Cost-Volume-Profit Relationships: Solutions To Questions

Chapter 5
Cost-Volume-Profit Relationships
Solutions to Questions
5-1 The contribution margin (CM) ratio is higher unit volume. (b) If the fixed cost
the ratio of the total contribution margin to total increased, then both the fixed cost line and the
sales revenue. It can also be expressed as the total cost line would shift upward and the break-
ratio of the contribution margin per unit to the even point would occur at a higher unit volume.
selling price per unit. It is used in target profit (c) If the variable cost per unit increased, then
and break-even analysis and can be used to the total cost line would rise more steeply and
quickly estimate the effect on profits of a the break-even point would occur at a higher
change in sales revenue. unit volume.
5-2 Incremental analysis focuses on the 5-7 The margin of safety is the excess of
changes in revenues and costs that will result budgeted (or actual) sales over the break-even
from a particular action. volume of sales. It is the amount by which sales
can drop before losses begin to be incurred.
5-3 All other things equal, Company B, with
its higher fixed costs and lower variable costs, 5-8 The sales mix is the relative proportions
will have a higher contribution margin ratio than in which a company’s products are sold. The
Company A. Therefore, it will tend to realize a usual assumption in cost-volume-profit analysis
larger increase in contribution margin and in is that the sales mix will not change.
profits when sales increase.
5-9 A higher break-even point and a lower
5-4 Operating leverage measures the impact net operating income could result if the sales
on net operating income of a given percentage mix shifted from high contribution margin
change in unit sales. The degree of operating products to low contribution margin products.
leverage at a given level of sales is computed by Such a shift would cause the average
dividing the contribution margin at that level of contribution margin ratio in the company to
sales by the net operating income at that level decline, resulting in less total contribution
of sales. margin for a given amount of sales. Thus, net
operating income would decline. With a lower
5-5 The break-even point is the level of contribution margin ratio, the break-even point
sales at which profits are zero. would be higher because more sales would be
required to cover the same amount of fixed
5-6 (a) If the selling price decreased, then costs.
the total revenue line would rise less steeply,
and the break-even point would occur at a
© The McGraw-Hill Companies, Inc., 2021. All rights reserved.

Solutions Manual, Chapter 5 1
Chapter 5: Applying Excel
The completed worksheet is shown below.

2 Managerial Accounting, 17th Edition
Chapter 5: Applying Excel (continued)
The completed worksheet, with formulas displayed, is shown below.

1. When the fixed expenses are changed to $270,000, the worksheet
changes as shown below:
The margin of safety percentage is now 10%, whereas it was 20%

before. This change occurred because the increase in fixed expenses
increased the break-even point and hence reduced the margin of safety
available for the current level of unit sales.

2. With the changes in the data, the worksheet should look like this:
The margin of safety percentage is 13% and the degree of operating

leverage is 8.

3. The degree of operating leverage can be used to estimate the expected
percentage increase in net operating income from a 15% increase in
unit sales as follows:
Percentage change in net operating income = Degree of operating
leverage × Percentage change in sales = 8.00 × 15% = 120%
An increase of 120% over the current net operating income of $60,000
would result in net operating income of $132,000. This is verified in part
(4) that follows.

4. Increasing the unit sales by 15% results in net operating income of
$132,000—an increase of 120% over the previous net operating income
of $60,000.

5. a. The initial plan for the Western Hombre motorcycle is summarized
below:

5. b. The modified plan for the Western Hombre motorcycle is summarized
below:

This does not appear to be a good plan. At best, Thad would only
break even—and that assumes that 600 units would still be sold
despite the drastic reduction in advertising expenses. The margin of
safety is zero which means that any decrease in sales to below 600
units would result in a loss.
The degree of operating leverage is displayed in the worksheet as
#DIV/0!. This means that Excel is unable to compute the degree of
operating leverage because the divisor is 0. The divisor is 0 because
the degree of operating leverage is the contribution margin divided
by the net operating income and the net operating income is zero.
Technically, the degree of operating leverage is undefined when net
operating income is zero.

