Cost-Volume-

Profit
Relationships

Chapter 5
 5-2

CVP Analysis

To determine how changes in costs and volume affect a company’s profit

Key Assumptions

 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).

 5-3

Basics of Cost-Volume-Profit Analysis

Racing Bicycle Company

Contribution Income Statement
For the Month of June Unit Sold - 500
Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 $ 200 100,000
Less: Fixed expenses 80,000
500
Net operating income $ 20,000

Contribution Margin (CM) is the amount remaining from sales revenue after
variable expenses have been deducted.
 5-4

The Contribution Approach

Racing Bicycle Company

 For each additional Contribution Income Statement
For the Month of June
bicycle the company Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
sells, $200 more in the Less: Variable expenses 150,000 300
contribution margin Contribution margin 100,000 $ 200
Less: Fixed expenses 80,000
 Contribution margin Net operating income $ 20,000
needs to be at least
$80,000 break-even

Break-even: profit is zero

 5-5

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 $ -
 5-6

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
 5-7

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
 5-8

Preparing the CVP Graph

Fixed expenses
$350,000

In a CVP graph, unit

volume is usually $300,000

represented on the $250,000

Dollars
horizontal (X) axis and
$200,000
dollars on the vertical (Y)
axis. $150,000

$100,000

$50,000

$0
0 100 200 300 400 500 600

Units
 5-9

Preparing the CVP Graph

$250,000

Draw a line parallel to the volume axis to $200,000
represent total fixed expenses.
$150,000

$100,000
Units Sold
0 200 400 600 $50,000
Sales $ - $ 100,000 $ 200,000 $ 300,000

Dollars
$0
Total variable expenses - 60,000 120,000 180,000 0 100 200 300 400 500 600
Contribution margin - 40,000 80,000 120,000 Fixed expenses

Fixed expenses 80,000 80,000 80,000 80,000 Units

Net operating income (loss) $ (80,000) $ (40,000) $ - $ 40,000

 5-10

Preparing the CVP Graph

 $250,000
Choose some sales volume, say 400 units, and
plot the point representing total expenses $200,000
(fixed and variable). Draw a line through the
data point back to where the fixed expenses
$150,000
line intersects the dollar axis.

Dollars
$100,000
Units Sold
0 200 400 600 $50,000

Sales $ - $ 100,000 $ 200,000 $ 300,000

$00
Total variable expenses - 60,000 120,000 180,000 100 200 300 400 500 600

Total expenses Fixed expenses

Contribution margin - 40,000 80,000 120,000
Units
Fixed expenses 80,000 80,000 80,000 80,000
Net operating income (loss) $ (80,000) $ (40,000) $ - $ 40,000
 5-11

Preparing the CVP Graph


Choose some sales volume, say 400 $300,000
units, and plot the point
representing total sales. Draw a line $250,000
through the data point back to the
point of origin. $200,000

Units Sold $150,000

Dollars
0 200 400 600
$100,000
Sales $ - $ 100,000 $ 200,000 $ 300,000
Total variable expenses - 60,000 120,000 180,000 $50,000

Contribution margin - 40,000 80,000 120,000

$0
Fixed expenses 80,000 80,000 80,000 80,000 0 100 200 300 400 500 600
Net operating income (loss) $ (80,000) $ (40,000) $ - $ 40,000 Sales Total expenses Fixed expenses

Units
 5-12

Preparing the CVP Graph

$350,000 Break-even point

(400 units or $200,000 in sales) Profit Area
$300,000

$250,000

$200,000
Dollars

Sales
Total expenses
$150,000 Fixed expenses

$100,000

$50,000

$0
0 100 200 300 400 500 600

Loss Area Units

 5-13

Preparing the Profit Graph

90,000 Profit = Unit CM × Q – Fixed Costs

60,000

30,000

Dollars
Q Profit 0
0 100 200 300 400 500 600 700 800
0 -80,000
-30,000
400 0
600 40,000 -60,000

800 80,000 -90,000

Units
 5-14

Contribution Margin Ratio (CM Ratio)

The CM ratio is Racing Bicycle Company

Contribution Income Statement
calculated by
For the Month of June
dividing the total Total Per Unit % of Sales
contribution margin Sales (500 bicycles) $ 250,000 $ 500 100%
by total sales. Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
Less: Fixed expenses 80,000
Net operating income $ 20,000
Each $1 increase in
sales results in a
total contribution
$100,000 ÷ $250,000 = 40%
margin increase of
40¢.
 5-15

Contribution Margin Ratio (CM Ratio)

The contribution margin ratio at Racing Bicycle is:

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛
𝐶𝑀 𝑅𝑎𝑡𝑖𝑜=
𝑆𝑎𝑙𝑒𝑠

= 40%

The CM ratio can also be calculated by dividing the

contribution margin per unit by the selling price per unit.
 5-16

Contribution Margin Ratio (CM Ratio)

If Racing Bicycle 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).
 5-17

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. 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
 5-18

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. An average
of 2,100 cups are sold each month. What is the CM Ratio
for Coffee Klatch?
a. 1.319 Unit contribution margin
CM Ratio =
b. 0.758 Unit selling price
c. 0.242 ($1.49 - $0.36)
=
d. 4.139 $1.49
$1.13
= = 0.758
$1.49
 5-19

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
 5-20

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
 5-21

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?
 5-22

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.
 5-23

Changes in Fixed Costs and Sales Volume

Alternative Solution 1 Alternative Solution 2

Expected total Contribution margin Increase in CM (40 units X $200) $ 8,000

$270,000 × 40% CM ratio $108,000 Increase in advertising expenses 10,000
Decrease in net operating income $ (2,000)
Present Total Contribution Margin
$250,000 × 40% CM ratio 100,000
Increase in total contribution margin 8,000
Change in Fixed Expense:
Less incremental advertising expense 10,000
Decreased net operating income $(2,000)
 5-24

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?
 5-25

Change in Variable Costs and Sales Volume

Per Unit
Sales $ 500
Less: Variable expenses 300
310
Contribution margin $ 200
190

Expected total Contribution margin with high quality raw materials

580 unit sales × $190 per unit
$110,200
Present Total Contribution Margin
500 × $200 per unit
100,000
 5-26

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?
 5-27

Change in Fixed Cost, Sales Price, and Volume

Per Unit
Sales $ 500
480
Less: Variable expenses 300
Contribution margin $ 200
180

Expected total Contribution margin with lower selling price

650 unit sales × $180 per unit
$117,000
Present Total Contribution Margin
500 × $200 per unit
100,000
Increase in total contribution margin 17,000
Change in Fixed Expense:
Less incremental advertising expense
 5-28

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?
 5-29

Change in Variable Cost, Fixed

Cost,
and Sales Volume
Per Unit
Sales $ 500
Less: Variable expenses 300
Contribution margin $ 315
200
185

Expected total Contribution margin with lower selling price

575 unit sales × $185 per unit
$106,375
Present Total Contribution Margin
500 × $200 per unit
100,000
Increase in total contribution margin 6,375
Change in Fixed Expense:
Add salaries avoided if a commission is paid 6,000
 5-30

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?
 5-31

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
 5-32

Break-even Analysis

Racing Bicycle Company

 Equation Method Contribution Income Statement
For the Month of June
 Formula Method 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 $ -
 5-33

Break-even in Unit Sales

Equation Method
Profit = Unit CM × Q – Fixed expenses

Suppose RBC wants to know how many bikes must be sold to break-even
(earn a target profit of $0).

$0 = $200 × Q - $80,000

$200 × Q = $80,000

Q = 400 bikes
 5-34

Break-even in Unit Sales

Formula Method

𝐹𝑖𝑥𝑒𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝑈𝑛𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛=
𝑈𝑛𝑖𝑡 𝐶𝑀

80,000
𝑈𝑛𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑏𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛=
200

𝑈𝑛𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛=400

 5-35

Break-even in Dollar Sales

Equation Method

Profit = CM ratio × Sales – Fixed expenses

$ 0 = 40% × Sales – $80,000 Racing Bicycle Company

Contribution Income Statement
For the Month of June
Sales = $80,000 ÷ 40% Total Per Unit CM Ratio
Sales (500 bicycles) $ 250,000 $ 500 100%
Sales = $200,000 Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
Less: Fixed expenses 80,000
Net operating income $ 20,000
 5-36

Break-even in Dollar Sales

Dollar

80,000
𝐷𝑜𝑙𝑙𝑎𝑟 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛=
40 %
𝐷𝑜𝑙𝑙𝑎𝑟 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛=$ 200,000
 5-37

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. 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
 5-38

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. An average of 2,100 cups are sold each month. What is the
break-even sales dollars?
a. $1,300 Break-even Fixed expenses
=
b. $1,715 sales CM Ratio
$1,300
c. $1,788 =
0.758
d. $3,129
= $1,715
 5-39

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.
 5-40

Target Profit Analysis

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
 5-41

Target Profit Analysis in Terms of

Unit Sales

Suppose Racing Bicycle Company wants to know how many

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

𝑇𝑎𝑟𝑔𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 + 𝐹𝑖𝑥𝑒𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

𝑈𝑛𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑎𝑡𝑡𝑎𝑖𝑛 𝑡h𝑒𝑡𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡=
𝑈𝑛𝑖𝑡 𝐶𝑀

$ 100,000+ $ 80,000
𝑈𝑛𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑎𝑡𝑡𝑎𝑖𝑛 𝑡h𝑒𝑡𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡=
$ 200

Unit sales = 900

 5-42

Target Profit Analysis

We can also compute the target profit in terms of

sales dollars using either the equation method or
the formula method.

