Cost-Volume-Profit Relationships: Mcgraw-Hill /irwin

Chapter 6
Cost-Volume-Profit Relationships
McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Basics of Cost-Volume-Profit Analysis
Racing
Racing Bicycle
Bicycle Company
Company
Contribution
Contribution Income
Income Statement
Statement
For
For the
the Month
Month of
of June
June
Sales
Sales(500
(500 bicycles)
bicycles) $$ 250,000
250,000
Less:
Less: Variable
Variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin 100,000
100,000
Less:
Less: Fixed
Fixed expenses
expenses 80,000
80,000
Net
Net operating
operating income
income $$ 20,000
20,000
Contribution Margin (CM) is the amount

remaining from sales revenue after variable
expenses have been deducted.
Basics of Cost-Volume-Profit Analysis
Racing
Racing Bicycle
Bicycle Company
Company
Contribution
Contribution Income
Income Statement
Statement
For
For the
the Month
Month of
of June
June
Sales
Sales(500
(500 bicycles)
250,000
Less:
Less: Variable
Variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin 100,000
100,000
Less:
Less: Fixed
Fixed expenses
expenses 80,000
80,000
Net
Net operating
operating income
income $$ 20,000
20,000
CM is used first to cover fixed

expenses. Any remaining CM
contributes to net operating income.
Learning Objective 1
Explain how changes in activity

affect contribution margin and
net operating income.
The Contribution Approach
Sales, variable expenses, and contribution margin can also

be expressed on a per unit basis. If RBC sells an additional
bicycle, $200 more in contribution margin will be generated
to cover fixed expenses and profit.
Racing
Racing Bicycle
Bicycle Company
Company
Contribution
Contribution Income
Income Statement
Statement
For
For the
the Month
Month of
of June
June
Total
Total Per
Per Unit
Unit
Sales
Sales(500
(500 bicycles)
250,000 $$ 500
500
Less:
Less: Variable
Variable expenses
expenses 150,000
150,000 300
300
Contribution
Contribution margin
margin 100,000
100,000 $$ 200
200
Less:
Less: Fixed
Fixed expenses
expenses 80,000
80,000
Net
Net operating
operating income
income $$ 20,000
20,000
To breakeven, RBC must generate $80,000

in total CM each month to cover fixed costs.
Racing
Racing Bicycle
Bicycle Company
Company
Contribution
Contribution Income
Income Statement
Statement
For
For the
the Month
Month of
of June
June
Total
Total Per
Per Unit
Unit
Sales
Sales(500
(500 bicycles)
250,000 $$ 500
500
Less:
Less: Variable
Variable expenses
expenses 150,000
150,000 300
300
Contribution
Contribution margin
margin 100,000
100,000 $$ 200
200
Less:
Less: Fixed
Fixed expenses
expenses 80,000
80,000
Net
Net operating
operating income
income $$ 20,000
20,000
If RBC sells 400 units a month, it will

be operating at the break-even point.
Racing
Racing Bicycle
Bicycle Company
Company
Contribution
Contribution Income
Income Statement
Statement
For
For the
the Month
Month of
of June
June
Total
Total Per
Per Unit
Unit
Sales
Sales(400
(400 bicycles)
200,000 $$ 500
500
Less:
Less: Variable
Variable expenses
expenses 120,000
120,000 300
300
Contribution
Contribution margin
margin 80,000
80,000 $$ 200
200
Less:
Less: Fixed
Fixed expenses
expenses 80,000
80,000
Net
Net operating
operating income
income $$ --
If RBC sells one more bike (401 bikes),

bikes net
operating income will increase by $200.
Racing
Racing Bicycle
Bicycle Company
Company
Contribution
Contribution Income
Income Statement
Statement
For
For the
the Month
Month of
of June
June
Total
Total Per
Per Unit
Unit
Sales
Sales(401
(401 bicycles)
200,500 $$ 500
500
Less:
Less: Variable
Variable expenses
expenses 120,300
120,300 300
300
Contribution
Contribution margin
margin 80,200
80,200 $$ 200
200
Less:
Less: Fixed
Fixed expenses
expenses 80,000
80,000
Net
Net operating
operating income
income $$ 200
200
We
We dodo not
not need
need toto prepare
prepare anan income
income statement
statement to
to
estimate
estimate profits
profits at
at aa particular
particular sales
sales volume.
volume. Simply
Simply
multiply
multiply the
the number
number of of units
units sold
sold above
above break-even
break-even
by
by the
the contribution
contribution margin
margin per
per unit.
unit.
If RBC sells 430

