Chapter 05

Cost-Volume-Profit Relationships

Chapter Study Suggestions

one of the key chapters in the book. Many of the chapters

ahead depend on concepts developed here. You should study several sec
tions in the chapter with particular attention. The first of these is the sec
tion titled, "Contribution Margin." Note how changes in the contribution
margin affect net operating income. The next section you should study
with particular care is titled "Contribution Margin Ratio." The contribu
tion margin ratio is used in much of the analytical work in the chapter.
Another section you should study very carefully is titled "Some Ap
plications of CVP Concepts." Much of the homework material is drawn
from this section. The section titled "Break-Even Analysis" also forms
the basis for much of the homework material. Finally, the section titled
"The Concept of Sales Mix" shows how to use CVP analysis when the
company has more than one product.
When studying this chapter, try especially hard to understand the
logic behind the solutions rather than just memorizing formulas.

65

Chapter

CHAPTER HIGHLIGHTS

A The contribution margin is a key concept. The

contribution margin is the difference between total
sales and total variable expenses. The unit contribution
margin is the difference between the unit
and the unit variable expense.
L Net

vlJ',-,.a.Ull.)e,

tion

income is equal to the contribu

expenses.

Sales ............................... ..

Variable expenses ........... ..

Contribution margin ........ .

Fixed expenses ................ .

Net
income ..... ..

4.
that fixed expenses are not att1cct,cO.
an increase (or decrease) in contribution
will be reflected dollar for dollar in increased (or
net ooeraLtlnl1! income.

5, The CM ratio is
company has multiple
volume is most
total dollar sales rather than in

useful when a
such
in tenns of

C. Cost-volume-profit (CVP)
can be used
in many day-to-day decisions. Carefully study the ex
amples
under the heading "Some
of CVP
in the
of the

xxx

2. The break-even point is the level of sales at

which
is zero. This is also the point at which the
total contribution
equals fixed expenses.

1. Notice that each solution makes use of either

the unit contribution
or the CM ratio, This un
derscores the
two l'".,l'P.... t"

3. The relation between contribution margin and

net operating income
a very powerful
ning tooL It
the manager the ability to predict
what profits will be at various activity levels without
the
detailed income statements.

2. Also notice that several of the

incremental analysis. An incremental
is
on
those costs and revenues that differ between
alternati ves.
D. Two
examples of CVP
called
break-even
and target prolit analysis, are
often used. Break-even analysis is a special case of
analysis, so
profit
is conbelow.

a.

The contribution
must first cover
fixed
If it doesn't, the company has a loss.
Below
break-even
every unit sold reduces
the loss by the amount of the unit contribution
Once the break-even point is
net
income will increase by the amount of the
unit contribution
for each additional unit sold.

1.

B. The contribution
ratio (CM
which
expresses the contribution margin as a percentage of
is another very
concept.

Profits

b.

VI-""'U;'.'HJ'F,

Fixed expenses

this equation is often rewritten as:

this basic
All of the problems can be worked
AmIM,A,., and
fonnu
some of the more
formulas are discussed
common
below.

. Contribution
CM ratlo= - - - - - - -...=-
Sales
a
product, the
2. In a vVJIJlIJ''''U with
CM ratio can also
computed as follows:

2.
is used in two basic
variations. In the first
the question is how
many units would have to be sold to attain the
In the second
the
is how
much total dollar sales would have to be to attain the
target profit. The fonnulas are:

Unit contribution
Unit selling price

3. The contribution
diet the
in total
result from a given change in dollar sales:
'-'H>"!l~,'-' in dollar sales ................ ..
CM ratio ...................................... .

'-'!l"'La~'-' in contribution margin .. ..

Variable expenses

Sales = Variable expenses + Fixed expenses + Profits

1. The contribution margin ratio is defined as fol

Sales

In CVP

lows:

CM

profit analysis is used to find out how

have to be sold to attain a ""'vv,uv
is based on the following equation:

Unit sales to

Fixed ext)em;es-t-Ta

attain target profit

xxx

Dollar sales to
attain target profit

66

~F~ix~e~d~~~~~~~~
CM ratio

Chapter

E. Break-even occurs when profit is zero. Thus,

Percentage change in dollar sales .. ... .

break-even analysis is really just a special case of tar

get profit analysis in which tlle target profit is zero.

Therefore, the break-even formulas can be stated as
follows:

Percentage change in net operating

income .......................................... .

