CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS 3-1

Cost-volume-profit (CVP) analysis examines the behavior of total revenues, total costs, and operating income as changes occur in the output level, selling price, variable costs per unit, and/or fixed costs of a product.

3-2
1. 2. 3. 4. 5. 6.

The assumptions underlying the CVP analysis outlined in Chapter 3 are: Changes in the level of revenues and costs arise only because of changes in the number of product (or service) units produced and sold. Total costs can be separated into a fixed component that does not vary with the output level and a component that is variable with respect to the output level. When represented graphically, the behavior of total revenues and total costs are linear (represented as a straight line) in relation to output units within a per unit relevant range and time period. The selling price, variable cost per unit, and fixed costs are known and constant. The analysis either covers a single product or assumes that the sales mix, when multiple products are sold, will remain constant as the level of total units sold changes. All revenues and costs can be added and compared without taking into account the time value of money.

3.3

Operating income is total revenues from operations for the accounting period minus cost of goods sold and operating costs (excluding income taxes): Operating income = Total revenues from operations Net income is operating income plus nonoperating revenues (such as interest revenue) minus nonoperating costs (such as interest cost) minus income taxes. Chapter 3 assumes nonoperating revenues and nonoperating costs are zero. Thus, Chapter 3 computes net income as: Net income = Operating income Income taxes

3-4

Contribution margin is the difference between total revenues and total variable costs. Contribution margin per unit is the difference between selling price and variable cost per unit. Contribution-margin percentage is the contribution margin per unit divided by selling price.

3-5

Three methods to calculate the breakeven point are the equation method, the contribution margin method, and the graph method. In the first two methods, the breakeven units are calculated by dividing total fixed costs by contribution margin per unit.

3-6

Breakeven analysis denotes the study of the breakeven point, which is often only an incidental part of the relationship between cost, volume, and profit. Cost-volume-profit relationship is a more comprehensive term than breakeven analysis.

31

3-7

CVP certainly is simple, with its assumption of output as the only revenue and cost driver, and linear revenue and cost relationships. Whether these assumptions make it simplistic depends on the decision context. In some cases, these assumptions may be sufficiently accurate for CVP to provide useful insights. The examples in Chapter 3 (the software package context in the text and the travel agency example in the Problem for Self-Study) illustrate how CVP can provide such insights. In more complex cases, the basic ideas of simple CVP analysis can be expanded.

3-8 3-9

An increase in the income tax rate does not affect the breakeven point. Operating income at the breakeven point is zero, and no income taxes are paid at this point. Sensitivity analysis is a "what-if" technique that managers use to examine how a result will change if the original predicted data are not achieved or if an underlying assumption changes. The advent of the electronic spreadsheet has greatly increased the ability to explore the effect of alternative assumptions at minimal cost. CVP is one of the most widely used software applications in the management accounting area.

3-10

Examples include: Manufacturingsubstituting a robotic machine for hourly wage workers. Marketingchanging a sales force compensation plan from a percent of sales dollars to a fixed salary. Customer servicehiring a subcontractor to do customer repair visits on an annual retainer basis rather than a per-visit basis.

3-11 Examples include:

Manufacturingsubcontracting a component to a supplier on a per-unit basis to avoid purchasing a machine with a high fixed depreciation cost. Marketingchanging a sales compensation plan from a fixed salary to percent of sales dollars basis. Customer servicehiring a subcontractor to do customer service on a per-visit basis rather than an annual retainer basis.

3-12

Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold, and hence, in contribution margin. Knowing the degree of operating leverage at a given level of sales helps managers calculate the effect of fluctuations in sales on operating incomes.

3-13

CVP analysis is always conducted for a specified time horizon. One extreme is a very short-time horizon. For example, some vacation cruises offer deep price discounts for people who offer to take any cruise on a day's notice. One day prior to a cruise, most costs are fixed. The other extreme is several years. Here, a much higher percentage of total costs typically is variable. CVP itself is not made any less relevant when the time horizon lengthens. What happens is that many items classified as fixed in the short run may become variable costs with a longer time horizon.

32

3-14 3-15

A company with multiple products can compute a breakeven point by assuming there is a constant mix of products at different levels of total revenue. Yes, gross margin calculations emphasize the distinction between manufacturing and nonmanufacturing costs (gross margins are calculated after subtracting fixed manufacturing costs). Contribution margin calculations emphasize the distinction between fixed and variable costs. Hence, contribution margin is a more useful concept than gross margin in CVP analysis.

3-16

(10 min.)

CVP computations.
Fixed Costs $300 300 300 300 Total Costs $ 800 1,800 1,000 1,200 Operating Income $1,200 200 0 300 Contribution Margin $1,500 500 300 600 Contribution Margin % 75.0% 25.0% 30.0% 40.0%

Revenues a. b. c. d. $2,000 2,000 1,000 1,500

Variable Costs $ 500 1,500 700 900

3-17
1a.

(10-15 min.) CVP computations. Sales ($25 per unit 180,000 units) Variable costs ($20 per unit 180,000 units) Contribution margin Contribution margin (from above) Fixed costs Operating income Sales (from above) Variable costs ($10 per unit 180,000 units) Contribution margin Contribution margin Fixed costs Operating income $4,500,000 3,600,000 $ 900,000 $ 900,000 800,000 $ 100,000 $4,500,000 1,800,000 $2,700,000 $2,700,000 2,500,000 $ 200,000

1b.

2a.

2b.

3. Operating income is expected to increase by $100,000 if Ms. Schoenens proposal is accepted. The management would consider other factors before making the final decision. It is likely that product quality would improve as a result of using state of the art equipment. Due to increased automation, probably many workers will have to be laid off. Patels management will have to consider the impact of such an action on employee morale. In addition, the proposal increases the companys fixed costs dramatically. This will increase the companys operating leverage and risk.

33

3-18
1a.

(35-40 min.) CVP analysis, changing revenues and costs. SP VCU CMU FC Q = 8% $1,000 = $80 per ticket = $35 per ticket = $80 $35 = $45 per ticket per ticket = $22,000 a month =
$22,000 FC = $45 per ticket CMU

= 489 tickets (rounded up) 1b. Q =

$22,000 + $10,000 FC + TOI = $45 per ticket CMU $32,000

= $45 per ticket = 712 tickets (rounded up) 2a. SP VCU CMU FC Q = $80 per ticket = $29 per ticket = $80 $29 = $51 per ticket = $22,000 a month =
$22,000 FC = $51 per ticket CMU

= 432 tickets (rounded up) 2b. Q =

$22,000 + $10,000 FC + TOI = $51 per ticket CMU $32,000

= $51 per ticket = 628 tickets (rounded up) 3a. SP VCU CMU FC Q 3-18 (Contd.) = 1,158 tickets (rounded up) 34 = $48 per ticket = $29 per ticket = $48 $29 = $19 per ticket = $22,000 a month =
$22,000 FC = $19 per ticket CMU

3b.

$22,000 + $10,000 FC + TOI = $19 per ticket CMU

= $19 per ticket = 1,685 tickets (rounded up) The reduced commission sizably increases the breakeven point and the number of tickets required to yield a target operating income of $10,000: 8% Commission (Requirement 2) 432 628 Fixed Commission of $48 1,158 1,685

$32,000

Breakeven point Attain OI of $10,000

4a. The $5 delivery fee can be treated as either an extra source of revenue (as done below) or as a cost offset. Either approach increases UCM by $5: SP VCU CMU FC Q = $53 ($48 + $5) per ticket = $29 per ticket = $53 $29 = $24 per ticket = $22,000 a month =
$22,000 FC = $24 per ticket CMU

= 917 tickets (rounded up) 4b. Q =

$22,000 + $10,000 FC + TOI = $24 per ticket CMU $32,000

= $24 per ticket = 1,334 tickets (rounded up) The $5 delivery fee results in a higher contribution margin which reduces both the breakeven point and the tickets sold to attain operating income of $10,000.

3-19

(15 min.)

Gross margin and contribution margin, making decisions.

Salaries and wages of $150,000 could be variable costs and fixed costs. The answer assumes they are all fixed costs. 35

1.

Revenues Deduct variable costs: Cost of goods sold Sales commissions Other operating costs Contribution margin
$210,000

$500,000 $200,000 50,000 40,000

290,000 $210,000

2. Contribution margin percentage = $500,000 = 42% 3. Incremental revenue (20% $500,000) = $100,000 Incremental contribution margin (42% $100,000) $42,000 Incremental fixed costs (advertising) 10,000 Incremental operating income $32,000

If Mr. Schmidt spends $10,000 more on advertising, the operating income will increase by $32,000 converting an operating loss of $10,000 to an operating income of $22,000. Proof (Optional): Revenues (120% $500,000) Cost of goods sold (40% of sales) Gross margin Operating costs: Salaries and wages Sales commissions (10% of sales) Depreciation of equipment and fixtures Store rent Advertising Other operating costs: Variable ( $500,000 $600,000) Fixed Operating income
$40,000

$600,000 240,000 360,000 $150,000 60,000 12,000 48,000 10,000 48,000 10,000 338,000 $ 22,000

36

3-20

(20 min.) Revenues

CVP exercises.
Variable Costs $8,200,000G 8,020,000 8,380,000 8,200,000 8,200,000 8,856,000f 7,544,000h 9,020,000j 7,790,000l Contribution Margin $1,800,000 1,980,000a 1,620,000b 1,800,000 1,800,000 1,944,000 1,656,000 1,980,000 2,210,000 Fixed Costs $1,700,000G 1,700,000 1,700,000 1,785,000c 1,615,000d 1,700,000 1,700,000 1,870,000k 1,785,000m Budgeted Operating Income $100,000 280,000 (80,000) 15,000 185,000 244,000 (44,000) 110,000 425,000

Orig. 1. 2. 3. 4. 5. 6. 7. 8.
Gstands

$10,000,000G 10,000,000 10,000,000 10,000,000 10,000,000 10,800,000e 9,200,000g 11,000,000i 10,000,000

for given.

a$1,800,000 1.10; b$1,800,000 0.90; c$1,700,000 1.05; d$1,700,000 0.95; e$10,000,000 1.08; f$8,200,000 1.08; g$10,000,000 0.92; h$8,200,000 0.92; i$10,000,000 0.10; j$8,200,000 1.10; k$1,700,000 1.10; l$8,200,000 0.95; m$1,700,000 1.05

3-21
1a. 1b.

(20 min.)

CVP exercises.

[Units sold (Selling price Variable costs)] Fixed costs = Operating income [5,000,000 ($0.50 $0.30)] $900,000 = $100,000 Fixed costs Contribution margin per unit = Breakeven units $900,000 [($0.50 $0.30)] = 4,500,000 units Breakeven units Selling price = Breakeven revenues 4,500,000 units $0.50 per unit = $2,250,000 or, Fixed costs Contribution margin ratio = Breakeven revenues $900,000 0.40 = $2,250,000 Contribution margin ratio =
Selling price -Variable costs Selling price $0.50 - $0.30 = = 0.40 $0.50

2. 3. 4. 5. 6.

5,000,000 ($0.50 $0.34) $900,000 [5,000,000 (1.1) ($0.50 $0.30)] [$900,000 (1.1)] [5,000,000 (1.4) ($0.40 $0.27)] [$900,000 (0.8)] $900,000( 1.1) ($0.50 $0.30) ($900,000 + $20,000) ($0.55 $0.30) 37

= $ (100,000) = $ 110,000 = $ 190,000 = = 4,950,000 units 3,680,000 units

3-22
1. 2.

(1015 min.) CVP analysis, income taxes. Operating income = Net income (1 tax rate) = $84,000 (1 0.40) = $140,000

Contribution margin Fixed costs = Operating income Contribution margin $300,000 = $140,000 Contribution margin = $440,000 Revenues Variable costs = Contribution margin Revenues 0.80 Revenues = Contribution margin 0.20 Revenues = $440,000 Revenues = $2,200,000 Breakeven revenues = Fixed costs Contribution margin percentage Breakeven revenues = $300,000 0.20 = $1,500,000 (2025 min.) CVP analysis, income taxes. Variable cost percentage is $3.20 $8.00 = 40% Let R = Revenues needed to obtain target net income R 0.40R $450,000 = 0.60R = $450,000 + $150,000 R = $600,000 0.60 R = $1,000,000 or, Breakeven revenues = Proof: = Contribution margin percentage $1,000,000 400,000 600,000 450,000 150,000 45,000 $ 105,000
Target net uncome 1 Tax rate $105,000 1 0.30

3.

4.

3-23
1.

$450,000 + 0.60

$105,000 1 0.30

= $1,000,000

Revenues Variable costs (at 40%) Contribution margin Fixed costs Operating income Income taxes (at 30%) Net income

2.

a.

Customers needed to earn net income of $105,000: Total revenues Sales check per customer $1,000,000 $8 = 125,000 customers Customers needed to break even: Contribution margin per customer = $8.00 $3.20 = $4.80 Breakeven number of customers = Fixed costs Contribution margin per customer = $450,000 $4.80 per customer = 93,750 customers 38

b.

3-23 (Contd.) 3. Using the shortcut approach: Change in net income = (1 Tax rate) = (150,000 125,000) $4.80 (1 0.30) = $120,000 0.7 = $84,000 = $84,000 + $105,000 = $189,000 $1,200,000 480,000 720,000 450,000 270,000 81,000 $ 189,000

New net income

The alternative approach is: Revenues, 150,000 $8.00 Variable costs at 40% Contribution margin Fixed costs Operating income Income tax at 30% Net income

3-24
1.

(30 min.) CVP analysis, sensitivity analysis. SP = $30.00 (1 0.30 margin to bookstore) = $30.00 0.70 = $21.00 VCU = $ 4.00 variable production and marketing cost 3.15 variable author royalty cost (0.15 $30.00 0.70) $ 7.15 CMU = $21.00 $7.15 = $13.85 per copy FC = $ 500,000 fixed production and marketing cost 3,000,000 up-front payment to Washington $3,500,000

Exhibit 3-24A shows the PV graph.

39

3-24 (Contd.) EXHIBIT 3-24A PV Graph for Media Publishers

$4,000

FC = $3,500,000 UCM = $13.85 per book sold

3,000 2,000

Operating income (000s)

1,000

0 100,000 200,000 300,000 400,000 500,000

Units so ld

-1,000

252,708; $0

-2,000

-3,000

(0; $3.5 million)

-4,000

2a. =
FC CMU
$3,500,000 $13.85

= 252,708 copies sold (rounded up) 2b. Target OI =

FC + OI CMU

310

3-24 (Contd.)
$3,500,000 + $2,000,000 $13.85 $5,500,000 = $13.85

= 397,112 copies sold (rounded up) 3a. Decreasing the normal bookstore margin to 20% of the listed bookstore price of $30 has the following effects: SP = $30.00 (1 0.20) = $30.00 0.80 = $24.00 VCU =$ 4.00 variable production and marketing cost + 3.60 variable author royalty cost (0.15 $30.00 0.80) $ 7.60 CMU = $24.00 $7.60 = $16.40 per copy =
FC CMU

$3,500,000 $16.40

= 213,415 copies sold (rounded) The breakeven point decreases from 252,708 copies in requirement 2 to 213,415 copies. 3b. Increasing the listed bookstore price to $40 while keeping the bookstore margin at 30% has the following effects: = $40.00 (1 0.30) = $40.00 0.70 = $28.00 VCU = $ 4.00 variable production and marketing cost + 4.20 variable author royalty cost (0.15 $40.00 0.70) $ 8.20 SP CMU= $28.00 $8.20 = $19.80 per copy =
$3,500,000 $19.80

= 176,768 copies sold (rounded) The breakeven point decreases from 252,708 copies in requirement 2 to 176,768 copies. 3c. The answer to requirements 3a and 3b decreases the breakeven point relative to requirement 2 because in each case fixed costs remain the same at $3,500,000 while contribution margin per unit increases.

311

3-25
1.

(10 min.)

CVP analysis, margin of safety.

