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Chapter 5 Cost-Volume-Profit Relationships Key assumptions of CVP analysis (1) Selling price is constant. (2) Costs are linear. (3) In multi-product companies, the sales mix is constant. (4) In manufacturing companies, the level of inventories does not change. LO1: How do changes in activity affect contribution margin and net operating income? 1. The contribution income statement variable costs from fixed costs. (1) Contribution margin, which is sales revenue minus variable expenses , is used first to cover fixed expenses. Any remaining contribution margin contributes to net operating income. (2) Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. (3) The contribution format income statement can be expressed in the following equation: Profit = (Sales Variable expenses) Fixed expenses . (4) When a company has only one product we can further refine this equation as Profit = (P Q V Q) Fixed expenses , where P is unit selling price, Q is units sold, and V is unit variable expenses. (5) Since Unit CM = P V, we can express the simple profit equation as Profit = Unit CM * Q Fixed expenses . Example : A hypothetical contribution income statement for Racing Bicycle Company: Racing Bicycle Company Contribution Income Statement For the Month of June 500 bikes Per Unit 400 bikes 401 bikes 430 bikes Sales 250,000 500 200,000 200,500 215,000 Less: Variable expenses 150,000 300 120,000 120,300 129,000 Contribution margin 100,000 200 80,000 80,200 86,000 Less: Fixed expenses 80,000 80,000 80,000 80,000 Net operating income 20,000 0 200 6,000 We can learn the following from the statement: A. Each month RBC must generate at least $80,000 in total contribution margin to break-even (when revenues equal expenses, and profit is zero). Therefore, if RBC sells 400 units a month, it will be operating at the break-even point. B. For each additional unit RBC sells, $200 more in contribution margin will help to cover fixed expenses and provide a profit. In other words, if RBC sells one more bike (401 bikes), net operating income will increase by $200 . C. There is no need to prepare an income statement to estimate profits at a particular sales volume. We can simply follow the following formula: 1 Profit = unit CM * units sold above break-even . For example, if RBC sells 430 bikes, its net operating income will be $6,000 . D. In equation form, profit of selling 430 bicycles is ($500 * 430 - $300 * 430) - $80,000 = ($215,000 - $129,000) - $80,000 = $300 * 430 - $80,000 = $6,000 LO2: A cost-volume-profit (CVP) graph.... View Full Document