Chapter 4 Cost-Volume-Profit Analysis

QUESTIONS 1. Variable costs are costs that change in response to changes in activity (e.g., production or sales activity). Fixed costs are costs that do not change in response to changes in activity. 2. A mixed cost is a cost that has a fixed cost component and a variable cost component. For example, the amount paid for telecommunication services would be a mixed cost if there was a fixed monthly fee plus a charge for use. 3. Discretionary fixed costs are those fixed costs that management can easily change in the short-run (e.g., advertising). Committed fixed costs are those fixed costs that cannot be easily changed in the short-run (e.g., rent). 4. Commissions paid to salespersons and direct materials are examples of variable costs. 5. Rent and insurance expenses are examples of fixed costs. 6. Salespersons are paid a base salary plus commissions. The base amount is fixed and commissions are variable. Thus, total compensation paid to the sales force is mixed. 7. With telecom, there is likely to be a basic service charge (fixed) plus a charge for use (which will be variable if use increases with business activity). 8. The horizontal axis would be production. 9. With account analysis, managers use judgment to classify costs as either fixed or variable. The total of the costs classified as variable can then be divided by a measure of activity to calculate the variable cost per unit of activity. The total of the costs classified as fixed provides the estimate of fixed cost. 10. With the high-low method, you use the highest and lowest levels of activity. 11. The relevant range is the range of activity for which estimates of costs are likely to be accurate.

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12. The contribution margin is equal to the selling price minus variable cost. The contribution margin ratio is the contribution margin per dollar of sales. 13. The profit equation states that profit is equal to revenue (selling price times quantity) minus variable cost (variable cost per unit times quantity) minus total fixed cost. Profit = SP (x) - VC (x) - TFC 14. It would not be appropriate to focus on weighted average contribution margin per unit if the units were dissimilar (e.g., pencils and computers at an office supply warehouse). 15. The assumptions in C-V-P- analysis are: 1. Costs can be separated into fixed and variable components. 2. Fixed costs remain fixed and variable costs per unit do not change. 3. When performing multiproduct C-V-P, an important assumption is that the mix remains constant. 16. Companies that have relatively higher fixed costs are said to have higher operating leverage. Thus, a software company with a large investment in research and development (a fixed cost) would likely have higher operating leverage compared to a manufacturing company that used little equipment but expensive labor (a variable cost). 17. When there is a constraint, focus on the contribution margin per unit of the constraint.

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EXERCISES

E1. With high fixed costs, a business is quite risky. This follows because if sales fail to meet expectations, the company may have a large loss. Paul may be able to make rent a variable expensepay the mall owner a percent of total revenue rather than a fixed monthly amount. This type of arrangement is quite common in shopping malls. He may also be able to pay employees relatively low base salaries with bonuses tied to sales. This would make salary expense more of a variable expense. E2. The cost structure at Microsoft is heavily weighted toward fixed cost (e.g., research and development). Consider the variable cost associated with selling an additional unit of the product Office through the OEM (original equipment manufacturer) channel. The product sells for well over $100 but the incremental cost (ignoring tax) is probably less than $1. With high operating leverage, its not surprising that profit grew faster than sales. E3. At the Mens Warehouse, the gross margin is equal to net sales less cost of goods sold, including buying and occupancy costs. Since store occupancy cost is primarily a fixed cost, dividing the gross margin by sales is not likely to provide a good estimate of the contribution margin ratio. At Best Buy, the gross profit is equal to revenues less cost of goods sold. Since cost of goods sold is the companys primary variable cost, dividing gross profit by revenues may yield a relatively good estimate of the firms weighted average contribution margin ratio.

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Jiambalvo Managerial Accounting

E4. Depreciation appears to be a fixed cost.

Direct labor appears to be a variable cost.

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Telecommunications appears to be a mixed cost. Note that the intercept is $10,000.

E5. ($20,000 - $8,000) (8,000 - 2,000) = $2 per machine hour of variable repair cost
$8,000 - ($2 x 2,000) = $4,000 per month of fixed repair cost.

E6. a. The highest level of activity is sales of $28,000 with cost of $23,800. The lowest level of activity is sales of $19,000 with cost of $18,400.
($23,800 - $18,400) ($28,000 - $19,000) = $.60 of variable cost per dollar of sales.

$23,800 ($.60 x $28,000) = $7,000 per month of fixed cost. Thus, Cost = $7,000 + ($.60 x Sales). b. For $1 of sales, there will be $.60 of variable cost and $.40 (i.e., $1 - $.60) of contribution margin. That is, the contribution margin for a dollar of sales (known as the contribution margin ratio) is $1 - $.60. c. For a sales increase of $50,000, profit will increase by $20,000 (i.e., $50,000 - ($.60 x $50,000) = $20,000).