Breakeven point revenues = Contribution margin percentage
Fixed costs

Contribution margin percentage = $1,000,000 = 0.40 2. Contribution margin percentage = 0.40 =

Selling price Variable cost per unit Selling price

$400,000

SP $12 SP

0.40 SP = SP $12 0.60 SP = $12 SP = $20 3. Revenues, 80,000 units $20 Breakeven revenues Margin of safety (25 min.) $1,600,000 1,000,000 $ 600,000

3-26
1a.

Operating leverage.

Let Q denote the quantity of carpets sold Breakeven point under Option 1 $500Q $350Q = $5,000 $150Q = $5,000 Q = $5,000 $150 = 34 carpets (rounded) Breakeven point under Option 2 $500Q $350Q (0.10 $500Q) = 0 100Q = 0 Q = 0 Operating income under Option 1 = $150Q $5,000 Operating income under Option 2 = $100Q Find Q such that $150Q $5,000 = $100Q $50Q = $5,000 Q = $5,000 $50 = 100 carpets For Q = 100 carpets, operating income under both Option 1 and Option 2 = $10,000

1b.

2.

3a.

For Q > 100, say, 101 carpets, Option 1 gives operating income Option 2 gives operating income So Color Rugs will prefer Option 1.

= $150 101 $5,000 = $10,150 = $100 101 = $10,100

3-26 (Contd.) 312

3b.

For Q < 100, say, 99 carpets, Option 1 gives operating income Option 2 gives operating income So Color Rugs will prefer Option 2. Degree of operating leverage =

= $150 99 $5,000 = $100 99

= $9,850 = $9,900

4.

Contribution margin Operating income $150 100 = 1.5 $10,000 $100 100 = 1.0 $10,000

Under Option 1, degree of operating leverage = Under Option 2, degree of operating leverage =

5. The calculations in requirement 4 indicate that when sales are 100 units, a percentage change in sales and contribution margin will result in 1.5 times that percentage change in operating income for Option 1, but the same percentage change in operating income for Option 2. The degree of operating leverage at a given level of sales helps managers calculate the effect of fluctuations in sales on operating incomes.

3-27
1.

(10 min.)

CVP analysis, international cost structure differences.

Unit Breakeven Contrib. Point in Margin Units (5)= (2) (3) (6) = (1) (4) (5) $13 15 10 500,000 300,000 1,200,000

Variable Variable Manuf. Mark./Distr. Annual Fixed Costs per Costs per Costs Selling Price Sweater Sweater (1) (2) (3) (4) Singapore Thailand U.S. $ 6,500,000 4,500,000 12,000,000 $32 32 32 $ 8.00 5.50 13.00 $11.00 11.50 9.00

Singapore Thailand U.S.

(a) Breakeven point in units sold 500,000 300,000 1,200,000

(b) Breakeven point in revenues Col. (a) $32 $16,000,000 9,600,000 38,400,000

313

3-27 (Contd.) 2. Revenues $32 Variable 800,000 Costs $25,600,000 $15,200,0001 25,600,000 13,600,0002 25,600,000 17,600,0003
2

Singapore Thailand U.S.

1

Fixed Costs $6,500,000 4,500,000 12,000,000

Operating Income $3,900,000 7,500,000 (4,000,000)

3

($8 + $11) 800,000

($5.50 + $11.50) 800,000

($13 + $9) 800,000

Thailand has the lowest breakeven pointit has both the lowest fixed costs ($4,500,000) and the lowest variable cost per unit ($17.00). Hence, for a given selling price, Thailand will always have a higher operating income (or a lower operating loss) than Singapore or the U.S. The U.S. breakeven point is 1,200,000 units. Hence, with sales of 800,000 units, it has an operating loss of $4,000,000.

3-28
1.

(30 min.)

Sales mix, new and upgrade customers.

New Customers $210 90 120 Upgrade Customers $120 40 80

SP VCU CMU

Let S = Number of units sold to upgrade customers 1.5S = Number of units sold to new customers Revenues Variable costs Fixed costs = Operating income [$210 (1.5S) + $120S] [$90 (1.5S) + $40S] $14,000,000 = OI $435S $175S $14,000,000 = OI Breakeven point is 134,616 units when OI = 0 $260S = $14,000,000 S = 53,846 units sold to upgrade customers 1.5S = 80,770 units sold to new customers 134,616 units Check Revenues ($210 80,770; $120 53,846) Variable costs ($90 80,770; $40 53,846) Contribution margin Fixed costs Operating income (subject to rounding) $23,423,220 9,423,140 14,000,080 14,000,000 $ 0

314

3-28 (Contd.) 2. When 200,000 units are sold, mix is: Units sold to new customers (60% 200,000) 120,000 Units sold to upgrade customers (40% 200,000) 80,000 Revenues ($210 120,000; $120 80,000) Variable costs ($90 120,000; $40 80,000) Contribution margin Fixed costs Operating income 3a. Let S = Number of units sold to upgrade customers then S = Number of units sold to new customers [$210S + $120S] [$90S + $40S] $14,000,000 = OI 330S 130S = $14,000,000 200S = $14,000,000 S = 70,000 units sold to upgrade customers S = 70,000 units sold to new customers 140,000 units Check Revenues ($210 70,000; $120 70,000) Variable costs ($90 70,000; $40 70,000) Contribution margin Fixed costs Operating income 3b. $23,100,000 9,100,000 14,000,000 14,000,000 $ 0 $34,800,000 14,000,000 20,800,000 14,000,000 $ 6,800,000

Let S = Number of units sold to upgrade customers then 9S = Number of units sold to new customers [$210 (9S ) + $120S] [$90 (9S ) + $40S] $14,000,000 = OI 2,010S 850S = $14,000,000 1,160S = $14,000,000 S = 12,069 units sold to upgrade customers 9S = 108,621 units sold to new customers 120,690 units $24,258,690 10,258,650 14,000,040 4,000,000 $ 0

Check Revenues ($210 108,621; $120 12,069) Variable costs ($90 108,621; $40 12,069) Contribution margin Fixed costs Operating income (subject to rounding)

315

3-28 (Contd.) 3c. As Zapo increases its percentage of new customers, which have a higher contribution margin per unit than upgrade customers, the number of units required to break even decreases: Requirement 3(a) Requirement 1 Requirement 3(b) New Customers 50% 60 90 Upgrade Customers 50% 40 10 Breakeven Point 140,000 134,616 120,690

3-29
1.

(25-30 min.) Athletic scholarships, CVP analysis. Variable costs per scholarship offer: Scholarship amount Operating costs Total variable costs $20,000 2,000 $22,000

Let the number of scholarships be denoted by Q $22,000 Q = $5,000,000 $600,000 $22,000 Q = $4,400,000 Q = $4,400,000 $22,000 = 200 scholarships 2. Total budget for next year = $5,000,000 (1.00 0.22) = $3,900,000 Then $22,000 Q = $3,900,000 $600,000 = $3,300,000 Q = $3,300,000 $22,000 = 150 scholarships 3. Total budget for next year from above = $3,900,000 Fixed costs 600,000 Variable costs for scholarships $3,300,000 If the total number of scholarships is to remain at 200: Variable cost per scholarship $3,300,000 200 Variable operating cost per scholarship Amount per scholarship $16,500 2,000 $14,500

3-30
1a.
Fixed

(20 min.)
Operating income

CVP analysis, multiple cost drivers.

= Revenues
Cost of picture Quantity of Cost of Number of shipment shipments frames picture frames

costs
= ($45 40,000) ($30 40,000) ($60 1,000) $240,000 = $1,800,000 $1,200,000 $60,000 $240,000 = $300,000

316

1b.

Operating income

= ($45 40,000) ($30 40,000) ($60 800) $240,000 = $312,000

3-30 (Contd.) 2. Denote the number of picture frames sold by Q, then $45Q $30Q 500 $60 $240,000 = 0 $15Q = $30,000 + $240,000 = $270,000 Q = $270,000 $15 = 18,000 picture frames 3. Suppose Susan had 1,000 shipments. $45Q $30Q (1000 $60) $240,000 = 0 15Q = $300,000 Q = 20,000 picture frames

The breakeven point is not unique because there are two cost driversquantity of picture frames and number of shipments. Various combinations of the two cost drivers can yield zero operating income.

3-31
1a.

(20 min.)

Gross margin and contribution margin.

