The Basics of Cost-Volume-Profit (CVP) Analysis

W IND BICYCLE CO.

Contribution Income Sta te me nt
For the Month of June
Tota l Pe r Unit
Sa le s (500 bike s) $ 250,000 $ 500
Le ss: va ria ble e x pe nse s 150,000 300
Contribution ma rgin 100,000 $ 200
Le ss: fix e d e x pe nse s 80,000
Ne t ope ra ting income $ 20,000

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

W IND BICYCLE CO.

Contribution Income Sta te me nt
For the Month of June
Tota l Pe r Unit
Sa le s (500 bike s) $ 250,000 $ 500
Le ss: va ria ble e x pe nse s 150,000 300
Contribution ma rgin 100,000 $ 200
Le ss: fix e d e x pe nse s 80,000
Ne t ope ra ting income $ 20,000

CM
CM goes
goes to
to cover
cover fixed
fixed expenses.
expenses.

W IND BICYCLE CO.

Contribution Incom e Sta te m e nt
For the Month of June
Tota l Pe r Uni t
Sa le s (500 bike s) $ 250,000 $ 500
Le ss: va ria ble e x pe nse s 150,000 300
Contribution ma rgin 100,000 $ 200
Le ss: fix e d e x pe nse s 80,000
Ne t ope ra ting incom e $ 20,000

After covering fixed costs, any remaining CM contributes to

income.
The Contribution Approach

For each additional unit Wind sells, $200 more in contribution margin will help to cover
fixed expenses and profit.
Each month Wind must generate at least $80,000 in total CM to break even.

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

If Wind sells one more bike (401 bikes), net operating income will increase by $200.
WIND BICYCLE CO.
Contribution Income Sta te me nt
For the Month of June
Total Per Unit
Sa le s (401 bikes) $ 200,500 $ 500
Le ss: varia ble e x pe nse s 120,300 300
Contribution margin 80,200 $ 200
Le ss: fix ed ex pe nse s 80,000
Ne t ope ra ting income $ 200

CVP Relationships in Graphic Form

Viewing CVP relationships in a graph is often helpful. Consider the following information
for Wind Co.:
Income
Income Income
Income Income
Income
300
300units
units 400
400units
units 500
500units
units
Sales
Sales $ 150,000
$ 150,000 $$ 200,000
200,000 $$250,000
250,000
Less:
Less:variable
variableexpenses
expenses 90,000
90,000 120,000
120,000 150,000
150,000
Contribution margin
Contribution margin $$ 60,000
60,000 $$ 80,000
80,000 $$100,000
100,000
Less: fixed expenses
Less: fixed expenses 80,000
80,000 80,000
80,000 80,000
80,000
Net
Netoperating
operatingincome
income $$ (20,000)
(20,000) $$ -- $$ 20,000
20,000
 CVP Graph

450,000

400,000
Total Sales
350,000 Total Expenses
300,000

250,000
s Fixed expenses
ar 200,000

150,000
oll
100,000
D
50,000

-
- 100 200 300 400 500 600 700 800

Units

450,000

400,000

350,000
Pro
fit
s 300,000 Are
ar a
250,000
oll
D 200,000 Break-even point
150,000
ea
100,000 s Ar
s
Lo
50,000

-
- 100 200 300 400 500 600 700 800

Units

Contribution Margin Ratio

The contribution margin ratio is:
Total CM
CM Ratio = Total
For Wind Bicycle Co.sales
the ratio is:

$ 80,000 = 440%
$200,000
 Or, in terms of units, the contribution margin ratio is:
CM Ratio = Unit CM
Unit selling price
For Wind Bicycle Co. the ratio is:
$200 = 40%
$500

At Wind, each $1.00 increase in sales revenue results in a total contribution

margin increase of 40¢.
If sales increase by $50,000, what will be the increase in total contribution margin?

