Chapter 5 Cost-Volume-Profit Relationships
Key assumptions of CVP analysis
Selling price is constant.
Costs are linear.
In multi-product companies, the sales mix is constant.
In manufacturing companies, the level of inventories does not change.
LO1: How do changes in activity affect contribution margin and net operating
The contribution income statement variable costs from fixed costs.
Contribution margin, which is
sales revenue minus variable expenses
used first to cover fixed expenses. Any remaining contribution margin contributes
to net operating income.
Sales, variable expenses, and contribution margin can also be expressed on
The contribution format income statement can be expressed in the
following equation: Profit =
(Sales – Variable expenses) – Fixed expenses
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.
Since Unit CM = P – V, we can express the simple profit equation as
Unit CM * Q – Fixed expenses
: A hypothetical contribution income statement for Racing Bicycle Company:
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Less: Variable expenses
Less: Fixed expenses
Net operating income
We can learn the following from the statement:
Each month RBC must generate at least
in total contribution
margin to break-even (when revenues equal expenses, and profit is zero).
Therefore, if RBC sells
units a month, it will be operating at the break-even
For each additional unit RBC sells,
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
There is no need to prepare an income statement to estimate profits at a
particular sales volume. We can simply follow the following formula: