CHAPTER 6

FINANCIAL MODELING FOR SHORT-TERM DECISION MAKING

Questions, Exercises, Problems, and Cases: Answers and Solutions
6.1

See text or glossary at the end of the book.

6.2

Operating profit = Sales revenue Variable cost Fixed cost

6.3

The unit contribution margin is the excess of the unit price over the unit
variable costs. The total contribution margin is the excess of total
revenue over total variable costs.

6.4

Assumptions:
1.

Revenues change proportionately with volume.

2.

Variable costs change proportionately with volume.

3.

Fixed costs do not change at all with volume.

(Other assumptions may include constant product mix and/or all CVP
costs are expensed.)

6-1

Solutions

6.5

Question

Breakeven Point

a.

Raises.
The contribution

Unit Contribution
Margin
No Effect.

Expected
Total Profit
Decreases.
More
of

the
margin (denominator) is fixed
while fixed costs
(numerator) are
increased.

contribution
margin
must be
used to
cover

fixed
b.

c.

d.
e.

6.6

Lowers.
A decrease in
variable costs
per unit increases contribution margin
per unit.
Lowers.
Increasing sales
price increases
contribution
margin.
No Effect.
Raises.
Increasing fixed
costs increases
breakeven point.

Increases.

costs.
Increases.

Increases.

Increases.

No Effect.
No Effect.

Increases.
Decreases.
More of the
contribution
margin
must be
used to cover
fixed costs.

Total contribution margin: Selling price variable manufacturing costs

variable nonmanufacturing costs = Total
contribution margin.
Gross margin:

Selling price variable manufacturing costs fixed

manufacturing costs = Gross margin.

6.7

Profit-volume analysis plots only the profit/loss line against volume, while
cost-volume-profit analysis plots total revenue and total costs against
volume. Profit-volume analysis is a simpler, but less complete, method of
presentation.

6.8

Spreadsheets make sensitivity analysis easier. Spreadsheets enable us to

see a range of possible outcomes given different values of the variables
used in the financial model.

Solutions

6-2

6.9

Both unit prices and unit variable costs (and resulting unit contribution
margin) are expressed on a per product basis as:
Operating Profit = (Product 1 unit contribution margin X Product 1
sales volume) + (Product 2 unit contribution margin X Product 2 sales
volume) Fixed costs

6.10

There are two ways to change the breakeven point for any company:
increase contribution or decrease fixed costs. A company can increase
contribution margin per unit by raising prices or reducing variable costs
per unit. However, price increases may decrease total contribution
because of lost sales. This is the situation faced by many companies that
have to lower variable costs to increase contribution margins and/or lower
total fixed costs in order to lower their breakeven points.

6.11

Costs that are "fixed in the short run" are usually not fixed in the long run.
In fact few, if any, costs are fixed (i.e., remain unchanged) over a very
long time horizon.

6.12

The accountant makes use of a linear representation to simplify the

analysis of costs and revenues. Generally, the accounting models which
record costs and form the basis for accounting reports are designed to
incorporate considerations of fixed and variable costs as well as a
constant sales price.
These simplifying assumptions are generally
reasonable within a relevant range of activity. Within this range, it is
generally believed that the additional costs required to employ nonlinear
analysis cannot be justified in terms of the benefits obtained. Thus,
within this range, the linear model is considered the "best" in a cost
benefit sense.

6.13

a.
b.
c.
d.

(2)
(1)
(1)
(1)*

*Assuming:

e.
f.
g.
h.

(4)
(5)
(2)
(1)

i. (4)
j. (5)*
k. (1)

Fixed costs > 0 and

Fixed costs < Total contribution margin before the change.

6.14

A company operating at "breakeven" 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 do not take a salary as large as the opportunity cost of
foregoing alternative employment.

6.15

A constant product mix is assumed to simplify the analysis. Otherwise,

there may be nearly an infinite number of solutions.

6-3

Solutions

6.16

The sum of the breakeven quantities would not be the breakeven point for
the company if there are common fixed costs which have not been
allocated to the products.

6.17

A negative contribution margin arises when variable cost exceeds the

units selling pricea common occurrence with the marketing procedure
known as a loss leader. With a loss leader, the retailer may intentionally
take a loss on selected products in hopes of generating additional store
traffic and customers. The goal is for an increase in sales of other items
(e.g., tennis racquets, golf clubs, athletic wear) and profits.

6.18

(Breakeven and target profits.)

a.

Contribution Margin (per Unit)

= Unit Selling Price Unit Variable Cost
= $16 $8
= $8.
Profit = (Contribution Margin per Unit X Units) Fixed Costs
$0 = ($8 X Units) $200,000
Units = 25,000.

b.

c.