3. The degree of operating leverage is not con

It changes as sales increase or decrease. In gen
eral, the degree of operating leverage decreases the
further a company moves away from its break-even
point.
~tant.

Break-even point _
Fixed expenses
in units sold - Unit contribution margin
Break-even point _ Fixed expenses
in total sales dollars CM ratio

1. When a company has more than one product, the

sales mix can be crucial. The sales mix refers to the
relative proportions in which the company's products
are sold.

F. CVP and break-even analysis can also be done

graphically. Exhibits 6-1 and 6-2 show how a CVP
graph is prepared and interpreted. A cost-volume
profit graph depicts the relations among sales, costs,
and volume.

I. When CVP analysis involves more than one

product, the analysis is normally based on the overall
contribution margin ratio. This is computed exactly
like the CM ratio is computed in a single product com
pany except that overall figures are used for both the
contribution margin and sales:

G. The margin ofsafety is the excess of budgeted (or

actual) sales over the break-even volume of sales. It is
the amount by which sales can drop before losses be
gin to be incurred. The margin of safety can be stated
in terms of either dollars or as a percentage of sales:

Total budgeted (or actual) sales .. ..

Less break-even sales .... .............. ..

Margin of safety ...... ............ ........ ..

Margin of safety
percentage

Margin of safety
Total budgeted (or actual) sales

H. Cost structure-the relative proportion of fixed

and variable costs- has an impact on how sensitive a
company's profits are to changes in sales. A company
with low fixed costs and high variable costs will tend
to have a lower CM ratio than a company with a
greater proportion of fixed costs. Such a company will
tend to have less volatile profits, but at the risk of los
ing substantial profits if sales trend sharply upward.
Operating leverage refers to the effect a given
percentage increase in sales will have on net operating
income.

I.

1. The degree of operating leverage is defined as:

Degree of operating
leverage

= Contribution margin
Net operating income

2. To estimate the percentage change in net op

erating income that would occur as the result of a
given percentage change in dollar sales; mUltiply the
change in sales by the degree of operating leverage.

Degree of operating leverage ..... ...... ..

.
Overa11 CM ratro

Overall contribution margin

----------=:.
Overall sales

2. When the company has more than one prod

uct, the overall CM ratio is used in the target profit
and break-even formulas instead of the CM ratio.

3. As the sales mix changes, the overall eM ratio

will also change. If the shift is toward less profitable
products, then the overall CM ratio will fall; if the
shift is toward more profitable products, then the over
all CM ratio will rise.
K. CVP analysis ordinarily relies on the following
assumptions:

I. The selling price is constant; it does not

change as unit sales change.
2. Costs are linear. Costs can be accurately di
vided into variable and fixed elements. The variable
cost per unit is constant and the total fixed cost is con
stant.
3. In multi-product situations, the sales mix is
constant.
4. In manufacturing companies, inventories do
not change.

67

Chapter

REVIEW AND SELF-TEST

Questions and Exercises

True or False
Enter a T or an F in the blank to indicate whether the

statement is true or false.

1. If product A has a higher unit contribution

margin than product B, then product A will also have a
higher CM ratio than product B.

month. What is the company's unit contribution mar

gin? a) $50; b) $30; c) $20; d) $80.
2. Refer to the data for Lester Company in
question 1 above. What is the company's contribution
margin ratio? a) 60%; b) 40%; c) 167%; d) 20%.
3. Refer to the data for Lester Company in
question 1 above. What is the company's break-even
in sales dollars? a) $500,000; b) $33,333; c) $200,000;
d) $400,000.

2. The break-even point occurs where the

contribution margin is equal to total variable expenses.
3. The break-even point can be expressed ei
ther in terms of units sold or in terms of total sales dol
lars.

4. Refer to the data for Lester Company in

question 1 above . How many units would the company
have to sell to attain target profits of $50,000?
a) 10,000; b) 12,500; c) 15,000; d) 13,333.

4. If the sales mix changes, the break-even

point may change.

5. Parker Company has provided the follow

ing data for the most recent year: net operating in
come, $30,000; fixed expense, $90,000; sales,
$200,000; and CM ratio, 60%. The company's margin
of safety in dollars is: a) $150,000; b) $30,000;
c) $50,000; d) $80,000.

5. For a given increase in sales dollars, a high

CM ratio will result in a greater increase in profits
than will a low CM ratio.
6. If sales increase by 8%, and the degree of
operating leverage is 4, then profits can be expected to
increase by 12%.

