5-1

Cost-Volume-Profit Relationships
Chapter 6
Cost-Volume-Profit (CVP) Analysis
• Cost-volume-profit (CVP) analysis uses the
concept of variable and fixed costs to identify the
profit associated with various levels of activity.

5-2
Cost-Volume-Profit (CVP) Analysis

CVP analysis assists managers in

answering all the above questions.

5-3
Learning Objective 1

Explain how changes in

activity affect
contribution margin and
net operating income.

5-4
Basics of Cost-Volume-Profit Analysis
The contribution income 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.
Racing Bicycle Company (RBC)
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

• Contribution Margin (CM) is 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. 5-5
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 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

5-6
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

5-7
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 $0

5-8
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

5-9
The Contribution Approach
If RBC sells one more bike (402 bikes), net
operating income will increase by $400.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (402 bicycles) $ 201,000 $ 500
Less: Variable expenses 120,600 300
Contribution margin 80,400 $ 200
Less: Fixed expenses 80,000 $200×2
Net operating income $ 400

5-10
The Contribution Approach
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 RBC sells 430 bikes, its net

operating income will be
$6,000 (=$200×30 bikes).

5-11
CVP Relationships in Equation Form

The contribution format income statement can

be expressed in the following equation:

Profit = (Sales – Variable expenses) – Fixed expenses

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

5-12
CVP Relationships in Equation Form
This equation can be used to show the profit
RBC earns if it sells 401. Notice, the answer of
$200 mirrors our earlier solution.

Profit = (Sales – Variable expenses) – Fixed expenses

$80,000
401 units × $500
401 units × $300

Profit = ($200,500 – $120,300) – $80,000

= $200
5-13
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)

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

= ($500 × 401 – $300 × 401) – $80,000
= $200
5-14
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
=P–V
Profit = (Sales – Variable expenses) – Fixed expenses
= (P × Q – V × Q) – Fixed expenses
= (P – V) × Q – Fixed expenses
= Unit CM × Q – Fixed expenses

Profit = Unit CM × Q – Fixed expenses

5-15
Learning Objective 2

Prepare and interpret a

cost-volume-profit (CVP)
graph and a profit graph.

5-16
CVP Relationships in Graphic Form
The relationships among revenue, cost, profit, and volume
can be expressed graphically by preparing a CVP graph.
Racing Bicycle developed contribution margin income
statements at 0, 200, 400, and 600 units sold. We will use
this information to prepare the CVP graph.
Units Sold
0 200 400 600
Sales $ - $ 100,000 $ 200,000 $ 300,000
Total variable expenses - 60,000 120,000 180,000
Contribution margin - 40,000 80,000 120,000
Fixed expenses 80,000 80,000 80,000 80,000
Net operating income (loss) $ (80,000) $ (40,000) $ - $ 40,000

5-17
Preparing the CVP Graph
$350,000

Draw a line parallel to the volume axis
$300,000
to represent total fixed expenses.
$250,000

$200,000

Fixed expenses
$150,000

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
5-18
Preparing the CVP Graph

Choose $350,000
some sales volume, say 400 units, and plot the point representing
total expenses (fixed and variable). Draw a line through the data point
$300,000
back to where the fixed expenses line intersects the dollar axis.
$250,000

$200,000

Total expenses
Fixed expenses
$150,000

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
5-19
Preparing the CVP Graph

Choose $350,000
some sales volume, say 400 units, and plot the point representing
total sales. Draw a line through the data point back to the point of origin.
$300,000

$250,000

$200,000
Sales
Total expenses
$150,000 Fixed expenses

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
5-20
Preparing the CVP Graph
$350,000 Break-even point
(400 units or $200,000 in sales) Profit Area
$300,000

$250,000

$200,000
Sales
Total expenses
$150,000 Fixed expenses

$100,000

$50,000

$0
0 100 200 300 400 500 600
Loss Area Units
5-21
Learning Objective 3

Use the contribution

margin ratio (CM ratio)
to compute changes in
contribution margin and
net operating income
resulting from changes
in sales volume.

5-22
Contribution Margin Ratio (CM Ratio)
Total CM CM per unit
CM Ratio = = SP per unit
Total Sales
Racing Bicycle Company Variable Expense
Contribution Income Statement Ratio
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%

5-23
Contribution Margin Ratio (CM Ratio)
If RBC increases sales from 400 to 500 bikes ($50,000),
contribution margin will increase by $20,000 ($50,000 × 40%).
Here is the proof:
400 Units 500 Units
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).