$1,600,000 500,000 $1,100,000

Cost of goods sold Fixed manufacturing costs Variable manufacturing costs

Variable manufacturing costs per unit = $1,100,000 200,000 = $5.50 per unit 1b. Total marketing and distribution costs Variable marketing and distribution (200,000 $4) Fixed marketing and distribution costs Selling price $1,150,000 800,000 $ 350,000

2.

= $2,600,000 200,000 units = $13 per unit Variable marketing Variable Contribution margin Selling = price manufacturing and distribution per unit costs per unit costs per unit = $13 $5.50 $4.00 = $3.50

Operating income =

Fixed marketing Contribution margin Sales Fixed manufacturing and distribution quantity per unit costs costs = ($3.50 230,000) $500,000 $350,000 = $45,000

317

Foreman has confused gross margin with contribution margin. He has interpreted gross margin as if it was all variable, and interpreted marketing and distribution costs as all fixed. In fact, the manufacturing costs, subtracted from sales to calculate gross margin, and marketing and distribution costs contain both fixed and variable components.

3-31 (Contd.) 3. Breakeven point in units = = Breakeven point in revenues

Fixed manufacturing, marketing and distribution costs Contribution margin per unit $850,000 = 242,858 units (rounded up) $3.50

= 242,858 $13 = $3,157,154.

3-32

(1520 min.) Uncertainty, CVP analysis.

1. King pays Foreman $2 million plus $4 (25% of $16) for every home purchasing the payper-view. The expected value of the variable component is: Demand Payment (2) = (1) $4 (1) 100,000 $ 400,000 200,000 800,000 300,000 1,200,000 400,000 1,600,000 500,000 2,000,000 1,000,000 4,000,000 Probability (3) 0.05 0.10 0.30 0.35 0.15 0.05 Expected Payment (4) $ 20,000 80,000 360,000 560,000 300,000 200,000 $1,520,000

The expected value of King's payment is $3,520,000 ($2,000,000 fixed fee + $1,520,000). 2. SP = $16 VCU = $ 6 ($4 payment to Foreman + $2 variable cost) CMU= $10 FC = $2,000,000 + $1,000,000 = $3,000,000 Q
FC UCM $3,000,000 = $10

= 300,000 homes If 300,000 homes purchase the pay-per-view, King will break even.

3-33

(15-20 min.) CVP analysis, service firm.

318

1.

Revenue per package $4,000 Variable cost per package 3,600 Contribution margin per package $ 400 Breakeven (units) = Fixed costs Contribution margin per package 3-33 (Contd.) = $400 per package = 1,200 tour packages 2. Contribution margin ratio =
Contribution margin per package $400 = = 10% Selling price $4,000 $480,000

Revenue to achieve target income = (Fixed costs + target OI) Contribution margin ratio =
$480,000 + $100,000 = $5,800,000, or 0.10

Number of tour packages to earn $100,000 operating income:

$480,000 + $100,000 = 1,450 tour packages $400

Revenues to earn $100,000 OI = 1,450 tour packages $4,000 = $5,800,000. 3. Fixed costs = $480,000 + $24,000 = $504,000 Breakeven (units) = Contribution margin per unit
Fixed costs

Contribution margin per unit =

Fixed costs Breakeven (units)

$504,000

= 1,200 tour packages = $420 per tour package Desired variable cost per tour package = $4,000 $420 = $3,580 Because the current variable cost per unit is $3,600, the unit variable cost will need to be reduced by $20 to achieve the breakeven point calculated in requirement 1. Alternate Method: If fixed cost increases by $24,000, then total variable costs must be reduced by $24,000 to keep the breakeven point of 1,200 tour packages. Therefore the variable cost per unit reduction = $24,000 1,200 = $20 per tour package. 319

320

3.34 (30 min.)

1.

CVP, target income, service firm.

$600 200 $400
Fixed costs

Revenue per child Variable costs per child Contribution margin per child

Breakeven quantity = Contribution margin per child = 2. Target quantity = = 3.

$5,600 = 14 children $400

Fixed costs + Target operating income Contribution margin per child

$5,600 + $10,400 = 40 children $400

Increase in rent ($3,000 $2,000) Field trips Total increase in fixed costs Divide by the number of children enrolled Increase in fee per child

$1,000 1,000 $2,000 40 $ 50

Therefore the fee per child will increase from $600 to $650. Alternatively, New contribution margin per child =
$5,600 + $2,000 + $10,400 = $450 40

New fee per child = Variable costs per child + New contribution margin per child = $200 + $450 = $650

3.35 (20-25 min.)

1.

CVP analysis, CMA adapted.

$16.00 12.00 $ 4.00
$600,000 = 150,000 units $4.00

Selling price Variable costs per unit: Purchase price $10.00 Shipping and handling 2.00 Contribution margin per unit (CMU)
Fixed costs

Breakeven point in units = Contr. margin per unit =

321

3-25 (Contd.) 2. Since Galaxy is operating above the breakeven point, any incremental contribution margin will increase operating income dollar for dollar. Increase in units sales = 10% 200,000 = 20,000 Incremental contribution margin = $4 20,000 = $80,000 Therefore, the increase in operating income will be equal to $80,000. Galaxys operating income in 2003 would be $200,000 + $80,000 = $280,000. 3. Selling price Variable costs: Purchase price $10 130% Shipping and handling Contribution margin per unit Target sales in units = $16.00 $13.00 2.00 15.00 $ 1.00

$600,000 + $200,000 FC + TOI = = 800,000 units $1 CMU

Target sales in dollars = $16 800,000 = $12,800,000

3-36
1.

(30-40 min.) CVP analysis, income taxes. Revenues Variable costs Fixed costs Let X = Net income for 2003 =
Target net income 1 Tax rate

20,000($25.00) 20,000($13.75) $135,000 =

X 1 0.40 X $500,000 $275,000 $135,000 = 0.60

$300,000 $165,000 $81,000 = X X = $54,000 Alternatively, Operating income = Revenues Variable costs Fixed costs = $500,000 $275,000 $135,000 = $90,000 Income taxes = 0.40 $90,000 = $36,000 Net income = Operating income Income taxes = $90,000 $36,000 = $54,000 2. Let Q = Number of units to break even $25.00Q $13.75Q $135,000 = 0 Q = $135,000 $11.25 = 12,000 units

322

3-36 (Contd.) 3. Let X = Net income for 2004 22,000($25.00) 22,000($13.75) ($135,000 + $11,250) $550,000 $302,500 $146,250 $101,250 = = =
X 1 0.40 X 0.60 X 0.60

X = $60,750 4. Let Q = Number of units to break even with new fixed costs of $146,250 $25.00Q $13.75Q $146,250 Q = $146,250 $11.25 Breakeven revenues = 13,000 $25.00 5. = 0 = 13,000 units = $325,000

Let S = Required sales units to equal 2003 net income $25.00S $13.75S $146,250 = $54,000
0.60

$11.25S = $236,250 S = 21,000 units Revenues = 21,000 units $25.00 = $525,000 6. Let A = Amount spent for advertising in 2004 $550,000 $302,500 ($135,000 + A) =
$60,000 0.60

$550,000 $302,500 $135,000 A = $100,000 $550,000 $537,500 = A A = $12,500

3-37
1.

(20 min.)

CVP analysis, decision making.

Tocchets current operating income is as follows: Revenues, $105 40,000 Variable costs, $55 40,000 Contribution margin Fixed costs Operating income $4,200,000 2,200,000 2,000,000 1,400,000 $ 600,000

323

3-37 (Contd.) Let the fixed marketing and distribution costs be F. We calculate F when operating income = $600,000 and the selling price is $99. ($99 50,000) ($55 50,000) $4,950,000 $2,750,000 F = $600,000 F = $600,000 F = $4,950,000 $2,750,000 $600,000 F = $1,600,000

Hence, the maximum increase in fixed marketing and distribution costs that will allow Tocchet to reduce the selling price and maintain $600,000 in operating income is $200,000 ($1,600,000 $1,400,000). 2. Let the selling price be P.

