COST ACCOUNTING AND CONTROL – Solutions Manual

CHAPTER 4
COST-VOLUME-PROFIT RELATIONSHIP

I. Answers to Questions
1. The total “contribution margin” is the excess of total revenue over total variable
costs. The unit contribution margin is the excess of the unit price over the unit
variable costs.
2. Total contribution margin:
Selling price - manufacturing variable costs expensed - nonmanufacturing
variable costs expensed = Total contribution margin.
Gross margin:
Selling price - variable manufacturing costs expensed - fixed manufacturing
costs expensed = Gross margin.
3. A company operating at “break-even” is probably not covering costs which are
not recorded in the accounting records. An example of such a cost is the
opportunity cost of owner-invested capital. In some small businesses, owner-
managers may not take a salary as large as the opportunity cost of forgone
alternative employment. Hence, the opportunity cost of owner labor may be
excluded.
4. In the short-run, without considering asset replacement, net operating cash
flows would be expected to exceed net income, because the latter includes
depreciation expense, while the former does not. Thus, the cash basis break-
even would be lower than the accrual break-even if asset replacement is
ignored. However, if asset replacement costs are taken into account, (i.e., on a
“cradle to grave” basis), the long-run net cash flows equal long-run accrual net
income, and the long-run break-even points are the same.
5. Both unit price and unit variable costs are expressed on a per product basis, as:
 = (P1 - V1) X1 + (P2 - V2) X2 +  + (Pn - Vn) Xn - F,
for all products 1 to n where:
 = operating profit,
P = average unit selling price,
V = average unit variable cost,
X = quantity of units,
F = total fixed costs for the period.
6. If the relative proportions of products (i.e., the product “mix”) is not held
constant, products may be substituted for each other. Thus, there may be almost
an infinite number of ways to achieve a target operating profit. As shown from
the multiple product profit equation, there are several unknowns for one
equation:

4-1
  = (P1 - V1) X1 + (P2 - V2) X2 +  + (Pn - Vn) Xn - F,
for all products 1 to n.
7. A constant product mix is assumed to simplify the analysis. Otherwise, there
may be no unique solution.
8. Operating leverage measures the impact on net operating income of a given
percentage change in sales. The degree of operating leverage at a given level of
sales is computed by dividing the contribution margin at that level of sales by
the net operating income.
9. Three approaches to break-even analysis are (a) the equation method, (b) the
contribution margin method, and (c) the graphical method. In the equation
method, the equation is: Sales = Variable expenses + Fixed expenses + Profits,
where profits are zero at the break-even point. The equation is solved to
determine the break-even point in units or peso sales.
10. The margin of safety is the excess of budgeted (or actual) sales over the break-
even volume of sales. It states the amount by which sales can drop before
losses begin to be incurred.
11. The sales mix is the relative proportions in which a company’s products are
sold. The usual assumption in cost-volume-profit analysis is that the sales mix
will not change.
12. A higher break-even point and a lower net operating income could result if the
sales mix shifted from high contribution margin products to low contribution
margin products. Such a shift would cause the average contribution margin
ratio in the company to decline, resulting in less total contribution margin for a
given amount of sales. Thus, net operating income would decline. With a
lower contribution margin ratio, the break-even point would be higher since it
would require more sales to cover the same amount of fixed costs.
13. The contribution margin (CM) ratio is the ratio of the total contribution margin
to total sales revenue. It can be used in a variety of ways. For example, the
change in total contribution margin from a given change in total sales revenue
can be estimated by multiplying the change in total sales revenue by the CM
ratio. If fixed costs do not change, then a peso increase in contribution margin
will result in a peso increase in net operating income. The CM ratio can also be
used in break-even analysis. Therefore, knowledge of a product’s CM ratio is
extremely helpful in forecasting contribution margin and net operating income.
14. Incremental analysis focuses on the changes in revenues and costs that will
result from a particular action.
15. All other things equal, Company B, with its higher fixed costs and lower
variable costs, will have a higher contribution margin ratio than Company A.
Therefore, it will tend to realize a larger increase in contribution margin and in
profits when sales increase.

4-2
 16. (a) If the selling price decreased, then the total revenue line would rise less
steeply, and the break-even point would occur at a higher unit volume. (b) If the
fixed cost increased, then both the fixed cost line and the total cost line would
shift upward and the break-even point would occur at a higher unit volume. (c)
If the variable cost increased, then the total cost line would rise more steeply
and the break-even point would occur at a higher unit volume.

II. Answers to Exercises

Exercise 1 (Contribution Format Income Statement)

Requirement 1
Total Per Unit
Sales (30,000 units × 1.15 = 34,500 units)...........................................................................
P172,500 P5.00
Less variable expenses...........................................................................................................
103,500 3.00
Contribution margin..............................................................................................................
69,000 P2.00
Less fixed expenses................................................................................................................
50,000
Net operating income............................................................................................................
P 19,000

Requirement 2
Sales (30,000 units × 1.20 = 36,000 units)...........................................................................
P162,000 P4.50
Less variable expenses...........................................................................................................
108,000 3.00
Contribution margin..............................................................................................................
54,000 P1.50
Less fixed expenses................................................................................................................
50,000
Net operating income............................................................................................................
P  4,000

Requirement 3
Sales (30,000 units × 0.95 = 28,500 units)...........................................................................
P156,750 P5.50
Less variable expenses...........................................................................................................
85,500 3.00
Contribution margin..............................................................................................................
71,250 P2.50
Less fixed expenses (P50,000 + P10,000).............................................................................
60,000
Net operating income............................................................................................................
P 11,250

Requirement 4
Sales (30,000 units × 0.90 = 27,000 units)...........................................................................
P151,200 P5.60
Less variable expenses...........................................................................................................
86,400 3.20
Contribution margin..............................................................................................................
64,800 P2.40
Less fixed expenses................................................................................................................
50,000
Net operating income............................................................................................................
P 14,800

Exercise 2 (Break-even Analysis and CVP Graphing)

4-3
Requirement 1

The contribution margin per person would be:

Price per ticket.......................................................................................................................
P30
Less variable expenses:
Dinner................................................................................................................................
P7
Favors and program..........................................................................................................
3 10
Contribution margin per person............................................................................................ P20

The fixed expenses of the Extravaganza total P8,000; therefore, the break-even
point would be computed as follows:
Sales = Variable expenses + Fixed expense + Profits

P30Q = P10Q + P8,000 + P0

P20Q = P8,000
Q = P8,000 ÷ P20 per person
Q = 400 persons; or, at P30 per person, P12,000

Alternative solution:
Break-even point Fixed expenses
in unit sales = Unit contribution margin
P8,000
= P20 per person

= 400 persons
or, at P30 per person, P12,000.

Requirement 2
Variable cost per person (P7 + P3)........................................................................................
P10
Fixed cost per person (P8,000 ÷ 250 persons)......................................................................
32
Ticket price per person to break even....................................................................................
P42
Requirement 3
Cost-volume-profit graph:

4-4
 P22,000

P20,000

P18,000
Total Sales
P16,000

Break-even point: 400 persons,

P14,000
or P12,000 in sales

P12,000
Pesos

P10,000 Total Expenses

Fixed Expenses
P8,000

P6,000

P4,000

P2,000

P0
0 100 200 300 400 500 600
Number of Persons

Exercise 3 (Break-even and Target Profit Analysis)

Requirement 1
Sales = Variable expenses + Fixed expenses + Profits
P900Q = P630Q + P1,350,000 + P0
P270Q = P1,350,000
Q = P1,350,000 ÷ P270 per lantern
Q = 5,000 lanterns, or at P900 per lantern, P4,500,000 in sales

Alternative solution:
Break-even point
in unit sales
Fixed expenses
= Unit contribution margin
P1,350,000
= P270 per lantern
4-5
= 5,000 lanterns
 or at P900 per lantern, P4,500,000 in sales

Requirement 2
An increase in the variable expenses as a percentage of the selling price would
result in a higher break-even point. The reason is that if variable expenses increase
as a percentage of sales, then the contribution margin will decrease as a percentage
of sales. A lower CM ratio would mean that more lanterns would have to be sold to
generate enough contribution margin to cover the fixed costs.

Requirement 3
Present: Proposed:
8,000 Lanterns 10,000 Lanterns*
Total Per Unit Total Per Unit
Sales P7,200,000 P900 P8,100,000 P810 **
Less variable expenses 5,040,000 630 6,300,000 630
Contribution margin 2,160,000 P270 1,800,000 P180
Less fixed expenses 1,350,000 1,350,000
Net operating income P 810,000 P 450,000

* 8,000 lanterns × 1.25 = 10,000 lanterns

** P900 per lantern × 0.9 = P810 per lantern

As shown above, a 25% increase in volume is not enough to offset a 10% reduction
in the selling price; thus, net operating income decreases.

Requirement 4
Sales = Variable expenses + Fixed expenses + Profits
P810Q = P630Q + P1,350,000 + P720,000
P180Q = P2,070,000
Q = P2,070,000 ÷ P180 per lantern
Q = 11,500 lanterns

Alternative solution:
Unit sales to attain Fixed expenses + Target profit
target profit = Unit contribution margin
P1,350,000 + P720,000
= P180 per lantern

= 11,500 lanterns

4-6
Exercise 4 (Operating Leverage)

Requirement 1
Sales (30,000 doors)..............................................................................................................
P18,000,000 P600
Less variable expenses...........................................................................................................
12,600,000 420
Contribution margin..............................................................................................................
5,400,000 P180
Less fixed expenses................................................................................................................
4,500,000
Net operating income............................................................................................................
P 900,000
Degree of operating Contribution margin
leverage = Net operating income
P5,400,000
= P900,000

= 6

Requirement 2
a. Sales of 37,500 doors represents an increase of 7,500 doors, or 25%, over
present sales of 30,000 doors. Since the degree of operating leverage is 6, net
operating income should increase by 6 times as much, or by 150% (6 × 25%).
b. Expected total peso net operating income for the next year is:
Present net operating income................................................................................................
P 900,000
Expected increase in net operating income next year
(150% × P900,000)...........................................................................................................
1,350,000
Total expected net operating income.....................................................................................
P2,250,000

Exercise 5 (Break-even Analysis; Target Profit; Margin of Safety)

Requirement 1
Sales = Variable expenses + Fixed expenses + Profits
P40Q = P28Q + P150,000 + P0
P12Q = P150,000
Q = P150,000 ÷ P12 per unit
Q = 12,500 units, or at P40 per unit, P500,000

Alternatively:
Break-even point Fixed expenses
in unit sales =
4-7Unit contribution margin
P150,000
= P12 per unit

= 12,500 units
 or, at P40 per unit, P500,000.

Requirement 2
The contribution margin at the break-even point is P150,000 since at that point it
must equal the fixed expenses.

Requirement 3
Unit sales to attain Fixed expenses + Target profit
target profit = Unit contribution margin
P150,000 + P18,000
= P12 per unit

= 14,000 units
Total Unit
Sales (14,000 units × P40 per unit).......................................................................................
P560,000 P40
Less variable expenses
(14,000 units × P28 per unit)............................................................................................
392,000 28
Contribution margin
(14,000 units × P12 per unit)............................................................................................
168,000 P12
Less fixed expenses................................................................................................................
150,000
Net operating income............................................................................................................
P 18,000

Requirement 4
Margin of safety in peso terms:
Margin of safety in pesos = Total sales – Break-even sales
= P600,000 – P500,000 = P100,000

Margin of safety in percentage terms:

Margin of safety Margin of safety in pesos
percentage = Total sales
P100,000
= P600,000

Requirement 5 = 16.7% (rounded)

4-8
The CM ratio is 30%.
Expected total contribution margin: P680,000 × 30%.........................................................
P204,000
Present total contribution margin: P600,000 × 30%............................................................
180,000
Increased contribution margin...............................................................................................
P 24,000

Alternative solution:
P80,000 incremental sales × 30% CM ratio = P24,000
Since in this case the company’s fixed expenses will not change, monthly net
operating income will increase by the amount of the increased contribution margin,
P24,000.

Exercise 6 (Changes in Variable Costs, Fixed Costs, Selling Price, and Volume)

Requirement (1)
The following table shows the effect of the proposed change in monthly advertising
budget:
Sales With
Additional
Current Advertising
Sales Budget Difference
Sales P225,000 P240,000 P15,000
Variable expenses............................... 135,000 144,000 9,000
Contribution margin........................... 90,000 96,000 6,000
Fixed expenses.................................... 75,000 83,000 8,000
Net operating income......................... P 15,000 P 13,000 P(2,000)
Assuming that there are no other important factors to be considered, the increase in
the advertising budget should not be approved since it would lead to a decrease in
net operating income of P2,000.
Alternative Solution 1
Expected total contribution margin:
P240,000 × 40% CM ratio..................................................... P96,000
Present total contribution margin:
P225,000 × 40% CM ratio..................................................... 90,000
Incremental contribution margin............................................... 6,000
Change in fixed expenses:
Less incremental advertising expense................................... 8,000
Change in net operating income................................................ P(2,000)
Alternative Solution 2
Incremental contribution margin:
P15,000 × 40% CM ratio...................................................... P 6,000

4-9
Less incremental advertising expense....................................... 8,000
Change in net operating income................................................ P(2,000)

Requirement (2)
The P3 increase in variable costs will cause the unit contribution margin to decrease
from P30 to P27 with the following impact on net operating income:
Expected total contribution margin with the higher-quality
components:
3,450 units × P27 per unit........................................................................... P93,150
Present total contribution margin:
3,000 units × P30 per unit........................................................................... 90,000
Change in total contribution margin............................................................... P 3,150
Assuming no change in fixed costs and all other factors remain the same, the
higher-quality components should be used.

Exercise 7 (Degree of Operating Leverage)

Requirement (1)
The company’s degree of operating leverage would be computed as follows:

Contribution margin......................................... P36,000

÷ Net operating income.................................... P12,000
Degree of operating leverage............................ 3.0
Requirement (2)
A 10% increase in sales should result in a 30% increase in net operating income,
computed as follows:
Degree of operating leverage......................................................................................
3.0
× Percent increase in sales.........................................................................................
10%
Estimated percent increase in net operating income................................................. 30%

Requirement (3)
The new income statement reflecting the change in sales would be:
Percent of
Amount Sales
Sales P132,000 100%
Variable expenses............................... 92,400 70%
Contribution margin........................... 39,600 30%
Fixed expenses.................................... 24,000
Net operating income......................... P 15,600

Net operating income reflecting change in sales................................................... P15,600

Original net operating income................................................................................
P12,000

4-10
Percent change in net operating income................................................................30%

Exercise 8 (Break-Even and Target Profit Analysis)

Requirement (1)
Variable expenses: P60 × (100% – 40%) = P36.

Requirement (2)
Selling price...................................................... P60 100%
Variable expenses.............................................. 36 60%
Contribution margin......................................... P24 40%
Let Q = Break-even point in units.
Sales = Variable expenses + Fixed expenses + Profits
P60Q = P36Q + P360,000 + P0
P24Q = P360,000
Q = P360,000 ÷ P24 per unit
Q = 15,000 units
In sales pesos: 15,000 units × P60 per unit = P900,000
Alternative solution:
Let X = Break-even point in sales pesos.
X = 0.60X + P360,000 + P0
0.40X = P360,000
X = P360,000 ÷ 0.40
X = P900,000
In units: P900,000 ÷ P60 per unit = 15,000 units
P60Q = P36Q + P360,000 + P90,000
P24Q = P450,000
Q = P450,000 ÷ P24 per unit
Q = 18,750 units
In sales pesos: 18,750 units × P60 per unit = P1,125,000

Alternative solution:
X = 0.60X + P360,000 + P90,000
0.40X = P450,000
X = P450,000 ÷ 0.40
X = P1,125,000
In units: P1,125,000 ÷ P60 per unit = 18,750 units
c. The company’s new cost/revenue relationships will be:

4-11
 Selling price........................................................................... P60 100%
Variable expenses (P36 – P3)................................................. 33 55%
Contribution margin.............................................................. P27 45%
P60Q = P33Q + P360,000 + P0
P27Q = P360,000
Q = P360,000 ÷ P27 per unit
Q = 13,333 units (rounded).
In sales pesos: 13,333 units × P60 per unit = P800,000 (rounded)
Alternative solution:
X = 0.55X + P360,000 + P0
0.45X = P360,000
X = P360,000 ÷ 0.45
X = P800,000
In units: P800,000 ÷ P60 per unit = 13,333 units (rounded)
Requirement (3)
Break-even point in Fixed expenses
a. unit sales = Unit contribution margin

= P360,000  P24 per unit = 15,000 units

In sales pesos: 15,000 units × P60 per unit = P900,000

Alternative solution:
Break-even point in Fixed expenses
sales pesos = CM ratio

= P360,000  0.40 = P900,000

In units: P900,000 ÷ P60 per unit = 15,000 units

Unit sales to attain Fixed expenses + Target profit

b. =
target profit Unit contribution margin
= (P360,000 + P90,000)  P24 per unit
= 18,750 units
In sales pesos: 18,750 units × P60 per unit = P1,125,000

Alternative solution:
Peso sales to attain Fixed expenses + Target profit
target profit = CM ratio

= (P360,000 + P90,000)  0.40

= P1,125,000
4-12
 In units: P1,125,000 ÷ P60 per unit = 18,750 units

c. Break-even point in Fixed expenses

unit sales = Unit contribution margin

= P360,000  P27 per unit

= 13,333 units (rounded)
In sales pesos: 13,333 units × P60 per unit = P800,000 (rounded)

Alternative solution:
Break-even point in Fixed expenses
sales pesos = CM ratio

= P360,000  0.45
= P800,000
In units: P800,000 ÷ P60 per unit = 13,333 (rounded)

III. Answers to Multiple Choice Questions

1. B 6. B 11. B 16. D 21. A 26. A

2. B 7. D 12. A 17. D 22. D 27. B
3. B 8. B 13. A 18. D 23. C 28. C
4. C 9. A 14. A 19. C 24. B 29. B
5. C 10. D 15. D 20. D 25. C 30. A

IV. Answers to Problems

Problem 1

Requirement 1: Break-even chart

600,000 TR

500,000
TC
400,000
(P)
Break-even
300,000 point
4-13
200,000

FC
100,000

5,000 10,000 15,000 20,000 25,000 30,000

(units)
Requirement 2: Profit-volume graph

250,000

P 200,000
R
O
F 150,000
I
T
100,000

50,000 Break-even
point

0
5,000 10,000 15,000 20,000 25,000 30,000
50,000

100,000
L
O 150,000
S
S
200,000

250,000

4-14
Problem 2 (CVP Relationships)

Requirement 1
Contribution margin P15
CM ratio = Selling price = P60 =
25%
Variable expense P45
Requirement
Variable 2 ratio
expense = Selling price = P60 =
Sales = Variable expenses + Fixed expenses + Profits 75%
P60Q = P45Q + P240,000 + P0
P15Q = P240,000
Q = P240,000 ÷ P15 per unit
Q = 16,000 units, or at P60 per unit, P960,000

Alternative solution:
X = 0.75X + P240,000 + P0
0.25X = P240,000
X = P240,000 ÷ 0.25
X = P960,000; or at P60 per unit, 16,000 units

Requirement 3
Increase in sales........................................................... P400,000
Multiply by the CM ratio............................................. x 25%
Expected increase in contribution margin................... P100,000
Since the fixed expenses are not expected to change, net operating income will
increase by the entire P100,000 increase in contribution margin computed above.

Requirement 4
Sales = Variable expenses + Fixed expenses + Profits
P60Q = P45Q + P240,000 + P90,000
P15Q = P330,000
Q = P330,000 ÷ P15 per unit
Q = 22,000 units

Contribution margin method:

Fixed expenses + Target profit P240,000 + P90,000
Contribution margin per unit = P15 per unit = 22,000 units

Requirement 5
Margin of safety in pesos = Total sales – Break-even sales
= P1,200,000 – P960,000 = P240,000
Margin of safety Margin of safety in pesos P240,000
percentage = Total sales = P1,200,000 = 20%
4-15
Requirement 6

Degree of operating leverage = Contribution margin P300,000

a. = = 5
Net operating income P60,000
b. Expected increase in sales................................................... 8%
Degree of operating leverage.............................................. x 5
Expected increase in net operating income........................ 40%

c. If sales increase by 8%, then 21,600 units (20,000 x 1.08 = 21,600) will be sold
next year. The new income statement will be as follows:
Percent of
Total Per Unit Sales
Sales (21,600 units)............... P1,296,000 P60 100%
Less variable expenses........... 972,000 45 75%
Contribution margin.............. 324,000 P15 25%
Less fixed expenses................ 240,000
Net operating income............. P 84,000
Thus, the P84,000 expected net operating income for next year represents a
40% increase over the P60,000 net operating income earned during the current
year:
P84,000 – P60,000 P24,000
P60,000 = P60,000 = 40% increase

Note from the income statement above that the increase in sales from 20,000 to
21,600 units has resulted in increases in both total sales and total variable
expenses. It is a common error to overlook the increase in variable expense
when preparing a projected income statement.

Requirement 7
a. A 20% increase in sales would result in 24,000 units being sold next year:
20,000 units x 1.20 = 24,000 units.
Percent of
Total Per Unit Sales
Sales (24,000 units)............... P1,440,000 P60 100%
Less variable expenses........... 1,152,000 48* 80%
Contribution margin.............. 288,000 P12 20%
Less fixed expenses................ 210,000†
Net operating income............. P 78,000

* P45 + P3 = P48; P48  P60 = 80%.

†
P240,000 – P30,000 = P210,000.

4-16
 Note that the change in per unit variable expenses results in a change in both the per unit contribution
margin and the CM ratio.

b. Break-even point Fixed expenses

in unit sales = Contribution margin per unit
P210,000
= P12 per unit
= 17,500 units
Break-even point Fixed expenses
in peso sales = CM ratio
P210,000
= 0.20
P1,050,000
=
c. Yes, based on these data the changes should be made. The changes will
increase the company’s net operating income from the present P60,000 to
P78,000 per year. Although the changes will also result in a higher break-even
point (17,500 units as compared to the present 16,000 units), the company’s
margin of safety will actually be wider than before:
Margin of safety in pesos = Total sales – Break-even sales
= P1,440,000 – P1,050,000 = P390,000
As shown in requirement (5) above, the company’s present margin of safety is
only P240,000. Thus, several benefits will result from the proposed changes.

Problem 3 (Basics of CVP Analysis; Cost Structure)

Requirement 1

The CM ratio is 30%.

Total Per Unit Percentage
Sales (13,500 units) P270,000 P20 100 %
Less variable expenses 189,000 14 70
Contribution margin P 81,000 P 6 30 %

The break-even point is:

Sales = Variable expenses + Fixed expenses + Profits
P20Q = P14Q + P90,000 + P0
P 6Q = P90,000
Q = P90,000 ÷ P6 per unit
Q = 15,000 units
15,000 units × P20 per unit = P300,000 in sales
Alternative solution:
Break-even point Fixed expenses
in unit sales = Contribution margin per unit
4-17
P90,000
= P6 per unit

= 15,000 units
 Break-even point Fixed expenses
in sales pesos = CM ratio
P90,000
= 0.30

= P300,000 in sales
Requirement 2
Incremental contribution margin:
P70,000 increased sales × 30% CM ratio.........................................................................
P21,000
Less increased fixed costs:
Increased advertising cost.................................................................................................
8,000
Increase in monthly net operating income............................................................................
P13,000
Since the company presently has a loss of P9,000 per month, if the changes are
adopted, the loss will turn into a profit of P4,000 per month.

Requirement 3
Sales (27,000 units × P18 per unit*).....................................................................................
P486,000
Less variable expenses
(27,000 units × P14 per unit)............................................................................................
378,000
Contribution margin..............................................................................................................
108,000
Less fixed expenses (P90,000 + P35,000).............................................................................
125,000
Net operating loss..................................................................................................................
P(17,000)
*P20 – (P20 × 0.10) = P18

Requirement 4
Sales = Variable expenses + Fixed expenses + Profits
P 20Q = P14.60Q* + P90,000 + P4,500
P5.40Q = P94,500
Q = P94,500 ÷ P5.40 per unit
Q = 17,500 units
* P14.00 + P0.60 = P14.60.
Alternative solution:
Unit sales to attain Fixed expenses + Target profit
target profit = CM per unit
P90,000 + P4,500
= P5.40 per unit**

= 17,500
4-18 units
 ** P6.00 – P0.60 = P5.40.

Requirement 5

a. The new CM ratio would be:

Per Unit Percentage
Sales P20 100 %
Less variable expenses 7 35
Contribution margin P13 65 %

The new break-even point would be:

Break-even point Fixed expenses
in unit sales = Contribution margin per unit
P208,000
= P13 per unit

= 16,000 units
Break-even point Fixed expenses
in sales pesos = CM ratio
P208,000
= 0.65

= P320,000 in sales
b. Comparative income statements follow:
Not Automated Automated
Total Per Unit % Total Per Unit %
Sales (20,000 units) P400,000 P20 100 P400,000 P20 100
Less variable expenses 280,000 14 70 140,000 7 35
Contribution margin 120,000 P 6 30 260,000 P13 65
Less fixed expenses 90,000 208,000
Net operating income P 30,000 P 52,000

c. Whether or not one would recommend that the company automate its
operations depends on how much risk he or she is willing to take, and depends
heavily on prospects for future sales. The proposed changes would increase the
company’s fixed costs and its break-even point. However, the changes would
also increase the company’s CM ratio (from 30% to 65%). The higher CM
ratio means that once the break-even point is reached, profits will increase
more rapidly than at present. If 20,000 units are sold next month, for example,

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 the higher CM ratio will generate P22,000 more in profits than if no changes
are made.
The greatest risk of automating is that future sales may drop back down to
present levels (only 13,500 units per month), and as a result, losses will be even
larger than at present due to the company’s greater fixed costs. (Note the
problem states that sales are erratic from month to month.) In sum, the
proposed changes will help the company if sales continue to trend upward in
future months; the changes will hurt the company if sales drop back down to or
near present levels.
Note to the Instructor: Although it is not asked for in the problem, if time
permits you may want to compute the point of indifference between the two
alternatives in terms of units sold; i.e., the point where profits will be the same
under either alternative. At this point, total revenue will be the same; hence,
we include only costs in our equation:
Let Q = Point of indifference in units sold
P14Q + P90,000 = P7Q + P208,000
P7Q = P118,000
Q = P118,000 ÷ P7 per unit
Q = 16,857 units (rounded)
If more than 16,857 units are sold, the proposed plan will yield the greatest profit; if
less than 16,857 units are sold, the present plan will yield the greatest profit (or the
least loss).

Answer to Test Material 4-1

Requirement 1

The CM ratio is 60%:

Selling price P150 100%
Less variable expenses 60 40
Contribution margin P 90 60%

Requirement 2
Break-even point Fixed expenses
in total sales pesos = CM ratio
P1,800,000
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= 0.60

= P3,000,000 in sales
Requirement 3
P450,000 increased sales × 60% CM ratio = P270,000 increased contribution
margin. Since fixed costs will not change, net operating income should also
increase by P270,000.

Requirement 4
P2,160,000
a. Degree of operating leverage = Contribution margin = P360,000 = 6
Net operating income
b. 6 × 15% = 90% increase in net operating income.

Requirement 5
Last Year: Proposed:
28,000 units 42,000 units*
Total Per Unit Total Per Unit
Sales P4,200,000 P150.00 P5,670,000 P135.00**
Less variable expenses
1,680,000 60.00 2,520,000 60.00
Contribution margin 2,520,000 P 90.00 3,150,000 P 75.00
Less fixed expenses 1,800,000 2,500,000
Net operating income P 720,000 P 650,000
* 28,000 units × 1.5 = 42,000 units
** P150 per unit × 0.90 = P135.00 per unit
No, the changes should not be made.

Requirement 6
Expected total contribution margin:
28,000 units × 200% × P70 per unit*...............................................................................
P3,920,000
Present total contribution margin:
28,000 units × P90 per unit...............................................................................................
2,520,000
Incremental contribution margin, and the amount by which
advertising can be increased with net operating income
remaining unchanged........................................................................................................
P1,400,000
* P150 – (P60 + P20) = P70

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 Answer to Test Material 4-2

Requirement 1
The contribution margin per patch would be:
Selling price...........................................................................................................................
P30
Less variable expenses:
Purchase cost of the patches..............................................................................................
P15
Commissions to the student salespersons.........................................................................
6 21
Contribution margin..............................................................................................................
P 9
Since there are no fixed costs, the number of unit sales needed to yield the desired
P7,200 in profits can be obtained by dividing the target profit by the unit
contribution margin:
Target profit P7,200
Unit contribution margin = P9 per patch = 800 patches

800 patches x P30 per patch = P24,000 in total sales

Requirement 2

Since an order has been placed, there is now a “fixed” cost associated with the
purchase price of the patches (i.e., the patches can’t be returned). For example, an
order of 200 patches requires a “fixed” cost (investment) of P3,000 (200 patches ×
P15 per patch = P3,000). The variable costs drop to only P6 per patch, and the new
contribution margin per patch becomes:
Selling price...........................................................................................................................
P30
Less variable expenses (commissions only).......................................................................... 6
Contribution margin..............................................................................................................
P24

Since the “fixed” cost of P3,000 must be recovered before Ms. Morales shows any
profit, the break-even computation would be:
Break-even point Fixed expenses
in unit sales = Unit contribution margin

P3,000
= P24 per patch = 125 patches
125 patches x P30 per patch = P3,750 in total sales

If a quantity other than 200 patches were ordered, the answer would change
accordingly.

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