Chapter 4

CHAPTER 4: COST - VOLUME - PROFIT RELATIONSHIP

LO1: Understanding the basics of CVP concepts

The contribution income statement: this statement is helpful to

managers in judging the impact on profits of changes in selling price, cost,
or volume. The emphasis is on cost behavior.

Example: let's look at a

hypothetical contribution
income statement for
Racing Bicycle Company
(RBC). Notice the
emphasis on cost
behavior. Variable costs
are separate from fixed
costs.

Contribution Margin:

- The amount remaining from sales revenue after variable expenses have
been deducted.
- CM is used first to cover fixed expenses. Any remaining CM contributes to
net operating income.

1. 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, 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).
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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).

If Racing sells 400 units a

month, it will be operating at the
break-even point. Total sales
will be 400 units times $500
each or $200,000, and total
variable expenses will be 400
units times $300 each for
$120,000.
contribution margin is exactly
equal to total fixed expenses.

If RBC sells one more bike (401

bikes), net operating income
will increase by $200.
You can see that the sale of one
unit above the break-even
point yields a net operating
income of $200, which is the
contribution margin per unit
sold.

If we develop equations to calculate break-even and net income, we will not have
to prepare an income statement to determine what net income will be at any
level of sales. Simply multiply the number of units sold above break-even by
the contribution margin per unit.
For example, we know that if Racing Bicycle sells 430 units, net operating
income will be $6,000. The company will sell 30 units above the break-even unit
sales and the contribution margin is $200 per unit, or $6,000.

2. CVP Relationships in Equation Form

Profit = (Sales – Variable expenses) –

Fixed expenses

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

Part I:
We begin by gathering the information for the variables in the equation.
Part II:
Chapter 4

We have now entered all the known amounts into the equation and solve for the
unknown profit.
Part III:
As you can see, our net operating income or profit is once again determined to
be $200.
This equation can also be used to show the $200 profit RBC earns if it sells 401
bikes.
→ $200 = ($500 × 401 – $300 × 401) – $80,000
In terms of the unit contribution margin (Unit CM)

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

3. Contribution margin ratio (CM ratio)

The CM ratio is calculated by dividing the total contribution margin by total

sales.

The contribution margin ratio

is calculated by dividing the
total contribution margin by
total sales ($100,000 /
$250,000). In the case of
Racing Bicycle, the ratio is
40%. Thus, each $1.00
increase in sales results in a
total contribution margin
increase of 40%.

The CM ratio can also be calculated by dividing the contribution margin per unit
by the selling price per unit:

CM ratio = CM per unit / SP per unit

A $50,000 increase in sales

revenue results in a
$20,000 increase in CM.
($50,000 × 40% =
$20,000)
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The variable expense ratio is the ratio of variable expenses to sales. It can be
computed by dividing the total variable expenses by the total sales, or in single
product analysis, it can be computed by dividing the variable expenses per unit
by the unit selling price.

At Racing Bicycles the

variable expense ratio is
60%.

4. Changes in
elements

Change in Fixed Costs and Sales Volume

- What is the profit impact if Racing Bicycle can increase unit sales from 500
to 540 by increasing the monthly advertising budget by $10,000?
- Would you recommend that the advertising campaign be undertaken?

As you can see, even if sales

revenue increases to
$270,000, RBC will experience
a $12,000 increase in variable
costs and a $10,000 increase
in fixed costs (the new
advertising campaign). As a
result, net operating income
will drop by $2,000.
$80,000 + $10,000
advertising = $90,000

→ The advertising campaign certainly would not be a good idea.

- By doing this, we can help management see the problem before any
additional monies are spent.
- There is a shortcut solution using incremental analysis:

Increase in CM (40 units x $ $

200) 8,000
Increase advertising
expenses 10,000
Decrease in net operating $
income (2,000)
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Change in Variable Costs and Sales Volume

- What is the profit impact if Racing Bicycle 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?
- Would you recommend the use of higher-quality raw materials?

Revenues will increase by

$40,000 (80 bikes times $500 per
bike), and variable costs will
increase by $29,800. Contribution
margin will increase by $10,200.
With no change in fixed costs, net
operating income will also
increase by $10,200.
580 units × $310 variable
cost/unit = $179,800

→ The use of higher quality raw materials appears to be a profitable

idea.

