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CMA Part 2

Financial Decision Making


SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• CVP = Break-even analysis
– Allows us to analyze the relationship between revenue and fixed and variable expenses
– It allows us to study the effects of changes in assumptions about cost behavior and the
relevant ranges (in which those assumption are valid) may affect the relationships
among revenues, variable costs, and fixed costs at various production levels
– Cost-volume-profit analysis is a tool to predict how changes in costs and sales levels
affect income; conventional CVP analysis requires that all costs must be classified as
either fixed or variable with respect to production or sales volume before CVP analysis
can be used.
– It considers the effects of:
• Sales volume
• Sales price
• Product mixes
• What else……?

2
SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• CVP analysis is done with what assumptions?
– Cost and revenue relationships are predictable
– Unit selling prices are constant
– Changes in inventory are insignificant
– Fixed costs remain constant over relevant range (see slide
5 & 6)
– Total variable cost change proportional with volume (see
slide 7 & 8)
Continued
3
SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
– The revenue (sales) mix is constant
– All costs are either fixed or variable (long-term all costs are
considered as variable)
– Volume is the sole revenue driver and cost driver
– The breakeven point is directly related to costs and
inversely related to the budgeted margin of safety and the
contribution margin
– Time value of money is ignored

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• Fixed Costs
– Total fixed cost remains unchanged in amount when volume of activity varies
from period to period within a relevant range.
– The fixed cost per unit of output decreases as volume increases (and vice
versa).
– When production volume and cost are graphed, units of product are usually
plotted on the Horizontal axis and dollars of cost are plotted on the vertical
axis.
– Fixed cost is represented by a horizontal line with no slope (cost remains
constant at all levels of volume within the relevant range).
– Intersection point of line on cost (vertical) axis is at fixed cost amount.
– Likely that amount of fixed cost will change when outside of relevant range.
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C1 SU- 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory
Fixed Costs

Telephone Bill per


Monthly Basic
Telephone Bill
Monthly Basic

Local Call
Number of Local Calls Number of Local Calls
Total fixed costs Cost per call
remain constant as declines as
activity increases. activity
6 increases.
SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• Variable Costs
– Total variable cost changes in proportion to changes in volume
of activity.
– Variable cost per unit remains constant but the total amount of
variable cost changes with the level of production.
– When production volume and cost are graphed
– Variable cost is represented by a straight line starting at the zero
cost level.
– The straight line is upward (positive) sloping. The line rises as
volume increases.

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C1 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory

Cost per Minute


Total Costs

Minutes Talked Minutes Talked


Total variable costs Cost per Minute
increase as is constant as
activity increases. activity increases.
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SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• Mixed Costs
– Include both fixed and variable cost components.
– When volume and cost are graphed,
• Mixed cost is represented by a straight line with an upward (positive)
slope.
• Start of line is at fixed cost point (or amount of total cost when volume
is zero) on cost (vertical) axis. As activity level increases, mixed cost
line increases at an amount equal to the variable cost per unit.
– Mixed costs are often separated into fixed and variable
components when included in a CVP analysis.

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P1
Scatter Diagrams
Draw a line through the plotted data points so that about equal
numbers of points fall above and below the line.
1,000’s of Dollars

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* ** *
Total Cost in

* * **
10 * *
Estimated fixed cost = 10,000

0
0 1 2 3 4 5 6
Activity, 1,000’s of Units Produced
10
P1
Scatter Diagrams
Δ in cost
Unit Variable Cost = Slope = Δ in units
1,000’s of Dollars

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* ** * Vertical
Total Cost in

* * **
distance is
10 * * the change
in cost.
Horizontal distance is the
change in activity.
0
0 1 2 3 4 5 6
Activity, 1,000’s of Units Produced
11
High-Low Method
• The following is not in this Study Unit, but it is
important to know and be able to calculate.

12
The High-Low Method
The following relationships between units
produced and total cost are observed:

Using these two levels of activity, compute:


 the variable cost per unit.
 the total fixed cost.

13
High-Low Method
Units Cost
High activity level - December 67,500 $ 29,000
Low activity level - January 17,500 20,500
Change in activity 50,000 $ 8,500

 Variable cost per unit is determined as follows:

 Fixed costs are determined as follows:

Total cost = $17,525 + $0.17 per unit produced


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Contribution Margin and its Measures
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

Contribution margin is the amount by which revenue


exceeds the variable costs of producing the revenue.
Total contribution margin is $60,000 and the
contribution margin per unit sold is $30.
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SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• Breakeven point is the level of output where total
revenues equals total expenses; the point at which
all fixed costs have been covered and operating
income is zero.
– What is the break-even point and where is it on a
graph on the next page?

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CVP Graph
Break-Even Point

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• BEP = output level at which Total Rev = Total Exp
– It is also the point at which all fixed cost have been
covered and operating income is zero

Revenue $100,000
Var. Cost $ 80,000
Gross Margin $ 20,000
Fixed Cost $ 20,000
Oper. Income $ 0

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• Other terms and definitions
– Margin of safety is the excess of “budgeted” sales over BE Sales
– Mixed costs (See slide 11) are costs that have both a fixed and variable
component. For example, the cost of operating an automobile includes some
fixed costs that do not change with the number of miles driven (e.g., operating
license, insurance, parking, some of the depreciation, etc.) Other costs vary
with the number of miles driven (e.g., gasoline, oil changes, tire wear, etc.).
– Revenue or sales mix is the composition of total revenues in terms of various
products
– Sensitivity analysis (See slide 12) examines the effect on the outcome of not
achieving the original forecast or of changing an assumption. Since many
decisions must be made due to uncertainty, probabilities can be assigned to
different outcomes (“what-if”).

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C1 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory

Mixed costs contain a fixed portion that is incurred even when the
facility is unused, and a variable portion that increases with
usage. Utilities typically behave in this manner.
Total Utility
Cost

Variable
Cost per KW
Fixed Monthly
Activity (Kilowatt Hours) 20 Charge
Utility
SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• Unit Contribution Margin (UCM) is an important term used with break-even point
or break-even analysis is contribution margin. In equation format it is defined as
follows:
Contribution Margin = Revenues – Variable Expenses
• The contribution margin for one unit of product or one unit of service is defined
as:
– Contribution Margin per Unit = Revenues per Unit (Sales price) – Variable
Expenses per Unit
– Expressed in either percentage of the selling price (contribution margin ratio)
or dollar amount
– Slope of total cost curve plotted so that volume is on the x-axis and dollar
value is on the y-axis

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• Break-even point in units

Fixed costs
UCM

• Break-even point in dollars

Fixed costs
CMR

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A1
Contribution Margin Ratio
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

Contribution Contribution margin per unit


margin ratio = Sales price per unit
Contribution $30 per unit
= = 30%
margin ratio $100 per unit
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P2
Computing the Break-Even Point
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

How much contribution margin must Rydell Company


have to cover its fixed costs (break-even)?
Answer: $24,000
How many units must Rydell sell to cover its fixed
costs (break-even)?
Answer: $24,000 ÷ $30 per unit = 800
25units
SU 8.1 – Cost-Volume-Profit (CVP) Analysis –
Theory Question 1
Cost-volume-profit (CVP) analysis is a key factor in many decisions,
including choice of product lines, pricing of products, marketing
strategy, and use of productive facilities. A calculation used in a CVP
analysis is the breakeven point. Once the breakeven point has been
reached, operating income will increase by the
A Gross margin per unit for each additional unit sold.
B Contribution margin per unit for each additional unit sold.
C Fixed costs per unit for each additional unit sold.
D Variable costs per unit for each additional unit sold.

