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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada3-2
Operating Leverage
How a small percentage
increase in sales volume can
produce a significantly
higher percentage increase in
profitability.
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Determining the Contribution Margin Per
Unit
Contribution margin (CM) is the difference between the
sales revenue and the variable costs.
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CM is a measure of the amount
available to cover fixed costs and
profits for an enterprise.
Determining the Contribution Margin Per
Unit
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For each additional K6 unit Jeff sells, $200
more in contribution margin will help to
cover fixed expenses and profit.
Determining the Contribution Margin Per
Unit
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Determining the Contribution Margin Per
Unit
Each month Jeff must generate
at least $80,000 in CM to
break even.
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Determining the Contribution Margin Per
Unit
If Jeff sells 400 units in a
month, it will be operating at
the break-even point.
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Determining the Contribution Margin Per
Unit
If Jeff sells one additional unit above the
break-even point, net income increases by
the amount of the contribution margin.
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Determining the Break-
Even Point
The break-even point is where total
revenue is equal total costs.
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Determining the Break-
Even Point
The break-even point in units
can be determined using the
following equation:
Break-Even Volume
in Units
= Fixed Costs
Contribution Margin Per Unit
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Determining the Break-
Even Point
The break-even point in units
can be determined using the
following equation:
Break-Even Volume
in Units
= Fixed Costs
Contribution Margin Per Unit
For Jeff’s K6 model computer the break-
even volume in units is:
$80,000
$200
= 400 computers
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada3-12
Estimating the Sales Volume Necessary
to Attain a Target Profit
At the break-even point
profits equal zero.
Sales Volume
in Units
= Fixed Costs + Desired Profit
Contribution Margin Per Unit
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Estimating the Sales Volume Necessary
to Attain a Target Profit
Jeff wants to know how many K6 computers
must be sold to earn a profit of $100,000.
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Estimating the Sales Volume Necessary
to Attain a Target Profit
Calculate volume in
units:Sales Volume
in Units
= Fixed Costs + Desired Profit
Contribution Margin Per Unit
Sales Volume
in Units
= $80,000 + $100,000
$200
Sales Volume
in Units
= 900 units
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Estimating the Sales Volume Necessary
to Attain a Target Profit
Here’s the proof:
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Estimating the Effects of Changes in
Sales Price
Competition is forcing Jeff to consider a drop in
selling price of the K6 model. What is the impact
on break-even of a drop in selling price from
$500 to $460 per unit?
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Estimating the Effects of Changes in
Sales Price
The new contribution per unit would be $160
($460 - $300).
Break-Even Volume
in Units
= Fixed Costs
Contribution Margin Per Unit
Break-Even Volume
in Units
=
$80,000
$160
Break-Even Volume
in Units
= 500 units
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Estimating the Effects of Changes in
Sales Price
Here is the proof . . .
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Changes in Fixed Costs and Sales
Volume
Jeff is currently selling 500 K6 computers per
month. The sales manager believes that an
increase of $10,000 in the monthly
advertising budget would increase sales to
540 units.
l Should Jeff authorize the requested
increase in the advertising budget?
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada3-20
Changes in Fixed Costs and Sales
Volume
Sales increased by $20,000, but net
income decreased by $2,000..
$80,000 + $10,000 advertising = $90,000
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Changes in Fixed Costs and Sales
Volume
The Shortcut Solution
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Cost-Volume-Profit Graph
Viewing CVP relationships in a graph gives managers a
perspective that can be obtained in no other way.
Consider the following information for Jeff:
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Cost-Volume-Profit Graph
Fixed expenses
Units
D
ol
la
rs Total Expenses
Total Sales
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D
ol
la
rs
Cost-Volume-Profit Graph
Break-even point
Units
Pro
fit A
rea
Los
s A
rea
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The Margin of Safety
The number of units (or sales
dollars) by which actual sales
can fall below budgeted sales
before a loss is of safety =
Let’s calculate the margin of safety
for Jeff’s K6 model.
Budgeted Sales - Break-even sales
Budgeted Sales
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The Margin of Safety
Jeff has a break-even point of $200,000. If
budgeted sales are $250,000, the margin of
safety is $50,000 or 100 units.
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The Margin of Safety
The margin of safety can be expressed as
20 percent of sales.
Margin of safety =
Budgeted Sales - Break-even sales
Budgeted Sales
Margin of safety = $250,000 - $200,000$250,000
Margin of safety = 20%
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Using Contribution to Assess the Effect of
Simultaneous Changes in CVP Variables
Jeff believes that by cutting the price of the K6
model by $25, sales will increase to 550 units.
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Using Contribution to Assess the Effect of
Simultaneous Changes in CVP Variables
Jeff believes that by cutting the price of the K6
model by $25, sales will increase to 550 units.
Profits will be reduced
from $20,000 to
$16,250.
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CVP Analysis Using the Contribution
Margin Ratio
The contribution margin is
expressed as a percentage of
sales price.
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CVP Analysis Using the Contribution
Margin Ratio
We can calculate the break-
even point in total sales
dollars as follows: Fixed expenses Fixed expenses CM ratio CM ratio==
Break-even point inBreak-even point in
total sales dollarstotal sales dollars
$80,000 $80,000
40% 40%
= $200,000= $200,000
Break-even point inBreak-even point in
total sales dollarstotal sales dollars =
=
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CVP Analysis Using the Equation
Method
Selling Price Per Unit
×
Number of Units Sold
Variable Cost Per Unit
×
Number of Units Sold
+ Fixed Cost=
If we let X equal the number of units, we can
express
Jeff’s break-even equation as:
$500X = $300X + $80,000
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada3-33
CVP Limitations
Selling price is constant
throughout the entire relevant
range.
Costs are linear throughout the
entire relevant range.
In multi-product companies, the
sales mix is constant.
In manufacturing companies,
inventories do not change (units
produced = units sold).
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