Equation OR Formula
Method Method
 5-43

Equation Method

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
 5-44

Formula Method


We can calculate the dollar sales needed to attain a target profit
(net operating profit) of $100,000 at Racing Bicycle.

𝑇𝑎𝑟𝑔𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 + 𝐹𝑖𝑥𝑒𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

𝐷𝑜𝑙𝑙𝑎𝑟 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑎𝑡𝑡𝑎𝑖𝑛 𝑡h𝑒 𝑡𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 =
𝐶𝑀 𝑅𝑎𝑡𝑖𝑜

$ 100,000+ $ 80,000
𝐷𝑜𝑙𝑙𝑎𝑟 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑎𝑡𝑡𝑎𝑖𝑛 𝑡h𝑒 𝑡𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 =
40 %

Dollar sales = $450,000

 5-45

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. 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
 5-46

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 expense per cup is $0.36. The average fixed expense per
month is $1,300. Use Unit
thesales
formula method
Targetto determine
profit how
+ Fixed many
expenses
cups of coffee would to attain
have = to attain target
to be sold Unitprofits
CM of $2,500
per month. target profit
a. 3,363 cups $2,500 + $1,300
= $1.49 - $0.36
b. 2,212 cups
c. 1,150 cups =
$3,800
d. 4,200 cups $1.13
= 3,363 cups
 5-47

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. 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. $5,013
c. $8,458
d. $10,555
 5-48

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. Use the formula
method to determine the sales Sales $
dollars that must
Target be generated
profit + Fixed expenses
to attain =
to attain target profits of $2,500 per month. CM ratio
target profit
a. $2,550
$2,500 + $1,300
b. $5,013 = ($1.49 – 0.36) ÷ $1.49
c. $8,458
$3,800
d. $10,555 =
0.758
= $5,013
 5-49

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.
 5-50

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
 5-51

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
 5-52

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
 5-53

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. 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
 5-54

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. 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 Margin of safety = Total sales – Break-even sales
c. 1,150 cups = 2,100 cups – 1,150 cups
d. 2,100 cups = 950 cups
 5-55

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.
 5-56

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.
 5-57

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
 5-58

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
 5-59

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%
 5-60

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.
 5-61

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. 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
 5-62

Quick Check 

Actual sales
Coffee Klatch is an espresso stand in a downtown
2,100 cups
office building. The average selling
Sales
price of a cup
$
of 3,129
coffee is $1.49 and the average variable
Less: Variable expense per 756
expenses
cup is $0.36. The averageContribution
fixed expense
marginper month is 2,373
$1,300. An average of 2,100
Less:cups
Fixedare sold each
expenses 1,300
month. What is the operating leverage?
Net operating income $ 1,073
a. 2.21
b. 0.45
c. 0.34 Operating Contribution margin
= Net operating income
d. 2.92 leverage
$2,373
= $1,073 = 2.21
 5-63

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.

 5-64

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.
 5-65

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.
 5-66

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.
 5-67

Multi-Product 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 $ 260,000 100% $ 1,040,000 100% $ 1,300,000 100.0%
Variable expenses 195,000 75% 520,000 50% $ 715,000 55.0%
Contribution margin 65,000 25.0% 520,000 50% $ 585,000 45.0%
Fixed expenses 351,000
Net operating income $ 234,000

Sales mix $ 260,000 20% $ 1,040,000 80% $ 1,300,000 100%

 5-68

Multi-Product Break-Even Analysis

𝐹𝑖𝑥𝑒𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝐷𝑜𝑙𝑙𝑎𝑟 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛=
𝐶𝑀 𝑅𝑎𝑡𝑖𝑜

$ 351,000
𝐷𝑜𝑙𝑙𝑎𝑟 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛=
45 %

Bicycle Carts Total

Sales $ 156,000 100% $ 624,000 100% $ 780,000 100.0%
Variable expenses 117,000 75% 312,000 50% 429,000 55.0%
Contribution margin 39,000 25% 312,000 50% 351,000 45.0%
Fixed expenses 351,000
Net operating income $ -

Sales mix $ 156,000 20% $ 624,000 80% $ 780,000 100.0%

 5-69

End of Chapter 05