The Foundational 15
1. The contribution margin per unit is calculated as follows:
Total contribution margin (a) .............. $8,000
Total units sold (b) ............................. 1,000 units
Contribution margin per unit (a) ÷ (b) . $8.00 per unit
The contribution margin per unit ($8) can also be derived by calculating
the selling price per unit of $20 (= $20,000 ÷ 1,000 units) and
deducting the variable expense per unit of $12 (= $12,000 ÷ 1,000
units).
2. The contribution margin ratio is calculated as follows:

Total contribution margin (a) .............. $8,000
Total sales (b) .................................... $20,000
Contribution margin ratio (a) ÷ (b) ...... 40%
3. The variable expense ratio is calculated as follows:

Total variable expenses (a) ................. $12,000
Total sales (b) .................................... $20,000
Variable expense ratio (a) ÷ (b) .......... 60%
4. The increase in net operating income is calculated as follows:

Contribution margin per unit (a) ................... $8.00 per unit
Increase in unit sales (b) ............................ 1 unit
Increase in net operating income (a) × (b) .. $8.00
5. If sales decline to 900 units, the net operating income would be

computed as follows:
Total Per Unit
Sales (900 units) .......... $18,000 $20.00
Variable expenses ......... 10,800 12.00
Contribution margin ...... 7,200 $ 8.00
Fixed expenses ............. 6,000
Net operating income ... $ 1,200

The Foundational 15 (continued)
6. The new net operating income would be computed as follows:
Total Per Unit
Sales (900 units) .......... $19,800 $22.00
Contribution margin ...... 9,000 $10.00
Fixed expenses ............. 6,000
7. The new net operating income would be computed as follows:

Total Per Unit
Sales (1,250 units) ....... $25,000 $20.00
Contribution margin ...... 8,750 $ 7.00
Fixed expenses ............. 7,500
8. The equation method yields the break-even point in unit sales, Q, as

follows:
Profit = Unit CM × Q − Fixed expenses
$0 = ($20 − $12) × Q − $6,000
$0 = ($8) × Q − $6,000
$8Q = $6,000
Q = $6,000 ÷ $8
Q = 750 units
9. The equation method yields the dollar sales to break-even as follows:
Profit = CM ratio × Sales − Fixed expenses

$0 = 0.40 × Sales − $6,000
0.40 × Sales = $6,000
Sales = $6,000 ÷ 0.40
Sales = $15,000
The dollar sales to break-even ($15,000) can also be computed by

multiplying the selling price per unit ($20) by the unit sales to break-
even (750 units).
10. The equation method yields the target profit as follows:

$5,000 = ($20 − $12) × Q − $6,000
$5,000 = ($8) × Q − $6,000
$8Q = $11,000
Q = $11,000 ÷ $8
Q = 1,375 units
11. The margin of safety in dollars is calculated as follows:

Sales .............................................................. $20,000
Break-even sales (at 750 units) ........................ 15,000
Margin of safety (in dollars) ............................. $ 5,000
The margin of safety as a percentage of sales is calculated as follows:

Margin of safety (in dollars) (a) ................. $5,000
Sales (b).................................................. $20,000
Margin of safety percentage (a) ÷ (b) ....... 25%
12. The degree of operating leverage is calculated as follows:

Contribution margin (a) . ...................... $8,000
Net operating income (b)...................... $2,000
Degree of operating leverage (a) ÷ (b) . 4.0
13. A 5% increase in unit sales should result in a 20% increase in net

operating income, computed as follows:
Degree of operating leverage (a) ............................. 4.0
Percent increase in sales (b) .................................... 5%
Percent increase in net operating income (a) × (b) ... 20%
14. The degree of operating leverage is calculated as follows:

Contribution margin ($20,000 – $6,000) (a) ......... $14,000
Net operating income (b) .................................... $2,000
Degree of operating leverage (a) ÷ (b) ................ 7.0


Degree of operating leverage (a) .............................. 7.0

Percent increase in sales (b) ..................................... 5%
Percent increase in net operating income (a) × (b) .... 35%