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis –
Theory Question 1 Answer
Correct Answer: B
At the breakeven point, total revenue equals total fixed costs plus the
variable costs incurred at that level of production. Beyond the
breakeven point, each unit sale will increase operating income by the
unit contribution margin (unit sales price – unit variable cost) because
fixed cost will already have been recovered.
Incorrect Answers:
A: The gross margin equals sales price minus cost of goods sold, including fixed cost.
C: All fixed costs have been covered at the breakeven point.
D: Operating income will increase by the unit contribution margin, not the unit
variable cost.

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis –
Theory Question 2
One of the major assumptions limiting the reliability of breakeven
analysis is that
A Efficiency and productivity will continually increase.
B Total variable costs will remain unchanged over the relevant range.
C Total fixed costs will remain unchanged over the relevant range.
D The cost of production factors varies with changes in technology.

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis –
Theory Question 2 Answer
Correct Answer: C
One of the inherent simplifying assumptions used in CVP analysis is that
fixed costs remain constant over the relevant range of activity.

Incorrect Answers:
A: Breakeven analysis assumes no changes in efficiency and productivity.
B: Total variable costs, by definition, change across the relevant range.
D: The cost of production factors is assumed to be stable; this is what is
meant by relevant range.

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis –
Theory Question 3
The margin of safety is a key concept of CVP analysis. The margin of
safety is the
A Contribution margin rate.
Difference between budgeted contribution margin and breakeven
B
contribution margin.
C Difference between budgeted sales and breakeven sales.
Difference between the breakeven point in sales and cash flow
D
breakeven.

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis –
Theory Question 3 Answer
Correct Answer: C
The margin of safety measures the amount by which sales
may decline before losses occur. It is the excess of budgeted
or actual sales over sales at the BEP.
Incorrect Answers:
A: The contribution margin rate is computed by dividing contribution margin
by sales. The contribution margin equals sales minus total variable costs.
B: The margin of safety is expressed in revenue or units, not contribution
margin.
D: Cash flow is not relevant.

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis –
Theory Question 4
The breakeven point in units increases when unit costs

A Increase and sales price remains unchanged.

B Decrease and sales price remains unchanged.

C Remain unchanged and sales price increases.

D Decrease and sales price increases.

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis –
Theory Question 4 Answer
Correct Answer: A
The breakeven point in units is calculated by dividing total fixed costs by the unit
contribution margin. If selling price is constant and costs increase, the unit
contribution margin will decline, resulting in an increase of the breakeven point.
Incorrect Answers:
B: A decrease in costs will cause the unit contribution margin to increase, lowering the breakeven
point.
C: An increase in the selling price will increase the unit contribution margin, resulting in a lower
breakeven point.
D: Both a cost decrease and a sales price increase will increase the unit contribution margin, resulting
in a lower breakeven point.

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Remember
Computing the Break-Even Point
We have just seen one of the basic CVP relationships
– the break-even computation.
Fixed costs
Break-even point in units =
Contribution margin per unit

Unit sales price less unit variable cost


($30 in previous example)

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Remember
Computing the Break-Even Point
The break-even formula may also be
expressed in sales dollars.
Fixed costs
Break-even point in dollars =
Contribution margin ratio

Unit contribution margin


Unit sales price

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SU 8.1 – Cost-Volume-Profit (CVP) Analysis –
Theory
• Review:
– What is the difference between gross margin and
contribution margin
– Effect of an increase in CM
– Effects on BEP by changes in CM

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SU 8.2 – CVP Analysis – Basic Calculations
• CVP Applications
– Target Operating Income
– Multiple products
– Choice of products
• Degree of Operating Leverage (DOL)
 Problems 8, 9, 10, 12 & 13 starting on page 255

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SU 8.2 – CVP Analysis – Basic Calculations
Question 1
Which of the following would decrease unit a contribution margin the
most?
A A 15% decrease in selling price.
B A 15% increase in variable expenses.
C A 15% decrease in variable expenses.
D A 15% decrease in fixed expenses.

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SU 8.2 – CVP Analysis – Basic Calculations
Question 1 Answer
Correct Answer: A
Unit contribution margin (UCM) equals unit selling price
minus unit variable costs. It can be decreased by either
lowering the price or raising the variable costs. As long as
UCM is positive, a given percentage change in selling
price must have a greater effect than an equal but
opposite percentage change in variable cost. The example
below demonstrates this point.
Continued
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SU 8.2 – CVP Analysis – Basic Calculations
Question 1 Answer
Original: UCM = SP – UVC
= $100 – $50
= $50
Lower Selling Price: UCM = (SP × .85) – UVC
= $85 – $50
= $35
Higher Variable Cost: UCM = SP – (UVC × 1.15)
= $100 – $57.50
= $42.50
Since $35 < $42.50, the lower selling price has the greater effect.
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SU 8.2 – CVP Analysis – Basic Calculations
Question 2
The breakeven point in units sold for Tierson Corporation is 44,000. If fixed
costs for Tierson are equal to $880,000 annually and variable costs are $10
per unit, what is the contribution margin per unit for Tierson Corporation?
A $0.05

B $20.00

C $44.00

D $88.00

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SU 8.2 – CVP Analysis – Basic Calculations
Question 2 Answer
Correct Answer: B
The breakeven point in units is equal to the fixed costs divided by
the contribution margin per unit. Thus, the UCM is $20.00
($880,000 ÷ 44,000 units).

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SU 8.2 – CVP Analysis – Basic Calculations
Question 3
A manufacturer contemplates a change in technology that would reduce
fixed costs from $800,000 to $700,000. However, the ratio of variable costs
to sales will increase from 68% to 80%. What will happen to breakeven level
of revenues?
A Decrease by $301,470.50.
B Decrease by $500,000.
C Decrease by $1,812,500.
D Increase by $1,000,000.

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SU 8.2 – CVP Analysis – Basic Calculations
Question 3 Answer
Correct Answer: D
The original breakeven level was:
Breakeven point = Fixed costs ÷ Contribution margin ratio
= $800,000 ÷ (1.0 – .68)
= $2,500,000

The new level is:


Breakeven point = Fixed costs ÷ Contribution margin ratio
= $700,000 ÷ (1.0 – .80)
= $3,500,000

Thus, there is an increase of $1,000,000 ($3,500,000 – $2,500,000).

