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CHAPTER 18

COST VOLUME PROFIT ANALYSIS


ANSWERS TO REVIEW QUESTIONS

18.1 (a) The break-even point in sales units is calculated using the following formula:
fixed costs
=
unit contribution margin
(b) The break-even point is calculated in sales dollars using the following formula:
fixed costs
=
contribution margin ratio
(c) In the graphical approach, sales revenue and total costs are graphed. The break-even point occurs
at the intersection of the total revenue and total cost lines.

18.2 A CVP graph plots the total cost line and the revenue line. The profit is the difference between the
values on these two lines for any volume of sales. The break-even point is at the sales volume where the
two lines intersect (i.e. revenue equals total costs). A profit volume graph shows the profit to be earned
at each level of sales volumethere is only one line plotted, which depicts the profit at each level of
sales volume. The break-even point on this graph is at the sales volume where the graph crosses the
horizontal axis.

18.3 The formula to estimate break-even sales revenue can be adjusted to estimate the sales revenue required
to achieve a target net profit by adding the profit required to the fixed costs in the formula. The amount
used in the numerator of the formula must always represent the total contribution margin required.
Break-even point calculations consider the sales level at which fixed costs will just be covered; the total
contribution margin required is the same as fixed costs. Target profit calculations calculate the sales
level at which the total contribution margin equals fixed costs plus the required profit. The same
approach can be used for profit before or after taxthe profit margin can be converted to an after tax
profit and added to fixed costs.

18.4 An increase in variable costs per unit can result in decreased fixed costs if the behaviour of a cost has
changed such that it requires a change in classification. An example is the increasing opportunity to hire
equipment as and when required rather than purchase the equipment and record fixed depreciation costs.
This means that the variable cost per unit has increased but the fixed costs have decreased.
At Malaka Oyster Company it is possible that crew members were previously rewarded on the basis of a
fixed payment per trip but this has changed to the size of the catch. The unit contribution margin, which
is the denominator of the break-even (sales volume) equation, decreases when the unit variable cost
increases. This increases the break-even point. However, the fixed cost (the numerator) has decreased,
and this will decrease the break-even point.
So, the firms break-even sales volume increases with the decrease in unit contribution margin but
would decrease when there is a decrease in fixed costs. Whether the final break-even sales volume has
increased or decreased will depend on the relationship between the decreases in (a) the numerator and
(b) the denominator. If both increase by the same percentage the break-even sales volume will remain
the same. If the fixed costs decrease by a greater percentage than the unit contribution margin the break-
even volume will reduce, and vice versa.

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18.5 Variable costs that could increase include payments to doctors, the cost of hiring medical equipment,
the cost of medical supplies and the hourly cost of receptionist labour. An increase in variable costs will
decrease the contribution margin, and therefore increase the break-even point. A decrease in
contribution margin may mean that the practice does not break even.

18.6 The fixed costs of a travel agency may include the salaries of travel consultants, line rentals included in
the phone bills, and rent of the agency premises or depreciation of office equipment. The increases in
these fixed costs would mean a higher break-even point in the number of sales to clients, because more
sales are required to cover the higher fixed costs.

18.7 The safety margin is the amount by which budgeted sales revenue exceeds break-even sales revenue. It
is the amount by which actual sales can fall below budgeted sales before losses are incurred. Managers
may use this information to highlight how close a project or enterprise is to the break-even point and
hence focus on maintaining activities so that revenue does not fall below the break-even point. In this
way managers can focus on keeping operations profitable, which adds to shareholder value.

18.8 The annual donation will partially offset the art gallerys fixed costs. The reduction in net fixed costs
will reduce the gallerys break-even point.

18.9 The low selling-price company may have a higher sales volume than the high selling-price company. By
spreading its fixed costs across a larger sales volume, the low-price firm can afford to charge a lower
price and still earn the same profit as the high-price company.
In the following example, Companies A and B have the identical variable cost per unit, fixed cost and
total profits. However, the higher sales volume of 350 units allows Company A to charge customers
only $10 per unit, whereas Company B charges $20 per unit.

Company A Company B

Sales revenue:

350 units at $10 $3 500

100 units at $20 $2 000

Variable costs:

350 units at $6 2 100

100 units at $6 600

Contribution margin 1 400 1 400

Fixed costs 1 000 1 000

Profit $400 $400

18.10 Cost-volume-profit analysis can be used in budgeting by projecting the profit that will be achieved at the
budgeted sales volume. Budgeting in a cafe business begins with a sales forecast of number of coffees
and cake to be sold. A CVP analysis also shows how pricing would contribute to the profitability, as
changes in coffee and cake prices would change the contribution margin and affect the break-even sales
volume. However, it is important to understand that CVP analysis ignores the effect that sales price has
on sales volume because it is not designed to predict sales.
18.11 The sales mix of a multi-product business such as Tassal is the relative proportion of the different types
of products provided by the salmon producer. The weighted-average unit contribution margin is the
average of the unit contribution margins for Tassals products (e.g. fresh salmon, frozen salmon, smoked
salmon, canned salmon and roasted canned salmon) with each products contribution margin weighted
by its relative proportion of the total quantity of output.

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18.12 In a car rental firm the use of CVP assumes that both revenue and costs are linear. This is not strictly
true since it is usual to charge less per day for longer rentals and costs will vary according to the wear
and tear on the car. Some renters will use the hire cars to travel long distances in short periods, some
will drive on rough roads, some may stick to city driving with wear on the clutch, and so on. However,
average daily costs and average daily revenues are calculated and applied in a CVP calculation.
A further assumption made in the use of CVP analysis is that volume is the only cost driver. In the case
of the car rentals it is normally assumed that time (number of days) is the cost driver. Until about 20
years ago renters were charged according to time and distance driven above a set limit but competitive
practice has changed the situation. However, CVP analysis would have only used one cost driver.
A car rental firm with cars in three different size/quality categories assumes that the mix of usage
between the different products is constant when performing CVP calculations: a weighted average
contribution margin is calculated, which is based on the relative sales mix of the products. Thus, the
break-even point is only valid for that particular sales mix. This does not mean that using CVP analysis
in multi-product firms is of little value, it simply means that we must be conscious that the firm will
have a variety of break-even points depending on the particular forecast sales mixes.
The management accountant is not only responsible for performing CVP analysis but also for making
managers aware of the limitations of use. The assumptions and their importance will sometimes need to
be explained. While it is not expected to be totally accurate, managers often find the analysis to be
accurate enough for the purpose.

18.13 When a company is liable for income taxes, then this may be taken into account when determining the
target sales volume. When a target profit is stated as an after-tax amount, then the break-even formula
must be modified to account for the amount of taxation payable. However, income taxes make no
difference to determining the break-even point, as there is no tax payable on zero profit.

18.14 CVP analysis enables us to estimate how many units need to be sold to break even or to achieve a target
profit. However, it does not take account of how a products price influences the demand for that
product and, therefore the number of units sold. It ignores the effect that sales price has on sales volume
because it is not designed to predict sales.

