Chapter 6

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen

Cost-Volume-Profit Relationships

Chapter 4

Garrison, Noreen, Brewer, Cheng & Yuen © 2015 McGraw-Hill Education

Learning Objective 1

Explain how changes in

activity affect contribution
margin and net operating
income.

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 Chapter 6

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
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.

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© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen

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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© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen

Assume that unit price, VC and FC are unchanged

The Contribution Approach CM incremental=CM per unit x increase in unit volume
-> increase net income = increase in CM
Sales, variable expenses, and contribution margin can
also be expressed on a per unit basis. If Racing sells an Assume that the company will invest in 1000$ advertising cost, it leads in additional 200 bicycles to be sold.
additional bicycle, $200 additional CM will be generated How much will net income be increasing?
to cover fixed expenses and profit. Increase in cost = 200 $ x200 bicycyles=40000
Racing Bicycle Company Increse in Net Income= CM income - additional FC =40000-1000=39,000
Contribution Income Statement
For the Month of June cách 2
Total Per Unit
Profit= (P-VC per unit) x sales volume - FC
=(500-300) x (500+200) -(80,000+1000)=59,000
Sales (500 bicycles) $ 250,000 $ 500
Incrase in net income= 59,000-20,000=39,000
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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 Chapter 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

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 6

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 $ -

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 7

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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 Chapter 6

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 Racing sells
430 bikes, its net
operating income
will be $6,000.

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© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen

CM ratio = CM% = CM per unit/ Unit selling price x100%

= Total CM/ total sales Revenue x 100% =200/500 %= 40%
CVP Relationships in Equation Form
Assumed that unit selling price, VC per unit, FC are unchanged
The contribution format income statement can be Increase in CM= CM% x increase in sale dollars
expressed in the following equation: Increase in NI = Increase in CM

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

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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

401 units × $500 $80,000

401 units × $300

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

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 Chapter 6

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

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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

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© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen

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CVP Relationships in Equation Form

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

Profit = ($500 – $300) × 401 – $80,000

Profit = $200 × 401 – $80,000
This equation
Profit = $80,200 – $80,000 can also be
Profit = $200 used to
compute RBC’s
$200 profit if it
sells 401 bikes.

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 Chapter 6

Learning Objective 2

Prepare and interpret a

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

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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

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Preparing the CVP Graph

$350,000

$300,000

$250,000

$200,000

$150,000

$100,000
In a CVP graph, unit volume is usually
$50,000
represented on the horizontal (X) axis
and dollars on the vertical (Y) axis.
$0
0 100 200 300 400 500 600

Units
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 Chapter 6

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

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Preparing the CVP Graph

$350,000 
Choose some sales volume, say 400 units, and plot the point representing
total expenses
$300,000
(fixed and variable). Draw a line through the data point
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

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Preparing the CVP Graph

$350,000 
Choose 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

20
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 Chapter 6

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

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Preparing the CVP Graph

Profit = Unit CM × Q – Fixed Costs

$ 60,000

$ 40,000

$ 20,000
Profit

$0

-$20,000 An even simpler form of

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

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Preparing the CVP Graph

$ 60,000 Break-even point, where

profit is zero , is 400
$ 40,000
units 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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 Chapter 6

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.

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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%

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Contribution Margin Ratio (CM Ratio)

The contribution margin ratio at Racing Bicycle is:

CM per unit $200

CM Ratio = = = 40%
SP per unit $500

The CM ratio can also be calculated by

dividing the contribution margin per unit by
the selling price per unit.

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 Chapter 6

Contribution Margin Ratio (CM Ratio)

If Racing Bicycle increases sales by $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)

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Quick Check 
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. 2,100 cups are sold each month on average.
What is the CM Ratio for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139

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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, what would management expect profit or net
operating income to be?
Profit = 40% × $250,000 – $80,000
Profit = $100,000 – $80,000
Profit = $20,000

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 Chapter 6

Learning Objective 4

Show the effects on

contribution margin of
changes in variable costs,
fixed costs, selling price,
and volume.

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The Variable Expense Ratio

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 a single
product analysis, it can be computed by dividing the
variable expenses per unit by the unit selling price.
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

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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?

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 Chapter 6

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.

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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)

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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?

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 Chapter 6

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.

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Change in Fixed Cost, Sales Price

and Volume

What is the profit impact if 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?

