06 Cost Volume Profit Relationships

11th Edition
Chapter 6
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Cost-Volume-Profit
Relationships
Chapter Six

Basics of Cost-Volume-Profit Analysis
Contribution Margin (CM) is the amount

remaining from sales revenue after variable
expenses have been deducted.
Basics of Cost-Volume-Profit Analysis
CM is used first to cover fixed

expenses. Any remaining CM
contributes to net operating income.
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.

Each month Racing must generate at least

$80,000 in total CM to break even.

If Racing sells 400 units in a month, it will be

operating at the break-even point.

If Racing sells one more bike (401 bikes), net

operating income will increase by $200.

We do not need to prepare an income statement

to estimate profits at a particular sales volume.
Simply multiply the number of units sold above
break-even by the contribution margin per unit.
If Racing sells
430 bikes, its
net income will
be $6,000.

CVP Relationships in Graphic Form
The relationship among revenue, cost, profit and

volume can be expressed graphically by preparing
a CVP graph. Racing 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

300 units 400 units 500 units
Sales $ 150,000 $ 200,000 $ 250,000
Less: variable expenses 90,000 120,000 150,000
Contribution margin $ 60,000 $ 80,000 $ 100,000
Less: fixed expenses 80,000 80,000 80,000
Net operating income $ (20,000) $ - $ 20,000

CVP Graph
450,000
400,000
350,000
300,000
250,000
200,000
In a CVP graph, unit volume is
150,000
usually represented on the
100,000
horizontal (X) axis and dollars on
50,000
the vertical (Y) axis.
-
- 100 200 300 400 500 600 700 800
Units

CVP Graph
450,000
400,000
350,000
300,000
250,000
200,000
150,000 Fixed Expenses

100,000
50,000
-
- 100 200 300 400 500 600 700 800
Units

CVP Graph
450,000
400,000
350,000
300,000
250,000
Total Expenses
200,000

100,000
50,000
-
- 100 200 300 400 500 600 700 800
Units

CVP Graph
450,000
400,000
350,000 Total Sales

300,000
250,000
Total Expenses
200,000

100,000
50,000
-
- 100 200 300 400 500 600 700 800
Units

CVP Graph
450,000
400,000
Break-even point
(400 units or $200,000 in sales)
350,000
300,000
250,000
200,000
150,000
100,000
50,000
-
- 100 200 300 400 500 600 700 800
Units

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 $1.00 increase in sales results in a
total contribution margin increase of 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 Bikes 500 Bikes

Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 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 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. 2,100 cups are sold
each month on average. What is the CM Ratio for
Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139

Quick Check 

each month on average. What is the CM Ratio for
Coffee Klatch? Unit contribution margin
CM Ratio =
a. 1.319 Unit selling price
b. 0.758 ($1.49-$0.36)
=
c. 0.242 $1.49
d. 4.139 $1.13
= = 0.758
$1.49
Changes in Fixed Costs and Sales Volume
What is the profit impact if Racing can

increase unit sales from 500 to 540
by increasing the monthly advertising
budget by $10,000?

$80,000 + $10,000 advertising = $90,000
Sales increased by $20,000, but net operating

income decreased by $2,000.
The Shortcut Solution

Increase in CM (40 units X $200) $ 8,000
Increase in advertising expenses 10,000
Decrease in net operating income $ (2,000)

Change in Variable Costs and Sales Volume
What is the profit impact if Racing 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?

Change in Variable Costs and Sales Volume
580 units × $310 variable cost/unit = $179,800
Sales increase by $40,000, and net operating income

McGraw-Hill/Irwin
increases by $10,200.
Copyright © 2006, The McGraw-Hill Companies, Inc.
Change in Fixed Cost, Sales Price and Volume
What is the profit impact if Racing (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?

Change in Fixed Cost, Sales Price and Volume
Sales increase by $62,000, fixed costs increase by

$15,000, and net operating income increases by $2,000.
Change in Variable Cost, Fixed Cost and Sales Volume
What is the profit impact if Racing (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?

Change in Variable Cost, Fixed Cost and Sales Volume
Sales increase by $37,500, variable costs increase by

$31,125, but fixed expenses decrease by $6,000.
Change in Regular Sales Price
If Racing 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 ÷ 150 bikes = $ 20 per bike

Variable cost per bike = 300 per bike
Selling price required = $ 320 per bike
150 bikes × $320 per bike = $ 48,000

Total variable costs = 45,000
Increase in net income = $ 3,000

Break-Even Analysis
Break-even analysis can be

approached in two ways:
1. Equation method
2. Contribution margin 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 Racing Bicycle Company:
Total Per Unit Percent

Sales (500 bikes) $ 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

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 Unit contribution margin
Break-even point in Fixed expenses

total sales dollars = CM ratio

Contribution Margin Method
Let’s use the contribution margin method

to calculate the break-even point in total
sales dollars at Racing.
Break-even point in Fixed expenses
total sales dollars = CM ratio
$80,000
= $200,000 break-even sales
40%

Quick Check 

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. 2,100 cups
are sold each month on average. 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 

of a cup of coffee is $1.49 and theFixed
average variable
expenses
Break-even =
Unit CM
$1,300
each month on average. = What is the break-even
$1.49/cup - $0.36/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 

each month on average. What is the break-even
sales in dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129

Quick Check 

each month on average. What is the break-even
sales in dollars?
a. $1,300 Break-even Fixed expenses
=
b. $1,715 sales CM Ratio
$1,300
c. $1,788 =
0.758
d. $3,129
= $1,715
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 

expense per month is $1,300. How many cups of
coffee would have to be sold to attain target profits
of $2,500 per month?
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups

Quick Check 
Unit sales Fixed expenses + Target profit
to attain =
Coffee Klatch is an espresso Unit CM
stand in a
target profit
downtown office building. The average
$1,300 + $2,500 selling price
=
of a cup of coffee is $1.49 and -the average variable
$1.49 $0.36
$3,800 How many cups of
expense per month is= $1,300.
$1.13
coffee would have to be sold to attain target profits
of $2,500 per month?= 3,363 cups
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups

The Margin of Safety
The margin of safety is the excess of

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

determine the margin of safety.