Exercise 5-1 (20 minutes)
1. The revised net operating income would be:
Total Per Unit
Sales (10,100 units) ........ $353,500 $35.00
Variable expenses ........... 202,000 20.00
Contribution margin ........ 151,500 $15.00
Fixed expenses ............... 135,000
Net operating income ...... $ 16,500
You can get the same net operating income using the following
approach:
Original net operating income .... $15,000
Change in contribution margin
(100 units × $15.00 per unit) .. 1,500
New net operating income ......... $16,500

Total Per Unit
Sales (9,900 units) ............ $346,500 $35.00
Variable expenses ............. 198,000 20.00
Contribution margin .......... 148,500 $15.00
Fixed expenses ................. 135,000
Net operating income ........ $ 13,500
You can get the same net operating income using the following
approach:
Original net operating income ............. $15,000
Change in contribution margin
(-100 units × $15.00 per unit) .......... (1,500)
New net operating income .................. $13,500

Exercise 5-1 (continued)
Total Per Unit
Sales (9,000 units) ........ $315,000 $35.00
Contribution margin ...... 135,000 $15.00
Fixed expenses ............. 135,000
Net operating income .... $ 0
Note: This is the company’s break-even point.

1. The CVP graph can be plotted using the three steps outlined in the text.
The graph appears on the next page.
Step 1. Draw a line parallel to the volume axis to represent the total
fixed expense. For this company, the total fixed expense is $24,000.
Step 2. Choose some volume of sales and plot the point representing
total expenses (fixed and variable) at the activity level you have
selected. We’ll use the sales level of 8,000 units.
Fixed expenses ................................................... $ 24,000
Variable expenses (8,000 units × $18 per unit) .... 144,000
Total expense ..................................................... $168,000
Step 3. Choose some volume of sales and plot the point representing
total sales dollars at the activity level you have selected. We’ll use the
sales level of 8,000 units again.
Total sales revenue (8,000 units × $24 per unit) .. $192,000
2. The break-even point is the point where the total sales revenue and the
total expense lines intersect. This occurs at sales of 4,000 units. This
can be verified as follows:
= ($24 − $18) × 4,000 − $24,000
= $6 × 4,000 − $24,000
= $24,000 − $24,000
= $0

CVP Graph
$200,000
$150,000
Dollars
$100,000
$50,000
$0
0 2,000 4,000 6,000 8,000
Volume in Units
Fixed Expense Total Expense Total Sales Revenue

1. The profit graph is based on the following simple equation:
Profit = ($16 − $11) × Q − $16,000
Profit = $5 × Q − $16,000
To plot the graph, select two different levels of sales such as Q = 0 and
Q = 4,000. The profit at these two levels of sales are -$16,000 (= $5 ×
0 − $16,000) and $4,000 (= $5 × 4,000 − $16,000).
Profit Graph
$5,000
$0
-$5,000
Profit
-$10,000
-$15,000
-$20,000
0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000
Sales Volume in Units

2. Looking at the graph, the break-even point appears to be 3,200 units.
This can be verified as follows:
= $5 × Q − $16,000
= $5 × 3,200 − $16,000
= $16,000 − $16,000
= $0

1. The company’s contribution margin (CM) ratio is:
Total sales ............................ $200,000
Total variable expenses ......... 120,000
Total contribution margin (a) . $ 80,000
Total contribution margin (a) . $80,000

Total sales (b)....................... $200,000
CM ratio (a) ÷ (b) ................. 40%
2. The change in net operating income from an increase in total sales of

$1,000 can be estimated by using the CM ratio as follows:
Change in total sales (a) .......................................... $1,000
CM ratio (b) ............................................................ 40%
Estimated change in net operating income (a) × (b) . $400
This computation can be verified as follows:

Total sales (a) .......................... $200,000
Total units sold (b) ................... 50,000 units
Selling price per unit (a) ÷ (b) .. $4.00 per unit
Increase in total sales (a) ......... $1,000

Selling price per unit (b) ........... $4.00 per unit
Increase in unit sales (a) ÷ (b) . 250 units
Increase in unit sales ............... 250 units
Original total unit sales ............. 50,000 units
New total unit sales .................. 50,250 units
Original New
Total unit sales ............... 50,000 50,250
Sales .............................. $200,000 $201,000
Variable expenses ........... 120,000 120,600
Contribution margin ........ 80,000 80,400
Fixed expenses ............... 65,000 65,000
Net operating income ...... $ 15,000 $ 15,400