400
400 Bikes
Bike s 500
500 Bikes
Bikes
Sales
Sales $$200,000
200,000 $$250,000
250,000
Le ss: va
Less: variable
riable ex penses
e xpenses 120,000
120,000 150,000
150,000
Contribution margin
Contribution margin 80,000
80,000 100,000
100,000
Le ss: fix ed expenses
Less: fixed expenses 80,000
80,000 80,000
80,000
Net
Net operating
operating income
income $$ -- $$ 20,000
20,000

A $50,000 increaase in sales revenue

400
400 Bikes
Bike s 500
500 Bikes
Bike s
Sa les
Sales $ 200,000
$ 200,000 $$250,000
250,000
Less:
Less: variable
variable ex expenses
penses 120,000
120,000 150,000
150,000
Contribution ma
Contribution ma rgin rgin 80,000
80,000 100,000
100,000
Less: fix ed e xpe nses
Less: fixe d ex pe nses 80,000
80,000 80,000
80,000
Ne
Nett ope
operating
ra ting income
income $$ -- $$ 20,000
20,000

A $50,000 increase in sales revenue results in a $20,000

increase in CM. ($50,000 × 40% = $20,000)

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 Unit contribution margin
CM Ratio = Unit selling price
b. 0.758
c. 0.242 ($1.49-$0.36)
d. 4.139 = $1.49
Ans: B $1.13
= 0.758
= $1.49
 Changes in Fixed Costs and Sales Volume
Wind is currently selling 500 bikes per month. The company’s sales manager believes
that an increase of $10,000 in the monthly advertising budget would increase bike
sales to 540 units.
Should we authorize the requested increase in the advertising budget?

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

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

Proje
Projecte
ctedd
Curre
Current
nt Sa le s
Sales Sa les
Sale s (540
(540
(500
(500 bikes)
bike s) bike
bikes)s)
Sale
Sa less $
$ 250,000
250,000 $
$ 270,000
270,000
Le ss: va
Less: ria ble
varia ble e
expe
x pense
nsess 150,000
150,000 162,000
162,000
Contribution
Contribution ma rgin
margin 100,000
100,000 108,000
108,000
Le ss: fix
Less: fixe d e
ed exxpe
penses
nse s 80,000
80,000 90,000
90,000
Net
Ne t opera
ope rating
ting income
income $
$ 20,000
20,000 $
$ 18,000
18,000

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

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

The Shortcut Solution

Increa
Increase
se in
in CM
CM (40
(40 units
units X X $200)
$200) $
$ 8,000
8,000
Increa se in advertising e xpenses
Increa se in a dvertising expenses 10,000
10,000
Decrease
De crease in
in net
ne t operating
ope ra ting income
income $
$ (2,000)
(2,000)

Break-Even Analysis
Break-even analysis can be approached in three ways:
Graphical analysis.
Equation method.
Contribution margin method.
 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

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

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

 We can also use the following equation to compute 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

X = 0.60X + $80,000 + $0
0.40X = $80,000
X = $80,000 ÷ 0.40
X = $200,000

Contribution Margin Method

The contribution margin method is a variation of the equation method.
Break-even point Fixed expenses
in units sold = Unit contribution margin

Break-even point in Fixed expenses

total sales dollars CM ratio
=
 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?
Fixed expenses
a. 872 cups Break-even =
Unit contribution margin
b. 3,611 cups
c. 1,200 cups $1,300
= $1.49 per cup - $0.36 per cup
d. 1,150 cups
= $1,300
$1.13 per cup
Ans: D
= 1,150 cups

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
b. $1,715 Break-even sales =
CM Ratio
c. $1,788
$1,300
d. $3,129
= 0.758
Ans: B = $1,715
B

Target Profit Analysis

Suppose Wind Co. wants to know how many bikes must be sold to earn a profit of $100,000.
We can use our CVP formula to determine the sales volume needed to achieve a target net
profit figure.

The CVP Equation

Sales = Variable expenses $500Q = $300Q + $80,000 + $100,000
+ Fixed expenses $200Q = $180,000
Q = 900 bikes
+ Profits
 The Contribution Margin Approach
We can determine the number of bikes that must be sold to earn a profit of $100,000
using the contribution margin approach.