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d. The regression indicates that variable cost per dollar of sales is $.52289 and fixed costs are $8,950 per month. However, care must be exercised since, as indicated in the graph of costs and sales, costs in April ($23,400) appear to be extreme given that sales were only $21,000. Using the regression, for a sales increase of $50,000, profit will increase by $23,855.50 (i.e., $50,000 - ($.52289 $50,000) = $23,855.50).
NoteThis output was generated using the regression function in Excel (in Excel, go to tools, then data analysis, and then regression).
SUMMARY OUTPUT

Regression Statistics
Multiple R R Square Adjusted R Square Standard Error Observations ANOVA 0.75838256 0.5751441 0.53265851 1382.7356 12

df
Regression Residual Total 1 10 11

SS
25882922.54 19119577.46 45002500

MS
25882922.5 1911957.75

F
13.5373925

Coefficients
Intercept Sales 8950 0.52288732

Standard Error
3386.996675 0.142115224

t Stat
2.64245904 3.67931958

P-value
0.0246298 0.00425115

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E7. a.

b. The relation appears to be approximately linear (note that R Square is .89). There are no obvious outliers.

E8. a. Arguably, the only variable costs in human resources are staff salaries and office supplies (and a case could be made that even staff salaries are fixed). In this case, variable costs are $504 per hire [($25,000 + $200) 50 hires]. Fixed costs are $8,800. b. The estimated cost for June with 60 new hires is: $8,800 + ($504 60) = $39,040. c. The incremental cost associated with 10 more employees is $5,040 (i.e., $504 10).

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E9. a. Arguably, the only variable costs are cleaning supplies ($800) and employee wages ($15,800). In this case, variable costs per dollar of sales are: Cleaning supplies Employee wages Total variable costs Divided by sales Variable cost per dollar of sales Fixed costs per month are: Rent Utilities Depreciation Owners salary Fixed costs per month $ 800 600 200 5,600 $7,200 $ 800 15,800 16,600 28,000 $ .5929

b. The contribution margin ratio = $1 - .5929 = .4071. In other words, if the company has approximately 59 cents of variable costs for every dollar of sales, then it must have approximately 41 cents of contribution margin per dollar of sales.

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E10. a. Variable costs are: Material Direct labor Other utilities (80% variable) Supervisory salaries (20% variable) Equipment repair (90% variable) Indirect materials Factory maintenance (10% variable) Total variable costs Divided by units produced Variable cost per unit Fixed costs per month are: Depreciation Phone Other utilities (20% fixed) Supervisory salaries (80% fixed) Equipment repair (10% fixed) Factory maintenance (90% fixed) Total fixed costs per month $10,000 200 560 8,800 500 5,040 $25,100 $ 30,000 20,000 2,240 2,200 4,500 400 560 $59,900 1,000 $ 59.90

b. The incremental costs of producing 100 units is $5,990 (i.e., $59.90 variable cost per unit 100 units).

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E11. a. The break-even point equals fixed cost divided by the contribution margin per unit. Thus, the break-even point is 100 pairs of speakers [i.e., $50,000 ($800 - $300) = 100 pairs of speakers]. b. The company must sell 140 pairs to earn a profit of $20,000. ($50,000 + $20,000) ($800 - $300) = 140 pairs of speakers

E12. a. Given that variable cost per dollar of sales is $.80, the contribution margin per dollar of sales (i.e., the contribution margin ratio) is $.20. The breakeven point equals fixed cost divided by the contribution margin ratio. Thus, the break-even point is $1,000,000 [i.e., $200,000 $.20 = $1,000,000]. b. ($200,000 + $60,000) $.20 = $1,300,000 c. The expected level of profit is: ($1,400,000 $.20) - $200,000 = $80,000.

E13. a. The contribution margin is $500 (i.e., $800 - $300). b. The effect on profit of selling 5 more pairs of speakers is $2,500 (i.e., $500 5).

E14. a. The contribution margin ratio is 0.625. Contribution margin ratio = contribution margin sales = $500 $800 = 0.625. b. The effect on profit of additional sales of $5,000 is $3,125 (i.e., $5,000 0.625).

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E15. a. Expected profit is $800 (120) - $300 (120) - $50,000 = $10,000. b. Breakeven sales are $50,000 $0.625 = $80,000. Expected sales are $120 $800 = $96,000. The margin of safety is equal to expected sales - break-even sales = $96,000 -$80,000 = $16,000.

