Cost-Volume-Profit Analysis

Problem I: Contribution Margin, Break-even Units, Break-even Sales, Margin of Safety,

Degree of Operating Leverage
Aldovar Company produces a variety of chemicals. One division makes reagents for
laboratories. The division’s projected income statement for the coming year is:

Sales (203,000 units @ $70) $14,210,000

Variable costs 8,120,000
Contribution margin $ 6,090,000
Fixed cost 4,945,500
Operating income $ 1,144,500

Required:
1. Compute the contribution margin per unit, and calculate the break-even point in units.
(Note: Round answer to the nearest unit.). Calculate the contribution margin ratio and
use it to calculate the break-even sales revenue. (Note: Round contribution margin ratio
to four decimal places, and round break-even sales revenue to the nearest dollar.)

2. The divisional manager has decided to increase the advertising budget by $250,000. This
will increase sales revenues by $1 million. By how much will operating income increase
or decrease as a result of this action?

3. Suppose sales revenues exceed the estimated amount on the income statement by
$1,500,000. Without preparing a new income statement, by how much are profits
underestimated?

4. Compute the margin of safety based on the original income statement.

5. Compute the degree of operating leverage based on the original income statement. If
sales revenues are 8% greater than expected, what is the percentage increase in
operating income? (Round operating leverage to two decimal places.)

Problem II: Contribution Margin Ratio, Break-even Sales, Operating Leverage

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Cost-Volume-Profit Analysis

Elgart Company produces plastic mailboxes. The projected income statement for the coming
year follows:

Sales $460,300
Variable costs 165,708
Contribution margin $294,592
Total fixed costs 150,000
Operating income $144,592

Required:
1. Compute the contribution margin ratio for the mailboxes.
2. How much revenue must Elgart earn to break-even?
3. What is the effect on the contribution margin ratio if the unit selling price and unit
variable cost each increase by 15%?
4. Suppose that management has decided to give a 4% commission on all sales. The
projected income statement does not reflect this commission. Recompute the
contribution margin ratio, assuming that the commission will be paid. What effect does
this have on the break-even point?
5. If the commission is paid as described in Requirement 4, management expects sales
revenue to increase by $80,000. How will this affect operating leverage? Is it a sound
decision to implement the commission? Support your answer with appropriate
computations.

Problem III: Multiple-Product Analysis, Changes in Sales Mix, Sales to Earn Target
Operating Income

Basu Company produces two types of sleds for playing in the snow, basic sled and aerosled.
The projected income for the coming year, segmented by product line, follows:

Basic Sled Aerosled Total

Sales $3,000,000 $2,400,000 $5,400,000
Total variable costs 1,000,000 1,000,000 2,000,000
Contribution margin $2,000,000 $1,400,000 $3,400,000
Direct fixed cost 778,000 650,000 1,428,000
Product margin $1,222,000 $ 750,000 $1,972,000
Common fixed cost 198,900
Operating income $1,773,100

The selling price are $30 for the basic sled and $60 for the aerosled. (Round break-even packages
and break-even units to the nearest whole unit.)

Required:
1. Compute the number of units of each product that must be sold for Basu to break-even.
2. Assume that the marketing manager changes the sales mix of the two products so that
the ratio is five basic sleds to three aerosleds. Repeat requirement 1.
3. Refer to the original data. Supposed that Basu can increase the sales of aerosleds with
increased advertising. The extra advertising would cost an additional $195,000 and some
of the potential purchasers of basic sleds would switch to aerosleds. In total, sales of

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Cost-Volume-Profit Analysis

aerosleds would increase by 12,000 units and sales of basic sleds would decrease by
5,000 units. Would Basu be better off with this strategy?

Partial solution for this problem:

1. To compute for the breakeven point for a firm selling multiple products, it will be
helpful to think that the firm is selling a package (or a bundle or a basket whichever is
more comfortable for you to use) where each package contains a combination of its
products. The number of each product in a package depends on the sales mix planned or
anticipated by the firm.

Based on the projected income statement, we will compute the projected sales volume
for each product.
Basic sled $3,000,000 / $30 per unit = 100,000 units
Aerosled $2,400,000 / $60 per unit = 40,000 units

Based on the computed projected sales volume, we can develop the ratio of the
combination of products in each package: 100,000:40,000 or 5:2. There are five basic sleds
and two aerosleds in a package.