$280,000 = ($8 X Units) $200,000

$480,000 = $8 X Units
60,000 = Units.
Profit = (.5* X $2,000,000) $200,000
= $800,000.
*Contribution Margin Ratio:
=
= = = 0.5 = 50%.

6.19

Solutions

(Cost-volume-profit; volume defined in sales dollars.)

6-4

a.

$2,100,000 $660,000 = $1,440,000

$1,440,000/$3,000,000 = 0.48 = 48%.

b.

Breakeven Revenue

Contribution Margin Ratio

= ($3,000,000 - $1,440,000)/$3,000,000
= .52

Breakeven Revenue

$660,000/.52

= $1,269,231.

Revenue

c.

Breakeven
Point
$1,269,231

1,500,000

Total Cost

1,200,000
$ of
Revenue 900,000
and Costs
660,000
600,000
300,000
0
600,000
1,200,000
1,800,000
300,000
900,000
1,500,000
$ of Revenue

6.20

d.

Profit = (.52 X $2,500,000) $660,000 = $640,000.

e.

Sales = $1,660,000/.52 = $3,192,308.

(Cost-volume-profit graph.)

6-5

Solutions

Total Revenue
Line b

Profit g
Area

Breakeven Point f
Slope =
Variable Cost
per Unit d

Total Costs
Line a
Loss h
Area

Total Variable Costs Area c

Total FixedCosts Area e

Loss
h Volume
6.21

Solutions

Breakeven Point

(Profit-volume graph.)
a.

Total fixed costs.

b.

Breakeven point.

c.

Slope = contribution margin per unit.

d.

Profit line.

e.

Net income area.

f.

Net loss area.

g.

Zero net income line.

6-6

Profit
g Volume

6.22

(Cost--volume-profit analysis.)
a.

$5,000,000 1,000,000 Units = $5 per Unit.

b.

$3,000,000 1,000,000 Units = $3 per Unit.

c.

$5 $3 = $2 per Unit.

d.

Operating Profit = [(Sales Price per Unit Variable Cost per Unit) X
Unit Sales] Fixed Cost
0 = [($5 $3) X Unit Sales] $1,000,000
Unit Sales = $1,000,000/$2 = 500,000 Units.

e.

After Tax Profit/(1 t) = Before Tax Profit

$1,200,000/(1 .4) = Before Tax Profit
$2,000,000 = Before Tax Profit
Then, go back to equation shown in Part d. above and set operating
profit to $2,000,000 as follows:
$2,000,000 = [($5 $3) X Unit Sales] $1,000,000
Unit Sales = $3,000,000/$2 = 1,500,000 Units.

6.23

(Breakeven and target profits; volume defined in sales dollars.)

6-7

Solutions

a.

Sales = $300,000/.40 = $750,000.

b.

Sales = $300,000/.25 = $1,200,000.

c.

Sales = ($300,000 + $100,000)/.4

= $1,000,000.

Solutions

6-8

6.24

(CVPSensitivity analysis.)
a.

Breakeven Point in Units

=
= $400,000/($200- $120)
= $400,000/$80 = 5,000 Students.

b.

Target Profit Point in Units

=
= ($400,000 + $200,000)/$80
= 7,500 Students.

c. (1) Profit = [($200 $120) X 8,000] $400,000

= $240,000.
(2) 10% price decrease. Now price = $180
Profit = [($180 $120) X 8,000] $400,000
= $80,000.
Profit decreases by $160,000 (67%).
20% price increase. Now price = $240
Profit = [($240 $120) X 8,000] $400,000
= $560,000.
Profit increases by $320,000 (133%).
(3) 10% variable cost decrease. Now variable cost = $108
Profit = [($200 $108) X 8,000] $400,000
= $336,000.
Profit increases by $96,000 (40%).

6-9

Solutions

6.24 c. continued.
20% variable cost increase. Now variable cost = $144
Profit = [($200 $144) X 8,000] $400,000
= $48,000.
Profit decreases by $192,000 (80%).
(4) Profit = [($200 $132) X 8,000] $360,000
= $184,000.
Profit decreases by $56,000 (23%).

6.25

Solutions

(Multiple product profit analysis.)

6-10

a.

b.