Change in Fixed Cost, Sales Price and Volume

- What is the profit impact of RBC: (1) cuts its selling price by $20 per unit,
(2) increases its advertising budget by $15,000 per month, and (3)
increases sales from 500 to 650 units per month?

650 units × $480 = $312,000

Sales increase by $62,000,
fixed costs increase by $15,000,
and net operating income
increase by $2,000.

→ This appears to be a good plan because net operating income will

increase by $2,000.

Change in Variable Cost, Fixed Cost, and Sales Volume

- What is the profit impact of 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?

575 units × $315 = $181,125

Chapter 4

Sales increase by $37,500, fixed expenses decrease by $6,000. Net operating

income increases by $12,375.

*Notice that sales revenue and variable expenses increased as well.

Fixed expenses were decreased as a result of making sales
commissions variable in nature.

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?
- What selling price should RBC quote to the wholesaler?

If we desire a profit of $3,000

on the sale of 150 bikes, we
must have a profit of $20 per
bike. The variable expenses
associated with each bike are
$300, so we would quote a
selling price of $320.

You can see the proof of the

quote. If we quote a price of
$320 per unit and sell an
additional 150 units, sales
will go up by $48,000.
Variable costs for the 150
units are $45,000, so net
operating income increases by the difference, $3,000.

LO2: Determine the break-even point, the number of sales required for
a target profit, the margin of safety, and the degree of operating
leverage

1. Break-even Analysis

The equation and formula methods can be used to determine the unit sales and
dollar sales needed to achieve
a target profit of zero
Chapter 4

Example: Use the Racing Bicycle information to complete the break-even

analysis.

Break-even Point in Terms of Unit Sales

Unit sales = $ 80,000 / $ 200 =

400

Break-even Point in Terms of Dollar Sales

Dollar sales = $ 80,000 / 40%

= $ 200,000

2. Target Profit Analysis

Target Profit Analysis in Terms of Unit Sales

Unit sales = ($ 100,000 + $ 80,000) / $ 200 = 900

Target Profit Analysis in Terms of Dollar Sales

- W
e

can calculate the dollar sales needed to attain a target profit (net
operating profit) of $100,000 at Racing Bicycle.

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

3. Preparing the CVP graph

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The break-even point is where the total revenue and total expenses
lines intersect. In the case of Racing Bicycle, break-even is 400 bikes sold
or sales revenue of $200,000.
The profit or loss at any given sales level is measured by the vertical
distance between the total revenue and the total expenses lines.

4. The margin of safety

In terms of Dollars

- The margin of safety in dollars is the excess of budgeted (or actual) sales
over the break-even volume of sales.

RBC is currently selling

500 bikes and producing
total sales revenue of
$250,000. Sales at the
break-even point are
$200,000, so the
company’s margin of
safety is $50,000.

Margin of safety in dollars = Total sales -

Break-even sales

In terms of Percentage

- We can express the margin of safety as a percent of sales. The margin of

safety percentage is equal to the margin of safety in dollars divided by the
total budgeted (or actual) sales in dollars.
Chapter 4

The margin of safety

is 20% ($50,000 /
$250,000).

In terms of the number of units sold

- The margin of safety at Racing is $50,000, and each bike sells for $500, so
the margin of safety in units is 100 bikes.
→ Racing Bicycle is selling 100 more bikes than are needed to break
even.

Margin of Safety in units = $ 50,000 / $ 500 =

100 bikes

5. 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.

DOL = Degree Of Operating Leverage = Contribution Margin / Net

Operating Income **
** Profit Before Tax is a commonly used alternative to Net
Operating Income in the degree of operating leverage calculation

DOL = $ 100,000 / $ 20,000 =

5

With operating leverage of 5,

if RBC increases its sales by
10%, net operating income
would increase by 50%.
Chapter 4

Verification

- A 10% increase in sales would increase bike sales from the current level
of 500 to 550. Look at the contribution margin income statement and
notice that income increased from $20,000 to $30,000. That $10,000
increase in net income is a 50% increase.
→ So it is true that a 10% increase in sales results in a 50% in net
income. This is powerful information for a manager to have.

High Operating Leverage Ratio

- signals the existence of high fixed costs.