bikes, its net
operating
income will be
$6,000.
Prepare and interpret

a cost-volume-profit
(CVP) graph.
CVP Relationships in Graphic Form
The relationship among revenue, cost, profit and volume

can be expressed graphically by preparing a CVP graph.
RBC developed contribution margin income statements
at 300, 400, and 500 units sold. We will use this
information to prepare the CVP graph.
Income
Income Income
Income Income
Income
300
300 units
units 400
400 units
units 500
500 units
units
Sales
Sales $$ 150,000
150,000 $$ 200,000
200,000 $$250,000
250,000
Less:
Less: variable
variable expenses
expenses 90,000
90,000 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin $$ 60,000
60,000 $$ 80,000
80,000 $$100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000 80,000
80,000
Net
Net operating
operating income
income $$ (20,000)
(20,000) $$ -- $$ 20,000
20,000
CVP Graph
In
In aa CVP
CVP graph,
graph, unit
unit volume
volume isis
Dollars
usually
usually represented
represented on
on the
the
horizontal
horizontal (X)(X) axis
axis and
and dollars
dollars on
on
the
the vertical
vertical (Y)
(Y) axis
axis..
Units
CVP Graph
Dollars
Fixed Expenses
Units
CVP Graph
Dollars
Total Expenses
Fixed Expenses
Units
CVP Graph
Total Sales
Dollars
Total Expenses
Fixed Expenses
Units
CVP Graph
Break-even point
(400 units or $200,000 in sales)
re a
fi t A
Pro
Dollars
r e a
s A
L o s
Units
Use the contribution margin ratio

(CM ratio) to compute changes in
contribution margin and net
operating income resulting from
changes in sales volume.
Contribution Margin Ratio
The contribution margin ratio is:

Total CM
CM Ratio =
Total sales
For Racing Bicycle Company the ratio is:
$80,000
= 40%
$200,000
Each
Each $1.00
$1.00 increase
increase in
in sales
sales results
results in
in aa
total
total contribution
contribution margin
margin increase
increase of
of 40¢.
40¢.
Or, in terms of units, the contribution margin ratio is:
Unit CM
CM Ratio =
Unit selling price
For Racing Bicycle Company the ratio is:
$200 = 40%
$500
400
400 Bikes
Bikes 500
500 Bikes
Bikes
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
A $50,000 increase in sales revenue

results in a $20,000 increase in CM.
($50,000 × 40% = $20,000)
Quick Check 
Coffee
Coffee Klatch
Klatch isis an
an espresso
espresso stand
stand inin aa
downtown
downtown office
office building.
building. The
The average
average selling
selling
price
price of
of aa cup
cup ofof coffee
coffee is
is $1.49
$1.49 and
and the
the
average
average variable
variable expense
expense per
per cup
cup isis $0.36.
$0.36.
The
The average
average fixed
fixed expense
expense per
per month
month is is
$1,300.
$1,300. On On average,
average, 2,100
2,100 cups
cups are
are sold
sold each
each
month.
month. What
What is is the
the CM
CM Ratio
Ratio for
for Coffee
Coffee
Klatch?
Klatch?
a.
a. 1.319
1.319
b.
b. 0.758
0.758
c.
c. 0.242
0.242
d.
d. 4.139
4.139
Quick Check 
Coffee
Coffee Klatch
Klatch isis an
an espresso
espresso stand
stand in in aa
downtown
downtown office
office building.
building. The
The average
average selling
selling
price
price of
of aa cup
cup ofof coffee
coffee is
is $1.49
$1.49 and
and the
the
average
average variable
variable expense
expense perper cup
cup isis $0.36.
$0.36.
The
The average
average fixed
fixed expense
expense per per month
month is is
$1,300.
$1,300. On On average,
average, 2,100
2,100 cups
cups are
are sold
sold each
each
month.
month. What
What is is the
the CM
CM Ratio
Ratio for
for Coffee
Coffee margin
Unit contribution
Klatch?
Klatch? CM Ratio =
Unit selling price
a.
a. 1.319
1.319 ($1.49-$0.36)
b. 0.758 =
b. 0.758 $1.49
c.
c. 0.242
0.242 $1.13
= = 0.758
d.
d. 4.139
4.139 $1.49
Show the effects on contribution

