Cost-Volume-Profit Relationships

Chapter 6

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Basics of Cost-Volume-Profit Analysis

Racing Bicycle Company

Contribution Income Statement
For the Month of June
Sales (500 bicycles) $ 250,000
Less: Variable expenses 150,000
Contribution margin 100,000
Less: Fixed expenses 80,000
Net operating income $ 20,000

CM is used first to cover fixed expenses. Any

remaining CM contributes to net operating income.

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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.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 $ 200
Less: Fixed expenses 80,000
Net operating income $ 20,000

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The Contribution Approach
Each month, RBC must generate at least
$80,000 in total contribution margin to break-even
(which is the level of sales at which profit is zero).
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 $ 200
Less: Fixed expenses 80,000
Net operating income $ 20,000

6-4
The Contribution Approach
If RBC sells 400 units in a month, it will be
operating at the break-even point.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (400 bicycles) $ 200,000 $ 500
Less: Variable expenses 120,000 300
Contribution margin 80,000 $ 200
Less: Fixed expenses 80,000
Net operating income $ -

6-5
The Contribution Approach
If RBC sells one more bike (401 bikes), net
operating income will increase by $200.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (401 bicycles) $ 200,500 $ 500
Less: Variable expenses 120,300 300
Contribution margin 80,200 $ 200
Less: Fixed expenses 80,000
Net operating income $ 200

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 CVP Relationships in Equation Form
When a company has only one product we can further
refine this equation as shown on this slide.

Profit = (Sales – Variable expenses) – Fixed expenses

Quantity sold (Q) Quantity sold (Q)

× Selling price per unit (P) × Variable expenses per unit (V)
= Sales (Q × P) = Variable expenses (Q × V)

Profit = (P × Q – V × Q) – Fixed expenses

6-7
CVP Relationships in Equation Form
It is often useful to express the simple profit equation in
terms of the unit contribution margin (Unit CM) as follows:

Unit CM = Selling price per unit – Variable expenses per unit

Unit CM = P – V
Profit = (P × Q – V × Q) – Fixed expenses
Profit = (P – V) × Q – Fixed expenses
Profit = Unit CM × Q – Fixed expenses

6-8
Preparing the CVP Graph
Break-even point
(400 units or $200,000 in sales) Profit
Profit Area
Area
Dollars

Loss
Loss Area
Area Units

6-9
Preparing the CVP Graph

Profit
Profit == Unit
Unit CM
CM ×× Q
Q –– Fixed
Fixed Costs
Costs
$ 60,000

$ 40,000

$ 20,000
Profit

$0

-$20,000
An even simpler form of
-$40,000 the CVP graph is called
-$60,000
the profit graph.
0 100 200 300 400 500 600
Number of bicycles sold

6-10
Preparing the CVP Graph

$ 60,000
Break-even
Break-even point,
point, where
where
$ 40,000 profit
profit is
is zero
zero ,, is
is 400
400
units
units sold.
sold.
$ 20,000
Profit

$0

-$20,000

-$40,000

-$60,000

0 100 200 300 400 500 600

Number of bicycles sold

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Contribution Margin Ratio (CM Ratio)
The CM ratio is calculated by dividing the total
contribution margin by total sales.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit CM Ratio
Sales (500 bicycles) $ 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

$100,000 ÷ $250,000 = 40%

6-12
The Formula Method

The formula uses the following equation.

Unit sales to attain Target profit + Fixed expenses

=
the target profit CM per unit

6-13
Target Profit Analysis in Terms of Unit Sales
Suppose Racing Bicycle Company wants to
know how many bikes must be sold to earn
a profit of $100,000.
Unit sales to attain Target profit + Fixed expenses
=
the target profit CM per unit

$100,000 + $80,000
Unit sales =
$200
Unit sales = 900

6-14
Formula Method

We can calculate the dollar sales needed to
attain a target profit (net operating profit) of
$100,000 at Racing Bicycle.
Dollar sales to attain Target profit + Fixed expenses
=
the target profit CM ratio

$100,000 + $80,000
Dollar sales =
40%
Dollar sales = $450,000

6-15
Break-even in Unit Sales:
Equation Method

Profits = Unit CM × Q – Fixed expenses

Suppose RBC wants to know how many
bikes must be sold to break-even
(earn a target profit of $0).

$0 = $200 × Q + $80,000

Profits are zero at the break-even point.

6-16
Break-even in Dollar Sales:
Formula Method

Now, let’s use the formula method to calculate the

dollar sales at the break-even point.

Dollar sales to Fixed expenses

=
break even CM ratio

$80,000
Dollar sales =
40%
Dollar sales = $200,000

6-17
 The Margin of Safety in Dollars

The margin of safety in dollars is the

excess of budgeted (or actual) sales over
the break-even volume of sales.
Margin of safety in dollars = Total sales - Break-even sales

Let’s look at Racing Bicycle Company and

determine the margin of safety.

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 Operating Leverage

Operating leverage is a measure of how sensitive net

operating income is to percentage changes in sales.
It is a measure, at any given level of sales, of how a
percentage change in sales volume will affect profits.

Degree of Contribution margin

operating leverage = Net operating income

6-19
Key Assumptions of CVP Analysis
 Selling price is constant.
 Costs are linear and can be accurately divided
into variable (constant per unit) and fixed
(constant in total) elements.
 In multiproduct companies, the sales mix is
constant.
 In manufacturing companies, inventories do not
change (units produced = units sold).

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End of Chapter 6

6-21