Unit sales to attain Fixed expenses + Target profit

the target profit =
Unit contribution margin

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

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 Unit sales to attain target profit Fixed expenses + Target profit
b. 2,212 cups Unit contribution margin
c. 1,150 cups $1,300 + $2,500
d. 4,200 cups
= $1.49 - $0.36

Ans: A $3,800
== $1.13

= 3,363 cups

The Margin of Safety

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

Margin of safety = Total sales - Break-even sales Let’s calculate the margin of
safety for Wind.

Wind has a break-even point of $200,000. If actual sales are $250,000, the
margin of safety is $50,000 or 100 bikes.
Bre ak-e ven
Bre a k-e ve n
sales Actual sales
sa les Actual sales
400 units 500 units
400 units 500 units
Sa les $ 200,000 $ 250,000
Sa les $ 200,000 $ 250,000
Less: va ria ble expenses 120,000 150,000
Less: va ria ble expe nses 120,000 150,000
Contribution margin 80,000 100,000
Contribution margin 80,000 100,000
Less: fixed expe nse s 80,000 80,000
Less: fixed e xpe nse s 80,000 80,000
Ne t opera ting income $ - $ 20,000
Ne t operating income $ - $ 20,000
 The margin of safety can be expressed as 20% of sales.
($50,000 ÷ $250,000)
Brea k-e ve n
Bre ak-e ve n
sa les Actua l sa les
sa le s Actual sale s
400 units 500 units
400 units 500 units
Sale s $ 200,000 $ 250,000
Sale s $ 200,000 $ 250,000
Le ss: variable ex pense s 120,000 150,000
Less: va riable e x pe nse s 120,000 150,000
Contribution ma rgin 80,000 100,000
Contribution ma rgin 80,000 100,000
Le ss: fixe d ex pe nses 80,000 80,000
Less: fixe d e x pe nse s 80,000 80,000
Net operating income $ - $ 20,000
Net ope rating income $ - $ 20,000

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 Margin of safety = Total sales – Break-even sales
c. 1,150 cups = 2,100 cups – 1,150 cups
d. 2,100 cups = 950 cups
Ans : B or
Margin of safety 950 cups
percentage = 2,100 cups = 45%

Operating Leverage
Actual sales
Actual sales
500 Bikes $100,000
Sales
Sales
Less: variable expenses
Less: variable expenses
$
$
500 Bikes
250,000
250,000
150,000
150,000
$20,000 = 5
Contribution margin 100,000
Contribution margin 100,000
Less: fixed expenses 80,000
Less: fixed expenses 80,000
Net income $ 20,000
Net income $ 20,000

With a operating leverage of 5, if Wind 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!
 10%
10% increase
increase in
in sales
sales from
from
$250,000
$250,000 to $275,000 .. .. ..
to $275,000

.. .. .. results
results in
in aa 50%
50% increase
increase in
in income
income from
from $20,000
$20,000 to
to $30,000.
$30,000.

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 leverage Contribution margin
b. 0.45 = Net operating income
c. 0.34
d. 2.92 $2,373
= = 2.21
Actual sales $1,073
2,100 cups
Sales $ 3,129
Less: Variable expenses 756
Contribution margin 2,373
Less: Fixed expenses 1,300
Net operating income $ 1,073

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, and the average fixed expense per month is $1,300.
2,100 cups are sold each month on average.
If sales increase by 20%, by how much should net operating income increase?
a. 30.0% Percent increase in sales 20.0%
b. 20.0% × Degree of operating leverage 2.21
c. 22.1% Percent increase in profit 44.20%
d. 44.2% Ans: D

Teaching Note:
Verify increase in profit
A ctual Increased
sales sales
2,100 cups 2,520 cups
Sa le s $ 3,129 $ 3,755
Le ss: Va ria ble e x pe nse s 756 907
Contribution ma rgin 2,373 2,848
Le ss: Fix e d e x pe nse s 1,300 1,300
Ne t ope ra ting income $ 1,073 $ 1,548
% cha nge in sa le s 20.0%
% cha nge in ne t ope ra ting income 44.2%