Cost-Volume-

Profit Analysis
Managerial Accounting, ADA

Instructor
Mehriban Ahmadova
Case Study
• Teresa is working on a fundraiser by selling T-shirts. It was decided to sell
T-shirts that cost $10 and sell for $15.
• She needs to pay a “student sale” fee $100 and cover the costs for a spring
trip. Six students have signed up for the trip. Trip cost per person is $125.
• How many T-shirts does Teresa need to sell to cover all expenses?
• Profit per T-shirt is $15 - $10 = $5
• To cover for a “student sale” fee she needs to sell 20 T-shirts ($5*20 shirts).
• 150 T-shirts to cover the trip costs ($5*150=$725).
• In total she needs to sell 170 T-shirts.
• These completed steps are called cost-volume-profit analysis.

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Outline
1. Contribution Margin
2. Break-Even Point
3. Break-Even Sensitivity Analysis
4. Margin of Safety
5. Operating Leverage

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Contribution Margin

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Contribution Margin
• Understanding how fixed costs, variable costs, and volume are related to
income is vital for sound decision-making.
• What is margin?
• Margin is the difference between a product or service’s selling price and its
cost of production.

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Contribution Margin Formula

• Contribution margin: the amount by which a product’s selling price
exceeds its total variable cost per unit.

𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 = 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 − 𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪

• If sales revenue from one t-shirt is $15 (10 units) and the variable cost of
one shirt is $10, what is contribution margin?
• Contribution margin is $50.
• Contribution margin is assumed to first cover fixed costs first and then
realized as profit.

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Unit Contribution Margin Formula

• Contribution margin per unit is useful to management because it is the per
unit contribution toward covering fixed costs.

𝑪𝑪𝑪𝑪 𝒑𝒑𝒑𝒑𝒑𝒑 𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼 = 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝒑𝒑𝒑𝒑𝒑𝒑 𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼 − 𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝒑𝒑𝒑𝒑𝒑𝒑 𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼

• It can be calculated either in dollars or as a percentage.

• If sales revenue from one t-shirt is $15 (10 units) and the variable cost of
one shirt is $10, what is contribution margin per unit?
• Contribution margin per unit is $5.

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Unit Contribution Margin Illustration

• Hicks Manufacturing is a small company that manufactures and sells
birdbaths to specialty retailers. Hicks Manufacturing sells its Blue Jay Model
for $100 and incurs variable costs of $20 per unit resulting in an $80
contribution margin per unit.

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Contribution Margin Ratio

𝑪𝑪𝑪𝑪 𝒑𝒑𝒑𝒑𝒑𝒑 𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼
𝑪𝑪𝑪𝑪 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹 =
𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝒑𝒑𝒑𝒑𝒑𝒑 𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼

Contribution margin ratio is 80%.

This means that $0.80 of every sales dollar goes toward meeting fixed costs,
and once those are met, $0.80 of every sales dollar will go toward profit.

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Unit Contribution Margin

• What does it mean?
• For every Blue Jay model they sell, they will have $80 to contribute toward
covering fixed costs (rent, insurance, salaries).
• Calculate its unit contribution margin for every model a company sells.

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Contribution Margin Income Statement

• Contribution margin Income Statement: Income statement that
separates variable costs from fixed costs
• Useful tool for analyzing the effect of changes in sales price, variable costs,
or fixed costs
• Suppose in April, Hicks sold 500 Blue Jay Models at $100 per unit, VC -
$20 per unit, FC - $23,000.
• Build Contribution Margin Income Statement:

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Contribution Margin
Illustration
You rent a kiosk in the mall for $300 a month and use it to sell T-shirts with
college logos from colleges and universities all over the world. You sell each
T-shirt for $25, and your cost for each shirt is $15. You also pay your
salesperson a commission of $0.50 per T-shirt sold in addition to a salary of
$400 per month. Construct a contribution margin income statement for two
different months: in one month, assume 100 T-shirts are sold, and in the
other, assume 200 T-shirts are sold.

 Workbook excel

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Total Contribution Margin

• “big picture” is gained by calculating total contribution margin.
• Total contribution margin is the total amount by which total sales exceed
total variable costs.
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶 = 𝑝𝑝𝑝𝑝𝑝𝑝 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝐶𝐶𝐶𝐶 × 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣
• Allows managers to determine how much profit a company is making
before paying its fixed expenses.
• How profitable is Blue Jay model?
• How sales from Blue Jay model contribute to the
overall profitability of the company?