We must also compute for the contribution margin per package. We would start with
the contribution margin of each product:
Basic sled $30 – ($1,000,000 / 100,000 units) = $20 per unit
Aerosled $60 – ($1,000,000 / 40,000 units) = $35 per unit

There are five basic sleds and two aerosleds in a package. Thus, the contribution margin
for each package is:
(5 basic sled x $20 per basic sled) + (2 aerosleds x $35 per aerosled) = $170 per package

To compute for the breakeven point, we must find out how many packages must be
sold. After computing the number of packages, we can solve for the sales volume for
each product.

Breakeven point (units of packages) = Total fixed costs / CM per package

Breakeven point (units of packages) = ($1,428,000 + $198,900) / $170 per package
Breakeven point (units of packages) = 9.570 packages

In each package, there are five basic sleds and two aerosleds. The sales volume for each
product are thus computed as:

9,570 packages x 5 basic sleds per package = 47,850 basic sleds

9,570 packages x 2 aerosleds per package = 19,140 aerosleds

To breakeven, 47,850 basic sleds and 19,140 aerosleds must be sold based on a sales mix
of 5:2.

Problem IV: Cost-Volume-Profit with Multiple Products, Sales Mix Changes, Changes in
Fixed and Variable Costs

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Cost-Volume-Profit Analysis

Artistic Woodcrafting Inc. began several years ago as a one-person, cabinet-making operation.
Employees were added as the business expanded. Last year, sales volume totaled $850,000.
Volume for the first five months of the current year totaled $600,000, and sales were expected to
be $1.6 million for the entire year. Unfortunately, the cabinet business in the region where
Artistic is located is highly competitive. More than 200 cabinet shops are all competing for the
same business.

Artistic currently offers two different quality grades of cabinets. Grade I and Grade II, with
Grade I being the higher quality. The average unit selling prices, unit variable costs, and direct
fixed costs are as follows:

Unit price Unit Variable Cost Unit Fixed Cost

Grade I $3,400 $2,686 $95,000
Grade II 1,600 1,328 95,000

Common fixed costs are $35,000. Currently, for every three Grade I cabinets sold, seven Grade II
cabinets are sold.

Required:
1. Calculate the number of Grade I and Grade II cabinets that are expected to be sold
during the current year.
2. Calculate the number of Grade I and Grade II cabinets that must be sold to break-even.
3. Artistic Company can buy computer-controlled machines that will make doors, drawers
and frames. If the machines are purchased, the variable costs for each type of cabinet
will decrease by 9% but common fixed cost will increase by $44,000. Compute the effect
on operating income, and also calculate the new break-even point. Assume the machines
are purchased at the beginning of the sixth month. Fixed costs for the company are
incurred uniformly throughout the year.
4. Refer to the original data. Artistic is considering adding a retail outlet. This will increase
common fixed cost by $70,000 per year. As a result of adding the retail outlet, the
additional publicity and emphasis on quality will allow the firm to change the sales mix
to 1:1. The retail outlet is also expected to increase sales by 30%. Assume that fixed costs
are incurred uniformly throughout the year.

Problem V: Ethics and CVP Application

Danna Lumus, the marketing manager for a division that produces a variety of paper products,
is considering the divisional manager’s request for a sales forecast for a new line of paper
napkins. The divisional manager has been gathering data so that he can choose between two
different production processes. The first process would have a variable cost of $10 per case and
total fixed cost of $100,000. The second process would have a variable cost of $6 per case and
total fixed cost of $200,000. The selling price would be $30 per case. Danna had just completed a
marketing analysis that projects annual sales of 30,000 cases.

Danna is reluctant to report the 30,000 forecast to the divisional manager. She knows that the
first process would be labor intensive, whereas the second would be largely automated with
little labor and no requirement for an additional supervisor. If the first process is chosen, Jerry
Johnson, a good friend, will be appointed as the line supervisor. If the second process is chosen,

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Cost-Volume-Profit Analysis

Jerry and an entire line of laborers will be laid off. After some consideration, Danna revises the
projected sales downward to 22,000 cases.

She believes that the revision downward is justified. Since it will lead the divisional manager to
choose the manual system, it shows a sensitivity to the needs of current employees – a
sensitivity she is afraid her divisional manager does not possess. He is too focused on
quantitative factors in his decision making and usually ignores the qualitative aspects.

Required:
1. Compute the break-even point for each process.
2. Compute for the sales volume for which the two processes are equally profitable.
Identify the range of sales for which the manual process is more profitable than the
automated process. Identify the range of sales for which the automated process is more
profitable than the manual process. Why does the divisional manager want the sales
forecast?
3. Discuss Danna’s decision to alter the sales forecast. Do you agree with it? Is she acting
ethically? Is her decision justified since it helps a number of employees retain their
employment? Should the impact on employees be factored into decisions? In fact, is it
unethical not to consider the impact of decisions on employees?

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