Cost-Volume-Profit

Relationships
Chapter Six

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6-2

Learning Objective 1

Explain how changes in

activity affect contribution
margin and net operating
income.

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6-3

Basics of Cost-Volume-Profit Analysis

Contribution
Contribution Margin
Margin (CM)
(CM) is
is the
the amount
amount
remaining
remaining from
from sales
sales revenue
revenue after
after variable
variable
expenses
expenses have
have been
been deducted.
deducted.
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6-4

Basics of Cost-Volume-Profit Analysis

CM is used first to cover fixed

expenses. Any remaining CM
contributes to net operating income.
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6-5

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.

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6-6

The Contribution Approach

Each month, Racing must generate at least
$80,000 in total CM to break even.

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6-7

The Contribution Approach

If Racing sells 400 units in a month, it will be
operating at the break-even point.

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6-8

The Contribution Approach

If Racing sells one more bike (401 bikes),
bikes net
operating income will increase by $200.

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6-9

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 income will
be $6,000.

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6-10

Learning Objective 2

Prepare and interpret a

cost-volume-profit (CVP)
graph.

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6-11

CVP Relationships in Graphic Form

The relationship among revenue, cost, profit and volume
can be expressed graphically by preparing a CVP
graph. Racing developed contribution margin income
statements at 300, 400, and 500 units sold. We will
use this information to prepare the CVP graph.
Income
Income
300
300 units
units
Sales
$$ 150,000
Sales
150,000
Less:
90,000
Less: variable
variable expenses
expenses
90,000
Contribution
$$ 60,000
Contribution margin
margin
60,000
Less:
80,000
Less: fixed
fixed expenses
expenses
80,000
Net
$$ (20,000)
Net operating
operating income
income
(20,000)

McGrawHill/Irwin

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

Copyright2008,TheMcGrawHillCompanies,Inc.

6-12

Dollars

CVP Graph

In a CVP graph, unit volume is

usually represented on the
horizontal (X) axis and dollars on
the vertical (Y) axis.

Units
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6-13

Dollars

CVP Graph

Fixed Expenses

Units
McGrawHill/Irwin

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6-14

Dollars

CVP Graph

Total Expenses
Fixed Expenses

Units
McGrawHill/Irwin

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6-15

CVP Graph

Dollars

Total Sales
Total Expenses
Fixed Expenses

Units
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6-16

CVP Graph
Break-even point
(400 units or $200,000 in sales)
Dollars

Los

a
e
r
A
t
i
f
ro

a
e
r
sA

Units
McGrawHill/Irwin

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6-17

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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6-18

Contribution Margin Ratio

The contribution margin ratio is:
Total CM
CM Ratio =
Total sales

For Racing Bicycle Company the ratio is:

$80,000
= 40%
$200,000

Each $1.00 increase in sales results in a

total contribution margin increase of 40.

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6-19

Contribution Margin Ratio

Or, in terms of units, the contribution margin ratio is:

Unit CM
CM Ratio =
Unit selling price

For Racing Bicycle Company the ratio is:

$200 = 40%
$500

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6-20

Contribution Margin Ratio

400
400 Bikes
Bikes
Sales
$$200,000
Sales
200,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000
Contribution
80,000
Contribution margin
margin
80,000
Less:
80,000
Less: fixed
fixed expenses
expenses
80,000
Net
$$
-Net operating
operating income
income

500
500 Bikes
Bikes
$$250,000
250,000
150,000
150,000
100,000
100,000
80,000
80,000
$$ 20,000
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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6-21

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

McGrawHill/Irwin

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6-22

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?
Unit contribution margin
CM Ratio =
a. 1.319
Unit selling price
b. 0.758
($1.49-$0.36)
=
$1.49
c. 0.242
$1.13
d. 4.139
=
= 0.758
$1.49

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6-23

Learning Objective 4

Show the effects on

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

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6-24

Changes in Fixed Costs and Sales Volume

What is the profit impact if Racing can

increase unit sales from 500 to 540
by increasing the monthly advertising
budget by $10,000?

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6-25

Changes in Fixed Costs and Sales Volume

$80,000
$80,000++ $10,000
$10,000advertising
advertising ==$90,000
$90,000

Sales
Sales increased
increased by
by $20,000,
$20,000, but
but net
net operating
operating
income
income decreased
decreased by
by $2,000
$2,000..
McGrawHill/Irwin

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6-26

Changes in Fixed Costs and Sales Volume

The Shortcut Solution

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Change in Variable Costs and Sales Volume

What is the profit impact if Racing 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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6-28

Change in Variable Costs and Sales Volume

580
580units
units $310
$310variable
variablecost/unit
cost/unit ==$179,800
$179,800

Sales
Sales increase
increase by
by $40,000,
$40,000, and
and net
net operating
operating income
income
increases
..
increases by
by $10,200
$10,200
McGrawHill/Irwin
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6-29

Change in Fixed Cost, Sales Price and Volume

What is the profit impact if Racing (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?