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Cost-Volume-Profit and Contribution

Margin Income statement
• Contribution margin Income Statement is for internal purposes only.
• Here operating income refers to “net operating income” without regard to
income taxes.
• Regardless of expression (per-unit basis, calculated as a ratio, income
statement), all three express how much sales revenues is available to cover
fixed expenses and contribute to profit.

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Cost-Volume-Profit and Contribution

Margin Income statement
• Finding total contribution margin without an income statement:

𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑪𝑪𝑪𝑪 = 𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 × 𝑪𝑪𝑪𝑪 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹

• Total Sales: $75,000
• CM Ratio: 80%
• 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶 = $75,000 × 80% = $60,000

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Cost-Volume-Profit and Contribution

Margin Income statement
• Finding units sold using contribution margin:

𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑪𝑪𝑪𝑪
# 𝒐𝒐𝒐𝒐 𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 =
𝒑𝒑𝒑𝒑𝒑𝒑 𝒖𝒖𝒖𝒖𝒖𝒖𝒖𝒖 𝑪𝑪𝑪𝑪
• Total CM: $40,000
• Per unit CM: $80
$40,000
• #𝑜𝑜𝑜𝑜 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = = 500 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
$80

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Cost-Volume-Profit
• You are evaluating orders from two new customers, but you will only be
able to accept one of the orders without increasing your fixed costs.
Management has directed you to choose the one that is most profitable for
the company. Customer A is ordering 500 units and is willing to pay $200
per unit, and these units have a contribution margin of $60 per unit.
Customer B is ordering 1,000 units and is willing to pay $140 per unit, and
these units have a contribution margin ratio of 40%. Which order do you
select and why?
 CVP (excel)

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Cost-Volume-Profit: Solution
Customer A Customer B
Units 500 1000
Sales per unit $200 $140

Variable costs

CM $60 40% Customer A Customer B

Units 500 1000
Sales $100,000 $140,000

Variable costs $70,000 $84,000

CM $30,000 $56,000

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Break-Even Point

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Break-Even

• Break-Even is the point at which:

Sales – Total Costs = 0 (no profit or loss)
Sales = Total Costs
Sales – Fixed Costs – Variable Costs = 0

Contribution margin can be used to find the break-even point.

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Break-Even Point
• Sales = Total Costs at Break-Even
or
• Sales = FC + VC

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Calculate a break-even point in units and

dollars
• What would break-even be for Hicks?

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Calculate a break-even point in units and

dollars
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑖𝑖𝑖𝑖 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 =
𝐶𝐶𝐶𝐶 𝑝𝑝𝑝𝑝𝑝𝑝 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈

$18,000
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑖𝑖𝑖𝑖 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 = = 225 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
$80

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Operating income $0
• The contribution margin income statement shows the results of selling 225
units:

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Operating Income $0 cont.

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Operating Income Negative

• What happens if Hicks only sells 175 units?

Break-even units 225

Current sales in units – 175
Difference in units 50
Contribution margin per unit × $80
Loss ($4,000)

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Operating Income Negative cont.

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Operating Income Positive

• What happens if Hicks only sells 300 units?

Break-even units 225

Current sales in units 300
Difference in units 75
Contribution margin per unit × $80
Profit $6,000

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Operating Income Positive cont.

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Break-Even Point in Dollars

• Finding the break-even point in dollars, formula approach:

𝑭𝑭𝑭𝑭
𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝒊𝒊𝒊𝒊 $ =
𝑪𝑪𝑪𝑪 𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹𝑹

$18,000
= $22,500
0.80

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Important Relationships
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 − 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

𝐶𝐶𝐶𝐶 𝑝𝑝𝑝𝑝𝑝𝑝 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈

𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑝𝑝𝑝𝑝𝑝𝑝 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈

𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 – 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = 0

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

𝐵𝐵𝐵𝐵𝐵𝐵 𝑖𝑖𝑖𝑖 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 =
𝐶𝐶𝐶𝐶 𝑝𝑝𝑝𝑝𝑝𝑝 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

𝐵𝐵𝐵𝐵𝐵𝐵 𝑖𝑖𝑖𝑖 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 =
𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅

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Additional Practice (Excel)

• Cindy Lou’s, Inc. produces and sells blankets for dorm room beds and
lofts. The selling price of each blanket is $80 and the variable costs per
blanket are $48. Fixed costs are $4,000.
¿ What is the break-even point in units and dollars?
¿ Present the contribution margin income statement at break-even.
¿ If Cindy Lou sells 150 blankets, what will be her income?
¿ If Cindy Lou has a contribution margin of $6,400, how many blankets did
she sell?
¿ If Cindy Lou’s fixed costs change to $4,640, how many additional units will
Cindy need to sell to break even?  Break-even (excel)
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Additional Practice: Solution