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SU 8.3 – CVP Analysis – Target Income
Calculations
• Target Operating Income
Fixed costs + Target operating income
UCM
• Target Net Income
Fixed costs + Target net income / (1.0 – tax rate)
UCM
 Problem 15, 16 and 18 on page 257

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Computing Sales (Dollars) for a
Target Net Income

To convert target net income to before-tax


income, use the following formula:

Target net income


Before-tax income =
1 - tax rate

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SU 8.3 – CVP Analysis – Target Income
Calculations Question 1
The data below pertain to the forecasts of XYZ Company for the upcoming year.
Total Cost Unit Cost
Sales (40,000 units) $1,000,000 $25
Raw materials 160,000 4
Direct labor 280,000 7
Factory overhead:
Variable 80,000 2
Fixed 360,000
Selling and general expenses:
Variable 120,000 3
Fixed 225,000
Continued

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SU 8.3 – CVP Analysis – Target Income
Calculations Question 1
How many units does XYZ Company need to produce and
sell to make a before-tax profit of 10% of sales?
A. 65,000 units.

B. 36,562 units.

C. 90,000 units.

D. 25,000 units.

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SU 8.3 – CVP Analysis – Target Income
Calculations Question 1 Answer
Correct Answer: C
Revenue minus variable and fixed expenses equals net income.
If X equals unit sales, revenue equals $25X, total variable expenses
equal $16X ($4 + $7 + $2 + $3), total fixed expenses equal $585,000
($360,000 + $225,000), and net income equals 10% of revenue. Hence, X
equals 90,000 units.
$25X - $16X -$585,000 = $25X × 10%
6.5X = $585,000

X = 90,000 units

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SU 8.3 – CVP Analysis – Target Income
Calculations Question 2
The data below pertain to the forecasts of XYZ Company for the upcoming year.
Total Cost Unit Cost
Sales (40,000 units) $1,000,000 $25
Raw materials 160,000 4
Direct labor 280,000 7
Factory overhead:
Variable 80,000 2
Fixed 360,000
Selling and general expenses:
Variable 120,000 3
Fixed 225,000
Continued

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SU 8.3 – CVP Analysis – Target Income
Calculations Question 2
Assuming that XYZ Company sells 80,000 units, what is the
maximum that can be paid for an advertising campaign while still
breaking even?
A. $135,000

B. $1,015,000
C. $535,000

D. $695,000

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SU 8.3 – CVP Analysis – Target Income
Calculations Question 2 Answer
Correct Answer: A
The company will break even when net income equals zero. Net income is equal to
revenue minus variable expenses and fixed expenses, including advertising. Thus, if X
equals advertising cost, the equation is

80,000)($25) – (80,000)($16) – $585,000 – X = 0


$2,000,000 – $1,280,000 – $585,000 – X = 0
X = $135,000

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SU 8.3 – CVP Analysis – Target Income
Calculations Question 3
For one of its divisions, Buona Fortuna Company has fixed costs of $300,000
and a variable-cost percentage equal to 60% of its $10 per unit selling price. It
would like to earn a pre-tax income of $90,000 per year from the division.
How many units will Buona Fortuna have to sell to earn a pre-tax income of
$90,000 per year?
A 65,000 units.
B 75,000 units.
C 77,250 units.
D 97,500 units.

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SU 8.3 – CVP Analysis – Target Income
Calculations Question 3 Answer
Correct Answer: D
Buona Fortuna’s unit contribution margin is $4 ($10 unit price – $6 unit variable cost).
By treating desired profit as an additional fixed cost, the target unit sales can be
calculated as follows:

Target unit sales = (Fixed costs + Target operating income) ÷ UCM


= ($300,000 + $90,000) ÷ $4
= 97,500

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Computing a Multiproduct
Break-Even Point
• The CVP formulas can be modified for use when a company sells
more than one product.
• The unit contribution margin is replaced with the contribution
margin for a composite unit.
• A composite unit is composed of specific numbers of each product
in proportion to the product sales mix.
• Sales mix is the ratio of the volumes of the various products.

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SU 8.4 – CVP Analysis – Multi-Product
Calculations
• Multiple Products (or Services)
– S = FC + VC = Calculated Weighted Average Contribution
Margin
 See example page 243

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SU 8.4 – CVP Analysis – Multi-Product
Calculations
• Choice of Product decisions – When resources are
limited companies have to choose which products to
produce
• A breakeven analysis of the point where the same
operating income or loss will result
 See example page 244

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SU 8.4 – CVP Analysis – Multi-Product
Calculations
• Special Orders (usually lower price than std.)
– The assumption are that idle capacity is sufficient to
manufacture extra units of a special order.

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SU 8.4 – CVP Analysis – Multi-Product
Calculations Question 1
Moorehead Manufacturing Company produces two products for which the data
presented to the right have been tabulated. Fixed manufacturing cost is applied
at a rate of $1.00 per machine hour. The sales manager has had a $160,000
increase in the budget allotment for advertising and wants to apply the money
to the most profitable product. The products are not substitutes for one
another in the eyes of the company’s customers.
Per Unit XY-7 BD-4
Selling price $4.00 $3.00
Variable manufacturing cost 2.00 1.50
Fixed manufacturing cost .75 .20
Variable selling cost 1.00 1.00

Continued
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SU 8.4 – CVP Analysis – Multi-Product
Calculations Question 1
Suppose Moorehead has only 100,000 machine hours that can be made
available to produce additional units of XY-7 and BD-4. If the potential increase
in sales units for either product resulting from advertising is far in excess of this
production capacity, which product should be advertised and what is the
estimated increase in contribution margin earned?
A Product XY-7 should be produced, yielding a contribution margin of $75,000.

B Product XY-7 should be produced, yielding a contribution margin of $133,333.

C Product BD-4 should be produced, yielding a contribution margin of $187,500.

D Product BD-4 should be produced, yielding a contribution margin of $250,000.

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SU 8.4 – CVP Analysis – Multi-Product
Calculations Question 1 Answer
Correct Answer: D
The machine hours are a scarce resource that must be allocated to the product(s) in a
proportion that maximizes the total CM. Given that potential additional sales of either product
are in excess of production capacity, only the product with the greater CM per unit of scarce
resource should be produced. XY-7 requires .75 hours; BD-4 requires .2 hours of machine time
(given fixed manufacturing cost applied at $1 per machine hour of $.75 for XY-7 and $.20 for BD-
4). XY-7 has a CM of $1.33 per machine hour ($1 UCM ÷ .75 hours), and BD-4 has a CM of
$2.50 per machine hour ($.50 ÷ .2 hours). Thus, only BD-4 should be produced, yielding a CM
of $250,000 (100,000 × $2.50). The key to the analysis is CM per unit of scarce resource.