1. The following table shows the effect of the proposed change in monthly
advertising budget:
Sales With
Additional
Current Advertising
Sales Budget Difference
Sales .............................. $180,000 $189,000 $ 9,000
Variable expenses ........... 126,000 132,300 6,300
Contribution margin ........ 54,000 56,700 2,700
Fixed expenses ............... 30,000 35,000 5,000
Net operating income ...... $ 24,000 $ 21,700 $ (2,300)
Assuming no other important factors need to be considered, the
increase in the advertising budget should not be approved because it
would lead to a decrease in net operating income of $2,300.
Alternative Solution 1
Expected total contribution margin:
$189,000 × 30% CM ratio .................. $56,700
Present total contribution margin:
$180,000 × 30% CM ratio .................. 54,000
Incremental contribution margin ........... 2,700
Change in fixed expenses:
Less incremental advertising expense . 5,000
Change in net operating income ............ $ (2,300)
Alternative Solution 2
Incremental contribution margin:
$9,000 × 30% CM ratio ..................... $2,700
Less incremental advertising expense .... 5,000
Change in net operating income ............ $ (2,300)

2. The $2 increase in variable expense will cause the unit contribution
margin to decrease from $27 to $25 with the following impact on net
operating income:
Expected total contribution margin with the
higher-quality components:
2,000 units × 1.1 × $25 per unit ............ $55,000
Present total contribution margin:
2,000 units × $27 per unit ..................... 54,000
Change in total contribution margin........... $ 1,000
Assuming no change in fixed expenses, the net operating income will
also increase by $1,000. The higher-quality components should be used.

1. The break-even point in unit sales, Q, is computed as follows:
$0 = ($15 − $12) × Q − $4,200
$0 = ($3) × Q − $4,200
$3Q = $4,200
Q = $4,200 ÷ $3
Q = 1,400 baskets
2. The break-even point in dollar sales is computed as follows:
Unit sales to break even (a) ............................ 1,400

Selling price per unit (b) ................................. $15
Dollar sales to break even (a) × (b) ................ $21,000
3. The new break-even point in unit sales, Q, is computed as follows:

$0 = ($15 − $12) × Q − $4,800
$0 = ($3) × Q − $4,800
$3Q = $4,800
Q = $4,800 ÷ $3
Q = 1,600 baskets
The break-even point in dollar sales is computed as follows:
Unit sales to break even (a) ............................ 1,600

Dollar sales to break even (a) × (b) ................ $24,000

1. The required unit sales, Q, to attain the target profit is computed as
follows:
$10,000 = ($120 − $80) × Q − $50,000
$10,000 = ($40) × Q − $50,000
$40 × Q = $10,000 + $50,000
Q = $60,000 ÷ $40
Q = 1,500 units
2. One approach to solving this requirement is to compute the unit sales

required to attain the target profit and then multiply this quantity by the
selling price per unit:
$15,000 = ($120 − $80) × Q − $50,000
$15,000 = ($40) × Q − $50,000
$40 × Q = $15,000 + $50,000
Q= $65,000 ÷ $40
Q= 1,625 units
Unit sales to attain the target profit (a)............ 1,625

Dollar sales to attain target profit (a) × (b) ...... $195,000

1. To compute the margin of safety, we must first compute the break-even
unit sales.
$0 = ($30 − $20) × Q − $7,500
$0 = ($10) × Q − $7,500
$10Q = $7,500
Q = $7,500 ÷ $10
Q = 750 units; or, at $30 per unit, $22,500
Sales (at the budgeted volume of 1,000 units) .. $30,000
Less break-even sales (at 750 units) ................ 22,500
Margin of safety (in dollars) ............................. $ 7,500
2. The margin of safety as a percentage of sales is as follows:

Margin of safety (in dollars) (a) ................ $7,500
Sales (b)................................................. $30,000
Margin of safety percentage (a) ÷ (b) ...... 25%