A. contribution margin per unit = $80 – $48 = $32
contribution margin ratio = $32 ÷ $80 = 0.40
break-even in units = $4,000 ÷ $32 = 125 units
break-even in dollars = $4,000 ÷ 0.40 = $10,000
or: break-even in dollars = 125 units × $80 = $10,000
B. Cindy Lou’s, Inc.
Contribution Margin Income Statement
Sales (125 units × $80) $10,000
Variable Costs (125 units × $48) 6,000
Contribution Margin $4,000
Fixed Costs 4,000
Operating Income $0
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Additional Practice: Solution

C. Cindy Lou’s, Inc.
Contribution Margin Income Statement
Units Sold 150
Sales (150 units × $80) $12,000
Break-even units – 125
Variable Costs (150 units × $48) 7,200 OR Difference in units 25
Contribution Margin $4,800 × contribution margin per unit × $32
Operating income $ 800
Fixed Costs 4,000
Operating Income $800

D. $6,400 ÷ $32 = 200 units

E. $4,640 ÷ $32 = 145 units – 125 original break-even units = 20 additional units to
break-even at new fixed costs
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Think It Through: The Cost of a Haircut (Exercise 3.1)

You are the manager of a hair salon and want to know how many ladies’ haircuts your salon
needs to sell in a month in order to cover the fixed costs of running the salon. You have
determined that, at the current price of $35 per haircut, you have $20 in variable costs
associated with each cut. These variable costs include stylist wages, hair product, and shop
supplies. Your fixed costs are $3,000 per month. You perform a break-even analysis on a per-
unit basis and discover the following:

You have 4 stylists plus yourself working in the salon and are open 6 days per week.
Considering the break-even point and the number of available stylists, will the salon ever break
even? If it does, what will need to happen? What can be done to achieve the break-even point?
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Target Numbers
• Companies want to do more than just break-even.
• Use break-even analysis to determine the level of sales to reach desired profit.
• If Hicks Manufacturing breaks even at 225 Blue Jay birdbaths, how to calculate
target profit?
• Add that target to their fixed costs.

𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 + 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷

𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼 =
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎 𝒑𝒑𝒑𝒑𝒑𝒑 𝒖𝒖𝒖𝒖𝒖𝒖𝒖𝒖

𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 + 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷

𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 =
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓
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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Target Numbers Calculations

• Target profit - $16,000
• Fixed costs - $18,000
• Contribution margin - $80

$18,000+$16,000
• 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 = = 425 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
$80

$18,000+$16,000
• 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 = = $42,500
0.80

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Target Numbers after tax

• If a company wants to earn $24,000 after-tax profit (tax rate 40%), we can
calculate pre-tax amount as follows:

𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑
𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 =
(𝟏𝟏 − 𝒕𝒕𝒕𝒕𝒕𝒕 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓)

$24,000
• 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = = $40,000
(1−0.40)

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Target Numbers after tax units & $

𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 + 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔 𝒊𝒊𝒊𝒊 𝒖𝒖𝒖𝒖𝒖𝒖𝒖𝒖𝒖𝒖 =
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎 𝒑𝒑𝒑𝒑𝒑𝒑 𝒖𝒖𝒖𝒖𝒖𝒖𝒖𝒖

𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄+𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑

𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔 𝒊𝒊𝒊𝒊 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅 =
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓

$18,0000+$40,000
• 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑖𝑖𝑖𝑖 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 = = 725 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
$80
$18,0000+$40,000
• 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑖𝑖𝑖𝑖 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 = = $72,500
0.80

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Workbook: Break-Even Concepts

• Marshall & Hirito, an accounting firm, for whom, completing tax returns is
their largest volume service. Data are:
• Charge to client (sales price per return) $400
• Variable cost per return $150
• Fixed Costs $14,000
• What is break-even in units and dollars?
• Show the contribution margin income statement at break-even.
• What units and service dollars are needed to earn a desired operating profit
(pre-tax) of $10,000?
• Show the contribution margin income statement at the desired operating profit
(pre-tax) of $10,000.  Application of BEP (excel) 3.4

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Workbook: Break-Even Concepts