- increases the risk of making a loss in adverse market conditions.
- increases opportunity to make a profit when higher demand exists.
- has a lower margin of safety percentage (MoS%)

LO3: Understand the underlying assumptions

and limitations of the CVP analysis tool

1. 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.
- When a company sells more than one product, break-even analysis
becomes more complex as the following example illustrates. 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 (The BE% Method)

There are multiple methods to calculate the breakeven points for different
products within a multi-product company:
- Using the Breakeven percentage to sales (BE%) method is straightforward
and simple. We only need to recall the MoS% equation being 1/DOL =
Net Operating Income/Contribution Margin
- Then calculate BE% by 1- MoS%
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- Use the BE% to multiply the original sales dollars and sales units to get
the break-even sales dollars and sales units respectively.
- When extending the RBC example to sell two different products, Bicycle,
and Carts, using the BE% method, we can calculate the MoS% by using its
relations with 1/DOL where DOL = Net Operating Income /
Contribution Margin. The calculation gives rise to MoS% as 35.85%,
implying BE% as 64.15%.
- Multiplying 64.15% to the existing sales dollars of the two products
provides the respective break-even sales dollars of two products

The breakeven points

would be $352,825 in
total with $160,375
and $192,450 from
bicycles and carts
respectively.

→ The number of breakeven units can also be obtained by multiplying

the BE% with the current sales units of the respective products. The
Breakeven % reduces the complications and number of times in
handling different sets of data.

Multi-Product Break-even Analysis (The CM Ratio Method)

Bikes comprise 45% of RBC’s total sales revenue and the carts comprise the
remaining 55%. RBC provides the following information:
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The combined contribution margin ratio = $ 265,000 / $ 550,000 =

48.2% (rounded)

- Break-even in sales dollars is $352,697. We calculate this amount in the

normal way. We divide total fixed expenses of $170,000 by the combined
contribution margin ratio.
- We begin by allocating total break-even sales revenue to the two
products. 45% of the total is assigned to the bikes and 55% to the carts.
- The variable costs-by-product is determined by multiplying the variable
expense percent times the assigned revenue. The contribution margin is
the difference between the assigned revenue and the variable expenses.
Once again, we subtract fixed expenses from the combined total
contribution margin for the two products. Because we used a rounded
contribution margin percent, we have a rounding error of $176.
→ The more products a company has, the more complex the break-even
analysis becomes.
Chapter 4

2. Key Assumptions of CVP Analysis

- The 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).

EXERCISE
E7-60B(Braun):

Gamma Manufacturing manufactures 256GB SD cards (memory cards for mobile

phones, digital cameras, and other devices). Price and cost data for a relevant
range extending to 200,000 units per month are as follows:

1. What is the company's contribution margin per unit? contribution margin

percentage? Total contribution margin?
2. What would the company's monthly operating income be if the company
sold 130,000 units?
Chapter 4

3. What would the company's monthly operating income be if the company

had sales of $4,500,000?
4. What is the breakeven point in units? In sales dollars?
5. How many units would the company have to sell to earn a target monthly
profit of $259,700?
6. Management is currently in contract negotiations with the labor union. If
the negotiations fail, direct labor costs will increase by 10% and fixed
costs will increase by $23,500 per month. If these costs increase, how
many units will the company have to sell each month to break even?
7. Return to the original data for this question and the rest of the questions.
What is the company's current operating leverage factor (round to two
decimals)?
8. If sales volume increases by 7%, by what percentage will operate income
increase?
9. What is the company's current margin of safety in sales dollars? What is
its margin of safety as a percentage of sales?
10.Say the company adds a second size SD card (512GB in addition to
256GB). A 512GB SD card will sell for $50 and have the variable cost per
unit of $28 per unit. The expected sales mix is four of the 256GB SD cards
for every one of the 512GB SD cards. Given this sales mix, how many of
each type of SD card will the company need to sell to reach its target
monthly profit of $259,700? Is this volume higher or lower than previously
needed (in Question 5) to achieve the same target profit? Why?

Instruction

1.
Contribution margin per unit = Sale price per unit — Variable cost per unit
= $25.00 - $7.50 - $5.00 - $3.30 - $2.20
= $25.00 - $18.00
= $7
Contribution margin ratio = Contribution margin per unit / Sales price per unit x
100
= $7.00 / $25.00 x 100 = 28%
Total contribution margin = Sales revenue - Variable expenses
= 100,000 units x $25 per unit - 100,000 units x $18.00
per unit

= $2,500,000 - $1,800,000 = $700,000

2.
Company monthly operating income = CM per unit * number of units sold - fixed
expense
= 7*130,000 - 241,600 - 357,600
= 310,800

