Chapter

Cost-Volume-Profit
Relationships

The Basics of Cost-Volume-Profit

(CVP) Analysis
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bikes)
$ 250,000
$ 500
Less: variable expenses
150,000
300
Contribution margin
100,000
$ 200
Less: fixedMargin
expenses
80,000
Contribution
(CM) is the
amount remaining
Net income
$ 20,000
from sales
revenue after variable
expenses have been

deducted.

Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc., 2002

The Basics of Cost-Volume-Profit

(CVP) Analysis
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
Total
Per
Sales (500 bikes)
$ 250,000
$
Less: variable expenses
150,000
Contribution margin
100,000
$
Less: fixed expenses
80,000
Net
income
$ 20,000
CM
goes to cover fixed
expenses.

Irwin/McGraw-Hill

Unit
500
300
200

The McGraw-Hill Companies, Inc., 2002

The Basics of Cost-Volume-Profit

(CVP) Analysis
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
Total
Per
Sales (500 bikes)
$ 250,000
$
Less: variable expenses
150,000
Contribution margin
100,000
$
Less: fixed expenses
80,000
Net income
$ 20,000

Unit
500
300
200

After covering fixed costs, any remaining CM

contributes to income.
Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc., 2002

The Contribution Approach

The break-even point can be defined either as:
The point where total sales revenue equals total
expenses (variable and fixed).
The point where total contribution margin equals
total fixed expenses.

Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc., 2002

Contribution Margin Ratio

The contribution margin ratio is:
Contribution margin
Sales

CM Ratio =

For Wind Bicycle Co. the ratio is:

$200 = 40%
$500

Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc., 2002

CVP Relationships in Graphic Form

Viewing CVP relationships in a graph gives managers a
perspective that can be obtained in no other way.
Consider the following information for Wind Co.:

Sales
Sales
Less:
Less: variable
variable expenses
expenses
Contribution
Contribution margin
margin
Less:
Less: fixed
fixed expenses
expenses
Net
Net income
income (loss)
(loss)

Irwin/McGraw-Hill

Income
Income
300
300 units
units
$$ 150,000
150,000
90,000
90,000
$$ 60,000
60,000
80,000
80,000
$$ (20,000)
(20,000)

Income
Income
400
400 units
units
$$ 200,000
200,000
120,000
120,000
$$ 80,000
80,000
80,000
80,000
$$
--

Income
Income
500
500 units
units
$$250,000
250,000
150,000
150,000
$$100,000
100,000
80,000
80,000
$$ 20,000
20,000

The McGraw-Hill Companies, Inc., 2002

CVP Graph
400,000
350,000
300,000

Total Expenses

Dollars

250,000
200,000

Fixed expenses

150,000
100,000
50,000

Irwin/McGraw-Hill

800

700

600

500

400

300

200

100

Units
8

The McGraw-Hill Companies, Inc., 2002

CVP Graph
400,000
350,000
300,000

Total Sales

Dollars

250,000
200,000
150,000
100,000
50,000

Irwin/McGraw-Hill

800

700

600

500

400

300

200

100

Units
9

The McGraw-Hill Companies, Inc., 2002

CVP Graph
400,000
350,000
300,000

ea
r
tA
i
f
ro

Dollars

250,000
200,000

Break-even point

150,000
100,000

Lo

50,000

ea
r
sA

Irwin/McGraw-Hill

800

700

600

500

400

300

200

100

Units
10

The McGraw-Hill Companies, Inc., 2002

The Margin of Safety

Excess of budgeted (or actual) sales over
the break-even volume of sales. The
amount by which sales can drop before
losses begin to be incurred.
Margin of safety = Total sales - Break-even sales

Lets calculate the margin of safety for Wind.

Irwin/McGraw-Hill

11

The McGraw-Hill Companies, Inc., 2002

Operating Leverage
A measure of how sensitive net income is to

percentage changes in sales.

With high leverage, a small percentage
increase in sales can produce a much larger
percentage increase in net income.
Degree of
operating leverage =

Irwin/McGraw-Hill

12

Contribution margin
Net income

The McGraw-Hill Companies, Inc., 2002

Operating Leverage
With a measure of operating leverage of 5,
if Wind increases its sales by 10%, net
income would increase by 50%.
Percent increase in sales
Degree of operating leverage
Percent increase in profits

10%
5
50%

Heres the proof!

Irwin/McGraw-Hill

13

The McGraw-Hill Companies, Inc., 2002

The Concept of Sales Mix

Sales mix is the relative proportions in

which a companys products are sold.

Different products have different selling
prices, cost structures, and contribution
margins.
Lets assume Wind sells bikes and carts and
see how we deal with break-even analysis.

Irwin/McGraw-Hill

14

The McGraw-Hill Companies, Inc., 2002

Assumptions of CVP Analysis

Selling price is constant throughout
the entire relevant range.
Costs are linear throughout the
entire relevant range.
In multi-product companies, the
sales mix is constant.
In manufacturing companies,
inventories do not change (units
produced = units sold).
Irwin/McGraw-Hill

15

The McGraw-Hill Companies, Inc., 2002