Chapter 7

Cost-Volume-Profit
Analysis

McGraw-Hill/Irwin Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objective 1

7-2
The Break-Even Point
The break-even point is the point in the volume of activity
where the organization’s revenues and expenses are equal.

Sales
Sales $$250,000
250,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 100,000
100,000
Net
Net income
income $$ --

7-3
Equation Approach
Sales revenue – Variable expenses – Fixed expenses = Profit

Unit Sales Unit Sales

sales × volume variable × volume
price in units expense in units

($500 × X) – ($300 × X) – $80,000 = $0

($200X) – $80,000 = $0
X = 400 surf boards
7-4
Learning Objective 2

7-5
Contribution-Margin Approach
Consider the following information
developed by the accountant at Curl, Inc.:
For each additional surf board sold, Curl
generates $200 in contribution margin.

Total
Total Per
Per Unit
Unit Percent
Percent
Sales
Sales(500
(500surf
surfboards)
boards) $$250,000
250,000 $$ 500500 100%
100%
Less:
Less: variable
variableexpenses
expenses 150,000
150,000 300
300 60%
60%
Contribution
Contributionmargin
margin $$100,000
100,000 $$ 200200 40%
40%
Less:
Less: fixed
fixedexpenses
expenses 80,000
80,000
Net
Net income
income $$ 20,000
20,000

7-6
Contribution-Margin Approach
Fixed expenses Break-even point
=
(in units)
Unit contribution margin
Total
Total Per
PerUnit
Unit Percent
Percent
Sales
Sales(500
(500surf
surfboards)
boards) $$250,000
250,000 $$ 500
500 100%
100%
Less: variable expenses
Less: variable expenses 150,000
150,000 300
300 60%
60%
Contribution
Contributionmargin
margin $$100,000
100,000 $$ 200
200 40%
40%
Less:
Less:fixed
fixedexpenses
expenses 80,000
80,000
Net
Netincome
income $$ 20,000
20,000

$80,000
= 400 surf boards
$200
7-7
Contribution-Margin Approach

Here is the proof!

Total
Total Per
Per Unit
Unit Percent
Percent
Sales
Sales(400
(400surf
surfboards)
boards) $$200,000
200,000 $$ 500500 100%
100%
Less:
Less: variable
variableexpenses
expenses 120,000
120,000 300
300 60%
60%
Contribution
Contributionmargin
margin $$ 80,000
80,000 $$ 200200 40%
40%
Less:
Less: fixed
fixedexpenses
expenses 80,000
80,000
Net
Net income
income $$ --

400 × $500 = $200,000 400 × $300 = $120,000

7-8
Contribution Margin Ratio

Calculate the break-even point in sales dollars rather

than units by using the contribution margin ratio.

Contribution margin
= CM Ratio
Sales
Fixed expense Break-even point
=
CM Ratio (in sales dollars)
7-9
Contribution Margin Ratio

Total
Total Per
Per Unit
Unit Percent
Percent
Sales
Sales(400
(400surf
surfboards)
boards) $$200,000
200,000 $$ 500500 100%
100%
Less:
Less: variable
variableexpenses
expenses 120,000
120,000 300
300 60%
60%
Contribution
Contributionmargin
margin $$ 80,000
80,000 $$ 200200 40%
40%
Less:
Less: fixed
fixedexpenses
expenses 80,000
80,000
Net
Net income
income $$ --

$80,000
= $200,000 sales
40%
7-10
Learning Objective 3

7-11
Graphing Cost-Volume-Profit Relationships

Viewing CVP relationships in a graph gives managers

a perspective that can be obtained in no other way.
Consider the following information for Curl, Inc.:

