1. CHAPTER 5
Cost-Volume-
Profit
Relationships
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

2. 2-2
Operating Leverage
10% Revenue
Increase
10% Gross
Profit Increase
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3. 2-3
Operating Leverage
10% Revenue
Increase
90% Gross
Profit Increase
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

4. 2-4
Lessons Learned
When all costs are variable, the potential
for profits is limited, because costs keep
growing with volume.
When all costs are fixed, after the fixed
costs are covered, every additional sales
dollar contributes the whole dollar to
gross profit. The profit potential is higher.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

5. 2-5
Operating Leverage
A measure of the extent to which fixed costs are
being used in an organization to change profit.
Operating leverage is greater in companies that
have a high proportion of fixed costs in
relation to variable costs.
Small Large
percentage percentage
change in change in
revenue profits
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6. 2-6
Measuring Operating Leverage
Using Contribution Margin
Operating Contribution margin
=
Leverage Net income
Show me
an example.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

7. 2-7
Measuring Operating Leverage
Using Contribution Margin
Operating $20,000
= = 4
Leverage $5,000
A 10% increase in sales will result in
a 40% increase (10% × 4) in net income.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

8. 2-8
Operating Leverage
10% Sales
Increase
40% Profit Increase
Verify: ($7,000 - $5,000) / $5,000 = 40 %
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

9. 2-9
Effect of Cost Structure
on Profit Stability
Earnings
Level of Operating
Volatility
Fixed Cost Leverage
& Risk
High High High
Low Low Low
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10. 2-10
Effect of Cost Structure on Profit Stability
If the number of units sold increases by 10% for all three
companies, which company will enjoy the highest net income?
Is it true that If the number of units sold decreases by 15% for
all three companies, All Variable Company will have higher net
income than All Fixed Company?
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

11. 2-11
Cost-Volume-Profit (CVP) Analysis
 CVP analysis summarizes the
relationship between an
organization’s volume of activity
and its costs, revenue and profit
within the relevant range.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

12. 2-12
CVP Analysis
When running any business –
• The first concern is if it can sell enough to
cover all its costs (Breakeven analysis).
• The second concern is whether it can
reach a desired profit (Target profit
analysis).
• The third concern is how to assess and
select different strategies (CVP impact
analysis)
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

13. 2-13
Determining the Break-even Point
•The break-even point is the point
where total revenue equals to total costs
(both variable and fixed), and therefore
the profit is zero.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

14. 2-14
Dollars Cost-Volume-Profit Graph
Break-even
Point
Revenue
Total Cost
Fixed Cost
Units Sold
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15. 2-15
The Equation Method
We can use the profit equation to find out the BE point in units.
At the break-even point:
Total Sales – Total Costs = Zero
Total Sales - Total Variable costs - Total Fixed Costs = Zero
where:
Total Sales = Selling price per unit * BE Units
Total Variable Costs = Variable cost per unit * BE Units
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

16. 2-16
Reaching a Target Profit Level
If we want to consider the desired
profit, the profit equation would be:
Total Sales – Total Costs = Desired Profit
Total Sales - Total Variable Costs - Total Fixed costs
= Desired profit
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

17. 2-17
Determining the Break-even Point
Using a Formula
By re-arranging the Profit Equation at break-
even, we can derive a formula to quickly compute
Break-even Point in Units.
Break-even Fixed costs
=
volume in units (Unit Selling Price – Unit Variable Cost)
 Break-even
volume in units
= Fixed costs
Contribution margin per unit
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

18. 2-18
Reaching a Target Profit
Using the Formula
The formula can be expanded to include a
target profit analysis.
Sales volume Fixed costs + Desired profit
=
in units (Unit Selling Price – Unit Variable Cost)
Sales volume Fixed costs + Desired profit
 in units
=
Contribution margin per unit
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

19. 2-19
CVP Analysis
What do you think “units” mean
in giant retailers, such as Wal Mart?
Can Wal Mart do a Break-even analysis?
Can it figure out the level of Sales to reach
its desired profit?
The answers to both are YES!
It uses Contribution Margin Ratio!
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

20. 2-20
Contribution Margin Ratio
The contribution margin ratio (CM%) measures the
percentage of sales that is contribution margin.
For example, a 25% CM ratio means for every
$100 of sales, $25 (25% of $100) is CM, and $75
(75% of $100) is variable cost.
Contribution Margin (CM) Ratio
= Total CM  Total sales
= Unit CM  Unit selling price
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

21. 2-21
Contribution Margin Ratio
By re-arranging the Profit Equation at break-
even, we can derive a formula to quickly compute
Break-even in Sales Dollars, using CM ratio.
Break-even in Sales Dollars
Fixed costs
=
CM ratio
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

22. 2-22
Contribution Margin Ratio
The formula with CM ratio can be further
expanded to include a target profit analysis.
Sales Dollars to reach a desired profit
Fixed costs + Desired profit
= CM ratio
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

23. 2-23
Contribution Margin Ratio
•Consider the following Income
Statement: CM%=$60,000/$100,000=60%
Sales $100,000
BE$ = TFC / CM%
- Variable Costs $40,000 = $30,000 / 60%
Contribution Margin $60,000 = $50,000
Sales for $60,000 profit
- Fixed Costs $30,000 = ($30,000+$60,000)/60%
Net Income $30,000 = $150,000
Total variable cost at BE
= BE sales * (1 – CM%)
= $50,000 * 40%
What is the Break-even Sales? = $20,000
What is the Total Sales if the target profit is $60,000?
What is the total Variable Cost at Break-even point?
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

24. 2-24
CVP Impact Analysis
1.To examine the profit impact of changes
in fixed costs, variable costs, selling price,
and the mix of products.
2.To find out the allowable selling price,
fixed costs, or variable costs, given a
target level of profit.
3.Examples:
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008

25. 2-25
BE and Target Profit Analysis
Equation Method:
Total Sales - Total Variable costs - Total Fixed costs = Desired profit
CM per unit Formula Method:
Sales volume Fixed costs + Desired profit
=
in units Contribution margin per unit
CM % Formula Method:
Sales Fixed costs + Desired profit
=
Dollars Contribution margin %
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc. 2008