Chicken
Burritos
(200,000)($4) +
(200,000)($2) +
(200,000)($2) +

Steak
Burritos
Total
(300,000)($6) = $ 2,600,000
(300,000)($3) =
(300,000)($3)
$1,300,000
200,000
$1,100,000

1,300,000

Weighted Average Unit Contribution Margin

= (0.4)($2) + (0.6)($3)
= $0.80 + $1.80
= $2.60,
where 0.4 = 200,000 chicken/(200,000 chicken + 300,000 steak)
and 0.6 = 300,000 chicken/(200,000 chicken + 300,000 steak)

Breakeven Point in Units

=
= 200,000/$2.60
= 76,923 total units
Chicken Burritos:
Steak Burritos:

(0.4)(76,923) = 30,769 Units.

(0.6)(76,923) = 46,154 Units.

6-11

Solutions

6.25 continued.
c.

Weighted Average Unit Contribution Margin (answers are rounded)

()($2) + ()($3)
= (0.8)($2) + (0.2)($3)
= $1.60 + $0.60

= $2.20.
Breakeven Point in Units =
= $200,000/$2.20
= 90,910 Total Units
Chicken Burritos:
Steak Burritos:
6.26

(0.8)(90,190) = 72,728 Units.

(0.2)(90,190) = 18,182 Units.

(Multiple product profit analysis.)

a.

TR = $27X
Slope = $27
TC = $48,000 + $17X

48,000

Slope = $17

Units
A Unit = production of one product R,
two product Q's, and
three product P's.
Variable Cost per Unit = (3 X $2) + (2 X $3) + (1 X $5) = $17.
Revenue per Unit = (3 X $3) + (2 X $5) + (1 X $8) = $27.

Solutions

6-12

6.26 continued.
b.

0 = Total Revenue Total Cost

0 = $27X ($17X + $48,000)
$10X = $48,000
X =

4,800 Units.

Not Required:
Total Revenue at Break-even Level = 4,800 Units X $27 = $129,600.
c.
A Unit = two product P's,
two product Q's, and
one product R.
Variable Cost per Unit =
Revenue per Unit =

(2 X $2) + (2 X $3) + (1 X $5) = $15.

(2 X $3) + (2 X $5) + (1 X $8) = $24.

0=

Total Revenue Total Cost

0=

$24X ($15X + $48,000)

$9X =
X=

$48,000
5,333.33 Units.

Not Required:
Total Revenue at Break-even Level = 5,333.33 Units X $24 =
$128,000.

6-13

Solutions

6.27

(Solving for cost-based selling price.)

Cost-based Price

= $15 X 1.5

= $22.50
a.

At 10,000 units: ($22.50 - $15 - $2) 10,000 units ($50,000 +

$75,000)
= $(70,000).

b.
At 20,000 units: ($22.50 - $15 - $2) 20,000 units ($50,000 +
$75,000)
= $(15,000).
c. The company shows losses at both volumes. The loss is lower at
20,000 units, but there is still a loss. A break-even analysis shows that
the break even point is:
Break even quantity = $125,000/$5.50
= 22,727 units.
Of course, we assume that fixed costs do not increase as volume
increases and that the price and variable costs per unit are linear with
respect to volume.

Solutions

6-14

6.28

(Explaining sales and cost changes.)

Dear Uncle Y:
The contribution increased by $25,000 between years 1 and 2. Here are
the analyses of revenue and variable costs:
Revenue Increase:
Ride hours in Year 1 = $750,000/$10 = 75,000.
Ride hours in Year 2 = $840,000/$12 = 70,000.
In Year 2, ride hours decreased by 5,000 but the admission price
increased by $2 per person per hour, resulting in a net increase of
$90,000 in revenue. The decline in number of hours is a bit troubling, but
we more than made up for the decline in hours with the price increase.
The analysis below shows that the variable costs increased per hour:
Increase in Variable Costs of Operations:
Costs in Year 1 $495,000/75,000 = $6.60 per ride hour.
Costs in Year 2 $560,000/70,000 = $8.00 per ride hour.
So, in Year 2, volume decreased by 5,000 hours but variable costs
increased by $1.40 per ride hour, resulting in a net increase of $65,000 in
costs.
Overall, the company is performing well. Thanks again for the loan.
Your loving nephew,
X

6-15

Solutions

6.29

(CVP Analysis and Financial Modeling.)

a.

Breakeven Point (in Units) =

$600,000/[$16 ($10 + $2)] = 150,000 Units.

b.

Net Income Based on 240,000 Units (200,000 X 1.2):

Sales (at $16 per Unit)........................................................ $3,840,000
Less Variable Costs (at $12 per Unit).................................. 2,880,000
Contribution Margin............................................................. $ 960,000
Less Fixed Costs..................................................................
600,000
Operating Profit................................................................... $ 360,000

c.

