Chapter 7 – Cost-Volume-Profit Analysis

7.1
Cost-Volume-Profit Analysis (CVP)
• Powerful tool that helps managers make important business decisions

• Relies on the interdependency of five components of information

1) Sales price per units
Total Sales
2) Volume sold
Total Variable Expenses
3) VE per unit

4) Fixed Expenses

5) Operating Income (profit or loss)

• If you know or can estimate four of these five components, you can compute the
remaining unknown amount

Assumptions Underlying CVP Analysis

Managers must be aware of these when using CVP:
1. Change in volume is only factor that affects costs

2. Managers can classify each cost as either variable or fixed.

• These costs are linear throughout relevant range

3. Revenues are linear throughout relevant range

4. Inventory levels will NOT change

5. The sales mix of products will NOT change

• Combination of products that make up total sales

Contribution Format Income Statement and

Contribution Margin Per Unit

Contribution Margin per Unit = Selling Price per unit – VE per unit
Or
= Total Contribution Margin / # of units
 Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable Ex penses 60,000 30
Contribution Margin $ 40,000 $ 20
Less: Fixe d Expenses 30,000
Operating Income $ 10,000

How many units did the company sell? Contribution margin per unit is
2,000 units the selling price of one unit
What would operating income be if the minus the variable cost per unit
company sold one more unit?
$20,020
more unit at $50 per unit?
Once a company’s contribution margin covers its fixed costs, each additional unit sold
increases profit by the amount of the unit contribution margin

Now assume sales are 2,500 units. What would operating income be?

Contribution Margin $20 per unit * 2500 units $50,000

Less Fixed Costs $30,000
Operating Income $20,000
Or
Original Operating Income + ( Additional units x CM per unit)
Original operating income $10,000+(500 units*$20 per unit)= $20,000

Contribution Margin Ratio (CMR)

• Percentage of each sales dollar that is available for covering fixed expenses and generating a
profit
• CMR is particularly useful when unit information is not available or a company has
multiple products.

Contribution Margin Ratio = Total CM / Total Sales

Or
= CM per unit / SP per unit
Using the information from our previous examples, contribution margin and variable
expenses can also be expressed as a percent of sales:

Total Unit %
Sales Revenue $ 100,000 $ 50 100%
Le ss: Variable Ex pe nse s 60,000 30 60%
Contribution Margin $ 40,000 $ 20 40%
Le ss: Fixed Ex pe nse s 30,000
Ope rating Income $ 10,000

If sales increase $1,000, how much will $40,000 or $20

operating income increase? $100,000 $50
$1000*40%= $400
 Notice that the Contribution Margin Ratio and the Variable Expense Ratio must = 100%.
Consequently, if you know the one of the ratios, you automatically know the other.

If sales are $125,000, what would operating income be?

Contribution Margin $125,000*40% $50,000
Less Fixed Costs $30,000
Operating Income $20,000

Mom and Pop's Ice Cream Shoppe sells ice cream cones for $5.00 per
customer. Variable costs are $2.25 per cone. Fixed costs are $3,000 per
month.
What is the company's contribution margin per ice cream cone?
$5.00-$2.25= $2.75
What is the company's contribution margin ratio?
$2.75/$5.00= 75%
Determine operating income if the company sells 3,000 cones in a month.
Sales-VC= CM
CM-FC= Operating Income
CM= $2.75*3000 units= $8,250
-$3,000 fixed costs, OI= $5,250

7.2
Breakeven Point
• Sales level at which operating income is zero .
o If sales are above breakeven , profit results
o If sales are below breakeven, loss results

• Fixed Expenses = Total Contribution Margin

• Total sales = Total Expenses

THREE METHODS:
 Income Statement Approach
Total Unit %
Sales Revenue $ 100,000 $ 50 100%
Less: Variable Expenses 60,000 30 60%
Contribution Margin $ 40,000 $ 20 40%
Less: Fixed Expenses 30,000
Operating Income $ 10,000

The contribution margin income statement can be expressed as an equation as follows:

 At Breakeven Point,
(Where X is units sold): Operating Income (Profit) = 0

( $50 x X ) - ( $30 x X ) - $30,000 = 0

$20 X - $30,000 = 0
$20 X = $30,000
X = $30,000 / $20
X = 1500 units to breakeven
Let’s check our answer:
Sales 1500 units*$50 selling price $75,000
Less Variable Expenses 1500 units*$30 variable cost per unit $45,000
Contribution Margin $30,000
Less Fixed Expenses $30,000
Operating Income 0

Anderson Dry Cleaners has determined the following about its costs: Total variable costs at the
current level of sales are $42,000, total fixed costs are $24,000, and the sales needed to breakeven
are $48,000.