margin of changes in variable
costs, fixed costs, selling price,
and volume.
Changes in Fixed Costs
and Sales Volume
What is the profit impact if RBC can

increase unit sales from 500 to 540 by
increasing the monthly advertising
budget by $10,000?
and Sales Volume
$80,000
$80,000 ++ $10,000
$10,000 advertising
advertising == $90,000
$90,000
Racing
Racing Bicycle
Bicycle Company
Company
Contribution
Contribution Income
Income Statement
Statement
For
For the
the Month
Month of
of June
June
Current
Current Sales
Sales Projected
Projected Sales
Sales
(500
(500 bikes)
bikes) (540
(540 bikes)
bikes)
Sales
Sales revenue
revenue $$ 250,000
250,000 $$ 270,000
270,000
Less:
Less: Variable
Variable expenses
expenses 150,000
150,000 162,000
162,000
Contribution
Contribution margin
margin 100,000
100,000 108,000
108,000
Less:
Less: Fixed
Fixed expenses
expenses 80,000
80,000 90,000
90,000
Net
Net operating
operating income
income $$ 20,000
20,000 $$ 18,000
18,000
Sales
Sales increased
increased by
by $20,000,
$20,000, but
but net
net
operating
operating income
income decreased
decreased byby $2,000
$2,000..
and Sales Volume
The Shortcut Solution

Increase
Increase inin contribution
contribution margin
margin
(40
(40 units
units ×× $200)
$200) $$ 8,000
8,000
Increase
Increase inin advertising
advertising 10,000
10,000
Decrease
Decrease in in net
net operating
operating income
income $$ (2,000)
(2,000)
Changes in Variable Costs
and Sales Volume
What is the profit impact if RBC 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?
Changes in Variable Costs
and Sales Volume
580
580 units
units ×× $310
$310 variable
variable cost/unit
cost/unit == $179,800
$179,800
Increase
contribution margin
margin
(580
(580 units
units ×× $190)
$190) –– (500
Racing (500 units
units ×× $200)
$200) $$ 10,200
10,200
Racing Bicycle
Bicycle Company
Company
Change
Change in in fixed
fixed expenses
expenses
Contribution
Contribution Income
Income Statement
Statement --
Increase
Increase inin net
net operating
For
For the
operating income
the Month of
of June
income
Month June $$ 10,200
10,200
Current
Current Sales
Sales Projected
Projected Sales
Sales
(500
(500 bikes)
bikes) (580
(580 bikes)
bikes)
Sales
Sales revenue
revenue $$ 250,000
250,000 $$ 290,000
290,000
Less:
Less: Variable
Variable expenses
expenses 150,000
150,000 179,800
179,800
Contribution
Contribution margin
margin 100,000
100,000 110,200
110,200
Less:
Less: Fixed
Fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net operating
operating income
income $$ 20,000
20,000 $$ 30,200
30,200
Sales
Sales increase
increase by
by $40,000,
$40,000, and and net net
McGraw-Hill /Irwin
operating
operating income
income increases
increases by
by $10,200
$10,200..
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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 unit
sales from 500 to 650 units per month?
Increase
Increase in
in contribution
contribution margin
margin
(650
(650 units
units ×× $180)
$180) –– (500
(500 units
units ×× $200)
$200) $$ 17,000
17,000
Increase
Increase in
in fixed
fixed costs
Racing
Racing Bicycle
costs Bicycle Company
Company 15,000
15,000
Contribution Income Statement
Increase
Increase in net Contribution
in net operating
operating Income
income
incomeStatement
For the Month of June
$$ 2,000
2,000
For the Month of June
Current
Current Sales
Sales Projected
Projected Sales
Sales
(500
(500 bikes)
bikes) (650
(650 bikes)
bikes)
Sales
Sales revenue
revenue $$ 250,000
250,000 $$ 312,000
312,000
Less:
Less: Variable
Variable expenses
expenses 150,000
150,000 195,000
195,000
Contribution
Contribution margin
margin 100,000
100,000 117,000
117,000
Less:
Less: Fixed
Fixed expenses
expenses 80,000
80,000 95,000
95,000
Net
Net operating
operating income
income $$ 20,000
20,000 $$ 22,000
22,000
Sales
Sales increase
increase by
by $62,000,
$62,000, fixed
fixed costs
costs increase
increase by
by
$15,000,
$15,000, and
and net
net operating
operating income
income increases
increases by
by $2,000
$2,000..
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?
Increase
contribution margin
margin
(575
(575 units
units ×× $185)
$185) –– (500
(500 units
units ×× $200)
$200) $$ 6,375
6,375
Reduced Racing
Racing Bicycle
Bicycle Company
Company
Reduced fixed
fixed costs
costs
Contribution
6,000
6,000
Contribution Income
Income Statement
Statement
Increase in net operating
Increase in net operating
For
For the
income
income
the Month
Month of
of June
June
$$ 12,375
12,375
Current
Current Sales
Sales Projected
Projected Sales
Sales
(500
(500 bikes)
bikes) (650
(650 bikes)
bikes)
Sales
Sales revenue
revenue $$ 250,000
250,000 $$ 287,500
287,500
Less:
Less: Variable
Variable expenses
expenses 150,000
150,000 181,125
181,125
Contribution
Contribution margin
margin 100,000
100,000 106,375
106,375
Less:
Less: Fixed
Fixed expenses
expenses 80,000
80,000 74,000
74,000
Net
Net operating
operating income
income $$ 20,000
20,000 $$ 32,375
32,375
Sales increase by $37,500, variable costs increase by