3.
Contribution margin = Sales * CM ratio = 4,500,000 * 28%
= 1,260,000
Chapter 4

Company monthly operating income = CM - fixed expense

= 1,260,000 - - 241,600 - 357,600
= 660,800

4.
Break-even point in unit = Fixed expense / CM per unit = 599,200/7 = 85,600
(units)
Break-even point in dollars = BE in unit * Sale price = 85,600 * 25 = 2,140,000

5.
Sell to earn the target profit = (fixed expense + operating income) / CM per unit
= (599,200 + 259,700)/7
= 122,700 (units)

6.
New BE in units = New fixed expense / New CM per unit
= (599,200 + 23,500) / (7 - 5*10%)
= 95,800 (units)

7.
Operating income = 700,000 - 599,200
= 100,800
Operating leverage factor = CM / Operating income
= 700,000/100,800
= 6.94

8.
Operating income increases in percentage = Increase in volume * Operating
leverage factor
= 7%*6.94
= 48.6%

9.
Margin of safety in sales dollars = Sales - Sales at BE
= 2,500,000 - 2,140,000
= 360,000
Margin of safety in percentage of sales = Margin of safety in sales dollars / Sales
* 100
= 360,000/2,500,000 * 100
= 14.4%

10.

Particular 256GB 512GB Total

Sales 25 50

Variable cost 18 28
Chapter 4

Contribution margin 7 22

Sales mix 4 1 5

Total CM 28 22 50

Weighted average CM per $10.00

unit

Needed to target sales = (Fixed expense + OI) / (Weighted average CM per unit)
= (599,200 + 259,700) / 10 = 85,890

Particular Total BE sales (in Sales BE sales (in

units) mix in units)
units

BE sales of 512GB 85,890 1 17,178

BE sales of 256GB 85,890 4 68,712

Total memory 85,890

cards

E4-5(GNBCY):

Data for Hermann Corporation are shown below:

Per Unit Percent of Sales

Selling price $90 100%

Variable expenses 63 70

Contribution margin $27 30%

Fixed expenses are $30,000 per month and the company is selling 2,000 units
per month.

The marketing manager argues that a $5,000 increase in the monthly

advertising budget would increase monthly sales by $9,000. Should the
advertising budget be increased?

Instruction:
Increase in contribution = 9000 * CM ratio = 9000 * 30% = 2700
Increase in fixed expense = 5000

The NOI decrease by = 2700 - 5000 = (2300)

Chapter 4

So we should now increase the advertising budget.

E4-10(GNBCY):

Lucido Products markets two computer games: Claimjumper and Makeover. A

contribution format income statement for a recent month for the two games
appears below:

Claimjumper Makeover Total

Sales 30,000 70,000 100,000

Variable 20,000 50,000 70,000

expenses

Contribution 10,000 20,000 30,000

margin

Fixed expenses 24,000

Net operating 6,000

income

1.
The overall CM ratio = total CM / total sales = 30,000 / 100,000 = 30%
2.

The overall break-even = Total fixed expenses / Overall CM ratio

= $24,000/30%= $80,000
3.

Claimjumper Makeover Total

Original dollar 30,000 70,000 100,000

sales

Percent of total 30% 70% %100

Sales at break- 24,000 56,000 80,000

even

Variable expenses:
Claimjumper variable expenses: ($24,000/$30,000) × $20,000 = $16,000
Makeover variable expenses: ($56,000/$70,000) × $50,000 = $40,000

E4-13(GNBCY):
Chapter 4

1.
Income statement

Contribution approach Amount

Sales (20,000*115%) 345,000

Variable expense (23,000*9) (207,000)

Contribution margin 138,000

Fixed expense (70,000)

NOI 58,000

2.

Income statement

Contribution approach Amount

Sales (20,000*125%) * (15-1.5) 337,500

Variable expense (25,000*9) (225,000)

Contribution margin 112,500

Fixed expense (70,000)

NOI 42,500

3.

Income statement

Contribution approach Amount

Sales (20,000*95%) * (15+1.5) 313,500

Variable expense (19,000*9) (171,000)

Contribution margin 142,500

Fixed expense (90,000)

NOI 52,500

4.
Chapter 4

Income statement

Contribution approach Amount

Sales (20,000*90%) * (15*112%) 302,400

Variable expense (18,000*9.6) (172,800)

Contribution margin 129,600

Fixed expense (70,000)

NOI 59,600