Determine the company’s 1) current sales revenue and 2) current operating income.

Break Even Ratio Current

Sales $48,000 $84,000
Less Variable Expenses $24,000 50% $42,000
Contribution Margin $24,000 50% $42,000
Less Fixed Expenses $24,000 $24,000
Operating Income $0 $18,000

2 Shortcut Approaches Using:

 Unit Contribution Margin
o Answer is in units
(Where X is units sold):
Sales – Variable Expenses – Fixed Expenses = Operating Income

Contribution Margin – Fixed Expenses = Operating Income

(CM per unit x X) = Fixed Expenses + Operating Income
X = Fixed Expenses + Operating Income
CM per Unit
 When Operating Income = 0,
(Fixed Cost+Operating Income)/CM
X is the Breakeven Pointper unit = units
in units

Back to our example:

Breakeven Units (X)= ($30,000+0)/$20 per unit= 1500 units

Note: Using the Income Statement Approach, our final calculation was
Fixed Expenses / CM per Unit

Healthy Greetings Corporation produces and sells fruit baskets for special events. The
unit selling price is $60, unit variable costs are $45, and total fixed costs are $2,670
Determine the unit contribution margin.
$60-$45= $15
Determine the number of fruit baskets that must be sold to breakeven.
($2,670+0)/$15= 178 baskets to breakeven
 Contribution Margin Ratio
o Answer is in sales dollars ($) At Breakeven Point,
Operating Income (Profit) = 0
o Useful for multi-product companies

Sales in Dollars ($) = Fixed Expenses + Operating Income

Contribution Margin Ratio

Back to our example:

Breakeven in $ = ($30,000 fixed cost+ 0)/.40 contribution margin= $75,000
or $1500 units*$50 selling price per unit= $75,000

Anthony Office Supplies sells refills on printer ink cartridges for $16 per refill. Variable costs are $4
per refill. Fixed costs are $2,000 per month.

What is the contribution margin ratio for the printer ink cartridge refills?
$16-$4=$12
$12/$16= 0.75
What is the breakeven point in sales dollars?
($2000 fixed cost+0)/.75= $2,667
Target Profit
  The three formulas used above can also be used to determine the level of sales needed to
achieve any desired (target) profit
o Instead of “0” for “Operating Income”, use the target profit.
o Unit Contribution Margin formula will yield the answer in units.
o Contribution Margin Ratio will yield the answer in sales dollar.
Back to our example:

How many units must be sold to yield a profit of $40,000?

Sales in Units = FE + P 30,000+40,000

CM per unit $20
Determine total sales necessary to achieve operating income of $40,000.

Sales in $ = FE + P 30,000+40,000
CM Ratio 12/16

CVP Graph
 volume of units is placed on the horizontal x-axis
 dollars (sales and costs) are on the vertical y-axis

Step 1 – Draw the total revenue line

 Can be drawn using one level of sales and the origin

Step 2 – Draw the fixed cost line

Step 3 – Draw the total cost line

 Starts at the fixed cost intercept on the y-axis

Step 4 – Find and label the Breakeven point

 Point where total cost line intersects with total revenue line
 Total costs = Total revenue

Step 5 – Find and label profit and loss areas

 Profit area - any point on revenue line below BE point
 Loss area - any point on revenue line below BE point

CVP GRAPH
 $14,000
Breakeven
$12,000 Point
$7,500,
$10,000 150 units

Revenue/Cost
$8,000
Total Revenue
$6,000 Total Cost
Fixed Cost
$4,000
Loss Area
$2,000

$-
0 50 100 150 200 250
Volume (units)

Owner Lei Wong is considering franchising her Global Chopsticks restaurant. She believes people will
pay $5.75 for a large bowl of noodles. Variable costs per bowl are $2.30. Wong estimates monthly fixed
costs for franchisees to be $8,400.