Number of Units =
= ($600,000 + $200,000)/[$16 ({$10 X 1.3} + $2)]
= 800,000 Units
Revenue = 800,000 X $16
= $12,800,000

d.

Solutions

Yes.
Paralleling the requirements of Parts b. and c., a model
integrates a companys financial relationships through a series of
equations, allowing a user to study the interaction of variations in
economic variables.
The user can thus assess the outcome of
numerous what-if scenarios without ever having to implement what
could be a disastrous business decision.

6-16

6.30

(CVPmissing data.)
a.

Let P = unit selling price that will yield a projected $300,000 profit.
Total sales total costs

= projected profit

200,000P $1,260,000 = $300,000

200,000P
P

b.

= $1,560,000
= $7.80 per unit.

Let PX = total dollar sales that will yield a projected 20% profit on
sales.
Total sales variable costs fixed costs = projected profit:
PX 0.6PX $420,000 = 0.2PX
0.4PX 0.2PX = $420,000
PX = $2,100,000 sales.

6.31

(CVP Analysis.)

6-17

Solutions

a.

The Deluxe system would be more profitable, as shown below.

Sales...........................................................
Less Variable Costs:
150,000 Units X $8.00.............................
150,000 Units X $6.40.............................
Commissions...........................................
Total Variable Cost......................................
Contribution Margin....................................
Less Fixed Costs.........................................
Net Income.................................................

b.

Breakeven Point in Units

Basic
Deluxe
$4,800,000 $5,700,000
$1,200,000
$ 960,000
480,000
570,000
$1,680,000 $1,530,000
$3,120,000 $4,170,000
520,000
672,000
$2,600,000 $3,498,000

=
= $672,000/[$38 ($6.40 + {$38 X 0.10})]
= 24,173 Units.

c.

Straight-line depreciation associated with the new equipment would

increase fixed costs by $22,400 (= $224,000/10 years). Thus,
Number of Units =
= ($520,000 + $22,400 + $40,000)/{$32 [$8 + ($32 x .10)]}
= $582,400/($32 - $11.20)
= 28,000 units.

d.

The point of indifference will produce equal levels of profitability. On

the basis of the information presented in Part a., the Basic system has
a unit contribution margin of $20.80 (= $3,120,000/150,000 units),
and the Deluxe system has a unit contribution margin of $27.80 (=
$4,170,000/150,000 units). Thus, if X = the required quantity at
which you are indifferent:
$20.80X $520,000 = $27.80X $672,000
$7.00X = $152,000
X = 21,714 Units.

6.32

(CVP with taxes.)

a.

Solutions

Sales .........................................
Variable Costs............................

6-18

$1,000,000 (= $40 X 25,000)

412,500 (= $16.50 X 25,000)

Contribution Margin....................
Fixed Costs.................................
Before-Tax Profit........................
Taxes (35% Rate).......................
After-Tax Profit...........................
b.

Breakeven in Units

$ 587,500
150,000
$ 437,500
153,125
$ 284,375

=
=
= $97,500/$15.275
= 6,383 Units (Rounded)

c.

d.

Sales ..........................................
Variable Costs..............................
Contribution Margin.....................
Fixed Costs..................................
$40,000)
Before-Tax Profit..........................
Taxes (35% Rate)........................
After-Tax Profit............................
Breakeven in Units

$1,120,000 (= $40 X 28,000)

462,000 (= $16.50 X 28,000)
$ 658,000
190,000 (=
$150,000
+
$ 468,000
163,800
$ 304,200

=
= [$190,000 (1 0.35)]/[($40 $16.50)(1-0.35)]
= $123,500/$15.275
= 8,085 Units (Rounded)

Breakeven in
Sales Dollars

= Sales Units X Sales Price

= 8,085 X $40
= $323,400

6-19

Solutions

e.

Target Profit in Units

=
= [($190,000 + $437,500)(1 0.35)]/

$15.275
= $407,875/$15.275
= 26,702 Units (Rounded)
Target Profit in Sales Dollars = Sales Units X Sales Price
= 26,702 X $40
= $1,068,080
f.

Sales ............................................
Variable Costs................................
Contribution Margin.......................
Advertising Costs...........................
Other Fixed Costs...........................
Before-Tax Profit............................
Taxes (35% Rate)...........................
After-Tax Profit...............................

$1,120,000 (= $40 X 28,000)

462,000 (= $16.50 X 28,000)
$ 658,000
?
150,000
$ 115,385 [= $75,000/(1 .35)]
40,385
$ 75,000

To find the maximum advertising cost to maintain after-tax profit of

$75,000, solve as follows:
Contribution Margin ($658,000) Advertising Costs Other Fixed
Costs ($150,000) = Before-Tax Profits ($115,385)
$658,000 $150,000 $115,385 = Advertising Costs
Maximum Advertising Costs = $392,615.