$31,125, but fixed expenses decrease by $6,000.
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?
Change in Regular Sales Price
$$ 3,000
3,000 ÷÷ 150
150 bikes
bikes == $$ 20
20 per
per bike
bike
Variable
Variable cost
cost per
per bike
bike == 300
300 per
per bike
bike
Selling
Selling price
price required
required == $$ 320
320 per
per bike
bike
150
150 bikes
bikes ×× $320
$320 per
per bike
bike == $$ 48,000
48,000
Total
Total variable
variable costs
costs == 45,000
45,000
Increase
Increase inin net
net operating
operating income
income == $$ 3,000
3,000
Compute the break-even point

in unit sales and dollar sales.
Break-Even Analysis
Break-even
Break-even analysis
analysis can
can be
be
approached
approached in
in two
two ways:
ways:
1.
1. Equation
Equation method
method
2.
2. Contribution
Contribution margin
margin method
method
Equation Method
Profits = (Sales – Variable expenses) – Fixed expenses

OR
Sales = Variable expenses + Fixed expenses + Profits
At the break-even point

profits equal zero
Break-Even Analysis
Here is the information from RBC:
Total
Total Per
Per Unit
Unit Percent
Percent
Sales
Sales(500
(500 bikes)
bikes) $$250,000
250,000 $$ 500
500 100%
100%
Less:
Less:variable
variable expenses
expenses 150,000
150,000 300
300 60%
60%
Contribution
Contribution margin
margin $$100,000
100,000 $$ 200
200 40%
40%
Less:
Less:fixed
fixed expenses
expenses 80,000
80,000
Net
Net operating
operating income
income $$ 20,000
20,000
Equation Method
 We calculate the break-even point as follows:
$500Q = $300Q + $80,000 + $0
Where:
Q = Number of bikes sold
$500 = Unit selling price
$300 = Unit variable expense
$80,000 = Total fixed expense
Equation Method
 We calculate the break-even point as follows:
$500Q = $300Q + $80,000 + $0

$200Q = $80,000
Q = $80,000 ÷ $200 per bike
Q = 400 bikes
Equation Method

The equation can be modified to calculate the
break-even point in sales dollars.
X = 0.60X + $80,000 + $0
Where:
X = Total sales dollars
0.60 = Variable expenses as a % of sales
$80,000 = Total fixed expenses
Equation Method