5-24
Contribution Margin Ratio (CM Ratio)
The relationship between profit and the CM ratio
can be expressed using the following equation:
Profit = (CM ratio × Sales) – Fixed expenses

If Racing Bicycle increased its sales volume to 500

bikes (or $250,000), what would management expect
profit or net operating income to be?
Profit = (40% × $250,000) – $80,000
= $100,000 – $80,000
= $20,000 5-25
Quick Check 1
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. An average of 2,100 cups are sold each
month. What is the CM Ratio for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139

5-26
Learning Objective 4

Show the effects on net

operating income of
changes in variable
costs, fixed costs,
selling price, and
volume.

5-27
(1) Changes 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?

5-28
(1) Changes in Fixed Costs and
Sales Volume
$80,000 + $10,000 advertising = $90,000

500 units 540 units

Sales $ 250,000 $ 270,000
Less: Variable expenses 150,000 162,000
Contribution margin 100,000 108,000
Less: Fixed expenses 80,000 90,000
Net operating income $ 20,000 $ 18,000

Sales increased by $20,000, but net operating

income decreased by $2,000.
5-29
(1) Changes in Fixed Costs and
Sales Volume

A shortcut solution using incremental analysis

Increase in CM (40 units X $200) $ 8,000

Increase in advertising expenses (10,000)
Decrease in net operating income $ (2,000)

5-30
(2) 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?

5-31
(2) Change in Variable Costs and
Sales Volume
580 units × $310 variable cost/unit = $179,800

500 units 580 units

Sales $ 250,000 $ 290,000
Less: Variable expenses 150,000 179,800
Contribution margin 100,000 110,200
Less: Fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,200

Sales increase by $40,000 and net operating income

increases by $10,200.
5-32
(3) 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 sales from 500 to 650 units
per month?

5-33
(3) Change in Fixed Cost, Sales Price,
and Volume
650 units × $480 = $312,000

500 units 650 units

Sales $ 250,000 $ 312,000
Less: Variable expenses 150,000 195,000
Contribution margin 100,000 117,000
Less: Fixed expenses 80,000 95,000
Net operating income $ 20,000 $ 22,000

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

$15,000, and net operating income increases by $2,000.
5-34
(4) Change in Variable Cost, Fixed
Cost, and Sales Volume
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?

5-35
(4) Change in Variable Cost, Fixed
Cost, and Sales Volume
575 units × $315 = $181,125

500 units 575 units

Sales $ 250,000 $ 287,500
Less: Variable expenses 150,000 181,125
Contribution margin 100,000 106,375
Less: Fixed expenses 80,000 74,000
Net operating income $ 20,000 $ 32,375

Sales increase by $37,500, fixed expenses decrease by

$6,000, and net operating income increases by $12,375.
5-36
(5) 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?

5-37
(5) 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 operating income = $ 3,000

5-38
Learning Objective 5

Determine the break-

even point.

5-39
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. Let’s use the RBC
information to complete the break-even analysis.

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

5-40
Break-Even in Unit Sales:
Equation Method
Suppose RBC wants to know how many
bikes must be sold to break-even (earn a
target profit of $0).

Profits = Unit CM × Q – Fixed expenses

$0 = $200 × Q – $80,000

Profits are zero at the break-even point.

5-41
Break-Even in Unit Sales:
Equation Method
Profits = Unit CM × Q – Fixed expenses
$0 = $200 × Q – $80,000

$200 × Q = $80,000

Q = 400 bikes

5-42
Break-Even in Unit Sales:
Formula Method
Profits = Unit CM × Q – Fixed expenses
At Break-Even:
Unit CM × Q = Fixed expenses
Unit sales to Fixed expenses
=
break even (Q) Unit CM

$80,000
Unit sales =
$200
Unit sales = 400 units 5-43
Break-Even in Dollar Sales:
Equation Method
Suppose Racing Bicycle wants to compute the
sales dollars required to break-even (earn a
target profit of $0). Let’s use the equation
method to solve this problem.

Profit = CM ratio × Sales – Fixed expenses

Solve for the unknown “Sales.”

5-44
Break-Even in Dollar Sales:
Equation Method
Profit = CM ratio × Sales – Fixed expenses
$ 0 = 40% × Sales – $80,000

40% × Sales = $80,000

Sales = $80,000 ÷ 40%

Sales = $200,000

5-45
Break-Even in Dollar Sales:
Formula Method
Profit = CM ratio × Sales – Fixed expenses
At Break-Even:
CM ratio × Sales = Fixed expenses

Dollar sales to Fixed expenses

=
break even CM ratio

$80,000
Dollar sales =
40%
Dollar sales = $200,000 5-46
Quick Check 2
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. An average of 2,100 cups are sold each
month. What is the break-even sales dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129

5-47
Quick Check 3
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. An average of 2,100 cups are sold each
month. What is the break-even sales units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups

5-48
Learning Objective 6

Determine the level of

sales needed to achieve
a desired target profit.

