CHAPTER 7

Cost-Volume-Profit Analysis

Solutions to exercises
EXERCISE 7-23 (20 MINUTES)
fixed expenses
1. Break-even point (in units) = unit contributi on margin

$54,000
= = 13,500 pizzas
$10 $6
unit contributi on margin
2. Contribution-margin ratio = unit sales price
$10 $6
= = .4
$10
fixed expenses
3. Break-even point (in sales dollars) = contributi on -margin ratio

$54,000
= = $135,000
.4
4. Let X denote the sales volume of pizzas required to earn a target net
profit of $60,000.
$10 X $6 X $54,000 = $60,000
$4 X = $114,000
X = 28,500 pizzas

EXERCISE 7-27 (25 MINUTES)

fixed costs
1. Break-even point (in units) = unit contributi on margin

2,000,000p
= 1,500p 1,000p = 4,000 components

p denotes Argentinas peso.

(2,000,000p ) (1.05)
2. New break-even point (in units) = 1,500p 1,000p
2,100,000p
= 500p
= 4,200 components

3. Sales revenue (7,000 1,500 p ) ..........................................

10,500,000 p
 Variable costs (7,000 1,000 p ).............................................
7,000,000 p
Contribution margin...............................................................
3,500,000 p
Fixed costs...........................................................................
2,000,000 p
Net income...........................................................................
1,500,000 p
2,000,000p
4. New break-even point (in units) = 1,400p 1,000p

= 5,000 components
5. Analysis of price change decision:
Price
1,500 p 1,400 p
Sales revenue: (7,000 1,500 p ).......................... 10,500,000 p
(8,000 1,400 p ).......................... 11,200,000 p
Variable costs: (7,000 1,000 p )..........................7,000,000 p
(8,000 1,000 p ).......................... 8,000,000 p
Contribution margin............................................. 3,200,000 p
3,500,000 p
Fixed expenses................................................... 2,000,000 p
Net income (loss)................................................
2,000,000 p 1,200,000 p

1,500,000 p

The price cut should not be made, since projected net income will
decline by 300,000 p .

EXERCISE 7-28 (25 MINUTES)

1. (a) Traditional income statement:

PACIFIC RIM PUBLICATIONS, INC.
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 20XX
Sales ...............................................................
$2,000,000
Less: Cost of goods sold..................................
1,500,000
Gross margin......................................................
500,000
Less: Operating expenses:
Selling expenses..................................... $150,000
Administrative expenses.......................... 150,000
300,000
 Net income.........................................................
200,000

(b) Contribution income statement:

PACIFIC RIM PUBLICATIONS, INC.
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 20XX
Sales ...............................................................
$2,000,000
Less: Variable expenses:
Variable manufacturing............................ $1,000,000
Variable selling........................................ 100,000
Variable administrative............................ 30,000
1,130,000
Contribution margin.............................................
870,000
Less: Fixed expenses:
Fixed manufacturing................................ $ 500,000
Fixed selling............................................ 50,000
Fixed administrative................................ 120,000
670,000
Net income.........................................................
200,000

contribution margin
2. Operatingleveragefactor (at $1,000,000sales level)=
net income
$870,000
= = 4.35
$200,000

percentageincrease operating
3.

Percentageincreasein et income
i nsalesrev nue lev ragefactor
= 15% 4.35
 = 65.25%

4. Most operating managers prefer the contribution income statement for answering
this type of question. The contribution format highlights the contribution margin and
separates fixed and variable expenses.

EXERCISE 7-33 (20 MINUTES)

fixed expenses
1. Break - even volume of service revenue
contribution margin ratio
$200,000
$800,000
.25

target after - tax net income

2. Target before - tax income
1 tax rate
$120,000
$200,000
1 .40

target after - tax net income

fixed expenses
3. Service revenue required to earn (1 t )

target after-tax income of contributi on margin ratio
$120,000 $120,000
$200,000
1 .40 $1,600,000
.25

4. A change in the tax rate will have no effect on the firm's break-even point. At the
break-even point, the firm has no profit and does not have to pay any income taxes.