We calculate P for which, after increasing fixed manufacturing costs by $100,000 to $900,000 and variable manufacturing cost per unit by $2 to $47, operating income = $600,000 $40,000 P ($47 40,000) ($10 40,000) $900,000 $600,000 = $600,000 $40,000 P $1,880,000 $400,000 $900,000 $600,000 = $600,000 $40,000 P = $600,000 + $1,880,000 + $400,000 + $900,000 + $600,000 $40,000 P = $4,380,000 P = $4,380,000 40,000 = $109.50 Tocchet will consider adding the new features provided the selling price is at least $109.50 per unit.

3-38
1.

(10-15 min.) Margin of safety. Selling price ($1,000,000 $10,000) $100 Variable cost per unit ($600,000 $10,000) Contribution margin
Fixed costs

60 $ 40

Breakeven point in units = Contribution margin per unit = $40 per unit = 6,250 footballs Breakeven point in dollars = 6,250 $100 = $625,000 2. Margin of safety in units = 10,000 6,250 = 3,750 footballs
$250,000

Margin of safety in dollars = $100 3,750 = $375,000 3-38 (Contd.) 324

3.

Contribution margin ratio =

Contribution margin per unit $40 = = 40% Selling price $100

Incremental operating income = 40% $200,000 = $80,000

3-39
1.

(2030 min.) CVP analysis, shoe stores. Contribution margin per pair = selling price Variable costs per pair = $30 $21 = $9 a pair Breakeven point in number of pairs:
Fixed costs $360,000 = = 40,000 pairs Contribution margin per pair $9.00

Breakeven points in revenues:

Fixed costs $360,000 = = $1,200,000 Contribution margin % per dollar of sales 100% 70%

2.

Revenues, $30 35,000 Variable costs, $21 35,000 Contribution margin Fixed costs Operating income (loss)

$1,050,000 735,000 315,000 360,000 $ (45,000)

An alternative approach is that 35,000 units is 5,000 units below the breakeven point, and the unit contribution margin is $9.00: $9.00 5,000 = $45,000 below breakeven 3. Fixed costs: $360,000 + $81,000 = $441,000 Contribution margin per pair = $30 $19.50 = $10.50 a. b. Breakeven point in units =
$441,000 = 42,000 pairs $10.50

Breakeven point in revenues = $30 42,000 = $1,260,000

325

3-39 (Contd.) 4. Fixed costs = $360,000 Contribution margin per pair = $30 $21 $0.30 = $8.70 a. b. 5. Breakeven point in units =
$360,000 = 41,380 pairs (rounded up) $8.70

Breakeven point in revenues = $30 41,380 = $1,241,400

Breakeven point = 40,000 pairs Store manager receives commission on 10,000 pairs. Cost of commission = $0.30 10,000 = $3,000 Revenues, $30 50,000 Variable costs: Cost of shoes Salespeople commission Manager commission Contribution margin Fixed costs Operating income $1,500,000 $975,000 75,000 3,000

1,053,000 447,000 360,000 $ 87,000

An alternative approach is 10,000 pairs $8.70 contribution margin per pair = $87,000.

326

3-39 (Contd.)

3-39 Excel Application

Cost-Volume-Profit Analysis Walk Rite Shoe Company Original Data Unit Variable Data: Selling price Cost of shoes Sales commissions Total variable costs Annual Fixed Costs: Rent Salaries Advertising Other fixed costs Total fixed costs Problem 1 Contribution margin per unit a. Breakeven units b. Breakeven revenues Problem 2 Revenues Cost of shoes Sales commissions Total variable costs Contribution margin Total fixed costs Operating income (Loss) Problem 3 Total fixed costs Contribution margin per unit a. Breakeven units b. Breakeven revenues Problem 4 Total variable cost per unit Contribution margin per unit a. Breakeven units b. Breakeven revenues Problem 5 Revenues Cost of shoes Sales commissions Managers commission Total variable costs Contribution margin Total fixed costs Operating Income (Loss) $30.00 $19.50 1.50 21.00 $60,000 200,000 80,000 20,000 $360,000

$9.00 40,000 $1,200,000 $1,050,000 682,500 52,500 735,000 $315,000 360,000 $(45,000)

$441,000 $10.50 42,000 $1,260,000 $21.30 $8.70 41,380 $1,241,409

$1,500,000 975,000 75,000 3,000 1,053,000 $447,000 360,000 $87,000

327

3-40

(2025 min.) CVP analysis, shoe stores (continuation of 3-39).

1. Because the unit sales level at the point of indifference would be the same for each plan, the revenue would be equal. Therefore, the unit sales level sought would be that which produces the same total costs for each plan. Let Q $19.50Q + $360,000 + $81,000 $81,000 Q 2. Sales in units Revenues at $30.00 Variable costs at $21.00 and at $19.50 Contribution margin Fixed costs Operating income = = = = unit sales level $21.00Q + $360,000 $1.50Q 54,000 pairs

Commission Plan Salary Plan 50,000 60,000 50,000 60,000 $1,500,000 $1,800,000 $1,500,000 $1,800,000 1,050,000 1,260,000 975,000 1,170,000 450,000 540,000 525,000 630,000 360,000 360,000 441,000 441,000 $ 90,000 $ 180,000 $ 84,000 $ 189,000

The decision regarding the plans will depend heavily on the unit sales level that is generated by the fixed salary plan. For example, as part (1) shows, at identical unit sales levels in excess of 54,000 units, the fixed salary plan will always provide a more profitable final result than the commission plan. 3. Let TQ = Target number of units = $168,000 = $609,000 = $609,000 $10.50 = 58,000 units = $168,000 = $528,000 = $528,000 $9.00 = 58,667 units (rounded)

$30.00TQ $19.50TQ $441,000 $10.50TQ TQ TQ $30.00TQ $21.00TQ $360,000 $9.00TQ TQ TQ

The decision regarding the salary plan depends heavily on predictions of demand. For instance, the salary plan offers the same operating income at 58,000 units as the commission plan offers at 58,667 units.

328

3-41
1.

(10-20 min.) Sensitivity and inflation (continuation of 3-40). Revenues, $30 48,000 $18 2,000 $1,440,000 36,000 975,000 73,800

$1,476,000

Variable costs: Goods sold $19.50 50,000 Commission, 5% $1,476,000 Contribution margin Fixed costs Operating income An alternative approach is:

1,048,800 427,200 360,000 $ 67,200

Contribution margin on 48,000 pairs $9.00 Deduct negative contribution margin on unsold pairs, 2,000 [$18.00 ($19.50 + $.90* commission)] Contribution margin Fixed costs Operating income
*5% of $18.00 = $0.90

$432,000 4,800 427,200 360,000 $ 67,200

2. Optimal operating income, given perfect knowledge, would be the $432,000 [($30 $19.50 $1.50) 48,000] contribution computed above, minus $360,000 fixed costs, or $72,000. 3. The point of indifference is where the operating incomes are equal. Let X = unit cost per pair that would produce the identical operating income of $67,200. Then: 48,000[$30.00 (X + $1.50)] $360,000 48,000($28.50 X) $360,000 $1,368,000 48,000X $360,000 48,000X X = = = = = $ 67,200 $ 67,200 $ 67,200 $940,800 $19.60

Therefore, any rise in purchase cost in excess of $19.60 per pair increases the operating income benefit of signing the long-term contract. In a shortcut solution, you could take the $4,800 difference between the "ideal" operating income (of $72,000) at the current cost per pair and the operating income under the contract (of $67,200) and divide it by 48,000 units to get 10 cents per pair difference.

329

3-42

(30 min.)

CVP analysis, income taxes, sensitivity.