The equation can be modified to calculate the
break-even point in sales dollars.
X = 0.60X + $80,000 + $0
0.40X = $80,000
X = $80,000 ÷ 0.40
X = $200,000
Contribution Margin Method
The contribution margin method

has two key equations.
Break-even point Fixed expenses

=
in units sold CM per unit
Break-even point in Fixed expenses

total sales dollars = CM ratio
Contribution Margin Method
The contribution margin method can

be illustrated using data from RBC.
Break-even point Fixed expenses
=
in units sold CM per unit
$80,000
= 400 bikes to breakeven
$200 per bike
Break-even point in Fixed expenses

=
total sales dollars CM ratio
$80,000
= $200,000 break-even sales
40%
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. On average 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
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
Fixed expenses
expense per cupBreak-even = average
is $0.36. The fixed
Unit CM
expense per month is $1,300. On average 2,100
$1,300
=
cups are sold each month. What is- $0.36/cup
the break-even
$1.49/cup
sales in units?
$1,300
a. 872 cups =
$1.13/cup
b. 3,611 cups
= 1,150 cups
c. 1,200 cups
d. 1,150 cups
Quick Check 
Coffee
Coffee Klatch
Klatch is
is an
an espresso
espresso stand
stand in in aa downtown
downtown
office
office building.
building. The
The average
average selling
selling price
price ofof aa cup
cup
of
of coffee
coffee is
is $1.49
$1.49 and
and the
the average
average variable
variable
expense
expense per per cup
cup isis $0.36.
$0.36. The
The average
average fixedfixed
expense
month is is $1,300.
$1,300. On
On average
average 2,1002,100
cups
cups are
are sold
sold each
each month.
month. What
What isis the
the break-even
break-even
sales
sales inin dollars?
dollars?
a.
a. $1,300
$1,300
b.
b. $1,715
$1,715
c.
c. $1,788
$1,788
d.
d. $3,129
$3,129
Quick Check 
Coffee
Coffee Klatch
Klatch is
is an
an espresso
espresso stand
stand in in aa downtown
downtown
office
office building.
building. The
The average
average selling
selling price
price ofof aa cup
cup
of
of coffee
coffee is
is $1.49
$1.49 and
and the
the average
average variable
variable
expense
expense per per cup
cup isis $0.36.
$0.36. The
The average
average fixedfixed
expense
month is is $1,300.
$1,300. On
On average
average 2,1002,100
cups
cups are
are sold
sold each
each month.
month. What
What isis the
the break-even
break-even
sales
sales inin dollars?
dollars?
a.
a. $1,300
$1,300 Break-even Fixed expenses
=
sales CM Ratio
b.
b. $1,715
$1,715 $1,300
=
c.
c. $1,788
$1,788 0.758
d.
d. $3,129
$3,129 = $1,715
Determine the level of sales

needed to achieve a desired
target profit.
Target Profit Analysis
The equation and contribution margin

methods can be used to determine the sales
volume needed to achieve a target profit.
Suppose Racing Bicycle Company wants to

know how many bikes must be sold to earn a
profit of $100,000.
The CVP Equation Method
$500Q = $300Q + $80,000 + $100,000
$200Q = $180,000
Q = 900 bikes
The Contribution Margin Approach
The contribution margin method can be

used to determine that 900 bikes must be
sold to earn the target profit of $100,000.
Unit sales to attain Fixed expenses + Target profit
=
the target profit Unit contribution margin
$80,000 + $100,000
= 900 bikes
$200/bike
Quick Check 
Coffee
Coffee Klatch
Klatch isis an
an espresso
espresso stand
stand inin aa downtown
downtown
office
office building.
building. The
The average
average selling
selling price
price ofof aa cup
cup
of
of coffee
coffee is
is $1.49
$1.49 and
and the
the average
average variable
variable
expense
expense perper cup
cup isis $0.36.
$0.36. The
The average
average fixed
fixed
expense
expense perper month
month is is $1,300.
$1,300. How
How many
many cups
cups ofof
coffee
coffee would
would have
have toto be
be sold
sold to
to attain
attain target
target profits
profits
of
of $2,500
$2,500 per
per month?
month?
a.
a. 3,363
3,363 cups
cups
b.
b. 2,212
2,212 cups
cups
c.
c. 1,150
1,150 cups
cups
d.
d. 4,200
4,200 cups
cups
Quick Check 
Unit sales
Fixed expenses + Target profit
to attain =
Unit CM
Coffee
Coffee Klatch is
is an
target profit
Klatch an espresso
espresso stand
stand inin aa downtown
downtown
office
office building.
building. The
The average
$1,300selling
average + $2,500
selling price
price of
of aa cup
cup
=
of
of coffee
coffee is
is $1.49
$1.49 and
and the
the average
$1.49 - $0.36
average variable
variable
expense
expense per
per cup
cup is
is $0.36.
$0.36. The
The average
$3,800 average fixed
fixed
expense
expense per month =is
per month is $1,300.
$1.13 How
$1,300. How many
many cups
cups of
of
coffee
coffee would
would have
have toto be
be sold
sold to
to attain
attain target
target profits
profits
of $2,500 per month? = 3,363 cups
of $2,500 per month?
a.
a. 3,363
3,363 cups
cups
b.
b. 2,212
2,212 cups
cups
c.
c. 1,150
1,150 cups
cups
d.
d. 4,200
4,200 cups
cups
Compute the margin of safety

