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Costvolumeprofit analysis

Solutions to Chapter 3 questions


In addition to the Instructors Manual the Examview testbank CD-ROM also
provides over 1 000 questions (with solutions) tailored to the content of this chapter
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Students can obtain the answers to questions 3.293.33 from Management and Cost
Accounting Students Manual. Care should therefore be exercised in using these
questions for assessment purposes.

Solution 3.24
The comparisons of CVP models represented in management accounting and economic
theory are presented in the first half of Chapter 3. Additional points include
the following:
(i) Both models are concerned with explaining the relationship between changes
in costs and revenues and changes in output. Both are simplifications of cost
and revenue functions because variables other than output affect costs and
revenues.
(ii) The value of both models is reduced when arbitrary cost allocation methods are
used to apportion joint costs to products or divisions.
(iii) The economic model indicates two break-even points whereas the management
accounting model indicates one break-even point.
(iv) Both models are based on single value estimates of total costs and revenues. It is
preferable to incorporate uncertainty into the analysis.

(v) The model based on economic theory provides a theoretical presentation of the
relationship between costs, revenues and output. The model is intended to provide
an insight into complex inter-relationships. The management accounting
model should be seen as a practical decision-making tool which provides a useful
approximation for decision-making purposes if certain conditions apply (e.g. relevant
range assumption)

Solution 3.25
(a) See Costvolumeprofit analysis assumptions in Chapter 3 for the answer to this
question.
(b) Examples of the circumstances where the underlying assumptions are violated
include:
(i) Variable cost per unit remaining constant over the entire range: This assumption is
violated where quantity discounts can be obtained from the purchase of
larger quantities. Consequently the variable cost per unit will not be constant
for all output levels. However, over a restricted range, or several restricted
ranges, a linear relationship or a series of linear relationships may provide a
reasonable approximation of the true cost function.
(ii) Selling price is constant per unit: In order to increase sales volume, the selling
price might be reduced. Therefore selling price will not be a linear function
of volume. A series of linear relationships may provide a reasonable approximation
of the true revenue function.
(iii) The sales mix is known: It is unlikely that the planned sales mix will be equal to
the actual sales mix. To incorporate the possibility that the actual sales mix
may differ from the planned sales mix, a range of total cost and revenue
curves should be prepared corresponding to each possible sales mix. This will
give a range of break-even points and profit/losses for possible mixes of sales.

90 COSTVOLUMEPROFIT ANALYSIS

Solution 3.26
(a) See Costvolumeprofit analysis assumptions in Chapter 3 for the answer to this
question.

(b) (i) Holiday resort cost and income statement


Guests Income Variable Contribution Fixed Surplus
in residence p.a. costs costs (deficit)
() () () () ()
6 18 000 7 740 10 260 16 000 (5740)
7 21 000 9 030 11 970 16 000 (4030)
8 24 000 10 320 13 680 16 000 (2320)
9 27 000 11 610 15 390 16 000 (610)
10 30 000 12 900 17 100 16 000 1100
11 33 000 14 190 18 810 22 000 (3190)
12 36 000 15 480 20 520 22 000 (1480)
13 39 000 16 770 22 230 22 000 230
14 42 000 18 060 23 940 22 000 1940
15 45 000 19 350 25 650 22 000 3650

There are two break-even points. If provision is made for between 6 and 10
guests, the first break-even point occurs just in excess of 9 guests per week (or
270 guests per annum). If provision is made for 11 or more guests per week,
the break-even point changes to 13 guests per week.
(ii) The total costs for various activity levels are as follows:

Guests Total costs


()
6 23 740
10 28 900
11 36 190
15 41 350

The above costs are plotted on the break-even chart shown in Figure Q3.26.

91PART II: SOLUTIONS

Figure Q3.26.

Solution 3.27
Task 1 Preliminary workings
Planned sales volume for draft budget = 0.75 3.2m = 2.4m units
Draft budget = 2/3 of maximum capacity
Therefore maximum capacity = 2.4m 3/2 = 3.6m units

The following is an analysis of the draft budget:

92PART II: SOLUTIONS

(a) (i) and (a)(ii)

Proposal A

Proposal B

Proposal C

(b) Proposal B would appear to be the best strategy in terms of profitability. All three
proposals increase the break-even point although proposal A shows the smallest
increase. However, provided that management is confident that the predicted
sales can be achieved proposal B should be chosen.

(c) Before making a final decision the following issues should be considered:
(i) the promotion campaign might generate increased sales beyond the current
year;
(ii) the price reduction for proposals B and C may cause competitors to react thus
provoking a price war;
(iii) the price reduction for proposals B and C may not result in the predicted sales
volume if customers perceive the product to be of low quality;
(iv) proposal C will result in the company operating at full capacity. This may
result in changes in cost structure if the company is operating outside the relevant
output range.