Solution 1
Total fixed costs $14,000
Break-Even Point in Units = = = 56 returns
Contribution margin per unit $250
Total fixed costs $14,000
Break-Even Point in Dollars = = = $22,400
Contribution margin ratio 0.625

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Workbook: Break-Even Concepts

Solution 2
Fixed costs + desired profit $14,000 + $10,000
Target Profit Units = = = 96
Contribution margin per unit $250

Fixed costs + desired profit $14,000 + $10,000

Target Profit Sales Dollars = = = $38,400
Contribution margin ratio 0.625

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Workbook: College Creations 3.5

• College Creations, Inc (CC), builds a loft that is easily adaptable to most dorm
rooms or apartments and can be assembled into a variety of configurations.
Each loft is sold for $500, and the cost to produce one loft is $300, including all
parts and labor. CC has fixed costs of $100,000.
• What happens if CC produces nothing?
• Now, assume CC produces and sells one unit (loft). What are their financial
results?
• Now, what do you think would happen if they produced and sold 501 units?
• How many units would CC need to sell in order to break even?
• How many units would CC need to sell if they wanted to have a pretax profit
of $50,000?

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Exercise 3.6
• A company manufactures and sells racing bicycles to specialty retailers.
The Bomber model sells for $450 and has per-unit variable costs of $200
associated with its production. The company has fixed expenses of
$40,000 per month. In May, the company sold 225 of the Bomber model
bikes.
• Calculate the contribution margin per unit for the Bomber.
• Calculate the contribution margin ratio of the Bomber.
• Prepare a contribution margin income statement for the month of May.

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Exercise 3.7
• Maple Enterprises sells a single product with a selling price of $75 and variable
costs per unit of $30. The company’s monthly fixed expenses are $22,500.
What is the company’s break-even point in units?
What is the company’s break-even point in dollars?
Construct a contribution margin income statement for the month of
September when they will sell 900 units.
How many units will Maple need to sell in order to reach a target profit of
$45,000?
What dollar sales will Maple need in order to reach a target profit of $45,000?
Construct a contribution margin income statement for Maple that reflects
$150,000 in sales volume.

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Break-Even Sensitivity Analysis

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Break-Even Sensitivity Analysis:

Single Product
• Business conditions constantly change.
• Sudden and unexpected effects (e.g., hurricane destroying supplier’s factory)
• Slow effects (e.g., union negotiations (labor costs))
• Cost-volume-profit analysis also can be used to conduct a sensitivity
analysis.
• Sensitivity analysis shows what will happen if the sales price, units sold,
variable cost per unit, or fixed costs change.
• This analysis helps businesses to consider possible scenarios that assist them
in planning.

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Break-Even Sensitivity Analysis:

Single Product – changing a single variable
• Back Door Café a small coffee shop
• roasts its own beans to make drinks
• sell baked goods and t-shirts
• Back Door Café uses CVP analysis to be sure that their sales cover their
fixed costs and provide a reasonable level of profit
 Back Door Café (excel)

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Break-Even Sensitivity Analysis:

Single Product – changing a single variable
• Other coffee shops in the area are charging $0.75 more for espresso
drinks. As a result, the owner wants to determine what would happen to
operating income if she increased her price by just $0.50 and sales
remained constant, so she performs the following analysis:
g y
Sale Price Change Analysis Contribution Margin Income Statement
Current Price Increase New Price Current Price vs New Price
Sales Price per Unit $3.75 Current Price New Price
Variable Cost per Unit $1.50 Unit Sales, Expected 1500 1500
Sales
Contribution Margin per Unit
Variable Costs
Fixed Costs $2,475 Contribution Margin
Fixed Costs
Break-even (in units) Net Income
Break-even (in dollars)

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Break-Even Sensitivity Analysis:

Single Product – Back Door Café
• Back Door Café is engaging in target pricing
• Target pricing is a process in which a company uses market analysis and
production information to determine the maximum price customers are
willing to pay for a good or service in addition to the markup percentage.