Incorrect Answers:
A: Product XY-7 actually has a CM of $133,333, which is lower than the $250,000 CM for product BD-4.
B: Product BD-4 has a higher CM at $250,000.
C: Product BD-4 has a CM of $250,000.

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SU 8.4 – CVP Analysis – Multi-Product
Calculations Question 2
Product A accounts for 75% of a company’s total sales revenue and has
a variable cost equal to 60% of its selling price. Product B accounts for
25% of total sales revenue and has a variable cost equal to 85% of its
selling price. What is the breakeven point given fixed costs of
$150,000?
A $375,000
B $444,444
C $500,000
D $545,455

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SU 8.4 – CVP Analysis – Multi-Product
Calculations Question 2 Answer
Correct Answer: B
Using the relationship: sales = total variable costs + total fixed costs, the combined breakeven
point can be calculated as follows:
S = 0.75S(0.60) + 0.25S(0.85) + $150,000
S = 0.45S + 0.2125S + $150,000
S – 0.6625S = $150,000
0.3375S = $150,000
S = $444,444
Incorrect Answers:
A: This amount is based on the contribution margin of Product A only rather than a weighted average.
C: This amount is based on half of the required sales at B’s contribution margin.
D: This amount is based on an unweighted average of the two contribution margins.

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SU 8.4 – CVP Analysis – Multi-Product
Calculations Question 3
Von Stutgatt International’s breakeven point is 8,000 racing bicycles and
12,000 5-speed bicycles. If the selling price and variable costs are $570 and
$200 for a racer, and $180 and $90 for a 5-speed respectively, what is the
weighted-average contribution margin?
A $100
B $145
C $179
D $202

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SU 8.4 – CVP Analysis – Multi-Product
Calculations Question 3 Answer
Correct Answer: D
Contribution margin equals selling price minus variable costs.
The product contribution margins are:
Racer: $570 – $200 = $370
5-Speed: $180 – $90 = $90
The sales mix is:
Racer: 8,000 ÷ (8,000 + 12,000) = 40%
5-Speed: 12,000 ÷ (8,000 + 12,000) = 60%
Multiply the CM by the sales mix for each product, and add the results.
Weighted-average CM = ($370 × 40%) + ($90 × 60%)
= $148 + $54
= $202

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SU 8.4 – CVP Analysis – Multi-Product
Calculations Question 3 Answer
Incorrect Answers:
A: The sales mix dictates how much of the total CM will come from sales of each
product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the
UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-
average CM.

B: The sales mix dictates how much of the total CM will come from sales of each
product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the
UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-
average CM.

C: The sales mix dictates how much of the total CM will come from sales of each
product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the
UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-
average CM.
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SU 8.4 – CVP Analysis – Multi-Product
Calculations Question 4
Catfur Company has fixed costs of $300,000. It produces two products, X and Y.
Product X has a variable cost percentage equal to 60% of its $10 per unit selling price.
Product Y has a variable cost percentage equal to 70% of its $30 selling price. For the
past several years, sales of Product X have averaged 66% of the sales of Product Y.
That ratio is not expected to change. What is Catfur’s breakeven point in dollars?
A $300,000
B $750,000
C $857,142
D $942,857

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SU 8.4 – CVP Analysis – Multi-Product
Calculations Question 4 Answer
Correct Answer: D
A helpful approach in a multiproduct situation is to make calculations based on the
composite unit, i.e., 2 units of Product X and 3 units of Product Y (a 66% ratio). The
selling price of this composite unit is $110 [(2 × $10) + (3 × $30)]. The UCM of the
composite unit is $35 {[2 × ($10 – $6)] + [3 × ($30 – $21)]}. Consequently, the
breakeven point in composite units is 8,571.43 ($300,000 FC ÷ $35 UCM), and the
breakeven point in sales dollars is $942,857 (8,571.43 × $110).
Incorrect Answers:
A: This amount equals the fixed costs.
B: This amount assumes a 40% contribution margin ratio.
C: This amount assumes a 35% contribution margin ratio.

68
SU 8.5 – Marginal Analysis
• Accounting Costs vs. Economic Costs
• Accounting Costs = The total amount of money or goods expended in an endeavor.
It is money paid out at some time in the past and recorded in journal entries and
ledgers.
• The economic cost of a decision depends on both the cost of the alternative
chosen and the benefit that the best alternative would have provided if chosen.
Economic cost differs from accounting cost because it includes opportunity cost.
– As an example, consider the economic cost of attending college. The accounting cost of
attending college includes tuition, room and board, books, food, and other incidental
expenditures while there. The opportunity cost of college also includes the salary or wage that
otherwise could be earning during the period. So for the two to four years an individual
spends in school, the opportunity cost includes the money that one could have been making
at the best possible job. The economic cost of college is the accounting cost plus the
opportunity cost.
– Thus, if attending college has a direct cost of $20,000 dollars a year for four years, and the lost
wages from not working during that period equals $25,000 dollars a year, then the total
economic cost of going to college would be $180,000 dollars ($20,000 x 4 years +
the interest of $20,000 for 4 years + $25,000 x 4 years).
69
SU 8.5 – Marginal Analysis
• Explicit vs. Implicit Costs
– Implicit cost, also called an imputed cost, implied
cost, or notional cost, is the opportunity cost equal to
what a firm must give up in order to use factors which
it neither purchases nor hires.
– An explicit cost is a direct payment made to others in
the course of running a business, such as wage, rent
and materials.

70
SU 8.5 – Marginal Analysis
• Accounting vs. Economic Profit
 See Tutorial at http://www.khanacademy.org/economics-finance-
domain/microeconomics/firm-economic-profit/economic-profit-tutorial/v/economic-profit-
vs-accounting-profit

• Accounting Profit = book income exceeds book


expenses
• Economic Profit = includes Accounting Profit +
Implicit costs

71
SU 8.5 – Marginal Analysis
• Marginal Revenue and Marginal Cost
– Marginal Revenue is the additional or incremental revenue of one
additional unit of output. See page 246
• See that Marginal Revenue is $540 between generating 4 vs. 5 units of output.
– Marginal Cost is the additional or incremental cost incurred of one
additional unit of output.
• Note that while cost decrease over some range they will at some point begin
to increase due to the process becoming lest efficient.
• Profit Maximization is where MR = MC
 See page 246

72
SU 8.5 – Marginal Analysis
• Short-Run Cost Relationship – See graph on page 248
• Other considerations/applications of CVP
– Make-or-Buy
– Capacity Constraints and Product Mix
– Disinvestments
– Sell-or-Process further

73
SU 8.6 – Short-Run Profit Maximization
• Pure Competition is a market structure in which a very
large number of firms sell a standardized product into
which entry is very easy in which the individual seller has
no control over the product price and in which there is
no non-price competition; a market characterized by a
very large number of buyers and sellers.
– Examples : Agricultural products such as potatoes and wheat

74
SU 8.6 – Short-Run Profit Maximization
• A Monopoly is a market structure in which one firm sells a unique product into
which entry is blocked in which the single firm has considerable control over
product price and in which non-price competition may or may not be found.
– Examples / Importance
1. Public utilities: gas, electric, water, cable TV, and local telephone service companies,
are often pure monopolies.
2. First Data Resources (Western Union), Wham-O (Frisbees), and the DeBeers diamond
syndicate are examples of "near" monopolies. (See Last Word.)
3. Manufacturing monopolies are virtually nonexistent in nationwide U.S. manufacturing
industries.
4. Professional sports leagues grant team monopolies to cities.
5. Monopolies may be geographic. A small town may have only one airline, bank, etc.