1. Use the contribution margin ratio approach to find a franchisee’s monthly breakeven sales in
dollars:

Contribution Contribution margin per unit

=
margin ratio Sale price per unit

5.75-2.30= $3.45
= CM per unit
5.75 selling price
= CM margin ratio=
60%

Breakeven sales Fixed expenses + Operating income

in dollars Contribution margin ratio

= 8400 fixed cost+0/.6 = $14,000 breakeven point in

dollars

2. Assume franchisees want a minimum monthly operating income of $6,000, and Wong believes
most locations could generate $26,000 in monthly sales. Is franchising a good idea? Yes

Target sales Fixed expenses + Operating income

=
in dollars Contribution margin ratio

= 8400 fixed cost+6000 desired profit/.6= $24,000 of noodles

7.3
Sensitivity Analysis
 Managers need to be prepared for possible changes such as:
o Increasing costs
o Pricing pressure from competitors
o Change in demand

 “What if” Analysis that changes one or more of the variables in the profit equation
Tota l Unit
Sa le s Re ve nue $ 100,000 $ 50
Le ss: Va ria ble Ex pe nses 60,000 30
Contribution Ma rgin $ 40,000 $ 20
Le ss: Fix e d Ex pe nse s 30,000
Ope ra ting Income $ 10,000

Remember from earlier problems: (BE point = 1,500 units; Current sales = 2,000 units)
Currently selling: $100,000/50= 2,000 units
Breakeven in units= $30,000+0/$20= 1500 units
Breakeven in sales dollars= $30,000+0/ 40%= $75,000

Change in Selling Price

1) What if competitive pressure forces the company to lower its selling price by 10%? Will the
breakeven point increase, decrease, or remain the same?
New selling price= $45 Calculate new
New CM per unit= $45-30 = $15 per unit Contribution
Breakeven point will increase margin
New breakeven= $30,000+0/$15= 2000 units

Change in Variable Costs

2) Assume that $20 of variable expenses relates to the cost of merchandise. The supplier raises the
price by 10%, but the business does not want to pass this increase on to customers. Will the
breakeven point increase, decrease, or remain the same?
New contribution margin= $50 selling price-$32= $18 per unit
30,000+0/18= 1,666.666= 1,667 units= new breakeven point in units

Change in Fixed Costs

3) Assume the rent on the store facility increases by $12,000 per year. Will the breakeven point
increase, decrease, or remain the same?
new fixed cost= 30,000+12,000= $42,000 No change in
new breakeven: 42,000+0/20= 2100 units Contribution
Margin

Change in Multiple Variables

4) Assume the rent on the store facility increases by $12,000 per year, but the company does not
want to increase its selling price to cover the additional costs. Instead, they are considering
 changing to a vendor that sells a similar product that uses a less costly material. Assuming that
sales volume remains constant; by how much must the variable costs decrease to maintain the
same original net operating income of $10,000?
Selling price(x)- variable cost(x)- fixed cost= operating income
$50(2000)- variable cost(2000)-$42,000= $10,000
$100,000-$42,000-$10,000= VC(2000)
$48,000/2000 units= vc= $24 per unit
VC decrease by $6

Use the information from the previous Global Chopsticks exercise. Wong did franchise her
restaurant, but due to her success, Noodles-n-More has come on the scene as a competitor. To
maintain its market share, Global Chopsticks must lower its price to $5.25 per bowl, but wants to
increase each restaurant’s volume to 6,500 bowls per month by embarking on an advertising
campaign. Each franchisee will have to contribute $400 per month to cover the costs. Prior to
these changes, most franchises were averaging 6,000 bowls per month in sales.

1. Determine the average restaurant’s operating income before these changes:

Contribution margin per unit 5.75-2.30 $3.45
x average sales volume units  6000
Contribution margin $20,700
Less: Fixed expenses $8,400
Operating income $12,300

2. Assuming that the proposed changes were implemented, and the volume was increased as
expected. Are the franchisees still meeting their target profit of $6,000?

New Contribution margin per unit 5.25-2.30 $2.95

New sales volume (units)  6500
Contribution margin $19,175
Less: New fixed expenses $8,400+$400 $8,800
Operating Income $10,375

Elizabeth Miller sells homemade knit scarves for $14 each at craft shows. Her
contribution margin ratio is 62.5%. Currently, craft show entrance fees are $1,400 per
year; however, the craft shows are raising their fees by 25% next year.
How many additional scarves must Elizabeth sell just to pay for the increase in entrance fees?