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Break-Even Sensitivity Analysis:

Single Product – changing a single variable
• In March, cup supplier informs Back Door that there is a $0.05 price
increase due to higher material prices. Assume that the example uses the
original $3.75 per unit sales price. The owner wants to know what would
happen to net operating income if she absorbs the cost increase, so she
performs the following analysis:
Contribution Margin Income Statement
Variable Cost Change Analysis
Current Variable Cost vs Increase Variable Cost
Current Cost Increase New Cost Current Cost New Cost
Sales Price per Unit $3.75 Unit Sales, Expected 1500 1500
Variable Cost per Unit $1.50 Sales
Contribution Margin per Unit Variable Costs
Fixed Costs $2,475 Contribution Margin
Fixed Costs
Break-even (in units) Net Income
Break-even (in dollars)

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Break-Even Sensitivity Analysis:

Single Product – changing a single variable
• Back Door Café’s lease is coming up for renewal. The owner calls the
landlord to indicate that she wants to renew her lease for another 5 years.
The landlord is happy to hear she will continue renting from him but
informs her that the rent will increase $225 per month.
Contribution Margin Income Statement
Fixed Cost Change Analysis
Current Fixed Cost vs Increased Fixed cost
Current Cost Increase New Cost
Current Cost New Cost
Sales Price per Unit $3.75
Unit Sales, Expected 1500 1500
Variable Cost per Unit $1.50
Sales
Contribution Margin per Unit
Variable Costs
Fixed Costs $2,475
Contribution Margin
Fixed Costs
Break-even (in units)
Net Income
Break-even (in dollars)

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Break-Even Sensitivity Analysis:

Single Product – changing a single variable
• Back Door Café wants to buy a new espresso machine that will reduce the
amount of coffee beans per drink. The new machine will cost $15,000,
but it will decrease the variable cost per cup by $0.05. The owner wants to
see what the effect will be on the net operating income and break-even
point if she purchases the new machine. She has arranged financing for
the new machine and the monthly payment will increase her fixed costs by
$400 per month. When she conducts this analysis, she gets the following
results: Contribution Margin Income Statement
Current FC and VC vs Increased FC and VC
Variable Cost and Fixed Cost Change Analysis Current Cost New Cost
Current Cost Increase New Cost Unit Sales, Expected 1500 1500
Sales Price per Unit $3.75 Sales
Variable Cost per Unit $1.50 Variable Costs
Contribution Margin per Unit Contribution Margin
Fixed Costs $2,475 Fixed Costs
Net Income
Break-even (in units)
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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Break-Even Sensitivity Analysis:

Single Product – Summary

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Break-Even Sensitivity Analysis:

Single Product – changing multiple variables

• CVP analysis is a powerful tool which can run unlimited number of what-
if scenarios until financial goals for a company are met.

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Break-Even Sensitivity Analysis:

Single Product – changing multiple variables
• What would happen if she purchased the new machine ($15,000) to
realize the variable cost savings (by $0.05) and also raised her price by just
$0.20? Financing for the new machine and monthly payment will increase
FC by $400. She runs the analysis as follows:
Selling Price, Variable Cost and Fixed Cost Change Analysis Contribution Margin Income Statement
Current Cost Increase New Cost Selling price, VC and FC change
Sales Price per Unit $3.75 Current Cost New Cost
Variable Cost per Unit $1.50 Unit Sales, Expected 1500 1500
Contribution Margin per Unit Sales
Fixed Costs $2,475 Variable Costs
Contribution Margin
Break-even (in units) Fixed Costs
Break-even (in dollars) Net Income

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Break-Even Sensitivity Analysis:

More Practice
• Manatee Manufacturing produces lawn mower engines that sell for $90 per
engine. The variable cost per engine is $60 dollars. Fixed costs are $24,000.
A. What is Manatee’s break-even in units and dollars?
B. If variable costs increase by $5, what is the new break-even in units and
dollars?
C. Manatee believes they can increase the selling price by $3 per unit without
losing any sales. Under this scenario, how many units would Manatee need to
sell to break-even?
D. Manatee sells 1,000 engines. What is the amount of operating income
generated by this number of engine sales with the increased variable cost and
the increased selling price per engine?

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Break-Even Sensitivity Analysis:

More Practice (solution)
Manatee Manufacturing produces lawn mower engines that sell for $90 per engine. The variable cost per
engine is $60 dollars. Fixed costs are $24,000.
A. $24,000 ÷ $30 = 800 break-even units
800 units × $90 per engine = $72,000 break-even sales dollars
B. New contribution margin is $90 – ($60 + $5) = $25
$24,000 ÷ $25 = 960 break-even units
960 units × $90 per engine = $86,400 break-even sales
C. New contribution margin = $93 – $65 = $28
$24,000 ÷ $28 = 857 units (rounded) 857 units x $93 = $79,701 break-even sales dollars
D. Income based on 1,000 engines: 1,000 × $93 = 93,000 sales
1,000 × $65 = 65,000 variable costs
28,000 contribution margin
24,000 fixed costs
4,000 income
or: 1,000 units – 857 units = 143 additional units × $28 contribution margin = $4,000 (rounded)
 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Break-Even Sensitivity Analysis:

Multi-Product Environment
• Break-even analysis is more complex for multi-product companies.
• Each product has a different selling price, different variable cost, and
different contribution margin.
• Sales mix represents the relative proportions of the products that a
company sells – a percentage of the company’s total revenue that comes
from product A, B, C and so on.
• Importance of sales mix – businesses strive to have a mix that maximizes
profit.