75
SU 8.6 – Short-Run Profit Maximization
• Monopolistic Competition is a market structure
in which many firms sell a differentiated product
into which entry is relatively easy in which the
firm has some control over its product price and
in which there is considerable non-price
competition.
– Examples are grocery stores and gas stations

76
SU 8.6 – Short-Run Profit Maximization
• Oligopoly is a market structure in which a few
firms sell either a standardized or differentiated
product into which entry is difficult in which the
firm has limited control over product price
because of mutual interdependence (except
when there is collusion among firms) and in
which there is typically non-price competition.

77
SU 8.6 – Short-Run Profit Maximization
• Law of Demand states that all other things remaining
unchanged, people demand (buy) more of any good /
service if the price of that good / service falls and
demand (buy) less if the price increases.
– Usually represented by a negatively-sloped demand curve
which slows that the quantity demanded (quantity of a
particular good people intending to buy) declines as price
rises and increases as price rises.

78
SU 8.6 – Short-Run Profit Maximization
• Elasticity of demand measures how responsive a
products demand is to changes in its price level.
– When we have inelastic demand, a consumer will pay
almost any price for the good.
– Elastic demand therefore means that demand for the
product will vary when its price changes. Generally goods
which have elastic demand tend to have many substitutes,
so if the price of one good increases too much I will
substitute out towards a similar good which is cheaper.

79
SU 8.6 – Short-Run Profit Maximization
• Calculating Price elasticity of demand
– Price elasticity of demand is calculated as the percentage change in quantity demanded
divided by the percentage change in price.
– There are a number of factors that can determine the price elasticity of demand for a
good or service.
– For example, the demand for luxury items tend to be more elastic than the demand for
necessities. For items that are essential, you tend to be less responsive to changes in
price. An example of this would be the demand for diamonds tends to be more price
elastic than the demand for electricity.
– Price elasticity of demand is also affected how large a percentage of your total income
an item is. We tend to be more elastic in regards to price changes for items that make up
a larger percentage of our incomes. For example, if the price of a pack of gum goes up
by 10%, I probably wouldn't even notice. On the other hand, if the price of a car I'm
considering purchasing goes up by 10%, I would definitely notice and I would probably
reconsider the purchase.

80
SU 8.6 – Short-Run Profit Maximization
• A third factor that influences the price elasticity of demand is the time
frame allowed for response. We tend to be more responsive to changes in
price in the long run than in the short run. For example, if the price of gas
were to go up overnight to $10/gallon I would still have to put gas in my
car tomorrow morning because I have to go to work and I have to go to
school. But if the price of gas were to stay at $10/gallon for a year, then I
have more options. I could move closer to work, start carpooling, or trade
in my car for a hybrid with better gas mileage so that I don't have to buy as
much gas. So in the long run, demand tends to be more elastic than in the
short run.

81
SU 8.6 – Short-Run Profit Maximization
Price Elasticity Example
Antoinette has a beauty salon. She services 100
customers per day. Her usual fee is $50. She wants to
expand her business. If she lowers her price (gives
everyone a coupon for $10 off), she expects to get an
extra 10 customers per day. Calculate the price
elasticity of demand. Did she make the correct
decision?

82
SU 8.6 – Short-Run Profit Maximization
Price Elasticity Example Answer
A) Percentage change in quantity demanded = 10% (100 customers increased to 110 customers)

B) Percentage change in price = -20% ($50 reduced to $40)


A/B = 10%/-20% = -0.5
The price elasticity of demand for this service is -0.5, and a price elasticity of demand less than 1
means that a good is inelastic, meaning that quantity demanded is relatively unresponsive to a
change in price.
So you could argue that she made the wrong decision, as the price decrease did not greatly affect
demand. She might have been better choosing another strategy, such as better advertising or her
services.

You could also argue that she is reducing the price by 20% in return for a 10% increase in volume.

83
SU 8.6 – Short-Run Profit Maximization
Price Elasticity Defined
A product with elasticity of 1.2 has elastic demand. What this means is that
for every 1% rise in the price, demand will fall by 1.2% (similarly, a 1% fall in
the price will lead to a 1.2% rise in demand).

The rule is:


Elasticity > 1 : elastic (% change in demand is greater than % change in price e.g. luxury
goods such as cars etc.)
Elasticity < 1 : inelastic (% change in demand is less than % change in price e.g. essential
goods such as food)
Elasticity = 1 : unitary elastic (% change in demand is equal to the % change in price)

Basically a firm producing an inelastic good can increase revenue by raising the price, as the
fall in demand is more than offset by the increased revenue on the remaining demand.

84
SU 8.6 – Short-Run Profit Maximization
Price Elasticity Defined
• Infinite or perfectly elastic - If it were “perfectly” elastic,
demand would be infinite at all prices less than $3. A perfectly
elastic demand graph is a vertical line. And, when the price is
at $3, you can not tell from the graph what the demand is
since the line is vertical. The demand could be at any value.
• Perfectly price inelastic - means that the quantity demanded
will not change when price changes. Vertical demand curve
• Also, perfectly price elastic means if price changes, quantity
demanded changes totally, Horizontal Demand Curve

85
CMA Part 2
Financial Decision Making
Objectives
• Use Marginal Analysis for decision making
• Calculate effect on operating income of a decision
• Identify and describe qualitative factors
• Identify the effects of changes in capacity
• Impact of income taxes on Marginal Analysis
• Recommend a course of action
• Relation between pricing and supply/demand
• Target costing and target pricing
• Define elastic and inelastic demand
• Evaluate and recommend pricing strategies
• Risk Assessment: financial/operational/strategic risks
• Identify and explain the benefits of Risk Management
87
SU 9.1 – Decision Making:
Applying Marginal Analysis
• Relevancy
– Be made in the future (not SUNK costs)
– Differ among the possible alternative courses of action
– Avoidable costs (controllable = subject to Management decision /
strategy)
– Incremental (marginal or differential)  Relevant Range = incremental
cost of an additional unit of output is the same. Outside range
incremental cost change.
• Committed costs are not part of the decision making process
• Be careful using UNIT revenue and cost
 Emphasis to be on TOTAL relevant revenues and costs