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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.

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 Chapter 6

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?

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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. Net operating income increases by $12,375.

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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?

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 Chapter 6

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

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Learning Objective 5

Determine the break-even

point.

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Break-even Analysis
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

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 Chapter 6

Break-even Analysis
We can use any of the following
methods to do break-even analysis:
1. Equation method
2. Formula method
3. Percentage method

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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 zero profit).

$0 = $200 × Q + $80,000

Profits are zero at the break-even point.

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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

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 Chapter 6

Break-even in Unit Sales:

Formula Method

Let’s apply the formula method to solve for

the break-even point.

Unit sales to Fixed expenses

=
break even CM per unit

$80,000
Unit sales =
$200
Unit sales = 400

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Break-even in Dollar Sales:

Equation Method
Suppose Racing Bicycle wants to compute
the sales dollars required to break-even (zero
profit). Let’s use the equation method to solve
this problem.

Profit = CM ratio × Sales – Fixed expenses

Solve for the unknown “Sales.”

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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

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 Chapter 6

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

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Break-even:
The Percentage Method
Now, let’s use the 3rd method: the break-even percentage
(BE%) method to calculate the break-even point in units as
well as in sales $. This method also efficiently calculates
break-even for multiple products.
$
BE% = x 100%
$

Since BE Sales $ =
%

 BE% = %
x 100%
$
Since CM% x Total Sales $ = CM
𝐅𝐄
 𝐁𝐄% = 𝐱 𝟏𝟎𝟎%
𝐂𝐌
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Break-even Units and Dollars:

The Percentage Method
Applying the BE% formula to the same company RBC
𝐅𝐄
𝐁𝐄% = 𝐗 𝟏𝟎𝟎%
𝐂𝐌
$𝟖𝟎,𝟎𝟎𝟎
𝐁𝐄% = 𝐗 𝟏𝟎𝟎% = 𝟖𝟎%
$𝟏𝟎𝟎,𝟎𝟎𝟎
 This means that the company requires 80% of its current
sales in order to break-even.
 Currently, the company’s sales are $250,000 or 500 units.
 A BE% of 80% means if the company sales are $200,000
($250,000 x 80%) or 400 units (500 units x 80%), the
company is break-even.
 These figures are consistent with both the equation and
the formula methods.

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 Chapter 6

Quick Check 
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. 2,100 cups are sold each month on average.
What is the break-even sales dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129

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

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Learning Objective 6

Determine the level of

sales needed to attain a
target profit.

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 Chapter 6

Target Profit Analysis

We can use any of the following
methods to do target profit analysis:
1. Equation method
2. Formula method
3. Percentage method

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Target Profit Analysis:

Equation Method for the Quantity required

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.

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Target Profit Analysis:

Equation Method for the Quantity required
Suppose Racing Bicycle 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

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 Chapter 6

Target Profit Analysis:

The Formula Method for the Quantity required

The formula uses the following equation.

Unit sales to attain Target profit + Fixed expenses

=
the target profit CM per unit

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Target Profit Analysis:

The Formula Method for the Quantity required
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

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Target Profit Analysis:

Equation Method for the Sales $ required
Profit = CM ratio × Sales – Fixed expenses
Our goal is to solve for the unknown “Sales” which
represents the dollar amount of sales that must be
sold to attain the target profit.
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

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 Chapter 6

Target Profit Analysis:

Formula Method for the Sales $ required
 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

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Target Profit Analysis:

The Percentage Method
Modifying the BE% formula to add target profit to FE
𝐅𝐄 𝐓𝐚𝐫𝐠𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭
Target Profit% = 𝐱 𝟏𝟎𝟎%
𝐂𝐌
$𝟖𝟎,𝟎𝟎𝟎 $𝟏𝟎𝟎,𝟎𝟎𝟎
Target Profit% = x 𝟏𝟎𝟎% = 𝟏𝟖𝟎%
$𝟏𝟎𝟎,𝟎𝟎𝟎
 This means that the company requires 180% of its current
sales in order to obtain the target profit.
 Currently, the company’s sales are $250,000 or 500 units.
 A Target Profit % of 180% means if the company sales
are $450,000 ($250,000 x 180%) or 900 units (500 units x
180%), the company has a target profit of $100,000.
 These figures are consistent with both the equation and
the formula methods.

