Solution to Analytical and critical thinking questions (Topic guide page2)

QUESTION 1: (CVP analysis for single product)

Lorna makes and sells decorative candles through gift shops. She knows she must sell 200
candles a month to break even. Every candle has a contribution margin of $1.50. So far this month,
Lorna has sold 320 candles. How much has Lorna earned so far this month in operating income? If
she sells 10 more candles, by how much will income increase?

Answer:
320 candles sold - 200 candles at breakeven = 120 candles above breakeven,
Lorna has earned operating income of $180 (120 x $1.50 = $180) so far during the month. An
additional 10 candles contribute $15 to operating income ($1.50 x 10).

QUESTIONS 2: (CVP analysis for multiple products)

Suppose a mens clothing store sells two brands of suits: designer suits with a contribution margin
of $600 each and regular suits with a contribution margin of $500 each. At breakeven, the store
must sell a total of 100 suits a month. Last month, the store sold 100 suits in total but incurred an
operating loss. There was no change in fixed cost, variable cost, or price. What happened?

Answer:
Probably, the sales mix shifted toward the relatively lower contribution margin suits. For example,
suppose that the break-even point for regular suits was 80, and the break-even point for designer
suits was 20. If the mix shifted to 90 regular and 10 designer, it is easy to see that less total
contribution margin (and, hence, operating income) would be realized.

QUESTION 3: (Finding a break-even point for a new business)

You are an accountant in private practice. A friend of yours, Linda, recently started a novelty
greeting card business. Linda designs greeting cards that allow the sender to write in his or her
own message. She uses heavy card stock, cut to size, and decorates the front of each card with
bits of fabric, lace, and ribbon in seasonal motifs (e.g., a heart for Valentines Day, a pine tree for
Christmas). Linda hired several friends to make the cards, according to Lindas instructions, on a
piece-work basis. (In piece work, the worker is paid on the basis of number of units produced.) The
workers could make the cards at their homes, meaning that no factory facilities were involved.

Linda designs the cards and travels around her four-state region to sell the completed cards on
consignment. For the few months the company has been in existence, the cards have been selling
well, but Linda is operating at a loss.

What types of information do you need to find the break-even point? How can the business owner
use this information to make decisions?

Answer:

In order to determine the break-even point, you need to determine the prices and variable costs for
the cards. Since creating a multiproduct break-even analysis could be complex, it may be easier to
determine the average price and the average variable cost for the cards, then find the total fixed
cost, and tell Linda how many cards she would need to sell to break even.

Suppose that the break-even number of cards is 250 per month, and that the average contribution
margin per card is $0.80. Then, as soon as Linda sells the 250th card, she knows she is in the
black. From then on, every card sold adds $0.80 to her profit. This was very important information
for Lindawhose business losses are coming right out of her familys checking account. Not only
does Linda have a sales goal for each month, she also knows at any point in time how much
income she has made.

Owners of small businesses find break-even analysis and concepts to be very helpful. A
knowledge of contribution margin helps owners know how they are doing at any point in time.




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QUESTION 4: (Operating leverage)

Two companies have identical sales revenue of $15 million. Is it true that both have the same
operating income and the same margin of safety? Is it possible that one company has a higher
margin of safety?

Answer:
It is not necessarily true that the two companies make the same operating income. If one company
has lower variable costs per unit and/or a lower total fixed cost, then its operating income would be
higher. The differences in variable cost per unit and total fixed cost would lead to different break-
even revenues. Of course, the company with the lower break-even sales would have a higher
margin of safety.

QUESTION 5: (Using Contribution Margin Income Statements to Consider Varying
Scenarios)

You are the chief accountant for Boyne winter sports. Early in the year, you had budgeted sales
prices (lift tickets, restaurant prices), costs, and expected quantity to be sold. However, once the
season starts, you will know from week to week more about the actual weather conditions.

How can you use this information about current weather conditions to better predict budgets for
Boyne?

Answer:
You can recast the budgeted statements according to how the weather will affect skiing. If the
snow is good, some costs will go down.

For example, you will lower the predicted cost of running the snow-making machines. However,
good weather and more skiers will require additional seasonal hiring as more direct labor will be
needed to run the lifts, operate ski equipment rental shops, restaurants, and so on. You can put
together contribution margin income statements under various scenarios, increasing volume with
good ski weather, decreasing it with poor weather.

Having the ability to recast budgets will help managers respond quickly to the changing conditions
and be able to raise or lower some prices as needed.