Solutions

6-20

6.33

(CVPmissing data; assumptions.)

a.
Revenues =
Net Income X9 =

Year 8

Year 9

$4,704,000

$4,725,000
.02 X $4,725,000 = $94,500.

Net Income X8 =

Net Income X9 + $129,500

= $94,500 + $129,500 = $224,000.

Year 8

Year 9

Average Total Cost

$2.20
$2.205
Total Cost =
$2.2 X Units Sold
$2.205 X Units Sold
Units Produced $224,000 = $4,704,000 $2.2X8 $94,500 = $4,725,000 $2.205X9
X8 = $4,480,000/$2.2
X9 = $4,630,500/$2.205
X8 = 2,036,364 Units
X9 = 2,100,000 Units
$4,704,000/2,036,364 units
= $2.31

b.

$4,725,000/2,100,000 units
= $2.25

The total fixed and variable cost per unit cannot be determined for
Year 9. The number of units produced and sold decreased while total
cost increased.
Assuming the total cost function is linear, this
suggests that the total cost function shifted upward in Year 9. We
cannot determine whether this increase resulted from an increase in
fixed cost, an increase in variable cost per unit, or a combination of
the two. The possibilities are illustrated in the graph.

Total
Cost
a

$4,630,000
a

$4,480,000

Year 9b

Year 9a
Year 8

224,000
210,000
Units Sold
Year 9a:
Year 9b:

Represents the cost curve if only fixed costs had increased.

Represents the cost curve if variable cost per unit
increased.

If costs increased by some combination of the two, the new cost curve
would lie between the lines Year 9a and 9b.
aTotal costs = total revenue profits.

6-21

Solutions

6.34

(Alternatives to reduce breakeven sales.)

a.

Variable Costs = Revenues Fixed Costs

= $2,250,000 $1,000,000
= $1,250,000.
Total Contribution Margin

= Revenues Variable Costs

= $2,250,000 $1,250,000
= $1,000,000.

OR
Breakeven point is where the total contribution margin equals total
fixed costs. Thus, if fixed costs equal $1,000,000, then the total
contribution margin must equal $1,000,000 at the breakeven point.
b.

Alternative A
Sales [$2,250,000 ($2,250,000 X 10%)]............................ $2,025,000
Variable Costs..................................................................... 1,250,000
Total Contribution Margin.................................................... $ 775,000
Contribution Margin Ratio

=
= $775,000/$2,025,000
= .38

Breakeven Point in Dollars =

= =800,000*/.38
= $2,105,263.
*$800,000 = $1,000,000 $200,000.

Solutions

6-22

6.34 continued.
c.

Alternative B
Sales ................................................................................. $2,250,000
Variable Costs (.95)($1,250,000)......................................... 1,187,500
Total Contribution Margin.................................................... $1,062,500
Contribution Margin Ratio

= $1,062,500/$2,250,000 = .47

Breakeven Point in Dollars = $1,300,000*/.47

= $2,765,957.
*$1,300,000 = $1,000,000 + $300,000.
d.

6.35

The company should choose the alternative that yields the

greatest profit in the projected relevant range, probably
Alternative A.

(CVP analysis with semifixed [step] costs.)

a.

Breakeven points:
Breakeven Unit Sales =
Breakeven Units (Level 1) = $40,000/($20 - $12) = 5,000 Units
Breakeven Units (Level 2) = $80,000/($20 - $12) = 10,000 Units
Breakeven Units (Level 3) = $100,000/($20 - $12) = 12,500 Units
Levels 2 and 3 provide a profit for the entire
range of activity, hence, there is no breakeven
point for either of these levels.

b.

Profit:
Level 1 (10,000 units): (10,000 X $8) $40,000 = $40,000
Level 2 (25,000 units): (25,000 X $8) $80,000 = $120,000
Level 3 (40,000 units): (40,000 X $8) $100,000 = $220,000
Profit is optimal at Level 3.

6-23

Solutions

6.36

(CVP analysis with semifixed costs and changing unit variable

costs.)
a.

First find the unit contribution margin last year:

Profit

= Total Sales Total Variable Cost Fixed Cost

$200,000 = ($50)(15,000 units) V(15,000 units) $100,000

(Level 1)
where V = Variable Cost per Unit
$200,000 = $750,000 V(15,000 units) $100,000
V(15,000 units) = $750,000 $100,000 $200,000
V = $450,000/15,000 units
= $30 per unit
Unit
Contribution
Margin

= $50 $30 = $20 per unit.