1a. In order to break even, Almo Company must sell 500 units. This amount represents the point where revenues equal total costs. Let Q denote the quantity of canopies sold. Revenue = Variable costs + Fixed costs $400Q = $200Q + $100,000 $200Q = $100,000 Q = 500 units Breakeven can also be calculated using contribution margin per unit. Contribution margin per unit = Selling price Variable cost per unit = $400 $200 = $200 Breakeven = Fixed Costs Contribution margin per unit = $100,000 $200 = 500 units 1b. In order to achieve its net income objective, Almo Company must sell 2,500 units. This amount represents the point where revenues equal total costs plus the corresponding operating income objective to achieve net income of $240,000. Revenue = Variable costs + Fixed costs + [Net income (1 Tax rate)] $400Q = $200Q + $100,000 + [$240,000 (1 0.4)] $400 Q = $200Q + $100,000 + $400,000 Q = 2,500 units 2. To achieve its net income objective, Almo Company should select the first alternative where the sales price is reduced by $40, and 2,700 units are sold during the remainder of the year. This alternative results in the highest net income and is the only alternative that equals or exceeds the companys net income objective. Calculations for the three alternatives are shown below. Alternative 1 Revenues Variable costs Operating income = $1,112,000 $610,000 $100,000 = $402,000 Net income = $402,000 (1 0.4) = $241,200 a$400 $40; b350 units + 2,700 units. Alternative 2 Revenues Variable costs Operating income Net income c$400 $30; d$200 $10. = ($400 350) + ($370c 2,200) = $954,000 = ($200 350) + ($190d 2,200) = $488,000 = ($400 350) + ($360a 2,700) = $1,112,000 = $200 3,050b = $610,000

= $954,000 $488,000 $100,000 = $366,000 = $366,000 (1 0.4) = $219,600

330

3-42 (Contd.) Alternative 3 Revenues Variable costs Operating income Net income = ($400 350) + ($380e 2,000) = $900,000 = $200 2,350f = $470,000

= $900,000 $470,000 $90,000g = $340,000 = $340,000 (1 0.4) = $204,000 e$400 0.05 $400 = 400 $20; f350 units + 2,000 units; g$100,000 $10,000

3-43
1.

(30 min.)

Choosing between compensation plans, operating leverage.

$11,700,000

Variable costs of goods sold as a percentage of revenues = $26,000,000 = 45% Let breakeven revenues be denoted by R, then R=
Variable manuf. + Fixed manuf. + Variable marketing + Fixed marketing costs costs costs costs

R = 0.45R + $2,870,000 + 0.18R + $3,420,000 R 0.45R 0.18R 0.37R R = $2,870,000 + $3,420,000 = $6,290,000 = $6,290,000 = $6,290,000 0.37 = $17,000,000

2. With its own sales force, Marstons fixed marketing costs would increase to $3,420,000 + $2,080,000 = $5,500,000. Variable cost of marketing = 10% of Revenues Let breakeven revenues be denoted by R, then R = 0.45R + $2,870,000 + 0.10R + $5,500,000 R 0.45R 0.10R 0.45R R = $2,870,000 + $5,500,000 = $8,370,000 = $8,370,000 = $8,370,000 0.45 = $18,600,000

331

3-43 (Contd.) 3. Revenues Variable manufacturing costs $26,000,000 0.45; 0.45 Variable marketing costs $26,000,000 0.18; 0.10 Contribution margin Fixed costs Fixed manufacturing costs Fixed marketing costs Total fixed costs Operating income
Contributi on margin Degree of = operating leverage Operating income

Using Sales Agents $26,000,000 11,700,000 4,680,000 9,620,000 2,870,000 3,420,000 6,290,000 $ 3,330,000

Employing Own Sales Staff $26,000,000 11,700,000 2,600,000 11,700,000 2,870,000 5,500,000 8,370,000 $ 3,330,000

$9,620,000 $11,700,000 = 2.89 = 3.51 $3,330,000 $3,330,000

The calculations indicate that at sales of $26,000,000, a percentage change in sales and contribution margin will result in 2.89 times that percentage change in operating income if Marston continues to use sales agents and 3.51 times that percentage change in operating income if Marston employs its own sales staff. The higher contribution margin per dollar of sales and higher fixed costs gives Marston more operating leverage, that is greater benefits (increases in operating income) if revenues increase but greater risks (decreases in operating income) if revenues decrease. 4. Variable costs of marketing Fixed marketing costs = 15% of Revenues = $5,500,000

Variable Fixed Variable Fixed Operating income = Revenues manuf. costs manuf. costs marketing marketing costs costs Denote the revenues required to earn $3,420,000 of operating income by R, then R 0.45R $2,870,000 0.15R $5,500,000 = $3,330,000 R 0.45R 0.15R = $3,330,000 + $2,870,000 + $5,500,000 0.40R = $11,700,000 R = $11,700,000 0.40 = $29,250,000

332

3-44

(1525 min.) Sales mix, three products.

1. Sales of A, B, and C are in ratio 20,000 : 100,000 : 80,000. So for every 1 unit of A, 5 (100,000 20,000) units of B are sold, and 4 (80,000 20,000) units of C are sold. Let Q = Number of units of A to break even 5Q = Number of units of B to break even 4Q = Number of units of C to break even Contribution margin Fixed costs = Zero operating income $3Q + $2(5Q) + $1(4Q) $255,000 = 0 $17Q = $255,000 Q = 15,000 ($255,000 $17) units of A 5Q = 75,000 units of B 4Q = 60,000 units of C Total = 150,000 units 2. Contribution margin: A: 20,000 $ 60,000 B: 100,000 $2 C: 80,000 80,000 Contribution margin Fixed costs Operating income Contribution margin A: 20,000 $3 B: 80,000 $2 C: 100,000 $1 Contribution margin Fixed costs Operating income Let Q = 4Q = 5Q = 200,000 $340,000 255,000 $ 85,000 $ 60,000 160,000 100,000 $320,000 255,000 $ 65,000 $3

$1

3.

Number of units of A to break even Number of units of B to break even Number of units of C to break even

Contribution margin Fixed costs = Breakeven point $3Q + $2(4Q) + $1(5Q) $255,000 $16Q Q 4Q 5Q Total = 0 = $255,000 = 15,938 ($255,000 $16) units of A (rounded) = 63,752 units of B = 79,690 units of C = 159,380 units

333

Breakeven point increases because the new mix contains less of the higher contribution margin per unit, product B, and more of the lower contribution margin per unit, product C. 3-45 (30 min.) Multiproduct breakeven, decision making. 1. Breakeven point in 2003 (units) = Contribution margin per unit = = 16,500 units $50 $20 Breakeven point in 2003 (in revenues) = 16,500 units $50 = $825,000 in sales revenues 2. Breakeven point in 2004 (in units) Evenkeel expects to sell 3 units of Plumar for every 2 units of Ridex in 2004, so consider a bundle consisting of 3 units of Plumar and 2 units of Ridex. Unit contribution Margin from Plumar = $50 $20 = $30 Unit contribution Margin from Ridex = $25 $15 = $10 The contribution margin for the bundle is $30 3 units of Plumar + $10 2 units of Ridex = $110 So bundles to be sold to break even = Breakeven point in 2004 (in units) Plumar, 4,500 3 = 13,500 units Ridex, 4,500 2 = 9,000 units Breakeven point in revenues: Plumar 13,500 units $50 per unit = $675,000 Ridex 9,000 units $25 per unit = 225,000 Total $900,000 3. Contribution margin percentage in 2003 = = Contribution margin percentage in 2004 = =
Contribution margin per unit in 2003 Selling price in 2003 Fixed costs

$495,000

$495,000 = 4,500 bundles $110

$30 = 60% $50

Contribution margin of bundle in 2004 Selling price of bundle in 2004

$110 $110 = = 55% (3 $50) + ( 2 $25) $200

334

The breakeven point in 2004 increases because fixed costs are the same in both years but the contribution margin generated by each dollar of sales revenue at the given product mix decreases in 2004 relative to 2003. 3-45 (Contd.) 4. Despite the breakeven sales revenue being higher, Evenkeel should accept Glastons offer. The breakeven points are irrelevant because Evenkeel is already above the breakeven sales volume in 2003. By accepting Glastons offer, Evenkeel has the ability to sell all the 30,000 units of Plumar in 2004 and make more sales of Ridex to Glaston without incurring any more fixed costs. Operating income in 2004 with and without Ridex are expected to be as folows: 2004 2004 without Ridex with Ridex $1,500,0001 $2,000,0002 600,0003 900,0004 900,000 1,100,000 495,000 495,000 $ 405,000 $ 605,000

Sales Variable costs Contribution margin Fixed costs Operating income

1 2

$50 30,000 units ($50 30,000 units) + ($25 20,000 units) 3 $20 30,000 units 4 ($20 30,000 units) + ($15 20,000 units)

335

3-46
1.