E16. Expected profit is $1,000 (120) - $300 (120) - $50,000 = $34,000.

E17. a. The weighted average contribution margin per unit is $178,000 5,000 = $35.60. b. The break-even point is $103,000 $35.60 = 2,893 units. c. The number of Smashers would be (1,000 5,000) 2,893 = 579. The number of Bashers would be (2,000 5,000) 2,893 = 1,157. The number of Dinkers would be (2,000 5,000) 2,893 = 1,157.

E18. a. The weighted average contribution margin ratio is $178,000 $300,000 = 0.59333 b. ($103,000 + $100,000) 0.59333 = $342,137. c. The sales of Smashers would be ($100,0000 $300,000) $342,137 = $114,046. The sales of Bashers would be ($120,0000 $300,000) $342,137= $136,855. The sales of Dinkers would be ($80,0000 $300,000) $342,137 = $91,236.

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E19. a. The weighted average contribution margin ratio is $679,000 $2,015,000 = 0.336973. b. ($237,000 + $500,000) .336973 = 2,187,121. c. The contribution margin ratios of the three departments are: Department A Department B Department C .60 .40 .20

All else equal, Department A should be emphasized in the weekly advertisement because this department earns $.60 on each incremental dollar of sales (more than either of the other departments).

E20. a. Currently, profit as a percent of sales is $442,000 $2,015,000 = .21935. b. The contribution margin ratio is $679,000 $2,015,000 = 0.336973. Thus, if sales increase by 20% ($2,015,000 .2 = $403,000), profit will increase by: Increase in sales Times contribution margin ratio Increase in profit $403,000 .336973 $135,800

The new sales level will be ($2,015,000 + $403,000 ) = $2,418,000. The new profit level will be ($442,000 + $135,800 ) = $577,800. Thus, profit as a percent of sales will be .23896 (i.e., $577,800 $2,418,000). When sales increase, variable costs increase, but fixed costs do not increase. Thus, when sales increase, profit as a percent of sales will also increase.

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E21.a. Selling price Variable costs Contribution margin Hours to produce 1 item Contribution margin per hour

Product A $80 20 60 5 $12

Product B $70 40 30 2 $15

The company should produce just Product B. With 320 hours available, this product will generate $4,800 of contribution margin ($15 320 hours) while Product A will generate just $3,840 ($12 320). b. If the company obtains additional labor, it should produce more Product B. The incremental benefit of 10 labor hours is $150 ($15 contribution margin per hour x 10 hours). As an aside, note that if production of Product A requires 5 labor hours and variable costs are only $20 per unit, workers at Howard Products must be paid less than $4 per hour because part of the variable costs are material costs! Perhaps production is taking place in a third-world country!

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PROBLEMS

P1. a. Depreciationfixed b. Salaries of restaurant staffmixed (a minimum number is required in slow months plus additional people are required from November through February) c. Salaries of administrative stafffixed d. Soap, and other toiletries (variable) e. Laundrymixed (part is variable and part is fixed, e.g., depreciation on laundry equipment) f. Food and beveragevariable g. Grounds maintenancefixed

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P2. a. Variable costs Component costs Supplies Assembly labor Shipping Total Variable cost per disc play ($93,740 140) Fixed costs Rent Supervisor salary Electricity Telephone Gas Advertising Administrative costs Total

$68,000 1,540 22,800 1,400 $93,740

$669.57

$2,000 5,000 200 220 100 2,000 12,500 $22,020

b. Expected cost in August = $122,455.50. $669.57 (150) + $22,020 = $122,455.50 c. Contribution margin = Selling price less variable cost = $1,200 - $669.57 = $530.43. d. Estimated profit at 150 units = $57,544.50. $1,200 (150) - $669.57 (150) - $22,020 = $57,544.50. e. The special order will increase profit by $13,043. ($800 - 669.57) 100 = $13,043.

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P3. a. High Low

Production 165 125 40

Cost $134,700 107,670 $ 27,030

Variable cost per unit = $27,030 40 = $675.75. Total cost at 165 units Less variable costs (165 $675.75) Fixed cost $134,700 111,499 $ 23,201

b. Break-even sales in units = 44. $23,201 ($1,200 - $675.75) = approximately 44 units. c. Margin of safety = 150 - 44 = 106 units. d. Total profit = $55,436.50. $1,200 (150) - $675.75 (150) - $23,201 = $55,436.50. e. A major limitation of the high-low method is that it estimates variable and fixed costs using extreme values. Also, the approach uses only two observations. A better approach would be to use regression analysis.