Level 1 Unit
Contribution
Margin

= $50 $30 = $20 per unit.

Level 2 Unit
Contribution
Margin
b.

= $50 1.4($30) = $50 $42 = $8 per unit.

Breakeven Point in Sales Units Level 1:

$30)

= $100,000/($50 = 5,000 units.

Breakeven Point in Sales Units Level 2: The company is profitable at

20,001 units. [(20,000 units X $20 contribution margin) + (1 unit X $8
contribution margin) $164,000 fixed costs = $236,008.]
c.

Compute the profits at the maximum volume for each level.

Level 1:
Profit = (Unit Contribution Margin)(Unit Sales) Fixed Cost
= ($50 $30)20,000 units $100,000 = $300,000.

Solutions

6-24

6.36 c. continued.
Level 2:
Profit = ($50 $30)20,000 units + ($50 $42)16,000 units
$164,000 = $364,000.
The company is more profitable at Level 2 with 36,000 units.
6.37

(CVP analysis with semifixed costs.)

a.

Operating Profit

= [($380 $80)30 students] [$1,200 X 6 teachers]

$900
= $9,000 $7,200 $900
= $900.

b.

Operating Profit = ($380 $80)X $1,200Q $900

where X = number of students and Q = number of teachers.
(Note: An incorrect but common method is to substitute the ratio X/6
for Q and solve for X. This gives 9 students, but it assumes 1 1/2
teachers are employed.)
This part demonstrates the impact of step costs on cost-volume-profit
analysis.
0 - 6 students:

Operating Profit = $300X ($1,200 X 1) $900

X = = 7 students, which is not feasible.

7 - 12 students:

Operating Profit = $300X ($1,200 X 2) $900

X = = 11 students.

13 - 18 students:

Operating Profit = $300X ($1,200 X 3) $900

X = = 15 students.
The Center shows a profit at 12 students, but a loss at 13 or 14
students, then breaking even again at 15 students.
19 - 24 students:

Operating Profit = $300X ($1,200 X 4) $900

X = = 19 students.
The Center breaks even at 19 students.

6-25

Solutions

6.37 continued.
c.

Operating Profit = $300X $1,200Q $900

where X = number of students and Q = number of teachers.
0 - 10 students:

Operating Profit = $300X ($1,200 X 1) $900

X = = 7 students.

11 - 20 students:

Operating Profit = $300X ($1,200 X 2) $900

X = = 11 students.
At 10 students, the Center would show a profit of $900 [i.e., ($300 X
10) $1,200 $900], but at 11 students it would just break even.
d.

Yes. The Center would increase profit by $1,800.

Two methods are presented here:
1. Total Method
Status quo: Operating Profit
Alternative: Operating Profit
6

= $900. (From Part a.)

= ($300 X 36 students) ($1,200 X
teachers) $900
= $10,800 $7,200 $900
= $2,700.

Therefore, the increase is $1,800 (= $2,700 $900).

2. Differential Method
Increase in total contribution = $300 X 6 = $1,800.
No change in fixed or step costs.
e.

6.38

Profit would decrease by $900. Although the contribution margin

would increase by $300, another teacher would be hired at a cost of
$1,200 if the maximum 6:1 student-teacher ratio is to be maintained.

(Break-even analysis for management education.)

The analysis classifies the costs associated with the executive program
into their variable, step and fixed components. Furthermore, it identifies
the opportunity cost of administrative personnel who will be unable to
fulfill their duties elsewhere. These numbers appear to be accurate given
the assumptions associated with cost-volume-profit analysis such as price
stability and current activity level.

Solutions

6-26

6.38 continued.
However, all the numbers presented in the analysis are estimates
and therefore not exact. A useful addition to this analysis would be a
sensitivity analysis where the parameters are changed to produce a best
case and a worst case scenario.
Cost-volume-profit analysis includes many assumptions including
that costs remain the same throughout the relevant range of activity. If
the number of students attending is vastly different from those expected,
the cost numbers may be inaccurate. Depending on the possibility of this
outcome, it can be modeled using sensitivity analysis to broaden the
scope of this analysis.
6.39

(Cost cutting to break even.)

a.

The breakeven point in units is,

X

= F/(P V)

where:
X
(P V)

= number of units
= average contribution margin per unit.

Plugging in the numbers for Auto, Inc.,

1,100,000
(P V)

= $3,100,000,000/(P V)
= $2,818.18.

b.

Management correctly realized the increasing level of competition in

the automobile industry. This meant that sales levels for individual
companies would probably fall as would prices on individual sales.
Faced with falling volume and contribution margin, the only
alternative to lower the breakeven point is to reduce fixed costs.

c.