18.15 Conventional CVP analysis assumes that product costs are driven by the volume of production and selling
costs are driven by the volume of sales (and that production volume equals sales volume). Whereas,
activity-based costing recognises a range of cost drivers, including non-volume based drivers such as the
number of batches. The classification of costs as fixed or variable with respect to production/sales volume
is no longer considered relevant under an ABC system, therefore, under ABC we cannot satisfy some of
the conventional assumptions of CVP analysis. Instead, we need to consider how to calculate the break-
even point, or target sales volume, by considering complex relationships between a range of cost drivers
and costs which can be considered as unit, batch or product-level costs for production, and order, customer,
and market-level costs for customer-related matters, as well as facility level costs.

18.16 CVP analysis is based on estimates of a number of variables, and whenever estimates are used, a degree
of uncertainty exists. Sensitivity analysis is an approach that examines how a result or outcome may
change if there are variations in the predicted data or underlying assumptions. Using simple spreadsheet
models, the sensitivity to changes in certain variables can be determined, such as the sensitivity of profit
to changes in fixed or variable costs.

18.17 CVP analysis assumes that costs are fixed or vary with the sales/production volume. Computer
modelling can be used to move from conventional CVP analysis to an activity-based costing model
which recognises a much broader range of cost drivers, such as the number of batches, products,
customers, orders and markets. Also a business can use computer modelling to perform sensitivity
analysis to assess the effects of changes in the variables underlying the CVP model. The sensitivity
analysis, therefore, can identify the effect on profits of varying assumptions about the cost structure and
cost drivers underlying CVP analysis.

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18.18 Operating leverage refers to the proportion of fixed costs in an organisations overall cost structure. An
organisation that has a relatively high proportion of fixed costs and low proportion of variable costs has
high operating leverage. A company with high operating leverage will see a rapid increase in profit as
revenue increases, and a rapid decrease in profits if revenue drops. Conversely a manager in a company
with low operating leverage will expect a slow increase in profits while revenue rises, but will be less
anxious in an economic downturn as profits will drop more slowly than in the highly leveraged firm.

18.19 East Ltd, which is highly automated, will have a cost structure dominated by fixed costs. West Ltds
cost structure will include a larger proportion of variable costs than East Ltds cost structure.
A firms operating leverage factor, at a particular sales volume, is defined as its total contribution margin
divided by its net profit. Since East Ltd has proportionately higher fixed costs, it will have a
proportionately higher total contribution margin. Therefore, East Ltds operating leverage factor will be
higher.

18.20 False. The statement is only partly true. A company with capital intensive processes is likely to have
higher fixed costs and higher operating leverage (which is equal to contribution margin/net profit). The
higher fixed costs often result in a higher break-even point and therefore a smaller safety margin.

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SOLUTIONS TO EXERCISES
EXERCISE 18.21 (25 minutes) Missing data; basic CVP relationships

Total
Sales Variable contribution Fixed Net Break-even
revenue costs margin costs profit sales revenue

1 $110 000 $ 22 000 $ 88 000 $50 000 $ 38 000 $ 62 500a

2 $240 000b $ 60 000 $180 000 $60 000 $120 000 $ 80 000

3 $ 80 000 $ 65 000 $ 15 000 $15 000c $ 0 $ 80 000

4 $360 000 $120 000 $240 000 $90 000 $150 000 $135 000d

Explanatory notes for selected items:


(a) The contribution margin ratio is 0.8 (total contribution margin total sales revenue), so break-even sales
revenue is fixed cost contribution margin ratio
= $(110 000 22 000 38 000) 0.8 = $50 000 0.8 = $62 500

(b) Break-even revenue $80 000

Fixed costs 60 000

Variable costs $20 000

Therefore, variable costs are 25 per cent of sales revenue.


When variable costs amount to $60 000, sales revenue is $240 000.

(c) $80 000 is the break-even sales revenue, which is identical to total sales revenue, so fixed costs must be
equal to the contribution margin of $15 000 and profit must be zero.

(d) $135 000 = $90 000 0.667, where 0.666667 is the contribution margin ratio
(240 000 / 360 000).

EXERCISE 18.22 (20 minutes) Basic CVP analysis: retailer


fixed costs
1 Break-even point (in units) =
unit contribution margin

$54 000
= = 13 500 pizzas
$10 - $6
unit contribution margin
2 Contribution margin ratio =
unit sales price

$10 - $6
= = 0.4
$10
Break - even point fixed costs
3 =
(in sales dollars) contribution margin ratio

$54 000
= = $135 000
0.4

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fixed costs + target profit
4 Target net profit =
unit contribution margin
$54 000 + $60 000
=
$10 - $6
= 28 500 pizzas

EXERCISE 18.23 (25 minutes) Cost volume profit graph: sports team
1 Cost-volume-profit graph:

Dollars per Profit


year Total revenue
line

900 000
Total revenue

Break-even point:
20 000 tickets
Total costs line
Profit
area

600 000 Total variable


costs
Fixed cost line

Loss area

300 000 Total fixed


costs

Tickets
sold per
year
5 000 10 000 15 000 20 000 25 000 30 000

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2 Stadium capacity 6000
Attendance rate 2/3
Attendance per game 4000
Break - even point (tickets) 20 000
= =5
Attendance per game 4 000

The team must play five games to break even.

EXERCISE 18.24 (25 minutes) Profit volume graph; safety margin: sports team
1 Profit-volume graph:

Dollars per
year

600 000

Profit Profit line


300 000
Total

Break-even point:
20 000 tickets
Profit area

Tickets
sold per
year
5000 10 000 15 000 20 000 25 000

Loss area

Loss Total
(300 000) profit/loss

Total fixed costs


$540 000
(600 000)

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2 Safety margin:

Budgeted sales revenue

(10 games 6000 seats 0.45 full $40) ...................................................................... $1 080 000

Break-even sales revenue

(20 000 tickets $40) ..................................................................................................... 800 000

Safety margin ......................................................................................................................... $280 000

3 Let P denote the break-even ticket price, assuming a 10-game season and 40 per cent attendance:

(10)(6000)(0.40)P (10)(6000)(0.40)($13) $540 000 = 0

24 000P = $852 000

P = $35.50 per ticket

EXERCISE 18.25 (25 minutes) Cost volume profit analysis and decisions:
manufacturer

fixed costs
1 Break-even point (in units) =
unit contribution margin

= 4 000 000 = 4000 TVs


3 000 - 2 000

2 New break-even point (in units) = (4 000 000) (1.10)


3000 2000

= 4 400 000 = 4400 TVs


1 000

3 Sales revenue (5000 3000) = $15 000 000

Variable costs (5000 2000) 10 000 000

Contribution margin 5 000 000

Fixed costs 4 000 000

Net profit $1 000 000

4 New break-even point (in units) = 4 000 000


2500 2000

= 8000 TVs

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5 Analysis of price change decision:

Price

$3 000 $2 500

Sales revenue: (5000 3000) 15 000 000

(6200 2500) 15 500 000

Variable costs: (5000 2000) 10 000 000

(6200 2000) ________ 12 400 000

Contribution margin 5 000 000 3 100 000

Fixed expenses 4 000 000 4 000 000

Net profit (loss) $1 000 000 ($900 000)

The price cut should not be made, since instead of $1 000 000 profit, a loss of $900 000 will incur.