88
SU 9.1 – Decision Making:
Applying Marginal Analysis
• Marginal / Differential / Incremental Analysis
– Problem in CMA will be an evaluation of choices among courses of
action
– What are the relevant and irrelevant costs?
– Quantitative analysis = ways in which revenues and costs vary with the
option chosen
– Focus on incremental revenue & costs, not total revenue & cost
 See example page 266 & 267  idle capacity (incremental impact)
– Compare marginal revenue and marginal cost (contribution margin)
– Fixed costs have already been “absorbed”

89
SU 9.1 – Decision Making:
Applying Marginal Analysis
– Qualitative Factors to consider
- Pricing rules
- Government regulation
- Cannibalization between products (stealing market share from
yourself)
- Outsourcing
- Employee morale

90
SU 9.1 – Decision Making:
Applying Marginal Analysis
• Add-or-drop-a-segment decisions
– Disinvestment / capital budgeting decisions
– Marginal cost > Marginal revenue = Firm should disinvest
• Four steps to be taken
1. Identify fixed costs that will be eliminated if disinvesting
2. Determine the revenue needed to justify continuing operations
3. Establish the opportunity cost of funds that will be received
4. Determine whether the carrying amount of the asset = economic value. If
not revalue use market fair value and not carrying amount. Cost of idle
capacity is relevant cost.
• Special Orders when excess capacity
– No opportunity costs
– Accept order = Variable costs (Contribution Margin)
91
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 1
The cost incurred by Gleason for the market study is a(n)

A Incremental cost.

B Prime cost.

C Opportunity cost.
D Sunk cost.

92
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 1 Answer
Correct Answer: D
A sunk cost is a previously incurred cost that is the result of a past irrevocable
management decision. Nothing can be done in the future about sunk costs.
The market study cost is an example.

93
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 2
Assuming that Gleason elects to produce the frozen dessert, the profit
that would have been earned on the breakfast rolls is a(n)
A Deferrable cost.

B Sunk cost.

C Avoidable cost.

D Opportunity cost.

94
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 2 Answer
Correct Answer: D
An opportunity cost is the maximum return that could have been earned on
the next best alternative use of a resource. In this case, the lost profit on the
rolls is an opportunity cost.

95
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 3
If Hermo decides to supply power to Quigley, it wants to be compensated for the
decrease in the life of the plant and the appropriate variable costs. Hermo has
decided that the charge for the decreased life should be based on the original cost of
the plant calculated on a straight-line basis. The minimum annual amount that
Hermo would charge Quigley would be
A $450,000
B $630,000
C $990,000
D Some amount other than those given.

96
SU 9.1 – Decision Making: Applying Marginal Analysis
Practice Question 3 Answer
Correct Answer: B
The minimum charge would include any variable costs incurred plus
depreciation on a straight-line basis. Currently, variable costs are $360,000 at
60% of capacity ($1,800,000 × 20%). If Quigley purchases energy equal to an
additional 30% of capacity, it can be assumed that the increase in total
variable costs will be half of the variable costs for 60% of capacity, or
$180,000. Also, allocating $21,000,000 over 14 years results in an annual
depreciation of $1,500,000. Of this amount, 30% will relate to the capacity
sold. Thus, the depreciation charge to Quigley is $450,000 ($1,500,000 ×
30%). The total charge is $630,000 ($450,000 depreciation + $180,000 VC).

97
SU 9.2 – Decision Making:
Special Orders
• Special Orders when excess capacity exists
– Differential (marginal or incremental) cost must be considered.
 Example on page 268
• Special Orders when no excess capacity exists
– Differential (marginal or incremental) cost must be considered.
 Example on page 268

98
SU 9.2 – Decision Making: Special Orders
Practice Question 1
Production of a special order will increase gross profit when the
additional revenue from the special order is greater than
A The direct materials and labor costs in producing the order.
B The fixed costs incurred in producing the order.

C The indirect costs of producing the order.

D The marginal cost of producing the order.

99
SU 9.2 – Decision Making: Special Orders
Practice Question 1 Answer
Correct Answer: D
Gross profit will increase if the incremental or marginal cost of producing the
order is less than the marginal revenue. Marginal cost equals the relevant
variable costs assuming fixed costs are not affected by the special order.

100
SU 9.2 – Decision Making: Special Orders
Practice Question 2
When considering a special order that will enable a company to make use
of currently idle capacity, which of the following costs is irrelevant?

A Materials.

B Depreciation.

C Direct labor.

D Variable overhead.

101
SU 9.2 – Decision Making: Special Orders
Practice Question 2 Answer
Correct Answer: B
Because depreciation will be expensed whether or not the company accepts
the special order, it is irrelevant to the decision. Only the variable costs are
relevant.

102
SU 9.2 – Decision Making: Special Orders
Practice Question 3
Which of the following cost allocation methods is used to determine the
lowest price that can be quoted for a special order that will use idle
capacity within a production area?
A Job order.

B Process.

C Variable.

D Standard.

103
SU 9.2 – Decision Making: Special Orders
Practice Question 3 Answer
Correct Answer: C
If idle capacity exists, the lowest feasible price for a special order is one
covering the variable cost. Variable costing considers fixed cost to be a period
cost, not a product cost. Fixed costs are not relevant to short-term inventory
costing with idle capacity because the fixed costs will be incurred whether or
not any production occurs. Any additional revenue in excess of the variable
costs will decrease losses or increase profits.

104
SU 9.3 – Decision Making: Make or Buy
• Make or Buy = insourcing or outsourcing (critical mass)
– Not enough capacity outsource least efficient product
– Support services can be outsourced
• Consider relevant costs to the investment decision
– Key variable is total relevant costs, not all total costs.
– Sunk cost and costs that do not change between choices are
irrelevant
– Opportunity costs are considered when at full capacity

105
SU 9.3 – Decision Making: Make or Buy
• Capacity constraint
– Use marginal analysis
– Maximize CM
– Product mix
• Sell or process further decisions
– Sell at split off point or process
– Joint cost of product is irrelevant
– Based on relationship between incremental cost and revenue

106
SU 9.3 – Decision Making: Make or Buy
Practice Question 1
A company’s approach to an insourcing vs. outsourcing decision
Depends on whether the company is operating at or below normal
A
volume.

B Involves an analysis of avoidable costs.

C Should use absorption (full) costing.

D Should use activity-based costing.

107
SU 9.3 – Decision Making: Make or Buy
Practice Question 1 Answer
Correct Answer: B
Available resources should be used as efficiently as possible before
outsourcing. If the total relevant costs of production are less than the cost to
buy the item, it should be produced in-house. The relevant costs are those
that can be avoided.

108
SU 9.3 – Decision Making: Make or Buy
Practice Question 2
In a make-versus-buy decision, the relevant costs include variable
manufacturing costs as well as
A Factory management costs.

B General office costs.

C Avoidable fixed costs.

D Depreciation costs.

109
SU 9.3 – Decision Making: Make or Buy
Practice Question 2 Answer
Correct Answer: C
The relevant costs in a make-versus-buy decision are those that differ
between the two decision choices. These costs include any variable costs plus
any avoidable fixed costs. Avoidable fixed costs will not be incurred if the
“buy” decision is selected.

