The McGraw-Hill Companies, Inc.

2008 McGraw-Hill/Irwin
CHAPTER 5
Cost-Volume-
Profit
Relationships
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Operating Leverage
10% Revenue
Increase
10% Gross
Profit Increase
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Operating Leverage
10% Revenue
Increase
90% Gross
Profit Increase
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Lessons Learned
When all costs are variable, the potential
for profits is limited, because costs keep
growing with volume.
When all costs are fixed, after the fixed
costs are covered, every additional sales
dollar contributes the whole dollar to
gross profit. The profit potential is higher.
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Operating Leverage
A measure of the extent to which fixed costs are
being used in an organization to change profit.
Operating leverage is greater in companies that
have a high proportion of fixed costs in
relation to variable costs.
Fixed Costs
Small
percentage
change in
revenue
Large
percentage
change in
profits
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Contribution margin
Net income
Operating
Leverage
=
Show me
an example.
Measuring Operating Leverage
Using Contribution Margin
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$20,000
$5,000
Operating
Leverage
= = 4
Measuring Operating Leverage
Using Contribution Margin
A 10% increase in sales will result in
a 40% increase (10% 4) in net income.
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Operating Leverage
10% Sales
Increase
40% Profit Increase
Verify: ($7,000 - $5,000) / $5,000 = 40 %
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Level of
Fixed Cost
Operating
Leverage
Earnings
Volatility
& Risk
High High High
Low Low Low
Effect of Cost Structure
on Profit Stability
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If the number of units sold increases by 10% for all three
companies, which company will enjoy the highest net income?
Effect of Cost Structure on Profit Stability
Is it true that If the number of units sold decreases by 15% for
all three companies, All Variable Company will have higher net
income than All Fixed Company?
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Cost-Volume-Profit (CVP) Analysis
CVP analysis summarizes the
relationship between an
organizations volume of activity
and its costs, revenue and profit
within the relevant range.
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CVP Analysis
When running any business
The first concern is if it can sell enough to
cover all its costs (Breakeven analysis).
The second concern is whether it can
reach a desired profit (Target profit
analysis).
The third concern is how to assess and
select different strategies (CVP impact
analysis)
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Determining the Break-even Point
The break-even point is the point
where total revenue equals to total costs
(both variable and fixed), and therefore
the profit is zero.
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Cost-Volume-Profit Graph
D
o
l
l
a
r
s

Units Sold
Revenue
Total Cost
Fixed Cost
Break-even
Point
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The Equation Method
We can use the profit equation to find out the BE point in units.
At the break-even point:
Total Sales Total Costs = Zero
Total Sales - Total Variable costs - Total Fixed Costs = Zero
where:
Total Sales = Selling price per unit * BE Units
Total Variable Costs = Variable cost per unit * BE Units
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Reaching a Target Profit Level
If we want to consider the desired profit,
the profit equation would be:
Total Sales Total Costs = Desired Profit
Total Sales - Total Variable Costs - Total Fixed costs
= Desired profit
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Determining the Break-even Point
Using a Formula
Break-even
volume in units
=
Fixed costs
Contribution margin per unit
By re-arranging the Profit Equation at break-even,
we can derive a formula to quickly compute
Break-even Point in Units.
Break-even
volume in units
=
Fixed costs
(Unit Selling Price Unit Variable Cost)

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Reaching a Target Profit
Using the Formula
The formula can be expanded to include a
target profit analysis.
Sales volume
in units
=
Fixed costs + Desired profit
(Unit Selling Price Unit Variable Cost)
Sales volume
in units
=
Fixed costs + Desired profit
Contribution margin per unit

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CVP Analysis
What do you think units mean
in giant retailers, such as Wal Mart?
Can Wal Mart do a Break-even analysis?
Can it figure out the level of Sales to reach
its desired profit?
The answers to both are YES!
It uses Contribution Margin Ratio!
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Contribution Margin Ratio
Contribution Margin (CM) Ratio
= Total CM Total sales
= Unit CM Unit selling price
The contribution margin ratio (CM%) measures the
percentage of sales that is contribution margin.
For example, a 25% CM ratio means for every
$100 of sales, $25 (25% of $100) is CM, and $75
(75% of $100) is variable cost.
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Contribution Margin Ratio
Break-even in Sales Dollars
Fixed costs

CM ratio
=
By re-arranging the Profit Equation at break-even,
we can derive a formula to quickly compute
Break-even in Sales Dollars, using CM ratio.
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Contribution Margin Ratio
Sales Dollars to reach a desired profit
Fixed costs + Desired profit
CM ratio
=
The formula with CM ratio can be further
expanded to include a target profit analysis.
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Contribution Margin Ratio
Consider the following Income Statement:
What is the Break-even Sales?
What is the Total Sales if the target profit is $60,000?
What is the total Variable Cost at Break-even point?
Sales $100,000
- Variable Costs $40,000
Contribution Margin $60,000
- Fixed Costs $30,000
Net Income $30,000
CM%=$60,000/$100,000=60%
BE$ = TFC / CM%
= $30,000 / 60%
= $50,000
Sales for $60,000 profit
= ($30,000+$60,000)/60%
= $150,000
Total variable cost at BE
= BE sales * (1 CM%)
= $50,000 * 40%
= $20,000
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CVP Impact Analysis
1.To examine the profit impact of changes
in fixed costs, variable costs, selling price,
and the mix of products.
2.To find out the allowable selling price,
fixed costs, or variable costs, given a
target level of profit.
3.Examples:
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BE and Target Profit Analysis
Equation Method:
Total Sales - Total Variable costs - Total Fixed costs = Desired profit
Sales volume
in units
=
Fixed costs + Desired profit
Contribution margin per unit
CM per unit Formula Method:
CM % Formula Method:
Sales
Dollars
=
Fixed costs + Desired profit
Contribution margin %