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Break-Even Sensitivity Analysis:

Multi-Product Environment - calculation
• This chart shows the detail for a basket of fruit. The product mix of the
basket is 5:3:2:1, with 5 being the number of apples in a basket, 3 the
number of oranges, etc. Each individual fruit has a contribution margin
and the basket also has contribution margin.  Fruit basket (excel)
Selling Total Cost
price selling per Contribution
Fruits # of units per unit price unit Total cost margin
Apple 5 $0.60 $3.00 $0.25 $1.25 $1.75
Orange 3 $1.00 $3.00 $0.75 $2.25 $0.75
Banana 2 $0.80 $1.60 $0.50 $1.00 $0.60
Pear 1 $1.90 $1.90 $1.50 $1.50 $0.40
Total $9.50 $6.00 $3.50
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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Break-Even Sensitivity Analysis:

Multi-Product Environment - calculation
• Look at what happens if the product mix (number of each type of fruit in
the basket) changes.
Selling Total Cost
price selling per Contribution
Fruits # of units per unit price unit Total cost margin
Apple 2 $0.60 $1.20 $0.25 $0.50 $0.70
Orange 4 $1.00 $4.00 $0.75 $3.00 $1.00
Banana 5 $0.80 $4.00 $0.50 $2.50 $1.50
Pear 3 $1.90 $5.70 $1.50 $4.50 $1.20
Total $14.90 $10.50 $4.40

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Break-Even Sensitivity Analysis:

Multi-Product Environment – West Brothers
• West Brothers manufactures and sells three types of house siding:
restoration vinyl, architectural vinyl, and builder grade vinyl, each with its
own sales price, variable cost, and contribution margin, as shown:  excel

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Break-Even Sensitivity Analysis:

Multi-Product Environment – West Brothers
• The product mix for West is 5:3:2 or for each 2 square feet of restoration
grade siding, there are 3 square feet of architectural and 5 square feet of
builder grade siding sold. One sales unit of this mix is referred to as a
composite unit. CM per composite unit? BEP per composite unit?
Variable
Selling cost
Sales price of a Variable of a
mix Sales price composite cost composite
sq.ft per sq.ft unit per sq.ft unit
Builder Grade 5 $6.25 $31.25 $3.25 $16.25
Architectural 3 $7.75 $23.25 $4.50 $13.50
Restoration 2 $9.25 $18.50 $6.25 $12.50
Total $73.00 $42.25

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Break-Even Sensitivity Analysis:

Multi-Product Environment – West Brothers

𝑪𝑪𝑪𝑪 𝒑𝒑𝒑𝒑𝒑𝒑 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼 = 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝒑𝒑𝒑𝒑𝒑𝒑 𝑪𝑪𝑪𝑪 − 𝑽𝑽𝑽𝑽 𝒑𝒑𝒑𝒑𝒑𝒑 𝑪𝑪𝑪𝑪

𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄

• 𝑩𝑩𝑩𝑩𝑩𝑩 𝒑𝒑𝒑𝒑𝒑𝒑 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼 =
𝑪𝑪𝑪𝑪 𝒑𝒑𝒑𝒑𝒑𝒑 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒖𝒖𝒖𝒖𝒖𝒖𝒖𝒖

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Break-Even Sensitivity Analysis:

Multi-Product Environment – West Brothers
Forecasted Contribution Margin
Income Statement at Break-Even
For Month Ended December 31, 2019

Sales
Builder Grade $147,357.72
Architectural $109,634.15
Restoration $87,235.77
Total Sales $344,227.64

Variable costs
Builder Grade $76,626.02
Architectural $63,658.54
Restoration $58,943.09
Total Variable costs $199,227.64

Contribution margin $145,000.00

Fixed costs $145,000.00
Net income $0.00

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Your Turn: Margins in the Sales Mix (ex.3.2)