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6-30

Change in Fixed Cost, Sales Price and Volume

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

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6-31

Change in Variable Cost, Fixed Cost and Sales Volume

What is the profit impact if Racing (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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6-32

Change in Variable Cost, Fixed Cost and Sales Volume

Sales
Sales increase
increase by
by $37,500,
$37,500, variable
variable costs
costs increase
increase by
by
$31,125,
$31,125, but
but fixed
fixed expenses
expenses decrease
decrease by
by $6,000
$6,000..
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6-33

Change in Regular Sales Price

If Racing 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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Change in Regular Sales Price

$$ 3,000
3,000 150
150 bikes
bikes
Variable
Variable cost
cost per
per bike
bike
Selling
Selling price
price required
required

McGrawHill/Irwin

==
==
==

$$ 20
20 per
per bike
bike
300
300 per
per bike
bike
$$ 320
320 per
per bike
bike

Copyright2008,TheMcGrawHillCompanies,Inc.

6-35

Learning Objective 5

Compute the break-even

point in unit sales and
sales dollars.

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6-36

Break-Even Analysis

Break-even analysis can be

approached in two ways:
1. Equation method
2. Contribution margin method

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Equation Method
Profits = (Sales Variable expenses)

Fixed expenses

OR
Sales = Variable expenses + Fixed expenses + Profits

At the break-even point

profits equal zero

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Break-Even Analysis

Here is the information from Racing Bicycle Company:

Total
Total
Sales
$$250,000
Sales(500
(500bikes)
bikes)
250,000
Less:
Less:variable
variable expenses
expenses 150,000
150,000
Contribution
$$100,000
Contributionmargin
margin
100,000
Less:
80,000
Less:fixed
fixedexpenses
expenses
80,000
Net
$$ 20,000
Netoperating
operatingincome
income
20,000

McGrawHill/Irwin

Per
PerUnit
Unit
$$ 500
500
300
300
$$ 200
200

Percent
Percent
100%
100%
60%
60%
40%
40%

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6-39

Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $0

Where:
Q = Number of bikes sold
$500 = Unit selling price
$300 = Unit variable expense
$80,000 = Total fixed expense

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6-40

Equation Method

We calculate the break-even point as follows:

Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $0

$200Q = $80,000
Q = $80,000 $200 per bike
Q = 400 bikes

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6-41

Equation Method

The equation can be modified to calculate the

break-even point in sales dollars.

Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + $80,000 + $0
Where:
X = Total sales dollars
0.60 = Variable expenses as a % of sales
$80,000 = Total fixed expenses
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6-42

Equation Method

The equation can be modified to calculate the

break-even point in sales dollars.

Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + $80,000 + $0
0.40X = $80,000
X = $80,000 0.40
X = $200,000
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6-43

Contribution Margin Method

The contribution margin method has two

key equations.
Break-even point
=
in units sold
Break-even point in
total sales dollars =

McGrawHill/Irwin

Fixed expenses
CM per unit
Fixed expenses
CM ratio

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6-44

Contribution Margin Method

Lets use the contribution margin method

to calculate the break-even point in total
sales dollars at Racing.
Break-even point in
total sales dollars =

Fixed expenses
CM ratio

$80,000
= $200,000 break-even sales
40%

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6-45

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

McGrawHill/Irwin

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6-46

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
Fixed
expenses
Break-even =
CM perfixed
Unit
expense per cup is $0.36. The average
expense per month is $1,300. 2,100
cups are sold
$1,300
= What is the break-even
each month on average.
$1.49/cup - $0.36/cup
sales in units?
$1,300
=
a. 872 cups
$1.13/cup
b. 3,611 cups
= 1,150 cups
c. 1,200 cups
d. 1,150 cups

McGrawHill/Irwin

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6-47

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
dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129

McGrawHill/Irwin

Copyright2008,TheMcGrawHillCompanies,Inc.

6-48

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
dollars?
a. $1,300
Fixed expenses
Break-even
=
CM Ratio
sales
b. $1,715
$1,300
c. $1,788
=
0.758
d. $3,129
= $1,715

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6-49

Learning Objective 6

Determine the level of

sales needed to achieve a
desired target profit.

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6-50

Target Profit Analysis

The equation and contribution margin
methods can be used to determine the sales
volume needed to achieve a target profit.