(2025 min.) Sales mix, two products. Let Q 3Q = Number of units of Deluxe carrier to break even = Number of units of Standard carrier to break even

Revenues Variable costs Fixed costs = Zero operating income $20(3Q) + $30Q $14(3Q) $18Q $1,200,000 = $60Q + $30Q $42Q $18Q = $30Q = Q = 3Q = units. 2a. 2b. Unit contribution margins are: Standard: $20 $14 = $6; Deluxe: $30 $18 = $12 If only Standard carriers were sold, the breakeven point would be: $1,200,000 $6 = 200,000 units. If only Deluxe carriers were sold, the breakeven point would be: $1,200,000 $12 = 100,000 units
Operating income = Contribution margin of Standard + Contribution margin of Deluxe Fixed costs

0 $1,200,000 $1,200,000 40,000 units of Deluxe 120,000 units of Standard

The breakeven point is 120,000 Standard units plus 40,000 Deluxe units, a total of 160,000

3.

= 180,000($6) + 20,000($12) $1,200,000 = $1,080,000 + $240,000 $1,200,000 = $120,000 Let Q 9Q = = Number of units of Deluxe product to break even Number of units of Standard product to break even = = = = = 0 $1,200,000 $1,200,000 18,182 units of Deluxe (rounded) 163,638 units of Standard

$20(9Q) + $30Q $14(9Q) $18Q $1,200,000 $180Q + $30Q $126Q $18Q $66Q Q 9Q

The breakeven point is 163,638 Standard + 18,182 Deluxe, a total of 181,820 units. The major lesson of this problem is that changes in the sales mix change breakeven points and operating incomes. In this example, the budgeted and actual total sales in number of units were identical, but the proportion of the product having the higher contribution margin declined. Operating income suffered, falling from $300,000 to $120,000. Moreover, the breakeven point rose from 160,000 to 181,820 units.

336

3-47
1.

(15 min.)

CVP analysis under uncertainty.

Both products have the same unit contribution margin: Unit contribution margin = Selling price per unit Variable costs per unit = $10 $8 = $2 Breakeven point = Unit contribution margin =
$400,000 $2
Fixed costs

= 200,000 units for each product 2. The expected demand for the two umbrellas is: Emerald Green (1) (2) (1) (2) Demand Probability Units 50,000 0.0 100,000 0.1 10,000 200,000 0.2 40,000 300,000 0.4 120,000 400,000 0.2 80,000 500,000 0.1 50,000 1.0 Expected demand 300,000 Event Shocking Pink (3) Probability 0.1 0.1 0.1 0.2 0.4 0.1 1.0 (1) (3) Units 5,000 10,000 20,000 60,000 160,000 50,000 305,000

Expected operating income of Emerald Green umbrellas: $2 (300,000) $400,000 = $200,000 Expected operating income of Shocking Pink umbrellas: $2 (305,000) $400,000

$210,000

The Shocking Pink umbrellas should be chosen because they have the higher expected operating income. 3. The expected operating income from the two products would be identical. If the choice criterion is to maximize expected operating income, the company will be indifferent between Emerald Green and Shocking Pink umbrellas. However, assume that management considers risk factors. Emerald Green umbrellas, for example, have a 10% chance of selling only 100,000 units, which would result in a net operating loss of $200,000. Also, there is a 30% chance that sales of Emerald Green will exceed 300,000 units. If this event happens, the operating income of Emerald Green umbrellas will be higher than the operating income of Shocking Pink umbrellas. If management is reluctant to take risks, it would prefer selling the 300,000 units of Shocking pink.

337

3-47 (Contd.) The expected values are important, but the dispersion of the probability distribution is also important. Normally, the wider the dispersion, the greater the risk. Knowledge of the entire probability distribution helps management assess the risk before reaching a decision.

3-48
1.

(30 min.)

Ethics, CVP analysis.

Revenues Variable costs Revenues

Contribution margin percentage = =

Breakeven revenues

$5,000,000 $3,000,000 $5,000,000 $2,000,000 = $5,000,000 = 40% Fixed costs = Contribution margin percentage

= 2.

$2,160,000 = $5,400,000 0.40

If variable costs are 52% of revenues, contribution margin percentage equals 48% (100% 52%) Breakeven revenues = Contribution margin percentage =
$2,160,000 = $4,500,000 0.48
Fixed costs

3.

Revenues Variable costs (0.52 $5,000,000) Fixed costs Operating income

$5,000,000 2,600,000 2,160,000 $ 240,000

4. Incorrect reporting of environmental costs with the goal of continuing operations is unethical. In assessing the situation, the specific Standards of Ethical Conduct for Management Accountants (described in Exhibit 1-7) that the management accountant should consider are listed below. Competence Clear reports using relevant and reliable information should be prepared. Preparing reports on the basis of incorrect environmental costs in order to make the companys performance look better than it is violates competence standards. It is unethical for Bush to not report environmental costs in order to make the plants performance look good.

338

3-48 (Contd.) Integrity The management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. Bush may be tempted to report lower environmental costs to please Lemond and Woodall and save the jobs of his colleagues. This action, however, violates the responsibility for integrity. The Standards of Ethical Conduct require the management accountant to communicate favorable as well as unfavorable information. Objectivity The management accountants Standards of Ethical Conduct require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountants standpoint, underreporting environmental costs to make performance look good would violate the standard of objectivity. Bush should indicate to Lemond that estimates of environmental costs and liabilities should be included in the analysis. If Lemond still insists on modifying the numbers and reporting lower environmental costs, Bush should raise the matter with one of Lemonds superiors. If after taking all these steps, there is continued pressure to understate environmental costs, Bush should consider resigning from the company and not engage in unethical behavior.

3-49

(35 min.)

Deciding where to produce.

1. The annual breakeven point in units at the Peoria plant is 73,500 units and at the Moline plant is 47,200 units, calculated as follows. Contribution margin per unit calculation: Selling price Less variable costs: Manufacturing Marketing and distribution Contribution margin per unit Peoria $150.00 72.00 14.00 $ 64.00 Moline $150.00 88.00 14.00 $ 48.00

Fixed costs calculation: Total fixed costs = (Fixed manufacturing costs per unit + Fixed marketing and distribution costs per unit) Production rate per day Normal working days Peoria Moline = = ($30.00 + $19.00) 400 240 = $4,704,000 ($15.00 + $14.50) 320 240 = $2,265,600

339

3-49 (Contd.) Breakeven calculation: Breakeven units Peoria Moline = = = Fixed costs Contribution margin per unit $4,704,000 $64 = 73,500 units $2,265,600 $48 = 47,200 units

2. The operating income that would result from the division production managers plan to produce 96,000 units at each plant is $3,628,800. The normal capacity at the Peoria plant is 96,000 units (400 240); however, the normal capacity at the Moline plant is 76,800 units (320 240). Therefore, 19,200 units (96,000 76,800) will be manufactured at Moline at a reduced contribution margin of $40.00 per unit ($48 $8). Contribution margin per plant: Peoria, 96,000 $64 Moline, 76,800 $48 Moline, 19,200 $40 Total contribution margin Deduct total fixed costs, $4,704,000 + $2,265,600 Operating income 3. $ 6,144,000 3,686,400 768,000 $10,598,400 6,969,600 $ 3,628,800

The optimal production plan is to produce 120,000 units at the Peoria plant and 72,000 units at the Moline plant. The full capacity of the Peoria plant, 120,000 units (400 units 300 days), should be utilized as the contribution from these units is higher at all levels of production than the contribution from units produced at the Moline plant. Contribution margin per plant: Peoria, 96,000 $64 Peoria 24,000 $64 $3 Moline, 72,000 $48 Total contribution margin Deduct total fixed costs Operating income $ 6,144,000 1,464,000 3,456,000 $11,064,000 6,969,600 $ 4,094,400

The contribution margin is higher when 120,000 units are produced at the Peoria plant and 72,000 units at the Moline plant. As a result, operating income will also be higher in this case since total fixed costs for the division remain unchanged regardless of the quantity produced at each plant.