The sales mix of a company selling two products, A and B, is 3:1. The per-
unit variable costs is $4 for Product A and $5 for Product B. Product A
sells for $10 and product B sells for $9. Fixed costs for the company are
$220,000.
A. What is the contribution margin per composite unit?
B. What is the break-even point in composite units?
C. How many units of product A and product B will the company sell at
the break-even point?
Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Think It Through: Selling Subs

You are the manager of a sub shop located near a college campus. The
college has recently added a fast-food style café to the student center,
which has reduced the number of students eating at your restaurant. Your
highest margin items are drinks (a contribution margin of approximately
90%) and vegetarian subs (a contribution margin of approximately 75%).
How can you use CVP analysis to help you compete with the college’s
café? What would you suggest as possible ways to increase business while
maintaining target income levels?
Margin of Safety

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Company’s Margin of Safety

• Margin of Safety: difference between a company’s current sales and its
break-even sales
• It tells us how much money a company could lose in sales before
company begins to lose money (before the company falls below the BEP)
• The higher the margin of safety is the lower the risk of not breaking even
or incurring loss.

𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 𝒐𝒐𝒐𝒐 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝒊𝒊𝒊𝒊 𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫

= 𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩 𝒐𝒐𝒐𝒐 𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔 − 𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩𝑩 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔

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Company’s Margin of Safety: Manteo Machine

• Manteo Machine makes machine parts and sells them to be used in the
manufacture of farm equipment.
BEP analysis
• Sales price = $90, VC - $40, Sales price per unit $90.00
• FC - $85,000 Variable cost per unit $40.00
CM per unit $50.00
• The break-even analysis:
Fixed cost $85,000.00
 excel
BEP in units 1700
CM ratio 55.56%
BEP in dollars $153,000.00
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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Company’s Margin of Safety: Manteo Machine

• Manteo has a current sales of 2,500 units. What is the margin of safety?

Sales (actual)
BEP (1700 units)
Margin of Safety

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Company’s Margin of Safety

• Determining the margin of safety after the fact is not as useful as being able to
determine the level of sales needed to remain at a certain level of safety.
• Option 1: Treat the desired margin of safety in dollars the same as a desired
profit.
𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝒂𝒂𝒂𝒂 𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 𝒐𝒐𝒐𝒐 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺
𝑭𝑭𝑭𝑭 + 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅 𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎 𝒐𝒐𝒐𝒐 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅
=
𝑪𝑪𝑪𝑪 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓

• Option 2: Use the margin of safety percentage.

𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 𝒐𝒐𝒐𝒐 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑
𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎 𝒐𝒐𝒐𝒐 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅
=
𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕 𝒃𝒃𝒃𝒃𝒃𝒃𝒃𝒃𝒃𝒃𝒃𝒃 (𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂) 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅
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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

3.11 Exercise
Marshall & Company produces a single product and recently calculated
their break-even point as shown.

What would Marshall’s target margin of safety be in units and dollars if

they required a $14,000 margin of safety?
Operating Leverage

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Operating Leverage
• Operating leverage: measurement of how sensitive operating income is
to a percentage change in sales dollars
• Typically, the higher the level of fixed costs, the higher the level of risk.
• As sales volumes increase, the payoff is typically greater with higher fixed
costs than with higher variable costs. In other words, the higher the risk,
the greater the payoff.
𝑪𝑪𝑪𝑪
𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫𝑫 𝒐𝒐𝒐𝒐 𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳𝑳 =
𝑵𝑵𝑵𝑵𝑵𝑵 𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰

% 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒏𝒏𝒏𝒏𝒏𝒏 𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊

= 𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐 𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍𝒍 × % 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔
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Operating Leverage: Cost Structure

• FC or VC?
Firm 1 Firm 2
• Balanced? Low FC High FC
• High FC? Low VC Sales $100,000 100% $100,000 100%
Variable Costs $60,000 60% $30,000 30%
• Low FC? High VC? CM (a) $40,000 40% $70,000 70%
Fixed Costs $30,000 $60,000
Operating income (b) $10,000 $10,000

Scenario 1 Sales increase 10% CM 4000 7000

plus 10000
Scenario 2 Sales decrease 10% CM -4000 -7000
minus 10000
BEP $75,000 $85,714
Margin of Safety $25,000 $14,286
Margin of Safety % 25% 14%

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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Operating Leverage
• Therefore, companies are concerned with managing their fixed and
variable costs and will sometimes move costs from one category to
another to manage this risk.
• Moving variable costs to fixed costs is riskier.
• Moving hourly employees (var.) to salaried employees (fixed)
• Replacing an employee (var.) with a machine (fixed)

• Managing this type of risk affects operating leverage as well as morale and
corporate climate.

