changing fixed costs
5. Multiproduct companies
a. Changing the mix of products offered for sale
b. Finding BE in sales units
c. Finding BE in sales revenue
7. Measures of Risk
a. Margin of safety
i. In units
ii. In sales dollars
iii. In percentage
b. Operating leverage
i. Operating leverage factor
ii. Characteristics of high operating leverage firms
iii. Characteristics of low operating leverage firms
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Copyright © 2012 Pearson Canada Inc.
Chapter 7
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Chapter 7
81
Copyright © 2012 Pearson Canada Inc.
Chapter 7
1. D 6. C
2. C 7. C
3. B 8. D
4. C 9. B
5. C 10. A
CHAPTER 7
TEN-MINUTE QUIZ
2. If the sales price is $12, the variable cost is $3, the fixed cost is $10,000, and
10,000 units are produced, the contribution margin per unit is:
A. $12. C. $9.
B. $11. D. $1.
3. If the sales price is $13, the variable cost is $4, the fixed cost is $9,000, and
10,000 units are produced, the break-even in units is:
A. 9,000. C. 818.
B. 1,000. D. 750.
4. If the sales price is $12, the variable cost is $3, and the fixed cost is $9,000, the
contribution margin ratio is:
A. 100%. C. 75%.
B. 92%. D. 83%.
5. If the sales price is $40, the variable cost is $26, and the fixed cost is $8,400, the
break-even in sales dollars is:
A. $ 8,400. C. $24,000.
B. $15,600. D. $35,000.
6. If the sales price is $15, the variable cost is $5, the fixed cost is $11,000, and
11,000 units are produced, how many units need to be sold if the desired profit is
$5,000?
A. 11,500
B. 8,500
C. 1,600
D. 500
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Chapter 7
10. In the cost-volume-profit graph (above), what is represented by the point marked
“D”?
A. Operating loss area
B. Operating income area
C. Break-even point
D. Fixed expenses
SAN DIEGO.
The enormous price of real estate in San Francisco, and the continual
rapid tide of emigration, will ere long cause the settlement of the new towns
seated at various points in the vicinity of the mining region. Many of these
are entirely new, but have grown and are growing with great rapidity. I
propose giving a description of their locations as a guide to those who may
desire to settle in any of them.
BENICIA.
The town or city of Benicia, which in the king’s English means Venice,
is situated in the straits of Carquinez, thirty-five miles from San Francisco,
which it promises yet to rival in point of commercial importance. The
ground upon which it is seated is a gentle slope descending to the water, and
as it reaches it becoming almost a plain. There is sufficient water at its bank
to enable vessels of the first class to lie at anchor there, and discharge their
cargoes, and the harbour is safe and exempt from violent winds. Benicia
contains already about a thousand inhabitants, including a garrison of
soldiers, having been made the head-quarters of the Pacific division of the
United States Army. The large deposits of quartermaster’s stores have been
removed from San Francisco to Benicia, and a site has been selected by
Commodore Jones for a navy-yard at this point. The town was originally
laid out some three years since by Robert Semple and Thomas O. Larkin.
Lots of fifty varas square are selling at from five hundred to two thousand
dollars.
MARTINEZ.
SUTTER.
VERNON.
Vernon is situated on the east bank of Feather River at the point of its
confluence with the Sacramento, one of the most eligible positions for a
town in the whole northern region of California. The banks of the river are
high and not subject to overflow, and this point is said to be at the head of
ship navigation on the Sacramento. The ground is a gentle slope,
surrounded by a beautiful country. From the town of Vernon, good and well
travelled roads diverge to the rich mineral regions of the North and Middle
Forks, Bear Creek, Yuba and Feather Rivers, rendering the distance much
less than by any other route. The town is growing rapidly, and promises to
become a great depot for the trade of the above-mentioned mines. The
proprietors are Franklin Bates, Elisha O. Crosby, and Samuel Norriss.
BOSTON.
The city of Boston is located on the northern bank of the American Fork,
at its junction with the Sacramento River, about one hundred yards above
the old Embarcadero, the site upon which Sacramento City now stands. It
extends upon the banks of both rivers for several miles, and is destined to
become a flourishing town. The banks of the Sacramento at this point are
not subject to overflow, being more than twelve feet in many places above
high water mark. The town is situated upon a broad and well-watered plain,
covered with many groves of magnificent oaks, and the largest class of
steamers, and all vessels navigating the Sacramento River can lie and
discharge directly at its banks.
Boston has been surveyed by J. Halls, Esq., and Lieut. Ringgold, U. S.
