1. Cost-Volume-Profit Relationships
Chapter 05
Chapter 5: Cost-volume-profit relationships
Cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit by focusing their attention on the interactions among the prices of products, volume of activity, per unit variable costs, total fixed costs, and mix of products sold. It is a vital tool used in many business decisions such as deciding what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 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.
The contribution income statement is helpful to managers in judging the impact on profits of changes in selling price, cost, or volume. For example, let's look at a hypothetical contribution income statement for Racing Bicycle Company (RBC). Notice the emphasis on cost behavior. Variable costs are separate from fixed costs. The contribution margin is defined as the amount remaining from sales revenue after variable expenses have been deducted.
Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted.

3. Contribution Margin Ratio (CM Ratio)
The CM ratio is calculated by dividing the total contribution margin by total sales.
The contribution margin ratio is calculated by dividing the total contribution margin by total sales. In the case of Racing Bicycle, the ratio is 40%. Thus, each $1.00 increase in sales results in a total contribution margin increase of 40¢.
$100,000 ÷ $250,000 = 40%

4. Contribution Margin Ratio (CM Ratio)
The contribution margin ratio at Racing Bicycle is:
CM per unit
SP per unit
CM Ratio =
= 40%
$200
$500 =
The CM ratio can also be calculated by dividing the contribution margin per unit by the selling price per unit.
The CM ratio can also be calculated by dividing the contribution margin per unit by the selling price per unit. Racing Bicycle has a CM ratio of 40%. This means that for each dollar increase in sales the company will produce 40¢ in contribution margin.

5. 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:
A $50,000 increase in sales revenue results in a $20,000 increase in CM ($50,000 × 40% = $20,000).
Let’s see how we can use the contribution margin ratio to look at the contribution margin income statement of Racing Bicycle in a little different way. If RBC is able to increase its sales from 400 to 500 bikes, the increase in contribution margin by $20,000, that is, $50,000 (100 bikes times $500 per bike) times 40%.

6. Equation Method 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.
The equation method is based on the contribution approach income statement. The equation we have used is that profit equals unit CM times units sold, Q, less 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.

7. 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
Suppose Racing Bicycle management wants to know how many bikes must be sold to earn a target profit of $100,000. Let’s use the Equation Method to help management.
Our equation should read $100,000 (the target profit) equals $200 (the Unit CM) times Q, (the unknown units to sell) less $80,000 (total fixed expenses). Now we solve this equation.
As you can see, the target unit sales to produce net operating income of $100,000 is 900 bikes. Why not take a few minutes and verify this answer.
$200 × Q = $100,000 – $80,000
Q = ($100,000 + $80,000) ÷ $200
Q = 900

8. The Formula Method The formula uses the following equation.
Target profit + Fixed expenses CM per unit =
Unit sales to attain the target profit
Target profit is expressed in units sold. For this equation we divide the sum of the desired target profit plus total fixed expenses by the contribution margin per unit.

9. 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 CM per unit =
Unit sales to attain the target profit
Suppose Racing Bicycle Company wants to earn net operating income of $100,000. How many bikes must the company sell to achieve this profit level? Let’s use the formula method.
Unit sales to attain the target profit level is equal to the sum of $100,000 (the target profit) plus $80,000 (total fixed expenses) divided by the unit contribution margin of $200. We arrive at 900 units sold to earn net operating income of $100,000.
$100,000 + $80,000
$200
Unit sales =
Unit sales = 900

10. Break-even in Dollar Sales: Equation Method
Suppose Racing Bicycle wants to compute the sales dollars required to break-even (earn a target profit of $0). Let’s use the equation method to solve this problem.
Profit = CM ratio × Sales – Fixed expenses
Suppose Racing Bicycle wants to compute the sales dollars required to break-even, earn a target profit of $0. Let’s use the equation method to solve this problem. We must setup the equation and solve for the unknown value of sales.
Solve for the unknown “Sales.”

11. Break-even in Dollar Sales: Equation Method
Profit = CM ratio × Sales – Fixed expenses
$ 0 = 40% × Sales – $80,000
40% × Sales = $80,000
Here is the equation that will always be used to calculate the break-even point in a single product company. Remember, we solve for the unknown “Sales.”
In the case of Racing Bicycle dollar sales must be $200,000 for the company to break-even.
Sales = $80,000 ÷ 40%
Sales = $200,000

12. Break-even in Dollar Sales: Formula Method
Now, let’s use the formula method to calculate the dollar sales at the break-even point.
Fixed expenses
CM ratio =
Dollar sales to break even
You can see that if we elect to use the formula method, we calculate the same sales of $200,000 at the break-even point.
$80,000
40%
Dollar sales =
Dollar sales = $200,000

13. 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 with lower proportion of fixed costs.
A disadvantage of a high fixed cost structure is that income will be lower in bad years compared to companies with lower proportion of fixed costs.
Generally, companies with a high fixed cost structure will show higher net income in good years than companies with lower fixed cost structures. Just the opposite is true in bad years. Companies with low fixed cost structures enjoy greater stability in income across good and bad years.
Companies with low fixed cost structures enjoy greater stability in income across good and bad years.

14. 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).
Here are the four key assumptions of cost-volume-profit analysis. You are probably familiar with the first three by now. The forth assumption tells us that there can be no change in inventory levels. That is, all units produced are sold in the current period.

15. End of Chapter 05
End of Chapter 5.