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P4. a. NoteThis output was generated using the regression function in Excel (in Excel, go to tools, then data analysis, and then regression).
Regression Statistics Multiple R R Square Adjusted R. Square Standard Error Observations ANOVA df Regression Residual Total 1 10 11 Coefficients 25699.20792 643.2475248 SS 609444867.3 54118532.67 663563400 Standard Error 8688.960364 60.6155316 MS 609444867.3 5411853.267 F 112.6129696 0.958354089 0.918442559 0.910286815 2326.339027 12

Intercept Production

t Stat 2.957685021 10.61192582

P-value 0.014344813 9.19871E-07

Based on the regression, fixed costs are $25,699.21 and variable costs are $643.25 per unit. b. Comparison of estimates: Variable cost $669.57 $675.75 $643.25 Fixed cost $21,220.00 $23,201.00 $25,699.21

Account analysis High-low Regression

The regression approach arguably provides the best estimates because it uses more data and is less subjective. However, in this case, all three of the estimates are reasonably close.

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P5. a. Number of trips (6 per week x 52 weeks) Total revenue Revenue per trip ($312,000 312) Variable costs: Fuel Maintenance Variable costs per trip ($224,640 312) Contribution margin per trip ($1,000 - $720) Fixed costs: Salary Depreciation of plane Depreciation of office equipment Rent Insurance Miscellaneous

312 $312,000

$1,000

$ 99,840 124,800 $224,640 $720

$280

$ 34,000 20,000 600 24,000 5,000 2,000 $ 85,600

Breakeven number of trips is 306 ($85,600 $280 = 305.71). b. If David draws a salary of $80,000, fixed costs will increase by $46,000 to $131,600. In this case, the breakeven number of trips is 470 ($131,600 $280). Note that this number of trips is not feasible if David can only fly one round trip per day.

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c. The average before tax profit per round trip is $1,760 312 = $5.64. d. The incremental profit associated with adding a round trip is the contribution margin per trip, which is $280.

P6 a. Account Analysis Fixed cost per month (April data) Day manager salary Night manager salary Depreciation

$ 4,000 3,500 10,000 $17,500

Variable costs per room (April data): Cleaning staff Continental breakfast Number of rooms Variable costs per room

$15,000 4,500 19,500 1,500 $ 13

b. High-Low Method ($38,600 $37,000) 300 rooms = $5.33 per occupied room of variable cost. $37,000 $5.33 x (1,500 rooms) = $29,005 of fixed costs per month. c. $85.00 $5.33 = $79.67 contribution margin per occupied room. P7. a Income will only be proportional to sales if all costs are variable. That assumption is wrong (for example, the registration fee and the pay to Jane Kramer are fixed).

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b. Sales Less cost of sales (60% of sales in prior year) Gross margin Less other expenses: Registration fee Booth rental (5% of sales) Salary of Jane Kramer Before tax profit P8.
Sales Less cost of components Gross margin Less: Staff salaries Rent Utilities Advertising Operating profit before bonuses Staff bonuses Profit before taxes and owner draw $1,000,000.00 700,000.00 300,000.00 180,000.00 24,000.00 3,600.00 2,000.00 90,400.00 36,160.00 $ 54,240.00 $ $1,100,000.00 770,000.00 330,000.00 180,000.00 24,000.00 3,600.00 2,000.00 120,400.00 48,160.00 72,240.00 $

$18,624.00 11,174.40 7,449.60 1,000.00 931.20 300.00 $ 5,218.40

$1,200,000.00 840,000.00 360,000.00 180,000.00 24,000.00 3,600.00 2,000.00 150,400.00 60,160.00 90,240.00

$1,300,000.00 908,000.16 391,999.84 180,000.00 24,000.00 3,600.00 2,000.00 182,399.84 72,959.94 $ 109,439.90

$1,400,000.00 964,000.16 435,999.84 180,000.00 24,000.00 3,600.00 2,000.00 226,399.84 90,559.94 $ 135,839.90

In the prior year, cost of components was 70% of sales. In the coming year, prices will be reduced by 20% on all purchases over $900,000. Purchases of $900,000 corresponds to sales of $1,285,714. ($900,000 .7). Thus, the calculation of cost of components when sales are $1,300,000 is: $900,000 + [($1,300,000 $1,285,714) x .7 x .8] = $908,000.16.