Solutions to Problems
PROBLEM 7-34 (30 MINUTES)

1. Break-even point in sales dollars, using the contribution-margin ratio:

fixed expenses
Break - even point =
contributi on - margin ratio
$650,000+ $250,000 $900,000
= =
$50 - $15 - $5 .6
$50
= $1,500,000

2. Target net income, using contribution-margin approach:

 fixed expenses + target net income
Salesunits required to earn income of $300,000=
unit contributi on margin
$900,000+ $300,000 $1,200,000
= =
$50 - $15 - $5 $30
= 40,000units

3. New unit variable manufacturing = $15 120%

cost
= $18.00
Break-even point in sales dollars:
$900,000 $900,000
Break - even point = =
$50.00- $18.00- $5.00 .54
$50
= $1,666,667(rounded)
4. Let P denote the selling price that will yield the same contribution-margin ratio:
$50.00- $15.00- $5.00 P - $18.00- $5.00
=
$50.00 P
P - $23.00
.6 =
P
.6P = P - $23.00
$23.00 = .4P
P = $23.00/.4
P = $57.50

Check: New contribution-margin ratio is:

$57.50- $18.00- $5.00
= .6
$57.50

PROBLEM 7-35 (30 MINUTES)

fixed costs
1. Break - evenpoint (in units)
unit contribution margin
$702,000
135,000units
$25.00 $19.80

fixed cost
2. Break - even point (in sales dollars)
contribution - margin ratio
$702,000
$3,375,000
$25.00 $19.80
$25.00

fixed costs target net profit

3. Number of sales units required
unit contributi on margin
to earn target net profit $702,000 $390,000
210,000units
$25.00 $19.80

4. Margin of = budgeted sales revenue break-even sales revenue

 safety
= (140,000)($25) $3,375,000 = $125,000

5. Break-even point if direct-labor costs increase by 10 percent:

New unit contribution margin = $25.00 $8.20 ($4.00)(1.10) $6.00 $1.60

= $4.80
fixed costs
Break-even point
new unit contributi on margin
$702,000
146,250units
$4.80
unit contributi on margin
6. Contribution-margin ratio
sales price
$25.00 $19.80
Old contribution-margin ratio
$25.00
.208

Let P denote sales price required to maintain a contribution-margin ratio of .208.

Then P is determined as follows:
P $8.20 ($4.00)(1.10) $6.00 $1.60
.208
P
P $20.20 .208P
.792P $20.20
P $25.51(rounded)

Check: New contribution- $25.51 $8.20 ($4.00)(1.

10) $6.00 $1.60

margin ratio $25.51
.208 (rounded)

PROBLEM 7-37 (30 MINUTES)

1. Unit contribution margin:

Sales $32.0
price 0
Less variable costs:
Sales commissions ($32 x 5%) $ 1.60

System variable 8.00
costs 9.60
Unit contribution $22.4
margin.. 0

Break-even point = fixed costs unit contribution margin

= $1,971,200 $22.40
= 88,000 units
2. Model B is more profitable when sales and production average 184,000
units.

Model A Model B

Sales revenue (184,000 units x $32.00) $5,888,00 $5,888,00

... 0 0
Less variable costs:
Sales commissions ($5,888,000 x 5%) $ $
294,400 294,400
System variable costs:
184,000 units x
$8.00. 1,472,000
184,000 units x
$6.40. 1,177,600
Total variable costs.. $1,766,40 $1,472,00
0 0
Contribution margin... $4,121,60 $4,416,00
0 0
Less: Annual fixed costs..
1,971,200 2,227,200
Net income $2,150,40 $2,188,80
0 0

3. Annual fixed costs will increase by $180,000 ($900,000 5 years)

because of straight-line depreciation associated with the new
equipment, to $2,407,200 ($2,227,200 + $180,000). The unit
contribution margin is $24 ($4,416,000 184,000 units). Thus:

Required sales = (fixed costs + target net profit) unit

contribution margin
= ($2,407,200 + $1,912,800) $24
= 180,000 units

4. Let X = volume level at which annual total costs are equal

$8.00X + $1,971,200 = $6.40X + $2,227,200
$1.60X = $256,000
X = 160,000 units

PROBLEM 7-43 (35 MINUTES)

1. Plan A break-even point = fixed costs unit contribution margin

= $33,000 $33*
= 1,000 units

Plan B break-even point = fixed costs unit contribution margin

 = $99,000 $45**
= 2,200 units

* $120 - [($120 x 10%) + $75]

** $120 - $75

2. Operating leverage refers to the use of fixed costs in an organizations overall

cost structure. An organization that has a relatively high proportion of fixed costs
and low proportion of variable costs has a high degree of operating leverage.