and explain its significance.
The Margin of Safety
The margin of safety is the excess of

budgeted (or actual) sales over the
break-even volume of sales.
Margin
Margin of
of safety
safety == Total
Total sales
sales -- Break-even
Break-even sales
sales
Let’s look at RBC and determine

the margin of safety.
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
The margin of safety can be

expressed as 20% of sales.
($50,000 ÷ $250,000)
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
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.
Margin of $50,000
= = 100 bikes
Safety in units $500
Quick Check 
Coffee
Coffee Klatch
Klatch is
is an
an espresso
espresso stand
stand in
in aa
downtown
downtown office
office building.
building. The
The average
average selling
selling
price
price of
of aa cup
cup ofof coffee
coffee is
is $1.49
$1.49 and
and the
the
average
average variable
variable expense
expense per
per cup
cup is
is $0.36.
$0.36.
The
The average
average fixed
fixed expense
expense per
per month
month is is
$1,300.
$1,300. OnOn average
average 2,100
2,100 cups
cups are
are sold
sold each
each
month.
month. What
What isis the
the margin
margin of
of safety?
safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
Quick Check 
Coffee
Coffee Klatch
Klatch isis an
an espresso
espresso stand
stand inin aa
downtown
Margin office
downtown of
office building.
safety = Total The
building. salesaverage
The selling
– Break-even
average sales
selling
price
price of
of aa cup
cup ofof coffee is
is $1.49
= 2,100
coffee cups –and
$1.49 1,150
and the
thecups
average
average variable
variable expense per
= 950 cups
expense per cup
cup is
is $0.36.
$0.36.
The
The average
average fixed
fixed expense
expense
or per
per month
month is is
$1,300.
$1,300. On
On average
Margin of safety2,100
average 2,100 cups
cups
950 cupsare
are sold
sold each
each
month.
month. What
What is
is the
percentage = 2,100
the margin
margin of cups = 45%
of safety?
safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
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.
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
will be higher in good years
compared to companies A disadvantage of a high fixed
with lower proportion of cost structure is that income
fixed costs. will be lower in bad years
compared to companies
with lower proportion of
fixed costs.
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.
Operating Leverage
A measure of how sensitive net operating

income is to percentage changes in sales.
Degree of Contribution margin

=
operating leverage Net operating income
Operating Leverage
Actual
Actual sales
sales
500
500 Bikes
Bikes
Sales
Sales $$ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000
Net
Net operating
operating income
income $$ 20,000
20,000
$100,000 = 5
$20,000
At RBC, the degree of operating leverage is 5.
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 net operating income 50%
Here’s the verification!
Operating Leverage
A 10% increase in sales from