Increase in sales revenue Inc in Fixed expenses

=
Contribution margin ratio

Additional scarves to cover increase

in craft show fees = Increase in sales revenue / Cost per scarf

7.4
Breakeven in Multi-Product Firms
In all previous examples we have assumed the company sells only one product. However, companies
may sell multiple products.

Breakeven in Units
 Must use weighted-average contribution margin per unit
rather than the per unit contribution margin.
o Using sales mix or the combination of products that makes up total sales.

Assume that our company has decided to offer a “deluxe” model of its product. In adding this product,
the company’s total fixed expenses increased to $50,000. The company expects to sell 1 deluxe model
for every 4 regular models.
Per Unit Information: Regular Deluxe
Selling Price $50 $80
Variable Expenses $30 $40
Contribution Margin $20*4 $40*1

Weighted Average Contribution Margin per Unit= ($20*4)+($40*1)/5 total units = $24

Units to BE = FC + 0 / WT Ave. CM per unit= (50,000+0)/$24= 2084 units needed to break even

Regular model = 2084*(4/5) = 1667 units

Deluxe model = 2084*(1/5) = 417 units

Breakeven in Sales Dollars

Companies that offer hundreds or thousands of products will not want to find the breakeven point in
terms of units.

 Breakeven or target profit in sales dollars makes much more sense.

 Use weighted-average contribution margin ratio
 A contribution format income statement for the company as a whole will easily provide the
weighted-average contribution margin ratio

Regular Deluxe Total %

Sales 100,000 40, 000 $ 140,000
Variable Expenses 60,000 20,000 80,000
Contribution Margin 40,000 20,000 60,000 $60,000/$140,000=
42.86%
Fixed Expenses 50,000
 Operating Income $10,000

BE in Sales $ = ($50,000 fixed+0)/42.86% = $116,659 sales dollars to breakeven

Rally Scooters plans to sell; a motorized standard scooter for $50 and a motorized chrome scooter for $60. The
standard scooter costs $35 and the Chrome scooter costs $40. Rally expects to sell two chrome scooters for every
three standard ones. Monthly fixed expenses are $14,450.

How many of each type must they sell to break even?

Rally Scooters
Weighted-Average Contribution Margin per Unit
Standard Chrome Total
Sale price per unit
Deduct: Variable expense per unit
Contribution margin per unit
Sales mix in units
Contribution margin
Weighted-average contribution margin
per unit

Sales in total units:

FC + OI
=
Wt Ave CM per unit

Breakeven sales of standard scooters

Breakeven sales of chrome scooters

How many must they sell to earn a profit of $11,900?

Sales in total units:

Target sales of standard scooters

Target sales of chrome scooters

Ullie Medical Supply is a retailer of home medical equipment. Last year, sales revenue totaled
$6,800,000 and total expenses were $2,600,000. Of this amount, $1,088,000 were variable. Since Ullie
offers thousands of products, its managers prefer to calculate the breakeven point in terms of total
sales dollars.

1. What is Ullie’s current operating income?

$6,800,000 revenue-$2,600,000 expenses = $4,200,000 operating income
2. What is the contribution margin ratio?
=CM/Sales CM=Sales-VC. $6,800,000-$1,088,000 = $5,712,000 $5,712,000/$6,800,000= 84% CM
ratio
3. What is the breakeven point in sales dollars?
FC+0/CMR. $2,600,000 total cost-$1,088,000 variable cost = $1,512,000 fixed cost
$1,512,000 fixed cost/.84 = $1,800,000 breakeven in dollars

4. Ullie’s top management is deciding whether to embark on a $250,000 advertising campaign that is
estimated to increase sales volume by 14%. What effect would this have on the company’s operating
income?
CM of $5,712,000*.14 = $799,680 CM increase
$799,680 CM increase- $250,000 additional cost= $549,680 total increase in operating income

7.5
Margin of Safety
 Used to measure risk in a business; risk of current operations as well as the risk of
new plans
 Excess of expected or actual sales over breakeven sales
 Drop in sales that the company can absorb before incurring a loss; the “cushion”
 Higher the margin of safety Less the risk
The margin of safety can be expressed in units, dollars, or as a percent of sales:

Margin of safety = Expected or actual - Breakeven sales

in units sales in units in units

Margin of safety = Expected or actual - Breakeven sales

in dollars sales dollars dollars

Margin of safety = Margin of safety in units or dollars

as a percent of Expected or actual sales in units or dollars
sales

Using our previous example where current sales = 2,000 units, breakeven sales = 1,500 units or $75,000

Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable Expenses 60,000 30
Contribution Margin $ 40,000 $ 20
Less: Fixed Expenses 30,000
Operating Income $ 10,000
Margin of safety in units = 2000-1500= 500 units
Margin of safety in dollars = $100,000-$75,000= $25,000
Margin of safety as % of sales = 500 units/2000 units or $25,000/$100,000= 25%

Sarah has an online poster business. Suppose Sarah expects to sell 1,000 posters. Her average sales
price is $31 and her average cost per poster is $21. Her fixed expenses total $6,000. Compute her
margin of safety in units, dollars, and as a percentage

a. Margin of safety Expected sales Breakeven sales

= −
in units in units in units

b. Margin of safety Target level Breakeven

= -
in dollars sales dollars sales dollars

c. Margin of safety Margin of safety in dollars

=
as a percentage Expected sales in dollars
of expected sales

=
Operating Leverage
 Another tool to measure risk and predict profits (losses)
 Measures responsiveness of a company’s operating income is to changes in
volume

Operating Leverage Factor = Total Contribution Margin

Operating Income
 The greater the operating leverage factors, the greater the impact a change in sales volume has
on operating income; both profits and losses
 Lowest possible value for this factor is 1, if the company has no fixed costs

Using our example:

Tota l Unit
Sa les Re ve nue $ 100,000 $ 50
Le ss: Va riable Ex pense s 60,000 30
Contribution Margin $ 40,000 $ 20
Le ss: Fix e d Ex pe nse s 30,000
Ope ra ting Income $ 10,000
Operating Leverage Factor = $40,000/$10,000= 4
If sales volume increases 10%, operating income will increase
10%*4= 40%
Let’s check it out: Remember,
Sales revenue $100,000*1.10 $110,000 whatever % sales
Variable Expenses $60,000*1.10 $66,000 volume changes,
Contribution Margin $44,000 variable expenses
and contribution
Fixed Expenses $30,000 margin will
Operating Income $14,000 increase by the
> $4,000/10,000= 40% same %
Using the data from Sarah’s poster business, suppose Sarah sells 1,000 posters as expected. Compute
her operating leverage factor. If sales increase by 10%, what will her net income be? Prove your
answer.
Contribution margin
Less: Fixed expenses
Operating income

Operating Leverage Factor Contribution margin

=
Operating income
=

New Contribution margin

Less: Fixed expenses
New Operating income
Change in OI / Original OI =

High operating leverage companies:

 Higher levels of fixed costs and lower levels of variable costs
 Higher contribution margin ratios
 Changes in volume significantly affect operating income
o Higher risk
o Higher potential for reward
Examples include golf courses, hotels, airlines (HIGH FIXED COSTS)
Low operating leverage companies:
 Higher levels of variable costs and lower levels of fixed costs
 Lower contribution margin ratios
 changes in volume do NOT have as significant an effect on operating income, so they
face:
o Lower risk
o Lower potential for reward
Examples include merchandising companies (HIGH VARIABLE COSTS)

Foster’s Repair Shop has monthly targeted operating income of $10,500. Variable expenses
 are 50% of sales and monthly fixed expenses are $7,000.

Req. 1 Compute the margin of safety in sales dollars if the shop achieves its income goal.

Contribution margin ratio =

Breakeven sales in dollars

=

Target sales in dollars

=
=

Margin of safety =

Req. 2 Margin of safety as a percent of sales

Margin of safety as
=
a percentage of target sales

Req. 3 Operating leverage factor at target level of operating income?

Target sales
Contribution margin ratio
Contribution margin
Less: Fixed expenses
Operating income

Operating Leverage Factor

=

Req. 4 If sales volume declines by 9%, what percentage will operating income decline?

Sales volume 32400

Net operating income 14894