If we assume that Racing Bicycle Company 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
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000

The margin of safety can be expressed as

20% of sales.
($50,000 ÷ $250,000)
Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000

The margin of safety can be expressed in

terms of the number of units sold. The
margin of safety at Racing is $50,000, and
each bike sells for $500.
Margin of $50,000
= = 100 bikes
Safety in units $500

Quick Check 

each month on average. What is the margin of
safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups

Quick Check 

downtown
Marginoffice building.
of safety Thesales
= Total average selling price
– Break-even sales
of a cup of coffee is $1.49 and
= 2,100 the –average
cups variable
1,150 cups
expense per cup is $0.36.
= 950The
cupsaverage fixed
expense per month is $1,300.or 2,100 cups are sold
each month on of
Margin average.
safety What 950iscups
the margin of
safety? percentage = 2,100 cups = 45%
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.
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
At Racing, the degree of operating leverage is 5.

Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income $ 20,000
$100,000
= 5
$20,000
Operating Leverage
With an operating leverage of 5, if Racing

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 profits 50%
Here’s the verification!

Operating Leverage
Actual sales Increased

(500) sales (550)
Sales $ 250,000 $ 275,000
Less variable expenses 150,000 165,000
Less fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,000
10% increase in sales from

$250,000 to $275,000 . . .
. . . results in a 50% increase in
income from $20,000 to $30,000.
Quick Check 

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. 2,100 cups are sold each month
on average. What is the operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
Quick Check 
Actual sales
Coffee Klatch is an espresso stand in2,100 a cups
downtown office building.
Sales The average $ 3,129
selling price of a cupLess:
of coffee isexpenses
Variable $1.49 and 756
the average variableContribution
expense margin
per cup is 2,373
Less: Fixed expenses 1,300
$0.36. The average fixed expense per month
Net operating income $ 1,073
is $1,300. 2,100 cups are sold each month
on average. What is the operating leverage?
a. 2.21 Operating Contribution margin
b. 0.45 leverage = Net operating income
c. 0.34 $2,373
= $1,073 = 2.21
d. 2.92
Quick Check 
At Coffee Klatch the average selling price of a cup

of coffee is $1.49, the average variable expense per
cup is $0.36, and the average fixed expense per
month is $1,300. 2,100 cups are sold each month on
average.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%

Quick Check 
At Coffee Klatch the average selling price of a cup

of coffee is $1.49, the average variable expense per
cup is $0.36, and the average fixed expense per
month is $1,300. 2,100 cups are sold each month on
average.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
Percent increase in sales 20.0%
b. 20.0%
× Degree of operating leverage 2.21
c. 22.1% Percent increase in profit 44.20%
d. 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
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 look at an 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.

The Concept of Sales Mix
• Sales mix is the relative proportion in which a

company’s products are sold.
• Different products have different selling prices,
cost structures, and contribution margins.
Let’s assume Racing Bicycle Company sells

bikes and carts and that the sales mix between
the two products remains the same.

Multi-product break-even analysis
Racing Bicycle Co. provides the following information:
$265,000
= 48.2% (rounded)
McGraw-Hill/Irwin $550,000 Copyright © 2006, The McGraw-Hill Companies, Inc.
Multi-product break-even analysis
Break-even Fixed expenses
sales = CM Ratio
$170,000
=
48.2%
= $352,697

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

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11th Edition

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Contribution Margin (CM) is the amount

CM is used first to cover fixed

Sales, variable expenses, and contribution margin can

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Each month Racing must generate at least

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

If Racing sells 400 units in a month, it will be

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

If Racing sells one more bike (401 bikes), net

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

We do not need to prepare an income statement

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

The relationship among revenue, cost, profit and

Income Income Income

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

150,000 Fixed Expenses

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

150,000 Fixed Expenses

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

350,000 Total Sales

150,000 Fixed Expenses

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

The contribution margin ratio is:

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

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

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

400 Bikes 500 Bikes

A $50,000 increase in sales revenue

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Coffee Klatch is an espresso stand in a

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Coffee Klatch is an espresso stand in a

What is the profit impact if Racing can

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Sales increased by $20,000, but net operating

The Shortcut Solution

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

What is the profit impact if Racing can

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

580 units × $310 variable cost/unit = $179,800

Sales increase by $40,000, and net operating income

What is the profit impact if Racing (1) cuts

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Sales increase by $62,000, fixed costs increase by

What is the profit impact if Racing (1) pays

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

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

If Racing has an opportunity to sell 150

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

$ 3,000 ÷ 150 bikes = $ 20 per bike

150 bikes × $320 per bike = $ 48,000

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Break-even analysis can be

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.