N., and is laid out in squares of two hundred and forty feet by three hundred
and twenty feet, subdivided each into eight building lots eighty feet by one
hundred and twenty feet, with large public squares, and reservations for
school-houses, churches, and public buildings. One of the peculiar
advantages of Boston is that, being located on the northern bank of the
American Fork, it is not necessary in proceeding to the gold mines to cross
that river, which is exceedingly high and rapid at some seasons of the year.
The direct and most travelled road proceeds from this point to the rich
placers of the Yuba, Feather River, Bear Creek, and the North, Middle, and
South Forks of the American. The soil is of the richest description, the
surrounding scenery highly picturesque, and the plains in the immediate
vicinity are covered with wild game of every variety which California
affords. The title to the land is indisputable, coming by warranty deed from
Captain J. A. Sutter to Eleab Grimes, Hiram Grimes, and John Sinclair,
bearing date August 10th, 1843. The present owner is Hiram Grimes, Esq.
Lots are selling rapidly at from $200 to $1000 each, and before many
months the city of Boston on the golden banks of the Rio Sacramento will
rival its New England namesake in business and importance.
STOCKTON.
The town of Stockton is the great mart through which flows the whole
transportation and travel to the placers of the Stanislaus, Mokelumne,
Mariposa, Mercedes, Tuolumne, and King’s River, and the various dry
diggings lying between them. Stockton is to the southern mines what
Sacramento is to the northern. The town is located upon a slough, or rather
a succession of sloughs, which contain the back waters formed by the
junction of the Sacramento and San Joaquin rivers. It is about fifty miles
from the mouth of the San Joaquin, and one hundred from San Francisco.
The ground is high and does not overflow, and is the centre of the two great
tracts of arable land which constitute the valleys of the rivers above named.
Vessels drawing from nine to ten feet of water can proceed up the San
Joaquin to Stockton, and discharge their cargoes on the bank.
The town of Stockton was laid out in the latter part of 1848 by Charles
M. Weber, and has been growing rapidly since. Eight months ago there
were but one frame building and a few tents, and now it is a town
containing a population of nearly two thousand permanent residents, and a
movable population of about a thousand more, on their way to and from the
southern mines. Several large brigs and schooners are constantly lying at
the banks, and two steamboats and a large number of launches are
constantly running from San Francisco. Real estate has risen greatly in
value within the past six months,—lots, which could have been purchased
at that time for $300, being now worth from $3000 to $6000. A theatre has
been established at Stockton, and the town promises ere long to be a large
and populous city.
STANISLAUS.
This town is laid out on the north bank of the Stanislaus River, at its
junction with the San Joaquin. The Stanislaus River is the first and largest
tributary of the San Joaquin, and the river is navigable for ordinary-sized
schooners and launches to this point, which, being nearer the southern
mining region than Stockton, will doubtless become a great resort for
miners and traders in that vicinity. The town was originally laid out by
Samuel Brannan & Co.
The city of South San Francisco is located on the bay, about two miles
south of San Francisco, which it promises to rival at no very distant day.
The depth of water at this point is the same as that in the harbour of San
Francisco, and it is said that vessels are more securely protected from the
wind. At many points in front of the town, vessels of the largest class can
lie within a boat’s length of the shore. The land rises in a gentle slope, and
is of a rich clayey soil, which effectually prevents dust during the
prevalence of the customary winds on the bay. The surrounding scenery is
delightful, and near the town is the rich and beautiful valley in which is
located the old mission of Dolores. A stream of fine water, sufficient to
supply all the shipping in the harbour, runs through the town, and the only
practicable road from San Francisco to San Josè, Monterey, and the whole
lower country, passes directly by it. South San Francisco, though it may
never equal its northern namesake, will at least become, at no very distant
day, what Brooklyn is to New York. The proprietors of South San Francisco
are John Townsend and Corneille De Boom.
ALVESO.
The want of a great commercial town at the head of the great bay of San
Francisco has been supplied by the location of Alveso. It is situated at the
head of the bay, on the Guadalupe River, a stream running directly through
the centre of the town, and navigable at all seasons of the year to vessels
drawing twelve feet of water. The depot and business headquarters of the
two finest valleys in California, the Santa Clara and the Pueblo, where
everything required for their already numerous population must be
received; convenient of access to the gold mines, and directly on the route
between them and San Francisco; with a climate unequalled, even in Upper
California; with pure water; free from inundations at all seasons; with mills
which even now furnish lumber at one-third its price in San Francisco,—the
town of Alveso must inevitably grow into importance. It has been carefully
surveyed and laid out into lots; contracts have been made for the immediate
erection of warehouses and dwellings, and a bridge is now being built
across the Guadalupe River, connecting the two portions of the town. The
proprietors are J. D. Koppe, Peter H. Burnett, and Charles B. Marvin, who
will doubtless reap a rich harvest, the fruits of their judicious enterprise.
CHAPTER XV.
LOWER CALIFORNIA.