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P9. a. Production costs: ($95,000 - $78,500) (150 95) = $300 variable cost per unit $95,000 ($300 x 150) = $50,000 fixed cost per month. Selling and administrative costs: ($16,000 - $13,800) (150 95) = $40 variable cost per unit $16,000 ($40 x 150) = $10,000 fixed cost per month. b. Sales (1,400 units x $800) Less production costs ($50,000 x 12) + ($300 x 1,400) Less selling and adm. ($10,000 x 12) + ($40 x 1,400) Income (loss) $1,120,000 1,020,000 176,000 ($ 76,000)

P10.

a. Audio Contribution margin $1,080,000 Sales 3,000,000 Contribution margin ratio (CM sales) 0.3600

Video $ 460,000 1,800,000 0.2556

Car $ 570,000 1,200,000 0.4750

b. A $100,000 increase in Audio sales would increase profit by $36,000 while the effect for Video would be $25,560 and $47,500 for the Car product line. All else equal, it would be better to increase sales of Car products. c. The weighted average contribution margin ratio is $2,110,000 $6,000,000 = .3516667 The break-even level of sales is: (Direct fixed + common fixed) contribution margin ratio = $4,123,222. ($760,000 + 690,000) .3516667 = $4,123,222

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d. Sales need to achieve a profit of $1,500,000 is ($1,500,000 + $760,000 + $690,000) .3516667 = $8,388,625. e. Audio sales = ($3,000,000 6,000,000) $8,388,625 = $4,194,313 Video sales = ($1,800,000 6,000,000) $8,388,625 = $2,516,587 Car sales = ($1,200,000 6,000,000) $8,388,625 = $1,677,725

P11. a. The contribution margin ratio is $493,000 $1,200,000 = 0.410833. Thus, if sales increase by 20% ($1,200,000 .2 = $240,000), profit will increase by: Increase in sales Times contribution margin ratio Increase in profit $240,000 .410833 $ 98,600

Thus, profit will increase by 42.87% ($98,600 $230,000) Profit increases at a faster rate than sales because some costs are fixed and do not increase with sales. b. If the owner of RealTimeService wanted to focus on the contribution margin per unit, he would, most likely, treat hours worked (on consulting, training, or repair services) as the unit of service. For example, if in the past fiscal year the company worked 6,000 hours, the contribution margin per hour would be $82.17 (i.e., $493,000 6,000 hours).

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P12. a. Sercon has the highest operating leverage (note that it has $50,000,000 of fixed costs versus only $20,000,000 for Zercon. b. For a 10% change in sales, Sercons profit will change by 60% while Zercons profit will change by only 30%. Sercon $6,000,000 10,000,000 60% Zercon $3,000,000 10,000,000 30%

Change in contribution margin Previous profit % change

c. Sercon is more risky. Note that if sales decrease by only 10%, profit will decline by 60% (versus a 30% decline for Zercon).

P13. a. Jens is not approaching this problem in a proper manner. Instead of focusing on profit per assembly hour, he should focus on the contribution margin per assembly hour. For sales of 2,000 units, the contribution margin is $1,000,000. To earn this contribution margin required 8,000 assembly hours. Thus, the contribution margin per assembly hour is $125 per hour. If four hours were available, profit would increase by $125 4 = $500 (which is the contribution margin per unit). b. Jens is underestimating the benefit of more assembly time. By focusing on profit per hour, he estimates an average benefit of $50 per hour. However, the real benefit is $125 per hour. c. If Jens pays workers $25 per hour of overtime premium, he will still make an incremental $100 per hour ($125 - $25).

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P14. a. The Finisher has the highest contribution per hour of assembly time. Therefore, only the minimum number of Masters should be produced and the remaining assembly time should be devoted to Finishers. Production of 2,000 Masters requires 4,000 assembly hours. This leaves 106,000 hours for production of Finishers indicating that 70,667 pairs of Finishers can be produced (106,000 1.5 hours = 70,667). The contribution margin for Masters is $110 per unit and the contribution margin for Finishers is $85 per unit. Contribution margin of Masters ($110 2,000) Contribution margin of Finishers ($85 70,667) Total

$ 220,000 6,006,695 $6,226,695

b. Production of 4,000 Masters requires 8,000 assembly hours. This leaves 102,000 hours for production of Finishers indicating that 68,000 pairs of Finishers can be produced (102,000 1.5 hours = 68,000). Contribution margin of Masters ($110 4,000) Contribution margin of Finishers ($85 68,000) Total

$ 440,000 5,780,000 $6,220,000

Note that the total contribution margin has declined by $6,695. Thus, the opportunity cost of requiring that at least 4,000 pairs of the Master be produced is $6,695.

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P15.

Increase in sales at normal prices Less 20% discount Increase in sales after discount Less incremental costs .58897387 x $2,500,000 Incremental profit

$2,500,000 500,000 2,000,000 1,472,435 $ 527,565

Note that since the regression was estimated using normal selling prices, the incremental costs must be calculated using normal selling prices.