93PART II: SOLUTIONS

Task 2

Note:
a It
is assumed that the direct labour of 0.8m charged to the order includes the
opportunity cost of the direct labour since the question implies that this labour
will be utilized elsewhere if the order is not accepted.
(b) The relevant cost approach described in Chapter 4 has been used in part (a). It is
assumed that it is a one time short-term special order and that no other costs can
be avoided if the order is accepted.

Solution 3.28
Task 1
(1) Production volume (packs) 40 000 50 000 60 000 70 000
(2) Average cost 430 388 360 340
(3) Total cost (1 2) 17 200 000 19 400 000 21 600 000 23 800 000
(4) Cost per extra 10 000 packs 2 200 000 2 200 000 2 200 000
(5) Unit variable cost ((4)/10 000) 220 220 220

(c) Break-even point (packs) = Fixed costs/Unit contribution = 8 400 000/200 =


42 000
(d) Margin of safety = (65 000 _ 42 000)/65 000 = 35.4%

Task 2
(a) Additional contribution = 5000 (330 _ 220) = 550 000
Fixed costs are assumed to remain unchanged. Therefore profits should increase
by 550 000.

(c) The order for 5000 units at 330 should be accepted since this yields an additional
contribution of 550 000. Fixed costs are assumed to remain unchanged for both
orders. However, accepting an order for 15 000 units can only be met by reducing
current sales by 10 000 units (planned existing sales are 65 000 units and capacity

94PART II: SOLUTIONS

is restricted to 70 000 units). The order can only be justified if the lost sales can be
recouped in future periods with no loss in customer goodwill.

(d) Non-financial factors that should be considered include:


(i) The effect on existing customers if they become aware that the company is
selling at a lower price to other customers.
(ii) The long-term potential of the new order. If the order is likely to result in
repeat sales it might be financially viable to increase capacity and obtain the
increased contribution without the loss of contribution from existing sales.
The financial appraisal should compare the present value of the increase in
contribution with the additional costs associated with increasing capacity.

Solution 3.29
(a) See Figure Q3.29.
(b) See Chapter 3 for the answer to this question.
(c) The major limitations are:
(i) Costs and revenue may only be linear within a certain output range.
(ii) In practice, it is difficult to separate fixed and variable costs, and the calculations
will represent an approximation.
(iii) It is assumed that profits are calculated on a variable costing basis.
(iv) Analysis assumes a single product is sold or a constant sales mix is
maintained.
(d) The advantages are:
(i) The information can be absorbed at a glance without the need for detailed
figures.
(ii) Essential features are emphasized.
(iii) The graphical presentation can be easily understood by non-accountants.

95PART II: SOLUTIONS

Figure Q3.29 (A) Break-even chart. (B) Contribution graph.

Figure Q3.29 (C) Profit-volume graph.

Solution 3.30
(a) (i)
Products 1 2 3 Total
1. Unit contribution 1.31 0.63 1.87
2. Specific fixed costs per unit 0.49 0.35 0.62
3. General fixed costs per unit 0.46 0.46 0.46
4. Sales volume (000s units) 98.2 42.1 111.8 252.1
5. Total contribution (1 _ 4) 128.642 26.523 209.066 364.231
6. Total specific fixed costs (2 _ 4) 48.118 14.735 69.316 132.169
7. Total general fixed costs (3 _ 4) 45.172 19.366 51.428 115.966
8. Unit selling price 2.92 1.35 2.83
9. Total sales revenue (8 _ 4) 286.744 56.835 316.394 659.973

Alternatively, the break-even point (sales value) can be calculated using the
following formula:

It is assumed that the question requires the calculation of the break-even


point to cover both general and specific fixed costs. An alternative answer
would have been to present details of the break-even point to cover only
specific fixed costs.
(ii) The planned sales mix for Product 2 that was used to calculate the breakeven
point in (i) is 42.1/252.1. Therefore the number of units of Product 2 at
the break-even point is:

42.1/252.1 171 743 units = 28 681

96PART II: SOLUTIONS

(b) At the forecast sales volume the profit/contributions are as follows:

Product 2 provides a contribution of 11 788 towards general fixed costs and,


unless savings in general fixed costs in excess of 11 788 can be made if Product
2 is abandoned, it is still viable to produce Product 2. If the company ceases
production of Product 2 it will lose a contribution of 11 788 and total profits
will decline by 11 788. The company should investigate whether a greater
contribution than 11 788 can be generated from the resources. If this is not
possible the company should continue production of Product 2.