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Quick Check 
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.
Use the formula method to 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

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 Chapter 6

Targeted sales = x Current sales

Quick Check 
$ , $ ,
= x 2,100
$ . $ . ,
Coffee Klatch is an espresso stand in a downtown office
building. The average selling
= 3,363 price of a cup of coffee is
cups
$1.49 and the average variable expense per cup is
$0.36. TheUnit salesfixed expense per month is $1,300.
average Target profit + Fixed expenses
to attain
Use the formula method= to determineUnit howCM
many cups of
target profit
coffee would have to be sold to attain target profits of
$2,500 per month. $2,500 + $1,300
= $1.49 - $0.36
a. 3,363 cups
b. 2,212 cups $3,800
=
c. 1,150 cups $1.13
d. 4,200 cups = 3,363 cups

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Quick Check 
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.
Use the formula method to determine the sales dollars
that must be generated to attain target profits of $2,500
per month.
a. $2,550
b. $5,011
c. $8,458
d. $10,555

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Learning Objective 7

Compute the margin of

safety and explain its
significance.

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 Chapter 6

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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The Margin of Safety in Dollars

If we assume that RBC has actual sales of
$250,000, given that we have already determined
the break-even sales to be $200,000, the
margin of safety is $50,000 as shown.
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

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The Margin of Safety Percentage

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

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 Chapter 6

The Margin of Safety

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 is 100 bikes.

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

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Quick Check 
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. 2,100 cups are sold each month on average.
What is the margin of safety expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups

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Linking Margin of Safety % (to sales) and

Break-even % (to sales)
Margin of safety in dollars = Total sales - Break-even sales
Margin of safety in dollars
Total sales in dollars
= Margin of safety percentage (MoS%)
Total sales − Breakeven sales
=
Total sales
Breakeven in dollars
=1−
Total sales in dollars
= 1 − Breakeven percentage
= 1 − BE%
Therefore: BE% = 1 − MoS %

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 Chapter 6

Breakeven Calculation
RBC’s margin of safety = 20% of sales

Actual sales
500 units
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net operating income $ 20,000

Break-even sales of RBC = 1 – 20% = 80% of sales

= $250,000 x 80%
= $200,000
= Break-even Sales on slide 75
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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.

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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.

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 Chapter 6

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.

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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.
Contribution Margin
DOL Degree of Operating Leverage 
Net Operating Income**
** Profit Before Tax is a commonly used alternative to Net Operating
Income in the degree of operating leverage calculation

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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

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 Chapter 6

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!

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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.

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Quick Check 
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. 2,100 cups
are sold each month on average. What is the
operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92

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 Chapter 6

Quick Check 
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%

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Verify Increase in Profit

Actual Increased
sales sales
2,100 cups 2,520 cups
Sales $ 3,129 $ 3,755
Less: Variable expenses 756 907
Contribution margin 2,373 2,848
Less: Fixed expenses 1,300 1,300
Net operating income $ 1,073 $ 1,548
% change in sales 20.0%
% change in net operating income 44.2%

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What does higher value of Operating

Leverage mean?

 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.
 has lower margin of safety percentage (MoS%)
1
DOL
MoS%

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 Chapter 6

Proof of Operating Leverage and Profit

Movement Relationship

Benchmark Co. High F.C. Co.

Total Sales (Same) $3,200,000 $3,200,000
Unit selling price (Same) $800 $800
Unit variable costs ($300) ($150)
Unit Contribution margin $500 $650
Unit sales (Same) 4,000 4,000
Contribution margin (CM) $2,000,000 $2,600,000
Fixed costs ($1,500,000) ($2,100,000)
Net Operating Profit (Same) (P) 500,000 500,000

Degree of operating leverage (CM/P) 4.0 5.2

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Proof of Operating Leverage and Profit

Movement Relationship
Benchmark Co. High F.C. Co.
Increase in sales 12.5% 12.5%
Degree of operating leverage X 4.0 X 5.2
Increase in profits 50% 65%

Proof:
Unit contribution margin $500 $650
Unit change in sales (4,000 x 12.5%) x 500 x 500
Change in profits $250,000 $325,000
Percentage increase from the original 50% 65%
$500,000 profit

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Proof of Operating Leverage and MoS%