5-49
Target Profit Analysis

We can compute the number of units

that must be sold to attain a target
profit using either:
(1) Equation method, or
(2) Formula method.

5-50
Target Profit Analysis: Equation Method

Profit = Unit CM × Q – Fixed expenses

Our goal is to solve for the unknown “Q” which

represents the quantity of units that must be sold
to attain the target profit.

5-51
Target Profit Analysis: Equation Method

Suppose RBC’s management wants to know how

many bikes must be sold to earn a target profit
of $100,000.

Profit = Unit CM × Q – Fixed expenses

$100,000 = $200 × Q – $80,000
$200 × Q = $100,000 + $80,000
Q = ($100,000 + $80,000) ÷ $200
Q = 900
5-52
Target Profit Analysis: Formula Method

The formula uses the following equation.

Unit sales to attain Target profit + Fixed expenses

=
the target profit CM per unit

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

5-53
Target Profit Analysis: Equation Method

Profit = CM ratio × Sales – Fixed expenses

Suppose RBC management wants to know the

sales volume that must be generated to earn a
target profit of $100,000.

$100,000 = 40% × Sales – $80,000

40% × Sales = $100,000 + $80,000

Sales = ($100,000 + $80,000) ÷ 40%

Sales = $450,000
5-54
Target Profit Analysis: 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
5-55
Quick Check 4
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.
Determine 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

5-56
Quick Check 5
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.
Determine the sales dollars that must be generated to
attain target profits of $2,500 per month.
a. $2,550
b. $5,013
c. $8,458
d. $10,555

5-57
Learning Objective 7

Compute the margin of

safety and explain its
significance.

5-58
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.

5-59
The Margin of Safety in dollars and
Percentage
• Assume that RBC has actual sales of $250,000, given
that the break-even sales is $200,000, the margin of
safety in dollars is $50,000 as shown.
• RBC’s 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
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
5-60
The Margin of Safety in Units
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;
hence, RBC’s margin of safety in units is 100 bikes.

Margin of $50,000
= = 100 bikes
Safety in Units $500

5-61
Quick Check 6
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. An average of 2,100 cups are sold each
month. What is the margin of safety expressed in
cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
5-62
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.

5-63
5-64
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 A disadvantage of a high fixed
will be higher in good years cost structure is that income
compared to companies will be lower in bad years
with lower proportion of compared to companies
fixed costs. with lower proportion of
fixed costs.
Companies with low fixed cost structures enjoy greater
stability in income across good and bad years.
5-65
Learning Objective 8

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.

5-66
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
High Operating Leverage ratio:
❖ signals the existence of high fixed
costs.
❖ increases risk of making loss in
adverse market conditions.
❖ increases opportunity to make profit
when higher demand exists.
5-67
Operating Leverage
To illustrate, let’s revisit the contribution
income statement for RBC.
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

Degree of
Operating $100,000
= $20,000 = 5
Leverage
5-68
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 profits 50%

Here’s the verification!

5-69
Operating Leverage
Actual sales Increased
(500) sales (550)
Sales $ 250,000 $ 275,000
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
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.
5-70
Quick Check 7
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. An average
of 2,100 cups are sold each month. What is the
operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
5-71
Quick Check 8
At Coffee Klatch the average selling price of a cup of
coffee is $1.49, the average variable expense per cup
is $0.36, the average fixed expense per month is
$1,300, and an average of 2,100 cups are sold each
month.
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%

5-72
Learning Objective 9

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.

5-73
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.
5-74
Multiproduct Break-Even Analysis
Bikes comprise 20% of RBC’s total sales revenue and the
carts comprise the remaining 80%. RBC provides the
following information:
Bicycle Carts Total
Sales $ 250,000 100% $ 1,000,000 100% $ 1,250,000 100.0%
Variable expenses 150,000 60% 475,000 47.5% 625,000 50.0%
Contribution margin 100,000 40.0% 525,000 52.5% 625,000 50.0%
Fixed expenses 170,000
Net operating income $ 455,000

Sales mix $ 250,000 20% $ 1,000,000 80% $ 1,250,000 100%

CM Ratio= $625,000 = 50%

$1,250,000
5-75
 Multiproduct Break-Even Analysis
Dollar sales to Fixed expenses
=
break even CM ratio

Dollar sales to $170,000

= = $340,000
break even 50%

Bicycle Carts Total

Sales $ 68,000 100% $ 272,000 100% $ 340,000 100.0%
Variable expenses 40,800 60% 129,200 47.5% 170,000 50.0%
Contribution margin 27,200 40% 142,800 52.5% 170,000 50.0%
Fixed expenses 170,000
Net operating income $ -

Sales mix $ 68,000 20% $ 272,000 80% $ 340,000 100.0%

5-76
End of Chapter 06

5-77