6. Refer to the data in question for Parker

Company in 5 above. The margin of safety in percent
age form is: a) 60%; b) 75%; c) 40%; d) 25%.

7. The degree of operating leverage remains

the same at all levels of sales.

8. Once the break-even point has been

reached, net operating income wiIl increase by the lmit
contribution margin for each additional unit sold.

7 . Refer to the data for Parker Company in

question 5 above. What is the company's total contri
bution margin? a) $110,000; b) $120,000;
c) $170,000; d) $200,000.

9. A shift in sales mix toward less profitable

products will cause the overall break-even point to
fall.

8. Refer to the data for Parker Company in

question 5 above. What is the company's degree of
operating leverage? a) 0.25; b) 0.60; c) 1.25; d) 4.00.

10. Incremental analysis focuses on the differ

_
ences in costs and revenues between alternatives.
_
11. If a company's cost structure shifts toward
higher fixed costs and lower variable costs, the com
pany's CM ratio will fall.

9. If sales increase from $400,000 to

$450,000, and if the degree of operating leverage is 6,
net operating income should increase by: a) 12.5%;
b) 75%; c) 67%; d) 50%.

12. One way to compute the break-even point

_
is to divide total sales by the CM ratio.
_
l3 . When a company has more than one prod
uct, a key assumption in break-even analysis is that the
sales mix will not change.

_
10. In mUltiple product companies, a shift in
the sales mix from less profitable products to more
profitable products will cause the company's break
even point to: a) increase; b) decrease; c) there will be
no change in the break-even point; d) none of these.

Multiple Choices

11. Herman Corp. has two products, A and B,

_
with the following total sales and total variable costs:

Choose the best answer or response by placing the

identifying letter in the space provided.

Sales... ... .... ....... ........ .

Variable expenses .... .

1. Lester Company has a single product. The

selling price is $50 and the variable cost is $30 per
unit. The company's fixed expense is $200,000 per

Product A
$10,000
$4,000

Product B
$30,000
$24,000

What is the overall contribution margin ratio? a) 70%;

b) 50%; c) 30%; d) 40%.

68

Chapter
Exercises
Exercise -1.

Hardee Company sells a single product. The selling price is $30 per unit and the variable expense

is $1& per unit. The company's most recent annual contribution fonnat income statement is given below:
Sales ............................. .
Variable expenses ......... .
Contribution margin ..... .
Fixed expenses ............ ..
Net operating income .. ..

$135,000

81,000

54,000

48,000

$ 6.000

a. Compute the contribution margin per unit. $_ _ _ __

b. Compute the CM ratio. _ _ _ _ %

c. Compute the break-even point in sales dollars. $_ _ _ __

d. Compute the break-even point in units sold. _____ units

e. How many units must be sold next year to double the company's profits? _____ Ullits
f. Compute the company's degree of operating leverage. _ _ _ __
g. Sales for next year (in units) are expected to increase by 5%. Using the degree of operating leverage,
compute the expected percentage increase in net operating income.
%

h. Verify your answer to part g above by preparing a contribution fonnat income statement showing a 5%
increase in sales.
Sales........ .. .................................................. .. ... ......

$_ _ _ _ _ __

Variable expenses ............... .......................... ....... ..

Contribution margin ....... .. .................. ....... .......... ..
Fixed expenses ..................................................... ..

Net operating income......... .... ........ .. ........... ... ........

69

$= == == =

Chapter
Exercise -2.

Using the data below, construct a cost-volume-profit graph like the one in Exhibit 6-1 in the text:
Sales: 15,000 units at $10 each.
Variable expense: $6 per unit.
Fixed expense: $40,000 total.

$200
$180
$160
$140

Iii' $120
Q
Q

~ $100
.!!!
'0
C $80

$60
$40
$20
$0

10

12

14

Units (0005)

What is the break-even point in units? _ _ _ _ _ _ _ __

What is the break-even point in total sales dollars? _ _ _ _ __ _ __

70

16

18

20

Chapter
Exercise -3.
low:

Seaver Company produces and sells two products, X and Y. Data concerning the products fol

Selling price per unit.. ............ ..

Variable expense per unit ...... ..
Contribution margin per unit ...