Suppose Racing Bicycle Company wants

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

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6-51

The CVP Equation Method

Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $100,000

$200Q = $180,000
Q = 900 bikes

McGrawHill/Irwin

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6-52

The Contribution Margin Approach

The contribution margin method can be
used to determine that 900 bikes must be
sold to earn the target profit of $100,000.
Unit sales to attain
=
the target profit

Fixed expenses + Target profit

CM per unit

$80,000 + $100,000
= 900 bikes
$200/bike

McGrawHill/Irwin

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6-53

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. 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

McGrawHill/Irwin

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6-54

Quick Check
Unit sales
Fixed expenses + Target profit
to attain =
Unit
CM
Coffee Klatch
is
an
espresso
stand
in
a
downtown
target profit
office building. The average
selling
price of a cup of
$1,300
+ $2,500
= average variable expense
coffee is $1.49 and the
$1.49 - $0.36

per cup is $0.36. The average fixed expense per

$3,800
month is $1,300. How
many
cups of coffee would
=
$1.13
have to be sold to attain target profits of $2,500 per
= 3,363 cups
month?
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
McGrawHill/Irwin

Copyright2008,TheMcGrawHillCompanies,Inc.

6-55

Learning Objective 7

Compute the margin of

safety and explain its
significance.

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6-56

The Margin of Safety

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

Margin of safety = Total sales - Break-even sales

Lets look at Racing Bicycle Company and

determine the margin of safety.

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6-57

The Margin of Safety

If we assume that Racing Bicycle Company 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
Break-even
sales
sales
400
400 units
units
Sales
$$ 200,000
Sales
200,000
Less:
120,000
Less: variable
variable expenses
expenses
120,000
Contribution
80,000
Contribution margin
margin
80,000
Less:
80,000
Less: fixed
fixed expenses
expenses
80,000
Net
$$
-Net operating
operating income
income

McGrawHill/Irwin

Actual
Actual sales
sales
500
500 units
units
$$ 250,000
250,000
150,000
150,000
100,000
100,000
80,000
80,000
$$
20,000
20,000

Copyright2008,TheMcGrawHillCompanies,Inc.

6-58

The Margin of Safety

The margin of safety can be expressed as
20% of sales.
($50,000 $250,000)
Break-even
Break-even
sales
sales
400
400 units
units
Sales
$$ 200,000
Sales
200,000
Less:
120,000
Less: variable
variable expenses
expenses
120,000
Contribution
80,000
Contribution margin
margin
80,000
Less:
80,000
Less: fixed
fixed expenses
expenses
80,000
Net
$$
-Net operating
operating income
income

McGrawHill/Irwin

Actual
Actual sales
sales
500
500 units
units
$$ 250,000
250,000
150,000
150,000
100,000
100,000
80,000
80,000
$$
20,000
20,000

Copyright2008,TheMcGrawHillCompanies,Inc.

6-59

The Margin of Safety

The margin of safety can be expressed in
terms of the number of units sold. The
margin of safety at Racing is $50,000, and
each bike sells for $500.
Margin of
$50,000
=
= 100 bikes
Safety in units
$500

McGrawHill/Irwin

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6-60

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?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups

McGrawHill/Irwin

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6-61

Quick Check
CoffeeMargin
Klatchof
is safety
an espresso
inBreak-even
a downtownsales
= Total stand
sales
office building. The average
price
of cups
a cup of
= 2,100selling
cups
1,150
coffee is $1.49 and the=average
950 cupsvariable expense
per cup is $0.36. The average
or fixed expense per
month is Margin
$1,300.of2,100
cups are
950 sold
cupseach month
safety
= 2,100
= 45%
on average.percentage
What is the margin
of cups
safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups

McGrawHill/Irwin

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6-62

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 organizations cost structure.

McGrawHill/Irwin

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6-63

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
will be higher in good years
compared to companies
A disadvantage of a high fixed
with lower proportion of
cost structure is that income
fixed costs.
will be lower in bad years
compared to companies
with lower proportion of
fixed costs.
McGrawHill/Irwin

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6-64

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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6-65

Operating Leverage
A measure of how sensitive net operating
income is to percentage changes in sales.
Degree of
Contribution margin
=
operating leverage
Net operating income

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6-66

Operating Leverage

At Racing, the degree of operating leverage is

5.
Actual
Actual sales
sales
Sales
Sales
Less:
Less: variable
variable expenses
expenses
Contribution
Contribution margin
margin
Less:
Less: fixed
fixed expenses
expenses
Net
Net income
income

500
500 Bikes
Bikes
$$ 250,000
250,000
150,000
150,000
100,000
100,000
80,000
80,000
$$ 20,000
20,000

$100,000 = 5
$20,000
McGrawHill/Irwin

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6-67

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

10%
5
50%

Heres the verification!

McGrawHill/Irwin

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6-68

Operating Leverage

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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6-69

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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6-70

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
Operating Contribution margin
leverage = Net operating income
b. 0.45
$2,373
c. 0.34
= $1,073 = 2.21
d. 2.92

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6-71

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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6-72

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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6-73

Key Assumptions of CVP Analysis

Selling price is constant.

Costs are linear.
In multiproduct companies, the sales mix is
constant.
In manufacturing companies, inventories do
not change (units produced = units sold).

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6-74

McGrawHill/Irwin

End of Chapter 6

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