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Operating Leverage
• If operating leverage is high, then a very small increase in sales can result
in a large increase in net operating income.
Firm 1 Firm 2
Low FC High FC
Sales $100,000 100% $100,000 100%
Variable Costs $60,000 60% $30,000 30%
CM (a) $40,000 40% $70,000 70%
Fixed Costs $30,000 $60,000
Operating income (b) $10,000 $10,000
Degree of operating
(f) 3.17 leverage (a/b) 4 7

Scenario 3 Sales increase 20% 20%

(f) 3.18 operating profit 80% 140%
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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Operating Leverage: Calculation

Company A Company B
• Same net income Sales $250,000.00 $315,000.00
• Company B has higher VC $102,000.00 $105,000.00
operating leverage Contribution margin (a)
FC $63,000.00 $125,000.00
• Company B has higher FC Net income (b)
Operating leverage (a/b)
Company A Company B
Sales $250,000.00 $315,000.00
VC $102,000.00 $105,000.00
Contribution margin (a) $148,000.00 $210,000.00
FC $63,000.00 $125,000.00
Net income (b) $85,000.00 $85,000.00
Operating leverage (a/b) 1.74 2.47
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Operating Leverage: Calculation

Company A Company B
• If both companies expect Sales $250,000.00 $315,000.00
10% sales increase VC $102,000.00 $105,000.00
• 1.74 × 10% = 17.4% Contribution margin (a)
FC $63,000.00 $125,000.00
• 2.47 × 10% = 24.7%
Net income (b)
• For every 10% increase in Operating leverage (a/b)
sales net operating income Company A Company B
will increase 17.4% (A) Sales $250,000.00 $315,000.00
• For company B, increase in VC $102,000.00 $105,000.00
Contribution margin (a) $148,000.00 $210,000.00
net operating income is
FC $63,000.00 $125,000.00
higher. Net income (b) $85,000.00 $85,000.00
Operating leverage (a/b) 1.74 2.47
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 Contribution Margin/Break-Even Point/Sensitivity Analysis/Margin of Safety/Operating Leverage

Operating Leverage Sales decrease 20%

Company A Company B
Sales 20% $200,000.00 $252,000.00
• What happens when there is a VC 20% $81,600.00 $84,000.00
sales decline? Contribution margin (a) $118,400.00 $168,000.00
FC $63,000.00 $125,000.00
• Companies look for ways to Net income (b) $55,400.00 $43,000.00
reduce fixed costs during Operating leverage (a/b)
periods of decline. % Change in NI

Company A Company B
Company A Company B
Sales 20% $200,000.00 $252,000.00
Sales $250,000.00 $315,000.00 VC 20% $81,600.00 $84,000.00
VC $102,000.00 $105,000.00 Contribution margin (a) $118,400.00 $168,000.00
Contribution margin (a) $148,000.00 $210,000.00 FC $63,000.00 $125,000.00
FC $63,000.00 $125,000.00 Net income (b) $55,400.00 $43,000.00
Net income (b) $85,000.00 $85,000.00 Operating leverage (a/b) 2.14 3.91
Operating leverage (a/b) 1.74 2.47 % Change in NI 34.82% 49.41%
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Summary
• Contribution margin can be used to calculate how much of every dollar in
sales is available to cover fixed expenses and contribute to profit and can
be expressed on a per-unit basis, as a ratio, or in total.
• Break-even analysis is a tool that almost any business can use for planning
and evaluation purposes. It helps identify a level of activity that is
necessary before an organization starts to generate a profit and can be
found on a per-unit or dollar basis.
• Cost-volume-profit analysis can be used to conduct a sensitivity analysis
that shows what will happen if there are changes in any of the variables:
sales price, units sold, variable cost per unit, or fixed costs.

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Summary cont.
• Companies provide multiple products, goods, and services to the
consumer and, as result, need to calculate their break-even point based on
the mix of the products, goods, and services.
• Businesses determine a margin of safety (sales dollars beyond the break-
even point). The higher the margin of safety is, the lower the risk is of not
breaking even and incurring a loss.
• Operating leverage is a measurement of how sensitive net operating
income is to a percentage change in sales dollars. A high degree of
operating leverage results from a cost structure that is heavily weighted in
fixed costs.

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