Product Y
$12

Product X
$10

--...2

.$..A

In the most recent month, the company sold 400 units of Product X and 600 units of Product Y. Fixed expense is
$5,000 per month.
a. Complete the following contribution format income statement for the most recent month (carry percentages
to one decimal point):
Product X
Amount
%

Sales ............... ..... .. ..... .... .

Product Y
Amount
%

$_-

$_-

$= = =

$===

Total
Amount

$_-

Variable expenses .......... .

Contribution margin ...... .
Fixed expenses .......... .... ..
Net operating income ......

$===

b. Compute the company's overall monthly break-even point in sales dollars. $_ _ __

c. If the company continues to sell 1,000 units, in total, each month, but the sales mix shifts so that an equal
number of units of each product is being sold, would you expect monthly net operating income to rise or
fall? Explain.

d.

Refer to the data in part c above. If the sales mix shifts as explained, would you expect the company's
monthly break-even point to rise or fall? Explain.

71

Chapter
Exercise -4.
Critical thought writing exercise: Able Company and Baker Company are competing COlTIo:a
nies that sell a product at the same
Both
above the break-even
and have
lar total
Able
costs are
Baker Company's costs are
fixed. In a
time of
sales, which company will tend to realize the most rapid increase in net
Ex
plain your answer.

--------------- - -.. - - - - - - - - - - -

----.----------------.----.--
..

------------_.

__

- - - ---- -------

..

72

------~

...

Chapter

Answers to Questions and Exercises

2b

True or False
1. F

Unit contribution margin .....

Unit selling price.... ...... .. ......
Contribution margin ratio .. ..

The eM ratio is the unit contribution mar

gin divided by the unit selling price. One
product might have a higher unit contribu
tion than another, but its selling price may
be lower.

$20
$50
40%

3. a
Breakeven point _ Fixed expenses
in total sales dollars CM ratio

2. F The break-even occurs where profit is zero.

3. T

The break-even can be computed in terms of

units sold or sales dollars .

4. T

A change in sales mix often results in a

change in the overall eM ratio. If the over
all CM ratio changes, the break-even will
also change.

5. T

The CM ratio measures how much of a sales

dollar is translated into increased contribu
tion margin.

$200,000 $500,000
0.40

4. b
Unit sales to _ Fixed expenses+Target profit
attain target profit - Unit contribution margin
$200,000+$50,000
$20 per unit
= 12,500 units
5. c
Break-even point _ Fixed expenses
in dollar sales eM ratio

6. F Profits should increase by 32% = 4 x 8%.

7. F

The degree of operating leverage decreases

as a company moves further and further
from its break-even.

8. T

At the break-even all fixed costs are cov

ered. All contribution margins generated
from that point forward increases net oper
ating income.

9. F

Margin of safety = $200,000 - $150,000

= $50,000

The reverse is true-the overall break-even

will rise because the average eM ratio will
be lower as a result of selling less profitable
products.

10. T

By definition, incremental analysis deals

only with differences between alternatives.

11. F

The reverse is true-one would expect the

company's CM ratio to rise. Variable costs
would be lower and hence the eM ratio
would be higher.

12. F

The break-even is computed by dividing to

tal fIXed expenses by the eM ratio.

13. T

This is a key assumption because a change

in the sales mix will change the break-even.

6. d $50,000 -7- $200,000

25%

7. b

Sales ... ............. .. ........... .

CM ratio .................. .. .. ..
Contribution margin .... ..

$200,000

x 0.60

$120,000

8. d

Contribution margin .... ..

Net operating income .. ..
Operating leverage ....... .

$120,000

..;. $30,000

4.0

9. b The computations are:

Perce~tage

change In sales

Multiple Choices

= $450,000 - $400,000 = 12.5%

$400,000

Percentage change in dollar sales .. .

Degree of operating leverage ........ ..
Percentage change in net operat
ing income .... ............................ ..

1. c

Unit selling price .... ........... ..

Less unit variable expenses.
Unit contribution margin .....

$90,000 = $150 000

0.60
'

$50

2.Q

$2.Q

73

12.5%
x 6.0
75.0%

Chapter
1O.b A shift to more profitable products would result
in an increase in the overall CM ratio. Thus,
fewer sales would be needed to cover the
fixed costs and the break-even would there
fore decrease.

11.c
Sales .. ......
Variable
expenses "
Contribution
margin ......

Product A

Product B

Total

$\0,000

$30,000

$4G,GGG

4,000

24,000

28,000

$ 6,000

$12000

Overall CM ratio = $12,000 +- $40,000 == 30%

Exercises
Exercise -1.
a.