110
SU 9.4 – Decision Making:
Other Situations
• Capacity Constraints and Product Mix
– Maximize the contribution margin per unit of the
constrained resource.
– Can be difficult with multiple constraints and requires
linear programing to solve.

111
SU 9.4 – Decision Making:
Other Situations
• Sell-or-Process-Further Decisions
– Determine whether to sell product at the split-off
point or process further
– Decision is based on difference between
incremental cost and incremental revenue

112
SU 9.4 – Decision Making: Other Situations
Practice Question 1
When a multiproduct plant operates at full capacity, quite often decisions must
be made as to which products to emphasize. These decisions are frequently
made with a short-run focus. In making such decisions, managers should select
products with the highest
A Sales price per unit.

B Individual unit contribution margin.

C Sales volume potential.

D Contribution margin per unit of the constraining resource.

113
SU 9.4 – Decision Making: Other Situations
Practice Question 1 Answer
Correct Answer: D
In the short run, many costs are fixed. Hence, contribution margin (revenues
– all variable costs) becomes the best measure of profitability. Moreover,
certain resources are also fixed. Accordingly, when deciding which products to
produce at full capacity, the criterion should be the contribution margin per
unit of the most constrained resource. This approach maximizes total
contribution margin.

114
SU 9.4 – Decision Making: Other Situations
Practice Question 2
In joint-product costing and analysis, which one of the following costs is relevant
when deciding the point at which a product should be sold to maximize profits?
A Separable costs after the split-off point.

B Joint costs to the split-off point.

C Sales salaries for the period when the units were produced.

D Purchase costs of the materials required for the joint products.

115
SU 9.4 – Decision Making: Other Situations
Practice Question 2 Answer
Correct Answer: A
Joint products are created from processing a common input. Joint costs are
incurred prior to the split-off point and cannot be identified with a particular
joint product. As a result, joint costs are irrelevant to the timing of sale.
However, separable costs incurred after the split-off point are relevant
because, if incremental revenues exceed the separable costs, products should
be processed further, not sold at the split-off point.

116
SU 9.5 – Price Elasticity of Demand
• Demand increases when price goes down in theory
• Price of product and quantity demanded are inversely
related
• Price Elasticity of Demand = Sensitivity
% change in Q
% change in P

117
SU 9.5 – Price Elasticity of Demand
• Price elasticity of demand
Percent change in quantity demanded
Percent change in price
• Most accurate way to calculate elasticity = ARC
method
%ΔQ = [(Q1 – Q2) / (Q1+Q2) ]
%ΔP [(P1 – P2) / (P1+P2)]

 See example page 297, #19


118
SU 9.5 – Price Elasticity of Demand
• Elasticity > 1 relatively elastic
– Small change in price = large change in quantity
• Elasticity = 1 unitary elastic
– Single-unit change in price = single-unit change in quantity
• Elasticity < 1 perfectly inelastic
– Large change in price = small change in quantity
• Infinite perfectly elastic
– Horizontal line
– Firm has no influence on market price
– Pure competition
• Elasticity = 0 perfectly inelastic
– Vertical line
– Consumer will pay

119
SU 9.5 – Price Elasticity of Demand
Practice Question 1
If the coefficient of elasticity is zero, then the consumer demand
for the product is said to be
A Perfectly inelastic.

B Perfectly elastic.

C Unit inelastic.
D Unit elastic.

120
SU 9.5 – Price Elasticity of Demand
Practice Question 1 Answer
Correct Answer: A
When the coefficient of elasticity (percentage change in demand/change in
price) is less than one, demand is inelastic. When the coefficient is zero, the
demand is perfectly inelastic.

121
SU 9.6 – Pricing Theory
• Pricing Objectives: profit maximization / target margin / forecasted
volume / image (segmentation – positioning) / stabilization
• Price-setting factors
– Supply & Demand = Economic (external factors)
• Type of market
• Customer perceptions
• Elasticity
• Competition
– Internal Factors
• Marketing & Mix
• Relevant cost
• Strategy
• Capacity

122
SU 9.6 – Pricing Theory
• External Factors
– Type of market (pure competition, monopolistic,
oligopolistic or monopoly)
– Customer perceptions of price and value
– Price / demand relationship
– Competitors’ products, costs, prices and amount
supplied.
• Timing of demand

123
SU 9.6 – Pricing Theory

• Cartels
– Illegal practice except in international markets
– Collusive oligopoly
– Restrict output & charge higher $$

124
SU 9.6 – Pricing Theory
• Cost-based pricing differs from target pricing
– Four basic formulas
– Target pricing
– Life cycle costing
 See example page 358
• Market-based pricing - what the consumer will pay
• Competition-based pricing - going rate & sealed bids
• New product pricing - skimming & penetration pricing
• Pricing by intermediaries - markups & downs

125
SU 9.6 – Pricing Theory
• Price adjustments
– Geographical pricing
– Discounts & Allowances
– Discriminatory pricing
– Psychological pricing
– Promotional pricing
– Value Pricing
– International pricing

126
SU 9.6 – Pricing Theory
• Product-mix pricing
– Product line
– Optional product
– Captive product
– By-product
– Product bundle

127
SU 9.6 – Pricing Theory
• Illegal pricing
– Pricing products below cost
– Price discrimination among customers
– Collusive pricing
– Dumping

128
SU 9.6 – Pricing Theory Practice Question 1
Several surveys point out that most managers use full product costs,
including unit fixed costs and unit variable costs, in developing cost-based
pricing. Which one of the following is associated with cost-based pricing?
A Price stability.

B Price justification.

C Target pricing.

D Fixed-cost recovery.

129
SU 9.6 – Pricing Theory Practice Question 1 Answer
Correct Answer: C
A target price is the expected market price of a product, given the company’s
knowledge of its customers and competitors. Hence, under target pricing, the
sales price is known before the product is developed. Subtracting the unit
target profit margin determines the long-term unit target cost. If cost-cutting
measures do not permit the product to be made at or below the target cost,
it will be abandoned.

130
SU 9.6 – Pricing Theory Practice Question 2
If a U.S. manufacturer’s price in the U.S. market is below an appropriate
measure of costs and the seller has a reasonable prospect of recovering the
resulting loss in the future through higher prices or a greater market share,
the seller has engaged in
A Collusive pricing.

B Dumping.

C Predatory pricing.

D Price discrimination.

131
SU 9.6 – Pricing Theory Practice Question 2 Answer

Correct Answer: C
Predatory pricing is intentionally pricing below cost to eliminate competition
and reduce supply. Federal statutes and many state laws prohibit the practice.
The U.S. Supreme Court has held that pricing is predatory when two
conditions are met: (1) The seller’s price is below “an appropriate measure of
its costs,” and (2) it has a reasonable prospect of recovering the resulting loss
through higher prices or greater market share.