3. Calculation of contribution margin and profit at 6,000 units of sales:

Plan A Plan B

Sales revenue: 6,000 units x $720,00 $720,00

$120. 0 0
Less variable costs:
Cost of purchasing product:
6,000 units x $75. $450,00 $450,00
0 0
Sales commissions: $720,000 x 10%
... 72,000 ----__
Total variable cost.. $522,00 $450,00
0 0
Contribution margin $198,00 $270,00
0 0
Fixed
costs. 33,000 99,000
Net $165,00 $171,00
income. 0 0

Plan A has a higher percentage of variable costs to sales (72.5%)

compared to Plan B (62.5%). Plan Bs fixed costs are 13.75% of sales,
compared to Plan As 4.58%.

Operating leverage factor = contribution margin net income

Plan A: $198,000 $165,000 = 1.2
Plan B: $270,000 $171,000 = 1.58 (rounded)

Plan B has the higher degree of operating leverage.

4 & 5. Calculation of profit at 5,000 units:

Plan A Plan B

Sales revenue: 5,000 units x $600,00 $600,00

$120. 0 0
 Less variable costs:
Cost of purchasing product:
5,000 units x $375,00 $375,00
$75.. 0 0
Sales commissions: $600,000 x 10% ----
... 60,000 __
Total variable $435,00 $375,00
cost.. 0 0
Contribution $165,00 $225,00
margin 0 0
Fixed
costs 33,000 99,000
Net $132,00 $126,00
income. 0 0

Plan A profitability decrease:

$165,000 - $132,000 = $33,000; $33,000 $165,000 = 20%

Plan B profitability decrease:

$171,000 - $126,000 = $45,000; $45,000 $171,000 = 26.3%
(rounded)

PneumoTech would experience a larger percentage decrease in income

if it adopts Plan B. This situation arises because Plan B has a higher
degree of operating leverage. Stated differently, Plan Bs cost structure
produces a greater percentage decline in profitability from the drop-off
in sales revenue.

Note: The percentage decreases in profitability can be computed by

multiplying the percentage decrease in sales revenue by the operating
leverage factor. Sales dropped from 6,000 units to 5,000 units, or
16.67%. Thus:

Plan A: 16.67% x 1.2 = 20.0%

Plan B: 16.67% x 1.58 = 26.3% (rounded)

6. Heavily automated manufacturers have sizable investments in plant and

equipment, along with a high percentage of fixed costs in their cost
structures. As a result, there is a high degree of operating leverage.

In a severe economic downturn, these firms typically suffer a

significant decrease in profitability. Such firms would be a more risky
investment when compared with firms that have a low degree of
operating leverage. Of course, when times are good, increases in sales
 would tend to have a very favorable effect on earnings in a company
with high operating leverage.

PROBLEM 7-46 (35 MINUTES)

$ 2, 2 00 , 00 0 - $ 80 0, 0 0
U ni t co nt r i b ut i o n m ar g i n =
1. 4 0 , 0 0 0u n i t s
= $ 35 p e r u ni t

f i x ed co s t s
B r e a k - ev e n po i n t ( i n u ni t s ) =
u n i t co nt r i bu t i o n m a r
$ 35 0 , 0 0 0
= = 1 0 , 0 0 0un i
$ 35

2. Number of sales units =

fixed costs + target net profit
required to earn target net unit contributi on margin
profit $350,000+ $210,000
= = 16,000units
$35

new fixed costs

3. New break - even point (in units) =
new unit contributi on margin
$350,000+ ($510,000/6) *
= = 15,000units
$35 - $6

*Annual straight-line depreciation on new machine

$6.00 = $12.00 $6.00 increase in the unit cost of the new part

4. Number of sales units new fixed costs + target net profit

to earn target net profit, given =
new unit contributi on margin
manufacturing changes
$435,000+ $1,050,000*
=
$29
= 51,207units (rounded)

*Last year's profit: ($55)(40,000) $1,150,000 = $1,050,000

unit contributi on margin

5. Contribution - margin ratio =
sales price
$35
Old contributi on - margin ratio = = .64 (rounded)
$55 *

*Sales price, given in problem.

Let P denote the price required to cover increased direct-material cost and
maintain the same contribution-margin ratio:
 P - $20 * - $6
= .64
P
P - $26 = .64P
.36P = $26
P = $72.22(rounded)

*Old unit variable cost = $20 = $800,000 40,000 units

Increase in direct-material cost = $6

Check:

$72.22 - $20 - $6
New contributi on - margin ratio =
$72.22
= .64 (rounded)