$250,000 to $275,000 . . .
. . . results in a 50% increase in net operating

income from $20,000 to $30,000.
Quick Check 
Coffee
Coffee Klatch
Klatch is
is an
an espresso
espresso stand
stand in
in aa
downtown
downtown office
office building.
building. The
The average
average selling
selling
price
price of
of aa cup
cup ofof coffee
coffee is
is $1.49
$1.49 and
and the
the
average
average variable
variable expense
expense perper cup
cup is
is $0.36.
$0.36.
The
The average
average fixed
fixed expense
expense per
per month
month is is
$1,300.
$1,300. OnOn average
average 2,100
2,100 cups
cups are
are sold
sold each
each
month
month on.
on. What
What is is the
the operating
operating leverage?
leverage?
a.
a. 2.21
2.21
b.
b. 0.45
0.45
c.
c. 0.34
0.34
d.
d. 2.92
2.92
Quick Check 
Actual sales
2,100 cups
SalesCoffee
Coffee Klatch
Klatch is is an
$ espresso
an espresso
3,129 stand
stand in
in aa
Less:downtown office
office building.
Variable expenses
downtown 756 The
building. The average
average selling
selling
Contribution
price ofmargin
price of aa cup
cup of 2,373
of coffee
coffee is
is $1.49
$1.49 and
and the
the
Less: Fixed expenses 1,300
average
average variable
variable expense
expense per
per cup
cup is
is $0.36.
$0.36.
Net operating income $ 1,073
The
The average
average fixed
fixed expense
expense per
per month
month is
is
$1,300.
$1,300. On
On average
average 2,100
2,100 cups
cups are
are sold
sold each
each
month
month on.
on. What
What is
is the
the operating
operating leverage?
leverage?
a.
a. 2.21
2.21 Operating Contribution margin
b.
b. 0.45
0.45 leverage = Net operating income
c.
c. 0.34
0.34 $2,373
= $1,073 = 2.21
d.
d. 2.92
2.92
Quick Check 
At
At Coffee
Coffee Klatch
Klatch the
the average
average selling
selling price
price of
of aa cup
cup
of
of coffee
coffee is
is $1.49,
$1.49, the
the average
average variable
variable expense
expense
per
per cupcup is
is $0.36,
$0.36, and
and the
the average
average fixed
fixed expense
expense
per
per month
month is is $1,300.
$1,300. On
On average
average 2,100
2,100 cups
cups are
are
sold
sold each
each month.
month.
IfIf sales
sales increase
increase by by 20%,
20%, by
by how
how much
much should
should net
net
operating
operating income
income increase?
increase?
a.
a. 30.0%
30.0%
b.
b. 20.0%
20.0%
c.
c. 22.1%
22.1%
d.
d. 44.2%
44.2%
Quick Check 
At
At Coffee
Coffee Klatch
Klatch the
the average
average selling
selling price
price of
of aa cup
cup
of
of coffee
coffee is
is $1.49,
$1.49, the
the average
average variable
variable expense
expense
per
per cupcup is
is $0.36,
$0.36, and
and the
the average
average fixed
fixed expense
expense
per
per month
month is is $1,300.
$1,300. On
On average
average 2,100
2,100 cups
cups are
are
sold
sold each
each month.
month.
IfIf sales
sales increase
increase by by 20%,
20%, by
by how
how much
much should
should net
net
operating
operating income
income increase?
increase?
a.
a. 30.0%
30.0% Percent increase in sales 20.0%
b.
b. 20.0%
20.0% × Degree of operating leverage 2.21
c.
c. 22.1%
22.1% Percent increase in profit 44.2%
d.
d. 44.2%
44.2%
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%
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
Let’s look
look at
at an
an example.
example.
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.
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.
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.
The Concept of Sales Mix
 Sales
 Sales mix
mix is
is the
the relative
relative proportion
proportion in
in which
which
aa company’s
company’s products
products are
are sold.
sold.
 Different
 Different products
products have
have different
different selling
selling
prices,
prices, cost
cost structures,
structures, and
and contribution
contribution
margins.
margins.
Let’s
Let’s assume
assume RBC
RBC sells
sells bikes
bikes and
and carts
carts and
and
that
that the
the sales
sales mix
mix between
between the
the two
two products
products
remains
remains the
the same.
same.
Multi-product Break-even Analysis
RBC provides the following information:

Racing
Racing Bicycle
Bicycle Company
Company
Contribution
Contribution Income
Income Statement
Statement
Bicycles
Bicycles Carts
Carts Total
Total
Sales
Salesrevenue
revenue $$ 250,000
250,000 100%
100% $$ 300,000
300,000 100%
100% $$ 550,000
550,000 100.0%
100.0%
Variable
Variable expenses
expenses 150,000
150,000 60%
60% 135,000
135,000 45%
45% 285,000
285,000 51.8%
51.8%
Contribution
Contribution margin
margin $$ 100,000
100,000 40%
40% $$ 165,000
165,000 55%
55% 265,000
265,000 48.2%
48.2%
Fixed
Fixed expenses
expenses 170,000
170,000
Net
Net operating
operating income
income $$ 95,000
95,000
Sales
Salesmix
mix $$ 250,000
250,000 45%
45% $$ 300,000
300,000 55%
55% $$ 550,000
550,000 100%
100%
$265,000
= 48.2% (rounded)
$550,000
Multi-product Break-even Analysis
Break-even Fixed expenses
sales = CM Ratio
$170,000
=
48.2%
= $352,697
Racing
Racing Bicycle
Bicycle Company
Company
Contribution
Contribution Income
Income Statement
Statement
Bicycles
Bicycles Carts
Carts Total
Total
Sales
Salesrevenue
revenue $$ 158,714
158,714 100%
100% $$ 193,983
193,983 100%
100% $$ 352,697
352,697 100.0%
100.0%
Variable
Variable expenses
expenses 95,228
95,228 60%
60% 87,293
87,293 45%
45% 182,521
182,521 51.8%
51.8%
Contribution
Contribution margin
margin $$ 63,485
63,485 40%
40% $$ 106,691
106,691 55%
55% 170,176
170,176 48.2%
48.2%
Fixed
Fixed expenses
expenses 170,000
170,000
Net
Net operating
operating income
income Rounding Error $$ 176
176
Sales
Salesmix
mix $$ 158,714
158,714 45%
45% $$ 193,983
193,983 55%
55% $$ 352,697
352,697 100%
100%
Key Assumptions of CVP Analysis
Selling price is constant.

Costs are linear.
In multi-product companies, the sales
mix is constant.
In manufacturing companies,
inventories do not change (units
produced = units sold).
End of Chapter 6

Cost-Volume-Profit Relationships: Mcgraw-Hill /irwin

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Chapter 6

Contribution Margin (CM) is the amount

CM is used first to cover fixed

Explain how changes in activity

Sales, variable expenses, and contribution margin can also

To breakeven, RBC must generate $80,000

If RBC sells 400 units a month, it will

If RBC sells one more bike (401 bikes),

If RBC sells 430

Prepare and interpret

The relationship among revenue, cost, profit and volume

Use the contribution margin ratio

The contribution margin ratio is:

Or, in terms of units, the contribution margin ratio is:

For Racing Bicycle Company the ratio is:

A $50,000 increase in sales revenue

Show the effects on contribution

What is the profit impact if RBC can

The Shortcut Solution

What is the profit impact if RBC can

What is the profit impact if RBC:

What is the profit impact if RBC: (1) pays a

Sales increase by $37,500, variable costs increase by

If RBC has an opportunity to sell 150 bikes to

Compute the break-even point

Profits = (Sales – Variable expenses) – Fixed expenses

Sales = Variable expenses + Fixed expenses + Profits

At the break-even point

Here is the information from RBC:

 We calculate the break-even point as follows:

Sales = Variable expenses + Fixed expenses + Profits

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

 We calculate the break-even point as follows:

Sales = Variable expenses + Fixed expenses + Profits

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

Sales = Variable expenses + Fixed expenses + Profits

Sales = Variable expenses + Fixed expenses + Profits

The contribution margin method

Break-even point Fixed expenses

Break-even point in Fixed expenses

The contribution margin method can

Break-even point in Fixed expenses

Coffee Klatch is an espresso stand in a downtown

Coffee Klatch is an espresso stand in a downtown

Determine the level of sales

The equation and contribution margin

Suppose Racing Bicycle Company wants to

Sales = Variable expenses + Fixed expenses + Profits

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

The contribution margin method can be

Compute the margin of safety

The margin of safety is the excess of

Let’s look at RBC and determine

If we assume that RBC has actual sales of

The margin of safety can be

The margin of safety can be expressed in

Cost structure refers to the relative proportion

There are advantages and disadvantages to high

Compute the degree of operating

A measure of how sensitive net operating

Degree of Contribution margin

With an operating leverage of 5, if RBC

Percent increase in sales 10%