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EXERCISE 18.26 (30 minutes) Cost volume profit analysis with multiple products:
retailer
1 Unit
Unit contribution
Bicycle type Sales price variable cost margin

Road bikes $2000 $800 ($750 + $50) $1200

Track bikes 1500 600 ($575 + $25 900

2 Sales mix:

Road bicycles 75%

Track bicycles 25%

3 Weighted-average unit = ($1200 75%) + ($900 25%)


contribution margin

= $1125

4 fixed expenses
Break - even point (in units) =
weighted - average unit contribution margin
$390 000
= = 347 bicycles
$1125

Break-even
Bicycle type sales volume Sales price Sales revenue

Road bikes 260 (347 0.25) $2000 $520 000

Track bikes 87 (347 0.75) 1500 130 500

Total $650 500*


There is a rounding error due to rounding up break-even point in units. Using 346.666667 reveals a break even sales revenue of
$650 000.

5 Target net profit:

$390 000 + $409 500


Sales volume required to earn target net profit of $409 500 =
$1125
= 711 bicycles
This means that the shop will need to sell the following volume of each type of bicycle to earn the target
net profit:
Road bikes 533 (711 0.75)
Track bikes 178 (711 0.25)

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EXERCISE 18.27(20 minutes) CVP analysis with income taxes: service firm
1 fixed expenses
Break - even volume of service revenue =
contribution margin ratio
$400 000
= = $1 600 000
0.25

2 target after - tax net profit


Target before - tax profit =
1 - tax rate
$260 000
= = $433 333
1 - 0.40

3 Service revenue required to earn target target after - tax net profit
fixed expenses +
after-tax profit of $260 000 (1 - t )
=
contribution margin ratio
$260 000
$400 000 +
= 1 - 0.40 = $3 333 333
0.25

4 A change in the tax rate will have no effect on the firms break-even point. At the break-even point, the
firm has no profit and does not have to pay any income taxes.

EXERCISE 18.28 (25 minutes) (appendix) Contribution margin statement; operating


leverage: manufacturer

1 (a) Traditional income statement:

East Asian Publications


Income Statement
for the year ended 31 December

Sales $2 000 000

Less: Cost of goods sold 1 500 000

Gross margin 500 000

Less: Operating expenses:

Selling expenses $150 000

Administrative expenses $150 000 300 000

Net profit $200 000

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(b) Contribution income statement:

East Asian Publications


Income Statement
for the year ended 31 December

Sales $2 000 000

Less: Variable expenses:

Variable manufacturing $1 000 000

Variable selling 100 000

Variable administrative 30 000 1 130 000

Contribution margin 870 000

Less: Fixed expenses:

Fixed manufacturing 500 000

Fixed selling 50 000

Fixed administrative $120 000 670 000

Net profit $200 000

contribution margin
Operating leverage factor (at $2 000 000 sales level)
net profit
2
$870 000
4.35
$200 000

3 percentage increase
Percentage increase in net profit = operating
in sales revenue leverage factor

= 10% 4.35
= 43.5%

4 Most operating managers prefer the contribution income statement for answering this type of question.
The contribution format highlights the contribution margin and separates fixed and variable expenses.

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EXERCISE 18.29 (25 minutes) (appendix) Cost structure and operating leverage:
service firm

1 The following income statement, often called a common-size income statement, provides a convenient
way to show the cost structure.

Amount Percent

Revenue $1 500 000 100

Variable costs 900 000 60

Contribution margin 600 000 40

Fixed costs 450 000 30

Net profit $ 150 000 10

Decrease in Contribution margin Decrease in


revenue percentage net profit

$300 000* 40% = $120 000

* $300 000 = $1 500 000 20%

The key to understanding this answer is to realise that the change in net profit will be the same as the
change in contribution margin, since fixed costs will not change.

3 contribution margin
Operating leverage factor (at revenue of $1 500 000) =
net profit
$600 000
= =4
$150 000

4 percentage increase operating leverage


Percentage change in net profit =
in revenue factor
= 25% 4
= 100%

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EXERCISE 18.30 (10 minutes) (appendix) Cost structure and operating leverage:
service firm

Requirement 1 Requirement 2

Revenue $1 875 000 $1 500 000

Less: Variable expenses 1 125 000 1 800 000

Contribution margin 750 000 (300 000)

Less: Fixed expenses 630 000 350 000

Net profit (loss) $ 120 000 $(650 000)

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SOLUTIONS TO PROBLEMS
PROBLEM 18.31 (30 minutes) Cost volume profit calculations; multiple break-even
points; CVP graph: manufacturer
1 Break-even point in sales dollars, using the contribution margin ratio:

fixed expenses
Break - even point =
contribution margin ratio
$540 000 + $216 000 $756 000
= =
$30 - $12 - $6 .4
$30
= $1 890 000

2 Target net profit, using contribution-margin approach:

fixed expenses + target net profit


Sales units required to earn profit of $540 000 =
unit contribution margin
$756 000 + $540 000 $1 296 000
= =
$30 - $12 - $6 $12
= 108 000 units

3 New unit variable manufacturing cost = $12 120%

= $14.40

Break-even point in sales dollars:

fixed expenses
Break - even point =
contribution margin ratio
$756 000
= = $2 362 500
0.32

4 Let P denote the selling price that will yield the same contribution-margin ratio:

$(30 - 12 6) / $30 = (P - $14.40 - $6.00) / P


0.4 = (P - $20.40) / P
0.4P = P - $20.40
$20.40 = 0.6P
P = $20.40 / 0.6
P = $34

Check: New contribution-margin ratio is:


$(34 - $14.40 - $6.00) / $34 = 0.4

5 The new break-even point can be calculated as follows:


Break-even point = fixed costs / contribution margin per unit

$300 000 + $216 000


= = 43 000 units
$30 - $18
Or = $1 290 000 revenue

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6

PROBLEM 18.32 (30 minutes) Cost volume profit relationships; indifference point:
manufacturer

1 Unit contribution margin:

Sales price $32.00

Less variable costs:

Sales commissions ($32 5%) $ 1.60

Variable component costs 8.00 9.60

Unit contribution margin $22.40

Break-even point = fixed costs unit contribution margin


= $1 971 200 $22.40
= 88 000 units

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2 Model A is more profitable when sales and production average 184 000 units.

Model A Model B

Sales revenue (184 000 units $32.00) $5 888 000 $5 888 000

Less variable costs:

Sales commissions ($5 888 000 5%) 294 400 294 400

Variable component costs:

184 000 units $8.00 1 472 000

184 000 units $6.40 1 177 600

Total variable costs 1 766 400 1 472 000

Contribution margin 4 121 600 4 416 000

Less: Annual fixed costs 1 971 200 2 227 200

Net profit $2 150 400 $2 188 800

3 Annual fixed costs will increase by $180 000 ($900 000 5 years) because of straight-line depreciation
associated with the new equipment, to $2 407 200 ($2 227 200 + $180 000). The unit contribution
margin is ($4 416 000 184 000 units) i.e. $24. Thus:
Required sales = (fixed costs + target net profit) unit contribution margin
= ($2 407 200 + $1 912 800) $24
= 180 000 units

4 Let X = volume level at which annual total costs are equal


$8.00X + $1 971 200 = $6.40X + $2 227 200
$1.60X = $256 000
X = 160 000 units

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PROBLEM 18.33 (30 minutes) Basic CVP relationships: manufacturer
1 fixed costs
Break - even point (in units) =
unit contribution margin
$702 000
= = 135 000 units
$25.00 - $19.80

2 fixed cost
Break - even point (in sales dollars) =
contribution - margin ratio
$702 000
= = $3 375 000
$25.00 - $19.80
$25.00

3 Number of sales units fixed costs + target net profit


required to earn target net =
unit contribution margin
profit $702 000 + $390 000
= = 210 000 units
$25.00 - $19.80

4 Margin of safety = budgeted sales revenue break-even sales revenue

= (140 000)($25) $3 375 000 = $125 000

5 Break-even point if direct labour costs increase by 10 per cent:

New unit contribution margin = $25.00 $8.20 ($4.00)(1.10) $6.00 $1.60

= $4.80

Break-even point fixed costs


=
new unit contribution margin
$702 000
= = 146 250 units
$4.80

6 Contribution margin ratio unit contribution margin


=
sales price

Old contribution margin ratio $25.00 $19.80



$25.00
0.208

Let P denote sales price required to maintain a contribution-margin ratio of .208. Then P is determined as
follows:

P $8.20 ($4.00)(1. 10) $6.00 $1.60


0.208
P
P $20.20 .0208 P
.792 P $20.20
P $25.51 (rounded)

Check: New contribution $25.51 $8.20 ($4.00)(1. 10) $6.00 $1.60


margin ratio
$25.51
0.208 (rounded)

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PROBLEM 18.34 (30 minutes) Basic CVP relationships; income taxes: manufacturer
1 fixed costs
Break - even point (in units) =
unit contribution margin
$702 000
= = 135 000 units
$25.00 - $19.80

2 fixed cost
Break - even point (in sales dollars) =
contribution - margin ratio
$702 000
= = $3 375 000
$25.00 - $19.80
$25.00

3 Number of sales units required fixed costs + (target net after profit/(1 - t))
to earn target net profit after tax =
unit contribution margin
$702, 000 + ($400 000/.7)
= = 244 890 units
$25.00 - $19.80

4 Margin of safety = budgeted sales revenue break-even sales revenue

= (140 000)($25) $3 375 000 = $125 000

5 Break-even point if direct labour costs increase by 10 percent:

New unit contribution margin = $25.00 $8.20 ($4.00)(1.10) $6.00 $1.60

= $4.80

Break-even point fixed costs


=
new unit contribution margin
$702 000
= = 146 250 units
$4.80

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PROBLEM 18.35 (40 minutes) Cost volume profit equation; sensitivity analysis:
manufacturer
1&2
Costs per unit

Direct material $8.20

Direct labour 4.00

Manufacturing overhead 6.00

Selling expenses 1.60

Fixed manufacturing costs $288 000

Fixed selling and admin costs $414 000

Sales 140 000 110 000 120 000 130 000 140 000 150 000 160 000 170 000

Selling price 25 33 31 28 25 22 19 16

Sales revenue 3 500 000 3 630 000 3 720 000 3 640 000 3 500 000 3 300 000 3 040 000 2 720 000

Direct material 1 148 000 902 000 984 000 1 066 000 1 148 000 1 230 000 1 312 000 1 394 000

Direct labour 560 000 440 000 480 000 520 000 560 000 600 000 640 000 680 000

Manufacturing overhead 840 000 660 000 720 000 780 000 840 000 900 000 960 000 1 020 000

Selling expenses 224 000 176 000 192 000 208 000 224 000 240 000 256 000 272 000

Total variable costs 2 772 000 2 178 000 2 376 000 2 574 000 2 772 000 2 970 000 3 168 000 3 366 000

Less fixed costs

Manufacturing fixed costs 288 000 288 000 288 000 288 000 288 000 288 000 288 000 288 000

Selling and admin fixed costs 414 000 414 000 414 000 414 000 414 000 414 000 414 000 414 000

Total fixed costs 702 000 702 000 702 000 702 000 702 000 702 000 702 000 702 000

Total costs 3 474 000 2 880 000 3 078 000 3 276 000 3 474 000 3 672 000 3 870 000 4 068 000

Profit before taxes 26 000 750 000 642 000 364 000 26 000 -372 000 -830 000 -1 348 000

Income taxes @ 30% 7 800 225 000 192 600 109 200 7 800 -111 600 -249 000 -404 400

Profit after taxes 18 200 525 000 449 400 254 800 18 200 -260 400 -581 000 -943 600

3 The use of electronic spreadsheets to conduct a sensitivity analysis is very useful to management. It
enables managers to determine the effect on profit of changing certain key variables, such as changing
selling prices and sales volumes.

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PROBLEM 18.36 (35 minutes) Cost volume profit relationships; automation:
manufacturer

1
$405 000
Unit contribution margin =
1 800 tonnes
= $225per tonne
fixed costs
Break - even point (in tonnes) =
unit contribution margin
= $247 500 / $225 = 1100 tonnes

2 The companys net profit would increase from this years $157 500 to next years net profit of
$225 500, if the sales volume is increased to 2100 tonnes next year. The revised contribution margin
statement is as follows:

Salesa $1 050 000

Variable costs:

Manufacturingb 367 500

Selling costsc 210 000

Total variable costs 577 500

Contribution margin 472 500

Fixed costs:

Manufacturing $ 100 000

Selling costs 107 500

Administrative 40 000

Total fixed costs 247 500

Net profit $225 000

a $900 000 x 2 100 / 1 800

b $315 000 x 2 100 / 1 800

c $180 000 x 2 100 / 1 800

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3 The firm would earn net profit of $ 352 500 under its full manufacturing capacity, as shown below.

Salesa $1 425 000

Variable costs:

Manufacturingb $525 000

Selling costsc 300 000

Total variable costs 825 000

Contribution margin 600 000

Fixed costs:

Manufacturing 100 000

Selling costs 107 500

Administrative 40 000

Total fixed costs 247 500

Net profit $352 500

a 1 500 x $500 + 1 500 x $450

b $315 000 x 3 000 / 1 800

c $180 000 x 3 000 / 1 800

4 If the firms current net profit of $157 500 is to be maintained, the firm will need to break even on its
sales in the new territory. The breakeven point on the new territory activity is 308 tonnes, as shown in
the following workings:
Contribution margin in new territory = $225 $25 = $200
BE units in new territory = $61 500 / $200
= 308 units (rounded)

5 The new break-even volume is 1224 tonnes and $612 000 in sales dollars, should the firm adopt
automation for its manufacturing process. The workings are shown below:
Contribution margin with automated process = $225 + $25 = $250
BE units with automated process = ($247 500 + $58 500) / $250 per tonne
= 1224 tonnes
BE sales dollars with automated process
= 1224 tonnes x $500 = $612 000
6 The new break-even sales dollars is $1 140 000, as shown below:
Contribution margin = $225 ($500 x 0.10) $40 = $135
Contribution margin ratio = $135/$450 = 0.30
Sales dollars to earning a net profit of $94 500
= $(247 500 + 94 500 )/ 0.30
= $1 140 000

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PROBLEM 18.37 (35 minutes) Basic CVP relationships; impact of operating changes;
target profit: manufacturer

1 Current profit:

Sales revenue ... $4 032 000

Less: Variable costs . $1 008 000

Fixed costs 2 736 000 3 744 000

Net profit.. $288 000

AudioFriend has a contribution margin of $72 [($4 032 000 $1 008 000) 42 000 units] and desires to
increase profit to $576 000 (i.e. $288 000 2). In addition, the current selling price is $96 ($4 032 000
42 000 units). Thus:
Required sales = (fixed costs + target net profit) unit contribution margin
= ($2 736 000 + $576 000) $72
= 46 000 sets or $4 416 000 (46 000 sets @ $96)

2 If operations are shifted to China, the new unit contribution margin will be $74.40 ($96.00 $21.60).
Thus:
Break-even point = fixed costs unit contribution margin
= $2 380 800 $74.40
= 32 000 units

3 (a) AudioFriend desires a 32 000-unit break-even point with a $72 unit contribution margin. Fixed
costs must therefore drop by $432 000, from $2 736 000 to $2 304 000, as follows:
Let X = fixed costs
X $72 = 32 000 units
X = $2 304 000
(b) As the following calculations show, AudioFriend will have to generate a contribution margin of
$85.50 to produce a 32 000-unit break-even point. Based on a $96.00 selling price, this means
that the company can incur variable costs of only $10.50 per unit. Given the current variable cost
of $24.00 ($96.00 $72.00), a decrease of $13.50 per unit ($24.00 $10.50) is needed.
Let X = unit contribution margin
$2 736 000 X = 32 000 units
X = $85.50

4 (a) Increase
(b) No effect
(c) Increase
(d) No effect

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PROBLEM 18.38 (45 minutes) Cost volume profit; multiple products; changes in
costs and sales mix: manufacturer
1 Greenfingers Gardening Tools Ltd (GGT)
Budgeted income statement
for the year ended 31 December

Weeders Hedge clippers Leaf blowers Total

Unit selling price $84 $108 $144

Variable manufacturing cost 39 36 75

Variable selling cost 15 12 18

Total variable cost 54 48 93

Contribution margin per unit 30 60 51

Unit sales 50 000 50 000 100 000

Total contribution margin $1 500 000 $3 000 000 $5 100 000 $9 600 000

Fixed manufacturing overhead $6 000 000

Fixed selling and administrative 1 800 000


costs

Total fixed costs 7 800 000

Profit before taxes 1 800 000

Income taxes (40%) 720 000

Budgeted net profit $1 080 000

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2

(a) (b) (a) (b)


Unit contribution Sales proportion

Weeders $30 0.25 $7.50

Hedge clippers 60 0.25 15.00

Leaf blowers 51 0.50 25.50

Weighted-average unit contribution


margin
$48.00

total fixed costs


Total unit sales to break even =
weighted - average unit contribution margin
$7 800 000
= = 162 500 units
$48
Sales proportions:

Sales Total unit Product line


proportion sales sales

Weeders 0.25 162 500 40 625

Hedge clippers 0.25 162 500 40 625

Leaf blowers 0.50 162 500 81 250

Total 162 500

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3

(a) (b) (a) (b)


Unit contribution Sales proportion

Weeders $30 0.20 $6.00

*Hedge clippers 57 0.20 11.40


Leaf blowers 36 0.60 21.60

Weighted-average unit contribution $39.00


margin

* Variable selling cost increases. Thus, the unit contribution decreases to $57 [$108 ($36 + $12 + $3)].
The variable manufacturing cost increases 20 per cent. Thus, the unit contribution
decreases to $36 [$144 (1.2 $75) $18].

total fixed costs


Total unit sales to break even =
weighted - average unit contribution margin
$7 800 000
= = 200 000 units
$39

Sales proportions:

Sales Total unit Product line


proportions sales sales

Weeders 0.20 200 000 40 000

Hedge clippers 0.20 200 000 40 000

Leaf blowers 0.60 200 000 120 000

Total 200 000

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PROBLEM 18.39 (40 minutes) Cost volume profit analysis; sales mix and employee
incentive systems: manufacturer
1 Sales mix refers to the relative proportion of each product sold when a company sells more than one
type of product.

2 (a) Yes. Plan A sales are expected to total 65 000 units (19 500 + 45 500), which compares
favourably with current sales of 60 000 units.
(b) The sales staff would be likely to promote Standard because it has a higher selling price than
Deluxe ($86 versus $74) and sales staff earn a commission based on gross dollar sales under plan
A. As the following figures show, Deluxe sales will comprise a greater proportion of total sales
under Plan A.

Current Plan A

Units Sales mix Units Sales mix

Deluxe .................................. 21 000 35% 45 500 70%

Standard ............................... 39 000 65% 19 500 30%

Total .............................. 60 000 100% 65 000 100%

(c) Yes. Commissions will total $535 600 ($5 356 000 10 per cent), which compares favourably
against the current flat salaries of $400 000.

Deluxe sales: 45 500 units $86 ............................................... $3 913 000

Cold King sales: 19 500 units $74 .......................................... 1 443 000

Total .................................................................................... $5 356 000

(d) No. The company would be less profitable under the new plan.

Current Plan A

Sales revenue:

Deluxe: 21 000 units $86; 45 500 units $86 ........................... $1 806 000 $3 913 000

Standard: 39 000 units $74; 19 500 units $74 ........................ 2 886 000 1 443 000

Total revenue ..................................................................... $4 692 000 $5 356 000

Less variable cost:

Deluxe: 21 000 units $65.00; 45 500 units $65.00 ................. $1 365 000 $2 957 500

Standard: 39 000 units $41.00; 19 500 units $41.00 .............. 1 599 000 799 500

Sales commissions (10% of sales revenue) .................................. 535 600

Total variable cost .............................................................. $2 964 000 $4 292 600

Contribution margin ......................................................................... $1 728 000 $1 063 400

Less fixed cost (salaries) .................................................................. 400 000 __

Net profit ......................................................................................... $1 328 000 $1 063 400

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3 (a) The total units sold under both plans are the same; however, the sales mix has shifted under Plan
B in favour of the more profitable product as judged by the contribution margin. Deluxe has a
contribution margin of $21.00 ($86.00 $65.00), and Standard has a contribution margin of
$33.00 ($74.00 $41.00).

Plan A Plan B

Units Sales mix Units Sales mix

Standard .......................................... 19 500 30% 39 000 60%

Deluxe ............................................. 45 500 70% 26 000 40%

Total ......................................... 65 000 100% 65 000 100%

(b) Plan B is more attractive than Plan A, both to the sales force and to the company. Salespeople also earn more
money under Plan B than the current flat salary ($549 900 vs. $400 000). However, the company is more
profitable in the current situation ($1 328 000) than under either plan ($1 283 100 for Plan B and $1 063 400
for plan A).

Current Plan B

Sales revenue:

Deluxe: 21 000 units $86; 26 000 units $86 ....................... $1 806 000 $2 236 000

Standard: 39 000 units $74; 39 000 units $74..................... 2 886 000 2 886 000

Total revenue ..................................................................... $4 692 000 $5 122 000

Less variable cost:

Deluxe: 21 000 units $65.00; 26 000 units $65.00 ............. $1 365 000 $1 690 000

Standard: 39 000 units $41.00; 39 000 units $41.00........... 1 599 000 1 599 000

Total variable cost .............................................................. $2 964 000 $3 289 000

Contribution margin ......................................................................... $1 728 000 $1 833 000

Less: Sales force compensation:

Flat salaries ............................................................................... 400 000

Commissions ($1 833 000 30%) ............................................ 549 900

Net profit.......................................................................................... $1 328 000 $1 283 100

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PROBLEM 18.40 (50 minutes) Cost volume profit and activity-based analysis;
product mix: manufacturer
1 Timber Polystyrene

Unit-related costs: Unit costs Total costs Unit costs Total costs

Assembling $36 $36

Packaging 6 4

Materials 70 52

112 $11 200.000a 92 $4 600 000b

Batch-related costs:

Setting-up 80 90

Inspection 60 50

Moving material 60 50

$200 50 000c $190 95 000d

Product-related costs:

Advertising 30 000 50 000

Total product, batch and unit $11 280 000 $4 745 000 $16 025 000
related costs

Facility costs e 360 000

$16 385 000


a- $112 x 100 000 units
b - $92 x 50 000 units
c - $200 x 250 batches
d - $190 x 500 batches
e- Facility level costs are not allocated to products as they have no identifiable cost driver. Alternatively these costs could
be allocated by number of units produced in which case the product costs would be $11 520 000 for the Timber Crates and
$4 865 000 for the Polystyrene Crates

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2 The sales mix for Timber crates is 2/3 (=100 000 units / 15 000 units),
and for Polystyrene crates is 1/3 (=50 000 units),
and so the weighted average contribution margin is 2/3 x ($138 - $112) + 1/3 x ($100 - $92)
= $20

totalbatch,productandfacility costs
Break - even points(Timber &Polystyrene)
weightedaveragecontributiononmargin
($145 000 $80 000 $360 000)

$20 perunit
($585 000 / $20 perunit)
29 250 units

Made up of 19 500 Timber crates and 9 750 Polystyrene crates

3 Assuming that the batch size for the Polystyrene crates is changed to 2000 units, then the batch related
cost for polystyrene crates is $4750 (= $190 x 25 batches) and the total batch related cost for the two
products is $54 750. The new break-even point is calculated as follows:

Break - even points (Timber &Polystyrene) = total batch, product and facility costs
weighted average contribution on margin
= ($54 750 + $80 000 + $360 000)
$20 per unit
= $494 750 / $20 per unit
= 24 738 units(rounded)

4 While the increase in batch size has caused a reduction in the break-even point, reducing batch sizes
may not be the best solution for the company.
Larger batch sizes might actually cause costs (facility costs) to increase. This is due to the costs
associated with inventory build-ups, including increased storage, insurance, spoilage and obsolescence
costs, and the opportunity costs associated with tying up funds in excessive levels of inventories.

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PROBLEM 18.41 (35 minutes) (appendix) Basic CVP relationships; incentive
systems; cost structure; operating leverage: wholesaler

1 Plan A break-even point = fixed costs unit contribution margin


= $49 500 $49.50*
= 1000 units
Plan B break-even point = fixed costs unit contribution margin
= $148 500 $67.50**
= 2200 units
* $180 [($180 10%) + $112.50]
** $180 $112.50

2 Operating leverage refers to the proportion of fixed costs in an organisations overall cost structure. An
organisation that has a relatively high proportion of fixed costs and low proportion of variable cost has a
high operating leverage.

3 Calculation of contribution margin and profit at 6000 units of sales:

Plan A Plan B

Sales revenue: 6000 units $180 $1 080 000 $1 080 000

Less variable costs:

Cost of purchasing product:


6000 units $112.50 $675 000 $675 000

Sales commissions: $1 080 000 0.10 108 000

Total variable cost 783 000 675 000

Contribution margin 297 000 405 000

Fixed costs 49 500 148 500

Net profit $247 500 $256 500

Plan A has a higher percentage of variable costs to sales (72.5 per cent) compared to Plan B (62.5 per
cent). Plan Bs fixed costs are 13.75 per cent of sales, compared to Plan As 4.58 per cent.
Operating leverage factor = contribution margin net profit
Plan A: $297 000 $247 500 = 1.2
Plan B: $405 000 $256 500 = 1.58 (rounded)
Plan B has the higher operating leverage, as it has a higher reliance on fixed costs.

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4 & 5 Calculation of profit at 5000 units:

Plan A Plan B

Sales revenue: 5000 units $180 $900 000 $900 000

Less variable costs:

Cost of purchasing product:


5000 units $112.50 562 500 562 500

Sales commissions: $900 000 0.10 90 000

Total variable cost 652 500 562 500

Contribution margin 247 500 337 500

Fixed costs 49 500 148 500

Net profit $198 000 $189 000

Plan A profitability decrease:


$247 500 $198 000 = $49 500; $49 500 $247 500 = 20%
Plan B profitability decrease:
$256 500 $189 000 = $67 500; $67 500 $171 000 = 26.3% (rounded)
ATA will experience a larger percentage decrease in profit if it adopts Plan B, because Plan B has a
higher operating leverage. Stated differently, Plan Bs decrease in sales revenue leads to a higher
percentage decline in profitability due to the high proportion of fixed costs in the cost structure.
Note: The percentage decreases in profitability can be calculated by multiplying the percentage decrease
in sales revenue by the operating leverage factor. Sales dropped from 6000 units to 5000 units, or 16.67
per cent. Thus:
Plan A: 16.67% 1.2 = 20.0%
Plan B: 16.67% 1.58 = 26.3% (rounded)

6 Heavily automated manufacturers have sizable investments in plant and equipment, so have a high
percentage of fixed costs in their cost structures. As a result, there is a high degree of operating
leverage.
In a severe economic downturn, when sales volume decreases, these firms suffer a significant decrease
in profitability. Such firms would be a more risky investment compared with firms that have a low
degree of operating leverage. Of course, when times are good, the increase in sales volume would have
a favourable impact on profitability in a company with high operating leverage.

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PROBLEM 18.42 (45 minutes) (appendix) Basic CVP relationships; cost structure;
operating leverage

1 Break-even point in units:


fixed costs
Break - even point =
unit contribution margin
Calculation of contribution margins:

Labour-intensive Computer-assisted
production system manufacturing system

Selling price $45.00 $45.00

Variable costs:

Direct material $8.40 $7.50

Direct labour 10.80 9.00

Variable overhead 7.20 4.50

Variable selling cost 3.00 29.40 3.00 24.00

Contribution margin per unit $15.60 $21.00

(a) Labour-intensive production system:

Break - even point in units = $1980 000 + $750 000


$15.60
= $2 730 000
$15.60 p.u.
= 175000 units

(b) Computer-assisted manufacturing system:

Break -even point in units = $3660 000 + $750 000


$21
= $4 410 000
$21 p.u.
= 210 000 units

2 Zodiacs management would be indifferent between the two manufacturing methods at the
volume (X) where total costs are equal.

$29.40X + $2 730 000 = $24X + $4 410 000

$5.40X = $1 680 000

X = 311 111 units*


* Rounded

3 Operating leverage is the extent to which a firms operations employ fixed operating costs. The greater
the proportion of fixed costs used to produce a product, the higher the operating leverage. Thus, the
computer-assisted manufacturing method utilises a higher level of operating leverage.
The higher the operating leverage, the greater the change in operating profit (loss) relative to a small
fluctuation in sales volume. Thus, there is a higher degree of variability in operating profit if operating
leverage is high.

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4 Management should employ the computer-assisted manufacturing method if annual sales are expected to
exceed 311 111 units, and the labour-intensive manufacturing method if annual sales are not expected to
exceed 311 111 units.

5 Zodiacs management should consider many other business factors before selecting a manufacturing
method. These include:
the variability or uncertainty with respect to demand quantity and selling price
the ability to produce and market the new product quickly
the ability to discontinue production and marketing of the new product while incurring the least
amount of loss.

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SOLUTIONS TO CASES
CASE 18.43 (50 minutes) Break-even analysis; safety margin: service firm
1 In order to break even, during the first year of operations, 10 220 clients must visit the law office being
considered by Steven Clark and his colleagues, as the following calculations show.
Fixed expenses:
Advertising $1 960 000
Rent (6000 $112) 672 000
Council rates 108 000
Utilities 148 000
Professional indemnity insurance 720 000
Depreciation ($240 000/4) 60 000
Wages and on costs:
Regular wages: ($100 + $80 + $60 + $40) 16 360 $1 612 800
Overtime wages: (200 $60 1.5) + (200 $40 1.5) 30 000
Total wages 1 642 800
On costs at 40% $657 120 2 299 920
Total fixed expenses $5 967 920

Break-even point:
0 = revenue variable cost fixed cost
0 = $120X + ($8000 0.2X 0.3)* $16X $5 967 920
0 = $120X + $480X $16X $5 967 920
$584X = $5 967 920
X = 10 220 clients (rounded)
* Revenue calculation: $120X represents the $60 consultation fee per client. ($8 000 .2X .30)
represents the predicted average settlement of $8 000, multiplied by the 20% of the clients whose
judgments are expected to be favourable, multiplied by the 30% of the judgment that goes to the
firm.

2 Safety margin:
Safety margin = budgeted sales revenue break-even sales revenue
Budgeted (expected) number of clients = 50 360 = 18 000
Break-even number of clients = 10 220 (rounded)
Safety margin = [($120 18 000) + ($8 000 18 000 0.20 0.30)] [($120 10 220) + ($8 000
10 220 0.20 0.30)]
= [$120 + ($8 000 .20 .30)] (18 000 10 220)
= $600 7 780
= $4 668 000

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3 The assumptions underlying the break-even analysis of this law office include that the variable costs of
serving each client are the same and the total fixed cost remains constant irrespective of the actual
number of clients served. For example, the staffs wages and advertising expenses are allocated equally
to each of 10,220 clients. The analysis ignores the possibility of cost drivers other than the number of
clients. It also makes a number of untested assumptions about the number of clients and the number of
favourable settlements or judgements. Where these assumptions are not met, the outcomes estimated
from the CVP analysis will not be achieved. Given the uncertainty surrounding some of these
assumptions it may be a good idea to use sensitivity analysis to assess how sensitive the estimated
breakeven point is to changes in key variables.

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CASE 18.44 (50 minutes) Break-even analysis; CVP relationships: hospital

1 The break-even point is 16 900 patient-days, calculated as follows:

Narooma Medical Centre


Calculation of break-even point in patient-days:
Paediatrics for the year ended 30 June

Total fixed costs:

Medical centre charges $6 960 000

Supervising nurses ($60 000 4)* 240 000

Nurses ($48 000 10)* 480 000

Aides ($21 600 20)* 432 000

Total fixed costs $8 112 000

Contribution margin per patient-day:

Revenue per patient-day $720

Variable cost per patient-day:

($4 800 000 20 000* patient-days) 240

Contribution margin per patient-day $480

*($14 400 000 $720 = 20 000 patient


days)

Break-even point in total fixed costs $8112 000


patient-days
contribution margin per patient - day $480
16 900 patient days

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2 Net earnings would decrease by $1 456 000, calculated as follows:

Narooma Medical Centre


Calculation of loss from rental of additional 20 beds: Paediatrics
for the year ended 30 June

Increase in revenue

(20 additional beds 90 days $720 charge per day) $1 296 000

Increase in expenses:

Variable charges by medical centre

(20 additional beds 90 days $240 per day) $432 000

Fixed charges by medical centre

($6 960 000 60 beds = $116 000 per bed)

($116 000 20 beds) 2 320 000

Salaries

(20 000 patient-days (before additional 20 beds) + 20 0


additional beds 90 days = 21 800, which does not exceed
22 000, therefore, no additional personnel are required.)

Total increase in expenses $2 752 000

Net change in earnings from rental of additional 20 beds $(1 456 000)

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CASE 18.45 (50 minutes) Contribution margin statement; sales mix; advantages and
disadvantages of CVP analysis: manufacturer

1 Delphina Products Ltd


Income Statement for the year ended June 30
(in thousands)

Dog food Cereal Breakfast bars Total

Sales (in kgs) 2 000 500 500 3 000

Sales revenue $1 000 $400 $200 $1 600

Variable manufacturing costs:

Direct material 330 160 100 590

Direct labour 90 40 20 150

Manufacturing overhead* 27 12 6 45

Total variable manufacturing costs 447 212 126 785

Manufacturing contribution margin 553 188 74 815

Other variable costs:

Commissions 50 40 20 110

Contribution margin 503 148 54 705

Direct operating costs:

Advertising 50 30 20 100

Licenses 50 20 15 85

Total direct operating costs 100 50 35 185

Product profit contribution $403 $98 $19 $520

Fixed costs:

Manufacturing overhead* 135

Sales salaries and benefits 60

General and administrative salaries and benefits 100

Total fixed costs 295

Operating profit before taxes $225


* Manufacturing overhead is 25 per cent variable and 75 per cent fixed. The variable portion includes the
indirect labour and supplies ($15 000) and the employee benefits on indirect labour ($30 000). Therefore,
$45 000/$180 000 = 25%.

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2 (a)

Dog Cereal Breakfast Total


food bars

Sales (in kgs) 2 000 500 500 3 000


Sales mix 66.67% 16.67% 16.67% 100%

Sales revenue $1 000 $400 $200 $1 600

Contribution margin 503 148 54 705


Contribution margin per unit $0.2515 $0.296 $0.108

Total direct operating costs 100 50 35 185

Break-even point (in kgs) 397.6 169.92 324.07


Contribution margin ratio 50.3% 37% 27%
Break even point in sales dollars $135.94 129.63
$1
98
.8

(b) Weighted-average unit contribution margin:


= $0.2515 x .66.67% + $0.296 x 16.67% + $0.108 x 16.67%
= $0.235
For the products to break-even on their direct costs:
Product related fixed costs = $185 000
Product related break-even in current product mix = 185 000/0.235 = 787 000
In the ratio 66.7:16.7:16.7 the product mix in kg would be
525 000 kg of dog food; 131 000 kg of cereal and 131 000 kg of breakfast bars
Sales would need to exceed this to cover costs that cannot be related to any particular product.
Therefore, we can look at the break-even point for the whole company when we include the other
fixed costs:
Total fixed costs to be covered for the company to break even = $185 000 +$295 000 = $480 000
Weighted-average unit contribution margin = $0.235 per kg
Break-even point for this sales mix = 2 043 000 kg (rounded)
In the current sales mix this represents 1 362 000 kg of dog food; 340 000 kg of cereal; 340 000 kg of
breakfast bars.

(c) The answer in part (a) and the first calculation in part (b) do not allow for the non-product related
costs and to ignore these costs could lead to inaccurate decisions. The analyst would need to allow a
margin to cover these other fixed costs.
The last break-even point (1 362 000 kg of dog food; 340 000 kg of cereal; 340 000 kg of breakfast
bars) takes into account all fixed costs. In sales revenues this break-even point is $681 000 of dog
food, $272 000 of cereal and $136 000 of breakfast bars. It should be noted that the calculation does
make an assumption that the sales mix will be constant, i.e. sales levels would rise and fall
proportionately.

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3 (a) Advantages that CVP analysis can provide include:
determining the marginal contribution of products, which can
assist management in planning sales volume and profitability
including the calculation of a break-even point
identifying products that can support heavy sales promotion
expenditures
assisting in decisions related to eliminating a product
accepting a special order at a discounted price.
(b) Difficulties that Delphina Products could expect to have in the CVP calculations include:
separating semi-variable costs into their fixed and variable
components
determining how to treat joint or common costs
determining efficiency and productivity within the relevant range
determining a constant sales mix within the relevant range.
(c) Delphinas management should be aware of the following dangers when using CVP analysis:
the use of inaccurate assumptions for the calculations
CVP analysis focuses on the short term.

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CASE 18.46 (45 minutes) Cost volume profit and comprehensive activity-based
analysis; financial planning model: manufacturer

Cool Camping Company

Initial data

Unit level costs Batch level costs

Direct material 70 Move materials to cutting 100

Cutting pattern 15 Set up cutting machines 250

Stitching 45 Move materials to sewing 120

Waterproofing 10 Set up sewing machines 180

Inspection 11 $650

Packaging 4

$155

Product level costs Order level costs

Production/process design $50 000 Processing order 70

Delivery 140

$210

Customer level costs Market level costs

Sales calls 150 Advertising $24 000

Handling complaints 75

$225 Facility level costs

Administration $220 000

Sales units 75 000

Unit selling price $205

Sales revenue 15 375 000

Unit contribution margin $50

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1 Profit model

Sales revenue $205 75 000 $15 375 000

Less costs: Driver cost Number Total

Unit level costs $155 75 000 $11 625 000

Other activity level costs:

Batch level $650 1 875 1 218 750

Product level 50 000

Order level $210 3 750 787 500

Customer level $225 185 41 625

Market level 24 000

Facility level 220 000

Profit 13 966 875


$1 408 125

2 Break-even point

Total other activity costs/Unit CM

Total activity costs $2 341 875

Unit CM 50

Units required 46 838

3 Profit target

Profit target $950 000

Other activity costs 2 341 875

Total CM required $3 291 875

Unit CM 50

Units required 65 838

4 Margin of safety

Budgeted sales 75 000

Less break even sales 46 838

28 162

The margin of safety is the excess of forecast sales over break-even sales and indicates the amount by
which sales may fall before the firm starts to incur losses.

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5 (a) Sensitivity analysis

Sales revenue $190 85 000 $16 150 000

Less costs: Cost Number Total

Unit level costs $155 85 000 $13 175 000

Other activity level costs:

Batch level $650 2 125* 1 381 250

Product level 50 000

Order level $210 4 250* 892 500

Customer level $225 185 41 625

Market level 24 000

Facility level 220 000 $15 784 375

Profit $365 625

* This solution assumes the batch size and order size do not change, and therefore the number of batches and
customers increases proportionately.

(b) Sensitivity analysis

Sales revenue $185 95 000 $17 575 000

Less costs: Cost Number Total

Unit level costs $155 95 000 $14 725 000

Other activity level costs:

Batch level $650 2 375* 1 543 750

Product level 50 000

Order level $210 4 450* 997 500

Customer level $225 185 41 625

Market level 24 000

Facility level 220 000 $17 601 875

Profit $26 875

* This solution assumes the batch size and order size do not change, and therefore the number of batches and
customers increases proportionately

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6 New marketing strategy

Sales revenue $205 60 000 $12 300 000

Less costs: Cost Number Total

Unit level costs $155 60 000 $9 300 000

Other activity level costs:

Batch level $650 1500* 975 000

Product level 50 000

Order level $210 1 050 220 500

Customer level $225 75 16 875

Market level 24 000

Facility level 220 000 $10 806 375

Profit $1 493 625

* This solution assumes same batch size as currently used.

7 The impact of the proposed changes to the original budget can be seen in the table below.

Original
budget Option 5 (a) Option 5 (b) Option ( 6)

$ $ $ $

Profit (loss) $1 408 125 $365 625 ($26 875) $1 493 625

Increase (decrease) over original --------- ($1 042 500) ($1 435 000) 85 500

Total contribution margin $3 750 000 $2 975 000 $2 850 000 $3 000 000

Other activity costs $2 341 875 $2 609 375 $2 876 875 $1 506 375

Increase (decrease) in contribution


margin over original ------ ($775 000) ($900 000) ($750 000)

Increase (decrease) in other activity


costs over original ------ $267 500 $535 000 ($835 500)

Decreasing the selling price is not an effective strategy at either level, since the new profit is lower than
the original forecast. This is due to the loss of contribution margin and increase in other activity costs. If
management wishes to pursue a price sensitivity strategy, it needs to seek cost reductions in the
activities associated with batch level and order level costs. To be profitable, the firm should consider
increasing both average batch size and average order sizes.
By changing the marketing strategy, which involves ceasing trading with camping equipment suppliers,
the firm loses $750 000 in contribution margin but saves $835 500 in activity costs above unit level. As
a result, profit increases by $85 500.
Cool Camping Company can use the information generated by the financial model to investigate the
outcomes of various strategies as the model indicates the factors which management should consider
when evaluating a particular strategy.

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