Cost cutting can significantly increase profits in the short run.

However, cutting costs can lead to reduced profits in the long run.
For example, if the company chooses to reduce advertising, this may
increase short run profits at the expense of lost sales in the long run.
Many companies cut costs during economic recessions, but are faced
with inadequate capacity when the economy improves.
As a
shareholder, I would be concerned that the company not cut costs so
drastically as to jeopardize its long-run profitability.

6-27

Solutions

6.40

(CVPpartial data; special order.)

a.

First Quarter Sales = $36,000/$3.60= 10,000 Units.

Total Costs = Fixed Costs (F) + Variable Cost per Unit (V) X Unit Sales
(X).
V = ($67,000 $49,000)/ (17,500 10,000 ) = $2.40 per Unit.
F = $67,000 ($2.40 X 17,500) = $25,000.
Breakeven Point = $25,000/($3.60 - $2.40) = 20,833 Units.

b.

University Officials
Contract Accepted
Accepted
Units
Revenue
Variable Costs:
Materials
Labor
Overhead
Fixed Costs
Operating Profit
(Loss)

University Officials
Contract
Not

25,000
$87,000a

17,500
$63,000

(15,000)b
(33,000)c
(15,000)
(28,000)e

(10,500)b
(21,000)d
(10,500)
(25,000)

$(4,000)

$(4,000)

a$87,000 = $63,000 + ($3.20 X 7,500).

bAmounts = $.60 per meal X number of meals.
$.60 per meal = 25% of $2.40 variable cost per meal according
to Part a. of the solution.
c$33,000 = $1.20 per meal X 1.1 for cost increase X 25,000 meals.
$1.20 per meal = 50% of $2.40 variable cost per meal according
to Part a. of the solution.
d$21,000 = $1.20 per meal X 17,500 meals.
e$28,000 = $25,000 + $3,000 cost increase.
No change in Operating Profit (Loss) if the order is accepted.

Solutions

6-28

6.40 continued.
c.

V = ($15,000 + $33,000 + $15,000)/25,000 = $2.52 per Unit.

Find X:
$6,800 = $3.60X + $24,000 $2.52X $18,900 $28,000
$6,800 = $1.08X $22,900
$29,700 = $1.08X
X = $29,700/$1.08

X =27,500 student meals.

6.41

(Financial modeling with multiple cost drivers.)

6-29

Solutions

a.

Memorandum
Date:
To:
From:
Subject:

Today
Vice-President for Manufacturing, Radio, Inc.
I.M. Student, Controller
Activity-Based Costing

The $150,000 cost that has been characterized as fixed will

not increase with increases in sales volume. However, as the
activity-based costing analysis demonstrates, these costs are
not fixed with respect to other important cost drivers. This is
the difference between a traditional costing system and an ABC
system. The latter recognizes that costs vary with respect to a
variety of cost drivers, not just sales volume.
b.

New breakeven point if automated equipment is installed:

Sales price...........................................................................
Costs that are variable (with respect to sales volume):
Unit variable cost [$525,000 $150,000 = $375,000;
($375,000 X 0.8) 25,000 units].................................
Unit contribution margin.....................................................

$ 26
12
$ 14

Costs that are fixed (with respect to sales volume):

Setup (300 setups at $50 per setup)............................... $ 15,000
Engineering (800 hours at $28 per hour)........................
22,400
Inspection (100 inspections at $45 per inspection).........
4,500
General factory overhead................................................ 166,100
Total............................................................................ $ 208,000
Fixed selling and administration costs................................
30,000
Total............................................................................ $ 238,000
Breakeven Point (in Units): Fixed Cost Unit Contribution Margin
$238,000 $14 = 17,000 units.
c.

Number of units = (Fixed Cost + Target Profit) Unit Contribution

Margin
($238,000 + $140,000) $14 = 27,000 units.

d.

If Radio, Inc. adopts the new manufacturing technology:

(1) The breakeven point will be higher (17,000 units instead of
15,000 units). The 15,000-unit figure is derived as follows:
Unit variable cost = $15 [= ($525,000 $150,000) 25,000
units]
Unit contribution margin = $10 (= $25 $15)

Solutions

6-30

Breakeven units = 15,000 (= $150,000 $10)

(2) The number of units sold to show a profit of $140,000 will be
lower than before (27,000 units instead of 29,000 units). The
29,000-unit figure is computed as follows:
[($150,000 +
$140,000) $10].
(3) These results are typical of situations where firms adopt advanced
manufacturing equipment and practices. The breakeven point
increases because of the increased fixed costs associated with the
large investment in equipment. However, at higher levels of sales
after fixed costs have been covered, the larger unit contribution
margin ($14 instead of $10) earns a profit at a faster rate. (The
higher contribution is usually the result of increased operating
efficiencies.) The overall outcome is that the firm needs to sell
fewer units to reach a given target profit level.