132
SU 9.6 – Pricing Theory Practice Question 3
Which one of the following will occur in an organization that gives managers
throughout the organization maximum freedom to make decisions?
Individual managers regarding the managers of other segments as they do
A
external parties.
Two divisions of the organization having competing models that aim for the
B
same market segments.
C Delays in securing approval for the introduction of new products.

D Greater knowledge of the marketplace and improved service to customers.

133
SU 9.6 – Pricing Theory Practice Question 3 Answer
Correct Answer: C
Decentralization is beneficial because it creates greater responsiveness to the
needs of local customers, suppliers, and employees. Managers at lower levels
are more knowledgeable about local markets and the needs of customers,
etc. A decentralized organization is also more likely to respond flexibly and
quickly to changing conditions, for example, by expediting the introduction of
new products. Furthermore, greater authority enhances managerial morale
and development. Disadvantages of decentralization include duplication of
effort and lack of goal congruence.

134
SU 9.6 – Pricing Theory Practice Question 4
A proposed transfer price may be based upon the outlay cost. Outlay cost
plus opportunity cost is the
A Retail price.
Price representing the cash outflows of the supplying division plus the
B
contribution to the supplying division from an outside sale.
C Price usually set by an absorption-costing calculation.
Price set by charging for variable costs plus a lump sum or an additional
D
markup, but less than full markup.

135
SU 9.6 – Pricing Theory Practice Question 4 Answer
Correct Answer: B
At this price, the supplying division is indifferent as to whether it sells
internally or externally. Outlay cost plus opportunity cost therefore represents
a minimum acceptable price for a seller. However, no transfer price formula is
appropriate in all circumstances.

136
SU 9.7 – Practice Question 1
Finn Products, a start-up company, wants to use cost-based pricing for its only
product, a unique new video game. Finn expects to sell 10,000 units in the
upcoming year. Variable costs will be $65 per unit and annual fixed operating costs
(including depreciation) amount to $80,000. Finn’s balance sheet is as follows: If
Finn wants to earn a 20% return on equity, at what price should it sell the new
product?
A $75.00
B $78.60
C $79.00
D $81.00

137
SU 9.7 – Practice Question 1 Answer
Correct Answer: C

The net income Finn will require is calculated as follows:


Return on equity = Net income ÷ Equity
Net income = Equity × Return on equity
= $300,000 × 20%
= $60,000

The necessary selling price can then be derived:


Net income = [(Selling price – Variable costs) × Units sold] – Fixed costs
Selling price = (Net income + Fixed costs + Variable costs) ÷ Units sold
= ($60,000 + $80,000 + $650,000) ÷ 10,000
= $790,000 ÷ 10,000
= $79 per unit

138
SU 9.7 – Practice Question 2
Leader Industries is planning to introduce a new product, DMA. It is expected that
10,000 units of DMA will be sold. The full product cost per unit is $300. Invested
capital for this product amounts to $20 million. Leader’s target rate of return on
investment is 20%. The markup percentage for this product, based on operating
income as a percentage of full product cost, will be
A 42.9%

B 57.1%

C 133.3%

D 233.3%

139
SU 9.7 – Practice Question 2 Answer

Correct Answer: C
Leader’s required return is $4,000,000 ($20,000,000 invested capital × 20%).
Full product costs amount to $3,000,000 (10,000 units × $300). The markup
percentage on DMA is therefore 133.3% ($4,000,000 ÷ $3,000,000).

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SU 9.8 – Risk Management
• Four types of risk
1. Hazard risks - insurable
2. Financial risks - interest rates
3. Operational risks - procedural failure
4. Strategic risks - global, political and regulatory
• Volatility and time

141
SU 9.8 – Risk Management
• Capital adequacy =
Solvency (cash flows)
Liquidity (reserves)
• Risk =
Severity of consequences
+ Likelihood of occurrence

142
SU 9.8 – Risk Management
• Five strategies for risk response
1. Risk avoidance - end the activity that establishes
the risk
2. Risk retention - acceptance of risk, self insurance
3. Risk reduction - mitigation
4. Risk sharing - move risk to third party. Insurance,
hedging, JV
5. Risk exploitation - deliberately entering to pursue
high return

143
SU 9.8 – Risk Management
• Residual risk is the risk that remains after the effects
of avoidance, sharing, or mitigation efforts.
• Inherent risk is the risk that arises for the activity itself.
• Risk appetite
• Benefits
- Efficient use of resources
- Fewer surprises
- Reassuring investors

144
SU 9.8 – Risk Management
• 5 Key Steps in Risk Management process
1. Identify risks
2. Assess risks
3. Prioritize risks
4. Formulate risk responses
5. Monitor risk responses

145
SU 9.8 – Risk Management
• Hazard risk management
– Insurance
• Financial risk management
– Hedging
– Sinking funds
– Rigid policies (maturity matching)

146
SU 9.8 – Risk Management
• Qualitative risk assessment tools
– Identification
– Ranking
– Mapping
• Quantitative risk assessment tools
– Value at risk (VaR)
See example page 284

147
SU 9.8 – Risk Management

148
SU 9.8 – Risk Management Practice Question 1
The risk associated with a project will increase in direct proportion to
all of the following the:
A Duration of the project.

B Volatility of the cash flows associated with the project.


Uncertainty surrounding the impact of Federal regulation on the
C
project.
D Capital adequacy of the organization.

149
SU 9.8 – Risk Management Practice
Question 1 Answer
Correct Answer: D
Capital adequacy is a term normally used in connection with financial
institutions. A bank must be able to pay those depositors that demand their
money on a given day and still be able to make new loans. Capital adequacy
can be discussed in terms of solvency (the ability to pay long-term obligations
as they mature), liquidity (the ability to pay for day-to-day ongoing
operations), reserves (the specific amount a bank must have on hand to pay
depositors), or sufficient capital.

150
SU 9.8 – Risk Management Practice Question 2
All of the following are potential benefits of risk management

A Lower cost of capital.

B Efficient allocation of resources.

C Flexibility in responding to unforeseen circumstances.

D Reduced inherent risk.

151
SU 9.8 – Risk Management Practice
Question 2 Answer
Correct Answer: D
Inherent risk is the risk of an activity that arises from the activity itself. For
example, uranium prospecting is inherently riskier than retailing.

152
SU 9.8 – Risk Management Practice Question 3
Which one of the following calculations does employ statistical
techniques such as the normal distribution?
A Cash flow at risk.

B Earnings distribution.

C Value at risk.

D Capital adequacy.

153
SU 9.8 – Risk Management Practice
Question 3 Answer
Correct Answer: D
Capital adequacy is a term normally used in connection with financial
institutions. A bank must be able to pay those depositors that demand their
money on a given day and still be able to make new loans. Capital adequacy
can be discussed in terms of solvency (the ability to pay long-term obligations
as they mature), liquidity (the ability to pay for day-to-day ongoing
operations), reserves (the specific amount a bank must have on hand to pay
depositors), or sufficient capital.

154