Learning Objectives
After studying Chapter 6, you should be able to:

• Explain how changes in activity affect contribution margin and net operating income.
• Prepare and interpret a cost-volume-profit (CVP) graph.
• Use the contribution margin ratio (CM ratio) to compute changes in contribution margin and net operating income resulting from changes in sales volume.
• Show the effects on contribution margin of changes in variable costs, fixed costs, selling price, and volume.
• Compute the break-even point.
• Determine the level of sales needed to achieve a desired target profit.
• Compute the margin of safety and explain its significance.
• Compute the degree of operating leverage at a particular level of sales and explain how the degree of operating leverage can be used to predict changes in net operating income.
• Compute the break-even point for a multiple product company and explain the effects of shifts in the sales mix on contribution margin and the break-even point.

Chapter 6

Cost-volume-profit (CVP) analysis is one of the most powerful tools that managers have at their command. It helps them understand the relationships among cost, volume, and profit in an organization by focusing on interactions between the following five elements:

1. Prices of products.
2. Volume or level of activity.
3. Per unit variable costs.
4. Total fixed costs.
5. Mix of products sold.

Because CVP analysis helps managers understand the relationships among cost, volume, and profit, it is a vital tool in many business decisions. These decisions include what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of production facilities to acquire. To help understand the role of CVP analysis in business decisions, consider the case of Acoustic Concepts, Inc., a company founded by Prem Narayan.

Summary

LO1 Explain how changes in activity affect contribution margin and net operating income.
The unit contribution margin, which is the difference between a unit’s selling price and its variable cost, indicates how net operating income will change as the result of selling one more or one fewer unit. For example, if a product’s unit contribution margin is $10, then selling one more unit will add $10 to the company’s profit.

LO2 Prepare and interpret a cost-volume-profit (CVP) graph.
A cost-volume-profit graph displays sales revenues and expenses as a function of unit sales. Revenue is depicted as a straight line slanting upward to the right from the origin. Total expenses consist of both a fixed element and a variable element. The fixed element is flat on the graph. The variable element slants upward to the right. The break-even point is the point at which the total sales revenue and total expenses lines intersect on the graph.

LO3 Use the contribution margin ratio (CM ratio) to compute changes in contribution margin and net operating income from changes in sales volume.
The contribution margin ratio is computed by dividing the unit contribution margin by the unit selling price, or by dividing the total contribution margin by the total sales.

The contribution margin shows by how much a dollar increase in sales will affect the total contribution margin and net operating income. For example, if a product has a 40% contribution margin ratio, then a $100 increase in sales should result in a $40 increase in contribution margin and in net operating income.

LO4 Show the effects on contribution margin of changes in variable costs, fixed costs, selling price, and volume.
Contribution margin concepts can be used to estimate the effects of changes in various parameters such as variable costs, fixed costs, selling prices, and volume on the total contribution margin and net operating income.

LO5 Compute the break-even point.
The break-even point is the level of sales at which profits are zero. It can be computed using several methods. The break-even point in units can be determined by dividing total fixed expenses by the unit contribution margin. The break-even point in sales dollars can be determined by dividing total fixed expenses by the contribution margin ratio.

LO6 Determine the level of sales needed to achieve a desired target profit.
The sales, in units, required to attain a desired target profit can be determined by summing the total fixed expenses and the desired target profit and then dividing the result by the unit contribution margin.

LO7 Compute the margin of safety and explain its significance.
The margin of safety is the difference between the total budgeted (or actual) sales of a period and the break-even sales. It expresses how much cushion there is in the current level of sales above the break-even point.

LO8 Compute the degree of operating leverage at a particular level of sales and explain how the degree of operating leverage can be used to predict changes in net operating income.
The degree of operating leverage is computed by dividing the total contribution margin by net operating income. The degree of operating leverage can be used to determine the impact a given percentage change in sales would have on net operating income. For example, if a company’s degree of operating leverage is 2.5, then a 10% increase in sales from current levels of sales should result in a 25% increase in net operating income.

LO9 Compute the break-even point for a multiple product company and explain the effects of shifts in the sales mix on contribution margin and the break-even point.
The break-even point for a multiproduct company can be computed by dividing the company’s total fixed expenses by the overall contribution margin ratio.

This method for computing the break-even point assumes that the sales mix is constant. If the sales mix shifts toward products with a lower contribution margin ratio, then more total sales are required to attain any given level of profits.