Selling price .... ...................... .

Variable expenses ............... ...
Unit contribution margin ....... .
b. CM ratio== Contribution margin
Sales
c.

Per Unit
$30
~

100%
60%

$l2

~%

= $54,000

Sales == Variable expenses + Fixed expenses + Profits

X = 0.60X + $48,000 + $0
OAOX = $48,000
X = $48,000 +- OAO
X == $120,000
Alternative solution:
. Breakeven point = Fixed expenses
III total sales dollars
CM ratio

d.

== 40%

$135,000

==

$48,000
OAO

$120 000
'

Sales = Variable expenses + Fixed expenses + Profits

$30Q = $18Q + $48,000 + $0
$12Q = $48,000
Q = $48,000 -7 $12 per unit
Q = 4,000 units
Alternative solution:

Breakeven point _
Fixed expenses
_ $48,000 _ 4000 .

ld -,
units
. .
III units so
Unit contribution margin
$12

e.

Sales = Variable expenses + Fixed expenses + Profits

$30Q = $18Q + $48,000 + $12,000
$12Q = $60,000
Q = $60,000 -7 $12 per unit
Q = 5,000 units
Alternative solution:
Units sold to _ Fixed expenses+Target profit _ $48,000 + $12,000 - 5 000 't
.
fi-,
ums
attam target pro It
Unit contribution margin
$12 per unit

74

Chapter

g.

Degree of operating _ Contribution margin $54,000 9.0

leverage
Net income
$6,000
Percentage change in dollar sales ....... .. ...... ",
5%
Degree of operating leverage .................. ....... i.
x 9.0
Percentage change in net operating income;...
45%

h.

New sales volume: 4,500 units x 105% = 4,725 units

f.

Sales (4,725 units @ $30 per unit) ... .................... .

Variable expenses (4,725 wilts @ $18 per unit) ... .
Contribution margin ........... .................................. .
Fixed expenses ........................................... ........... .
Net operating income .................... ....... ................. .

$141,750
85,050
56,700
48,000
$ 8.700

Current net operating income ............................... .

Expected increase: $6,000 x 45% ........................ ..
Expected net operating income (as above) ........... .

75

6,000
2,700
8700

Chapter
Exercise -2.

The completed CVP graph:

$200

$180

[Y

$140

'Vi' $120
o
o

til eak

~ $100
.!
'0
Q

../

$80

$20
$0

./

$60
$40

V/

T(] tal Sate~

$160

./

V
4

~~

Y{
~
V
Total \

i-"""

./

xpense~

b?'

F xed Ex ~enses

10
Units (OOOs)

The break-even point is 10,000 units or $100,000 in sales.

76

12

14

16

18

20

Chapter
Exercise -3.
a.

The completed income statement:

Sales ......... ...................... .

Variable expenses ...........

Contribution margin ...... .
Fixed expenses .............. ..
Net operating income .... ..
b.

Product X
Amount
%
$4,000
100
2,400
~
aQQ
-.A.Q

Product
Amount
$7,200
1,800
~

Y
%
100

..l2.

-.12

Total
Amount
$11,200
4,200
7,000
5,000
$ 2,QQ.Q

%
100.0
37.5
62.5

Breakeven point _ Fixed expenses _ $5,000 _ $8 000

in total sales dollars CM ratio
- 0.625 ,

c. Monthly net operating income will fall. The shift in sales mix means that less of Product Y and more of
Product X are being sold. Because Product Y has a higher contribution margin per unit than Product X, less
contribution margin in total will be available and profits will therefore fall.
d. The monthly break-even will rise. As explained above, the shift in sales mix will be toward the less profit
able Product X, which has a CM ratio of only 40% as compared to 75% for Product Y. Thus, the company's
overall CM ratio will fall, and the break-even will rise because less contribution margin will be available per
unit to cover the fixed costs.

Exercise -4.
Baker Company will have a higher contribution margin ratio (and contribution margin per unit)
due to its lower variable costs. Thus, the company's contribution margin (and net operating income) will increase
more rapidly than Able Company's as sales increase. Therefore, Baker Company will realize the most rapid in
crease in net operating income. The impact on net operating income can also be viewed in tenns of operating lev
erage. Baker Company will have a higher degree of operating leverage than Able Company because of its higher
contribution margin. Therefore, as sales increase, Baker's net operating income will rise more rapidly than will
Able's.

77