Solution 3.31

Average selling price per unit (2 106 000/5400 beds) = 390


Break-even point (sales revenue) = 8950 beds at 390 = 3 490 500

Task 2
The letter should include the items listed in (a) to (e) below:

The minimum profit required to compensate for loss of salary and interest is
11 550 (110 000 _ 98 450 fixed costs).

(b) Required volume = Required contribution (110 000)/Contribution per unit (11)
= 10 000 beds

(c) Average life of a bed = (9 years 0.10) + (10 years 0.60) + (11 years 0.3) =
10.2 years

Total bed population = 44 880 households 2.1 beds per market = 94 248

97PART II: SOLUTIONS

(d) The proposal will not achieve the desired profit. Estimated annual sales are 9240
beds but 10 000 beds must be sold to achieve the desired profit. The shortfall of
760 beds will result in profit being 8360 (760 11) less than the desired profit.

(e) The estimate of maximum annual sales volume may prove to be inaccurate
because of the following reasons:
(i) The population of Mytown may differ from the sample population. For example
the population of Mytown might contain a greater proportion of elderly
people or younger people with families. Either of these situations may result
in the buying habits of the population of Mytown being different from the
sample proportion.
(ii) The data is historic and does not take into account future changes such as an
increase in wealth of the population, change in composition or a change in
buying habits arising from different types of beds being marketed.

Task 3
This question requires a knowledge of the material covered in Chapter 4.

Monthly sales schedule and statement of profitability:

Note:
a The balance of storage space available for Model C is 300 square metres less the
amount allocated to A and B (285 metres) = 15 metres. This will result in the sales
of 3 beds (15 metres/5 metres per bed).

98PART II: SOLUTIONS

Solution 3.32
(a) Analysis of semi-variable costsa

Note:
aThe analysis is based on a comparison of total costs and activity levels at 350 000
and 450 000 copies per year.

Contribution per copy of new magazine

Calculation of net increase in company profits

Note:
aMethod A = specific fixed costs (80 000) + semi-variable element (20 000)
= 100 000
Method B = specific fixed costs (120 000) + semi-variable element (30 000)
= 150 000
(b)

The margin of safety is the difference between the anticipated sales and the breakeven
point sales:
Method A = 500 000 - 333 333 = 166 667 copies
Method B = 500 000 - 375 000 = 125 000 copies

(c) Method B has a higher break-even point and a higher contribution per copy
sold. This implies that profits from Method B are more vulnerable to a decline
in sales volume. However, higher profits are obtained with Method B when sales
are high (see 600 000 copies in (B)).

99PART II: SOLUTIONS

The break-even point from the sale of the existing magazine is 160 000 copies
(80 000/0.50) and the current level of monthly sales is 220 000 copies. Therefore
sales can drop by 60 000 copies before break-even point is reached. For every
10 copies sold of the new publication, sales of the existing publication will be
reduced by one copy. Consequently, if more than 600 000 copies of the new
publication are sold, the existing magazine will make a loss. If sales of the new
magazine are expected to consistently exceed 600 000 copies then the viability of
the existing magazine must be questioned.

Solution 3.33
(a) (i) The opportunity costs of producing cassettes are the salary forgone of 1000
per month and the rental forgone of 400 per month.
(ii) The consultants fees and development costs represent sunk costs.
(b) The following information can be obtained from the report.

Notes
a Fixed production cost + 1400 opportunity cost
b (10 000 units 1.75 contribution) 13 525 fixed costs = 3975 profit
b (18 000 units 1.25 contribution) 17 525 fixed costs = 4975 profit
c ( 7 500 units 1.75 contribution) 13 525 fixed costs = 400 loss
c (12 000 units 1.25 contribution) 17 525 fixed costs = 2525 loss
dFixed costs/contribution per unit

Conclusions
(i) The 10 selling price is less risky than the 9 selling price. With the 10 selling
price, the maximum loss is lower and the break-even point is only 3% above
minimum sales (compared with 17% for a 9 selling price).
(ii) The 9 selling price will yield the higher profits if maximum sales quantity is
achieved.
(iii) In order to earn 3975 profits at a 9 selling price, we must sell 17 200
units (required contribution of 17 525 fixed costs plus 3975 divided by a contribution
per unit of 1.25).

Additional information required


(i) Details of capital employed for each selling price.
(ii) Details of additional finance required to finance the working capital and the
relevant interest cost so as to determine the cost of financing the working
capital.
(iii) Estimated probability of units sold at different selling prices.
(iv) How long will the project remain viable?
(v) Details of range of possible costs. Are the cost figures given in the question
certain?

100PART II: SOLUTIONS

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