CVP analysis as presented in this chapter is based on a simple model of how profits respond to prices, costs, and volume. This model can be used to answer a variety of critical questions such as what is the company's break-even volume, what is its margin of safety, and what is likely to happen if specified changes are made in prices, costs, and volume.

A CVP graph depicts the relationships between sales volume in units on the one hand and fixed expenses, variable expenses, total expenses, total sales, and profits on the other hand. The CVP graph is useful for developing intuition about how costs and profits respond to changes in sales volume.

The contribution margin ratio is the ratio of the total contribution margin to total sales. This ratio can be used to quickly estimate what impact a change in total sales would have on net operating income. The ratio is also useful in break-even analysis. The break-even point is the level of sales (in units or in dollars) at which the company just breaks even. The break-even point can be computed using several different techniques that are all based on the simple CVP model. With slight modifications, the same techniques can be used to compute the level of sales required to attain a target profit.

The margin of safety is the amount by which the company's current sales exceeds the breakeven point.

The degree of operating leverage allows quick estimation of what impact a given percentage change in sales would have on the company's net operating income. The higher the degree of operating leverage, the greater is the impact on the company's profits. The degree of operating leverage is not constant—it depends on the company's current level of sales. The profits of a multiproduct company are affected by its sales mix. Changes in the sales mix can affect the break-even point, margin of safety, and other critical factors.

Learning Objectives

Explain how changes in activity affect contribution margin and net operating income.

Prepare and interpret a costvolume-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 in unit sales and sales dollars.

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 it can be used to predict changes in net operating income.

Compute the break-even point for a multiproduct company and explain the effects of shifts in the sales mix on contribution margin and the break-even point.