Relationship
Benchmark Co. High F.C. Co.
Total Sales (Same) (S) $3,200,000 $3,200,000
Contribution margin (CM) $2,000,000 $2,600,000
Fixed costs (F) ($1,500,000) ($2,100,000)
Net Operating Profit (Same) (P) 500,000 500,000

Degree of operating leverage (CM/P) 4.0 5.2

Break-even Sales Dollars [F/(CM/S)] 2,400,000 2,584,615
Break-even % (to sales) 75% 80.77%
MoS% = 1 – BE% (see slide 77) 25% 19.23%
1/MoS% 4.0 5.2
= Degree of operating leverage

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 Chapter 6

Structuring Sales Commissions

Companies generally compensate salespeople

by paying them either a commission based on
sales or a salary plus a sales commission.
Commissions based on sales dollars can lead to
lower profits in a company.

Let’s look at an example.

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Structuring Sales Commissions

Pipeline Unlimited produces two types of surfboards,

the XR7 and the Turbo. The XR7 sells for $100 and
generates a contribution margin per unit of $25. The
Turbo sells for $150 and earns a contribution margin
per unit of $18.

The sales force at Pipeline Unlimited is

compensated based on sales commissions.
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Structuring Sales Commissions

If you were on the sales force at Pipeline, you would

push hard to sell the Turbo even though the XR7
earns a higher contribution margin per unit.

To eliminate this type of conflict, commissions can

be based on contribution margin rather than on
selling price alone.

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 Chapter 6

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.

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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.

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Multi-Product Breakeven Analysis

(The BE% Method)
RBC’s Bikes and Carts sales and profit data are as follows:
Bicycle Carts Total
Sales $ 250,000 $ 300,000 $ 550,000
Variable expenses 150,000 135,000 285,000
Contribution margin 100,000 165,000 265,000
Fixed expenses 170,000
Net operating income $ 95,000
Contributi on Margin 1
Sales $ 250,000 $300,000 DOL  
x Net Operating Income MoS%
BE% = 64.15% Net Operating Income
 MoS% 
Contributi on Margin
Breakeven sales $160,375 $192,450 95 ,000
 MoS%   35 .85 %
265 ,000
Total break-even sales = $352,825  MoS%  1  BE%
 BE%  1  MoS%  1  35 .85  64 .15 %

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 Chapter 6

Multi-Product Breakeven Analysis

(The BE% Method)

Bicycle Carts Total

Sales $ 160,375 100% $ 192,450 100% $ 352,825 100.0%

Variable expenses 96,225 60% 86,603 45% 182,828 51.8%

Contribution margin 64,150 40% 105,847 55% 169,997 48.2%

Fixed expenses 170,000

Net operating income Rounding error $ (3)

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Multi-Product Breakeven 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:
Bicycle Carts Total
Sales $ 250,000 100% $ 300,000 100% $ 550,000 100.0%
Variable expenses 150,000 60% 135,000 45% 285,000 51.8%
Contribution margin 100,000 40.0% 165,000 55% 265,000 48.2%
Fixed expenses 170,000
Net operating income $ 95,000

Sales mix $ 250,000 45% $ 300,000 55% $ 550,000 100%

$265,000
= 48.2% (rounded)
$550,000

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Multi-Product Breakeven Analysis

(The CM Ratio Method)
Dollar sales to Fixed expenses
=
break even CM ratio

Dollar sales to $170,000 = $352,697

=
break even 48.2%

Bicycle Carts Total

Sales $ 158,714 100% $ 193,983 100% $ 352,697 100.0%
Variable expenses 95,228 60% 87,293 45% 182,521 51.8%
Contribution margin 63,485 40% 106,691 55% 170,176 48.2%
Fixed expenses 170,000
Net operating income Rounding error $ 176

Sales Mix $ 158,714 45% $ 193,983 55% $ 352,697 100.0%

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 Chapter 6

Compare the Breakeven Results calculated

by the BE% and CM ratio methods
Rounding difference
Bicycle Carts Total from the breakeven
Breakeven Sales Mix
The BE% method $ 160,375 45% $ 192,450 55% $ 352,825 100% $ 3
The CM ratio method $ 158,714 45% $ 193,983 55% $ 352,697 100% $ 176

Using different methods to calculate the

break-even points will result in slightly different
answers due to rounding differences at
different points of the calculations. In this
example, the BE% seems to provide a better
estimation.

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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 4

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