7-12
Cost-Volume-Profit Graph
450,000

400,000

350,000

300,000

250,000
Dollars

200,000

150,000

100,000
Fixed expenses

50,000

100 200 300 400 500 600 700 800

Units

7-13
Cost-Volume-Profit Graph
450,000

400,000

350,000

300,000

250,000
Dollars

200,000
se s
p e n
le x
150,000 T o ta
100,000
Fixed expenses

50,000

100 200 300 400 500 600 700 800

Units

7-14
Cost-Volume-Profit Graph
450,000

400,000

350,000

300,000

250,000
Dollars

200,000
se s
p e n
le x
150,000 T o ta
100,000
Fixed expenses

50,000

100 200 300 400 500 600 700 800

Units

7-15
Cost-Volume-Profit Graph
450,000

400,000
le s
350,000 l s a
o ta
T
300,000

250,000
Dollars

200,000
se s
p e n
le x
150,000 T o ta
100,000
Fixed expenses

50,000

100 200 300 400 500 600 700 800

Units

7-16
Cost-Volume-Profit Graph
450,000

400,000
le s
l s a a
350,000
o ta a re
Break-even T fi t
300,000
point Pr o
250,000
Dollars

200,000
se s
p e n
le x
150,000 T o ta
Fixed expenses
r ea
100,000
s a
50,000
L os

100 200 300 400 500 600 700 800

Units

7-17
Profit-Volume Graph
Some
Some managers
managers like like the
the profit-volume
profit-volume
graph
graph because
because itit focuses
focuses onon profits
profits and
and volume.
volume.
100,000

80,000

60,000
Break-even
point r ea
it a
40,000

r of
20,000 P
Profit

0 `

(20,000) 100 200 300 400 500 600 700

r ea Units
(40,000) s a
os
(60,000)
L

7-18
Learning Objective 4

7-19
Target Net Profit

We can determine the number of surfboards that Curl

must sell to earn a profit of $100,000 using the
contribution margin approach.

Fixed expenses + Target profit Units sold to earn

=
Unit contribution margin the target profit

$80,000 + $100,000
= 900 surf boards
$200

7-20
Equation Approach

Sales revenue – Variable expenses – Fixed expenses = Profit

($500 × X) – ($300 × X) – $80,000 = $100,000

($200X) = $180,000

X = 900 surf boards

7-21
Applying CVP Analysis
Safety Margin
The difference between budgeted sales revenue and break-
even sales revenue.
The amount by which sales can drop before losses occur.

7-22
Safety Margin
Curl, Inc. has a break-even point of $200,000
in sales. If actual sales are $250,000, the safety margin is
$50,000, or 100 surf boards.

7-23
Changes in Fixed Costs


Curl
Curlisiscurrently
currentlyselling
selling500
500surfboards
surfboardsper
peryear.
year.

The owner believes that an increase of $10,000 in the annual
The owner believes that an increase of $10,000 in the annual
advertising
advertisingbudget,
budget,would
wouldincrease
increasesales
salesto
to540
540units.
units.

 Should the company increase the advertising budget?

Should the company increase the advertising budget?

7-24
 Changes in Fixed Costs

540
540 units
units ×× $500
$500 per
per unit
unit == $270,000
$270,000
$80,000
$80,000 ++ $10,000
$10,000 advertising
advertising == $90,000
$90,000
7-25
Changes in Fixed Costs
Sales
Sales will
will increase
increase by
by
$20,000,
$20,000, but
but net
net income
income
decreased
decreased byby $2,000
$2,000..

7-26
Changes in Unit
Contribution Margin

Because of increases in cost of raw materials, Curl’s

variable cost per unit has increased from $300 to
$310 per surfboard. With no change in selling price
per unit, what will be the new break-even point?

($500 × X) – ($310 × X) – $80,000 = $0

X = 422 units (rounded)

7-27
Changes in Unit
Contribution Margin

Suppose Curl, Inc. increases the price of each surfboard to

$550. With no change in variable cost per unit, what will
be the new break-even point?

($550 × X) – ($300 × X) – $80,000 = $0

X = 320 units
7-28
 Predicting Profit Given Expected Volume

Fixed expenses
Given: Unit contribution margin Find: {req’d sales volume}
Target net profit

Fixed expenses
Given: Unit contribution margin Find: {expected profit}
Expected sales volume

7-29
Predicting Profit Given
Expected Volume
In the coming year, Curl’s owner expects to sell 525
surfboards. The unit contribution margin is
expected to be $190, and fixed costs are expected to
increase to $90,000.

Total contribution - Fixed cost = Profit

($190 × 525) – $90,000 = X

X = $99,750 – $90,000
X = $9,750 profit 7-30
Learning Objective 5

7-31
CVP Analysis with Multiple Products
For a company with more than one product, sales mix
is the relative combination in which a company’s
products are sold.
Different products have different selling prices, cost
structures, and contribution margins.

