Chapter 7 Cost-Volume-Profit Analysis and

Marginal
Analysis
Suggested Solutions

Discussion Questions

7.1
A fixed cost is one which is the same irrespective of the level of activity or
output. Typical examples of costs which are fixed, irrespective of the level of
production or provision of a service, include rent of business premises, salaries of
supervisory staff and electricity charges for heating and lighting.
A variable cost is one which varies with the level of activity or output. Examples
include raw materials and labour, where labour is rewarded in proportion to the
level of output.
Note particularly that it is relative to the level of activity that costs are fixed or
variable. Fixed costs will be affected by inflation and they will be greater for a
longer period than for a shorter one.

7.2
The relevant range refers to that range of activity/output that is reasonably
expected to occur.
Eg:
A baker may expect to sell between 500-600 loaves of bread each day.
A bus company may expect on average to have 27-39 on each coach trip.
Within this band of activity/output it becomes easier to classify costs as being
similar to fixed or like variable costs. If you go outside of this range then fixed
costs might become variable or variable costs become fixed.

7.7
The break-even point is the level of activity, either measured in physical units or
in value of sales at which the sales revenues exactly cover all of the costs, both
fixed and variable.

Break-even point (in terms of volume of activity) is calculated as:

Fixed costs/(sales revenue per unit - variable costs per unit)

which may alternatively be expressed as:

Fixed costs/contribution per unit

Thus break-even will occur when the contributions for the period are sufficient to
cover the fixed costs for the period.
Both diagrams or charts incorporate total revenue, total costs, profit or loss, and
level of activity.
However, with the break-even diagram the vertical axis is cost whereas the
profit-volume chart has a profit/loss vertical axis. The text suggests the profit-
volume chart is easier to understand.

7.8
Assumptions include:
I. The cost and revenue lines are linear.
II. That costs are affected solely by output (output or activity is the sole
independent variable).
III. That costs can be readily classified as either fixed or variable.

While the assumptions do not hold in the real world, over the relevant range of
activity they will be useful approximations of cost functions or behaviour, and
therefore can lead to rational economic decisions.

Application exercises
Note: solutions to selected application exercises are included at the back of the main text

7.2
This activity requires some manipulation of the technique used above. The
answer is $50,000, derived as follows:

Variable costs of $600,000 are 75% of the sales revenue of $800,000. Therefore
at a sales level of $600,000 variable costs will be $450,000. Since this is the
break-even point fixed costs must be $150,000. Hence, at a sales level of
$800,000 variable costs will be $600,000, fixed costs $150,000 and profit
$50,000.

7.4
Included in textbook

7.5
(a) October November
Sales (units of the service) 200 300
Sales ($) 5,000 7,500
Costs (balancing figure) 4,000 5,300
Operating profit ($) 1,000 2,200

The increase in output of 100 units (i.e. 300 - 200) gives rise to additional costs
of $1,300 (i.e.$5,300 - 4,000) or $13 per unit (i.e. $1,300/100). This is the
variable cost.

For October, total variable cost = 200 x $13 = $2,600. Therefore the fixed cost
must be $1,400 (ie $4,000 - 2,600).
This can be checked using the November figures.
Total variable cost = 300 x $13 = $3,900. Fixed cost = $5,300 - 3,900 = $1,400.
Sales revenue per unit = $5,000/200 or 7,500/300 = $25.
Break even point = Fixed cost/contribution = $1,400/(25 - 13) = 116.67 or 117
units per month.

(b) Knowledge of the break even point is useful because it enables the
management of the business to make some judgement about how close the
planned level of activity is to the point at which no profit will be made. This
enables some assessment of riskiness to be made.

7.7
The increase in output of 150 units (ie 650 - 500) gives rise to additional costs of
$1,800 (ie $8,300 - 6,500) or $12 per unit (ie $1,800/150). This is the variable
cost per unit.

For May, total variable cost = 500 x $12 = $6,000. Therefore the fixed cost must
be $500 (ie $6,500 - 6,000).

This can be checked using the June figures. Total variable cost = 650 x $12 =
$7,800. Fixed cost = $8,300 - 7,800 = $500.

Sales revenue per unit = $7,500/500 or 9,750/650 = $15.

Break-even point = fixed cost/contribution = $500/(15-12) = 166.67 or 167 units

per month.

7.8
Included in textbook

7.10
An increase in production and sales of 2,000 units leads to an increase in costs of
$100,000.
Hence it seems reasonable to assume that variable costs per unit = $50, selling
price per unit = $70, contribution per unit = $20, and fixed costs = $200,000.

Proposal 1
Contribution down to $17.50. Need to recover $240,000 (fixed cost + profit)
First 12,000 recover $17.50 per unit = $210,000 Rest recover $7.50.
Need to recover a further $30,000/7.50 = 4,000 units
ie 16,000 units in total.

Proposal 2
Contribution $20 per unit. Need to recover $260,000.
First 12,000 recovers $20 per unit = $240,000. Rest recover $10 per unit.
Need further 2,000 units - 14,000 in total.

Proposal 3
same as 1