340

Chapter 3 Internet Exercise

The Internet exercise is available to students only on the Prentice Hall Companion Website www.prenhall.com/horngren. Students can click on Cost Accounting, 11th ed., and access the Internet Exercise for the chapter, which links to the Web site of a company or organization. The Internet Exercise on the Web will be updated periodically so that it is current with the latest information available on the subject organization's Web site. A printout copy of the Internet exercise for this chapter as of early 2002 appears below. The solution to the Internet exercise, which will also be updated periodically, is available to instructors from the Companion Website's faculty view. To access the solution, click on Cost Accounting, 11th ed., Faculty link, and then register once to obtain your password through the online form. After the initial registration, you will have a personal login ID and password to use to log in. A printout of the solution to the Internet exercise for this chapter as of early 2002 follows. The exercise and solution provide instructors with an idea of the content of the Internet exercise for this chapter. Internet Exercise Southwest Airlines is the nation's fifth largest domestic carrier. It serves 57 cities with a fleet of 352 Boeing 737s. Southwest just marked its twenty-eighth consecutive year of profitability, and enjoys the distinction of having the lowest operating cost structure in the domestic airline industry. In this exercise you will examine factors that contribute to Southwest's success. Go to www.iflyswa.com/, and click on the "About SWA" link, followed by the "Investor Relations" link. From here you can access Southwest's 2000 annual report in Adobe Acrobat pdf format. Use Southwest's 2000 annual report to answer the following questions: 1. Skim Southwest Airline's annual report, pages 7-15, and explain how each of the following factors contributes to its low operating cost structure: a. Load factor. b. Type of aircraft. c. Choice of markets, flights, in-flight service, and aircraft boarding procedures. d. Method of ticketing. Go to Southwest's income statement and examine Southwest's 2000 operating expenses. Identify each expense as either a fixed, variable, or mixed cost (a combination of fixed and variable costs). Operating Expense Type

2a.

2b.

In the short run are Southwest's labor costs predominantly fixed or variable? Explain your answer.

341

Internet Exercise (Contd.) 3. Identify potential cost drivers for the following expenses: salaries, fuel and oil, maintenance materials and repairs, agency commissions, aircraft rentals, landing fees, and depreciation. Operating Expense Potential Cost Drivers

4.

In the year 2000, Southwest reported passenger revenues of $5,467,965,000 on 42,215,162,000 passenger-miles. Ignoring freight and other revenues calculate Southwest's breakeven point for operating income in revenues and passenger-miles assuming: Aircraft rentals, depreciation, $1,337,415,000, are 100% fixed. and other operating expenses, which totaled

Salaries, fuel, maintenance, agency commissions, and landing fees, which totaled $3,291,000,000, are 90% variable. 5. In light of your analysis in questions 1-4, discuss the strategy of Priceline.com. At Priceline.com you can purchase airline tickets, hotel rooms, and rental cars at 40% or more off the lowest published prices provided you are flexible about your flight plans and can travel at short notice.

Solution to Internet Exercise 1a. One of the most important factors influencing profitability is an airline's load factor. Airlines don't make money flying empty planes. Load factor refers to the proportion of a plane's seats that are occupied on each flight. Southwest consistently has the highest load factor in the industry. Its load factor was a record 70.5% in 2000. Southwest's choice of aircraft and operating strategy contributes to its high load factor. Southwest flies only Boeing 737s. Its commitment to a single type of aircraft simplifies its operations in terms of maintenance, scheduling, staffing, and training. Pilots can fly any plane, mechanics can service any plane, and flight crews can staff any flight. This minimizes training costs and spare part inventories, and minimizes the time that aircraft spend at the gate. Southwest provides short haul point-to-point service. This enables Southwest to avoid the cost of providing in-flight meals, and more importantly avoid the ground time required to load and unload meals from aircraft. In addition, Southwest utilizes open seating (first come, first served) for aircraft boarding. This minimizes the ground time for aircraft at the gate and results in higher aircraft and airport utilization.

1b.

1c.

342

Internet Exercise (Contd.) 1d. Southwest reduces ticketing costs by selling over 70% of its seats through its Web site or phone calls to reservation agents versus an industry average of 20% to 25%. In addition to lowering commission costs, this results in a greater use of e-tickets (electronic tickets). E-tickets speed check-in times and reduce paper and back-office processing costs.

2a. Operating Expense Salaries, wages, and benefits Fuel and oil Maintenance materials and repairs Agency commissions Aircraft rentals Landing fees Depreciation
*

Type Mixed Variable Mixed Variable Fixed* Variable Fixed

Refer to footnotes to the financial statements. Aircraft rentals are primarily long-term fixed commitments. 2b. In the short run Southwest's labor costs are predominantly fixed. While pilots, mechanics, flight attendants, and administrators may be compensated for overtime, base salaries are generally fixed. In the long run labor costs are variable. Southwest can layoff employees if business slows or hire additional employees to meet increased demand. Operating Expense Salaries, wages, and benefits Fuel and Oil Maintenance materials and repairs Agency commissions Aircraft rentals Landing fees Depreciation Potential Cost Drivers Number of flights, passengers, flight miles Flight miles Flight miles and time # of tickets, passenger revenues Number of flights, passengers, flight miles, Number of breakdowns by aircraft Number of flights, passengers Flight miles, cost of planes*

3.

* If the unit of production method of deprecation is used, the expense is a function of aircraft cost and usage. 4. Revenue per passenger mile Variable cost per passenger mile Contribution margin per mile $0.1295 ($5467,965,000 42,215,162,000) $0.0702 [(0.90 $3,291,000,000) 42,215,162,000] $0.0593

Breakeven miles = Fixed cost / Contribution margin per mile Breakeven miles = ($1,337,415,000 + $329,100,000 / $0.0593 = 28,103, 119,000 miles

343

Internet Exercise (Contd.) Breakeven revenues = $28,103,119,000 .1295 = $3,639,353,900 5. The variable cost of flying an additional passenger is very low. (How much can it possibly cost to prepare an airline meal?) Thus, airlines value the ability to price discriminate and offer low-priced tickets on empty flights to travelers with flexible flight plans.

Chapter 3 Video Case

The video case can be discussed using only the case writeup in the chapter. Alternatively, instructors can have students view the videotape of the company that is the subject of the case. The videotape can be obtained by contacting your Prentice Hall representative. The case questions challenge students to apply the concepts learned in the chapter to a specific business situation. STORE 24: COST-VOLUME-PROFIT ANALYSIS 1. Customers who might be attracted to money order services include those new to the location who dont have a bank checking account, or those who do not wish to establish a relationship with a bank for financial services. In the Northeast, Store 24 operates in neighborhoods with large immigrant populations, whose members have yet to open bank checking accounts. These customers are also likely to buy Store 24s other products once they are in the store. 2. Contribution margin per unit: Selling price: 69.0 cents Deduct: Direct labor 22.5 cents ($9.00 per hour/60 minutes) 1.5 minutes Processing fee 5.0 cents Contribution margin 41.5 cents per unit 3. Equation method formula: Revenues Variable costs Fixed costs (FC) = Operating income (OI) Where (Unit selling price quantity (Q)) (Unit variable costs Q) Fixed costs = OI (0.69Q) ((0.225 +0.05)Q) $25.00 = $0 0.415Q $25.00 = $0 0.415Q = $25.00 Q = $25.00/0.415 = 60.24 money orders (approx. 2 per day) Contribution margin method: $25.00/0.415 cents per unit = 60.24 units

344

Video Case (Contd.) 4. Revenues Variable costs Fixed costs (FC) = Operating income (OI) (0.69Q) ((0.225 +.05)Q) $25.00 = $100 0.415Q $25.00 = $100 0.415Q = $100 + 25.00 Q = $125.00/0.415 = 301.2 money orders (approx.10 per day) 5. Since it takes three times as long for a clerk to complete a money order transaction versus a typical product sale (90 seconds versus 30 seconds), customers who are not purchasing money orders will have to wait while the money order transaction is being completed. Some customers may choose not to wait, thereby costing the store those sales. It is impossible to calculate the exact cost since the number of customers who might leave and the contribution margin for the average $3.00 sale is not known. Students may try to calculate the cost using the gross margin percentage of 30%, but this percentage does not consider variable operating costs such as the labor of the store clerk.

345