6-31

Solutions

6.42

(Roseville Brewing Company; financial modeling for a brew pub.)

a.

Potential investors and bankers were concerned about the accuracy of

the income statement projections. They wanted to know what would
happen if the projections were overly optimistic. Operating profit was
heavily influenced by projected sales dollars and product mix. The
concern was over the impact changes in sales and product mix
(among other things) might have on operating profit.

b.

The first income statement was in the traditional format. In the

traditional format, costs are not show according to cost behavior.
Thus, it is difficult to predict what will happen with costs as changes
are made in sales volume. For example, if sales volume decreases by
10 percent, it is difficult to predict what will happen with cost of sales
and marketing and administrative expenses. Will they decrease by
the same percentage? (Unlikely unless all costs are variable!)

c.

The best way to quickly check for reasonableness is to compare the

operating profit as a percentage of sales to other similar businesses.
In addition, the dollar amount of operating profit can be compared to
other similar businesses. (In fact, the banks and investors who were
approached by RBC often looked at these two items as a starting
point to ensure the projected income statement was reasonable.)

d.

The cost of a pint of beer can range from $0.15 to $1.40 depending on
what is included in the cost. Should we include only the materials?
Should we include direct labor?
Indirect labor?
Manufacturing
overhead? The point is to understand what is included in the cost of a
product, particularly when this information is used for pricing and
other forms of decision-making.

e.

i. The breakeven point in sales dollars is $1,235,154, calculated as

follows:
Breakeven Point = Total Fixed Costs/Contribution Margin Ratio
= $520,000/($822,213/$1,953,000)
= $520,000/.421
= $1,235,154.
ii. The margin of safety is $717,846, calculated as follows:
= $1,953,000 $1,235,154
= $717,846.

Solutions

6-32

6.42 e. continued.
iii. RBC is selling many different products that change daily. It is
difficult if not impossible, to measure units of product for a brew
pub. This same argument holds true for most service companies
as well. Service companies do not sell units of service. Thus,
for these types of companies, breakeven points and target profit
points are calculated using sales dollars.
iv. The sales dollars required to achieve $200,000 in operating profit
is $1,710,214, calculated as follows:
Target Profit =
= ($520,000 + $200,000)/.421
= $720,000/.421
= $1,710,214.
The sales dollars required to achieve $500,000 in operating profit
is $2,422,803, calculated as follows:
Target Profit

=
= ($520,000 + $500,000)/.421
= $1,020,000/.421
= $2,422,803.

These calculations assume that the product mix is constant. The

contribution margin ratio is dependent on the product mix, and
will change as the product mix changes.

6-33

Solutions

6.42 continued.
f.

The revised income statement given the shift in product mix is as

follows:
Sales:
Beer Sales (25% of Total Sales)..............
Food Sales (70% of Total Sales)..............
Other Sales (5% of Total Sales)...............
Total Sales..................................................
Variable Costs:
Cost of Sales:
Beer (15% of Beer Sales)......................
Food (35% of Food Sales).....................
Other (33% of Other Sales)..................
Wages of Employees (25% of Sales).......
Supplies (1% of Sales).............................
Utilities (3% of Sales)..............................
Other: Credit Card, Misc. (2% of
Sales)....................................................
Total Variable Costs....................................
Contribution Margin....................................

$ 488,250
1,367,100
97,650
$1,953,000
$

73,238
478,485
32,225
488,250
19,530
58,590
39,060
1,189,378
$ 763,622

This page is intentionally left blank

Fixed Costs:
Salaries: Manager, Chef, Brewer............
Equipment & Building Maintenance........
Advertising..............................................
Other: Cleaning, Menus, Misc.................
Insurance and Accounting.......................
Property Taxes........................................
Depreciation............................................
Debt Service (Interest on Debt)..............
Total Fixed Costs........................................
Operating Profit..........................................

$ 140,000
30,000
20,000
40,000
40,000
24,000
94,000
132,000
520,000
$ 243,622

Thus, operating profits would decrease by $58,590 from the original

projection of $302,212.
This is a 19.4% decrease (=
$58,590/$302,212).
g.

Solutions

Answers will vary. Examples of strategic factors to be

considered include competition, economic conditions, and
demographics.

6-34