Let’s assume Curl sells surfboards and sail boards and see how
we deal with break-even analysis.

7-32
CVP Analysis with Multiple Products
Curl provides us with the following: information:

7-33
CVP Analysis with Multiple Products
Weighted-average unit contribution margin

$200 × 62.5%

$550 × 37.5%
7-34
CVP Analysis with Multiple Products

Break-even point
Break-even Fixed expenses
=
point Weighted-average unit contribution margin

Break-even $170,000
=
point $331.25

Break-even
= 514 combined unit sales
point

7-35
CVP Analysis with Multiple Products

Break-even point
Break-even
= 514 combined unit sales
point

7-36
Learning Objective 6

7-37
Assumptions Underlying
CVP Analysis
1. Selling price is constant throughout the
entire relevant range.
2. Costs are linear over the relevant range.
3. In multi-product companies, the sales
mix is constant.
4. In manufacturing firms, inventories do
not change (units produced = units sold).

7-38
Learning Objective 7

7-39
CVP Relationships and the Income Statement

A. Traditional Format
ACCUTIME COMPANY
Income Statement
For the Year Ended December 31, 20x1

Sales $500,000
Less: 380,000
Gross margin $120,000
Less: Operating expenses:
Selling expenses $35,000
Administrative expenses 35,000 70,000
Net income $50,000

7-40
CVP Relationships and the Income Statement
B. Contribution Format
ACCUTIME COMPANY
Income Statement
For the Year Ended December 31, 20x1

Sales $500,000
Less: Variable expenses:
Variable manufacturing $280,000
Variable selling 15,000
Variable administrative 5,000 300,000
Contribution margin $200,000
Less: Fixed expenses:
Fixed manufacturing $100,000
Fixed selling 20,000
Fixed administrative 30,000 150,000
Net income $50,000
7-41
Learning Objective 8

7-42
Cost Structure and Operating Leverage

The
The cost
cost structure
structure of
of an
an organization
organization is
is the
the relative
relative
proportion
proportion of
of its
its fixed
fixed and
and variable
variable costs.
costs.

Operating
Operating leverage
leverage is:
is:

the
the extent
extent to
to which
which an
an organization
organization uses
uses fixed
fixed costs
costs in
in its
its cost
cost
structure.
structure.

greatest
greatest in
in companies
companies that
that have
have aa high
high proportion
proportion of
of fixed
fixed costs
costs
in
in relation
relation to
to variable
variable costs.
costs.

7-43
Measuring Operating Leverage
Operating leverage Contribution margin
=
factor Net income

$100,000
= 5
$20,000 7-44
Measuring Operating Leverage
A
A measure
measure of of how
how aa percentage
percentage change
change inin sales
sales will
will affect
affect
profits.
profits. If
If Curl
Curl increases
increases its
its sales
sales by
by 10%,
10%, what
what will
will be
be the
the
percentage
percentage increase
increase inin net
net income?
income?

Percent increase in sales 10%

Operating leverage factor × 5
Percent increase in profits 50%

7-45
Measuring Operating Leverage

A firm with proportionately high fixed costs has

relatively high operating leverage. On the other
hand, a firm with high operating leverage has a
relatively high break-even point.
7-46
Learning Objective 9

7-47
CVP Analysis, Activity-Based Costing, and
Advanced Manufacturing Systems
An activity-based costing system provides a much more
complete picture of cost-volume-profit relationships and,
thus, it provides better information to managers.

Break-even = Fixed costs

point Unit contribution margin

7-48
Learning Objective 10

7-49
A Move Toward JIT and
Flexible Manufacturing
Overhead costs like setup, inspection, and material
handling are fixed with respect to sales volume, but they
are not fixed with respect to other cost drivers.

This is the fundamental distinction between a traditional

CVP analysis and an activity-based costing CVP
analysis.

7-50
Learning Objective 11

7-51
Effect of Income Taxes
Income taxes affect a company’s
CVP relationships. To earn a
particular after-tax net income, a
greater before-tax income will be
required.

Target after-tax net income Before-tax

=
net income
1 - t

7-52
End of Chapter 7
We made
it!

7-53