1. The company’s degree of operating leverage would be computed as
follows:
Contribution margin (a) .......................... $48,000
Net operating income (b)........................ $10,000
Degree of operating leverage (a) ÷ (b) ... 4.8

Degree of operating leverage (a) .......................................... 4.8
Percent increase in unit sales (b) .......................................... 5%
Estimated percent increase in net operating income (a) × (b) . 24%
3. The new income statement reflecting the change in unit sales is:
Percent
Amount of Sales
Sales ............................ $84,000 100%
Variable expenses ......... 33,600 40%
Contribution margin ...... 50,400 60%
Fixed expenses ............. 38,000
Net operating income .... $12,400
Net operating income reflecting change in sales ...... $12,400
Original net operating income (a) ........................... 10,000
Change in net operating income (b) ....................... $ 2,400
Percent change in net operating income (b) ÷ (a) ... 24%

1. The overall contribution margin ratio can be computed as follows:
Total contribution margin
Overall CM ratio =
Total sales
$30,000
= =30%
$100,000
2. The overall break-even point in dollar sales can be computed as follows:

Total fixed expenses
Overall break-even =
Overall CM ratio
$24,000
= = $80,000
30%
3. To construct the required income statement, we must first determine
the relative sales mix for the two products:
Claimjumper Makeover Total
Original dollar sales ....... $30,000 $70,000 $100,000
Percent of total ............. 30% 70% 100%
Sales at break-even ....... $24,000 $56,000 $80,000
Claimjumper Makeover Total

Sales ............................ $24,000 $56,000 $80,000
Variable expenses* ....... 16,000 40,000 56,000
Contribution margin ...... $ 8,000 $16,000 24,000
Fixed expenses ............. 24,000
Net operating income .... $ 0
*Claimjumper variable expenses: ($24,000/$30,000) × $20,000 = $16,000
Makeover variable expenses: ($56,000/$70,000) × $50,000 = $40,000

a. Case #1 Case #2
Number of units sold .. 15,000 * 4,000
Sales ......................... $180,000 * $12 $100,000 * $25
Variable expenses....... 120,000 * 8 60,000 15
Contribution margin .... 60,000 $4 40,000 $10 *
Fixed expenses........... 50,000 * 32,000 *
Net operating income . $ 10,000 $ 8,000 *
Case #3 Case #4
Number of units sold .. 10,000 * 6,000 *
Sales ......................... $200,000 $20 $300,000 * $50
Variable expenses....... 70,000 * 7 210,000 35
Contribution margin .... 130,000 $13 * 90,000 $15
Fixed expenses........... 118,000 100,000 *
Net operating income (loss).. $ 12,000 * $ (10,000) *
b. Case #1 Case #2
Sales.......................... $500,000 * 100% $400,000 * 100%
Variable expenses ....... 400,000 80% 260,000 * 65%
Contribution margin .... 100,000 20% * 140,000 35%
Fixed expenses ........... 93,000 100,000 *
Net operating income.. $ 7,000 * $ 40,000
Case #3 Case #4
Sales ......................... $250,000 100% $600,000 * 100%
Variable expenses ...... 100,000 40% 420,000 * 70%
Contribution margin ... 150,000 60% * 180,000 30%
Fixed expenses .......... 130,000 * 185,000
Net operating income (loss). $ 20,000 * $ (5,000) *
*Given

1.
Flight Dynamic Sure Shot Total Company
Amount % Amount % Amount %
Sales ............... $150,000 100 $250,000 100 $400,000 100.0
Variable
expenses ...... 30,000 20 160,000 64 190,000 47.5
Contribution
margin .......... $120,000 80 $ 90,000 36 210,000 52.5*
Fixed expenses 183,750
Net operating
income ......... $ 26,250
*$210,000 ÷ $400,000 = 52.5%
2. The break-even point for the company as a whole is:

Dollar sales to = Fixed expenses
break even Overall CM ratio
$183,750
= = $350,000
0.525
3. The additional contribution margin from the additional sales is computed
as follows:
$100,000 × 52.5% CM ratio = $52,500
Assuming no change in fixed expenses, all of this additional contribution
margin of $52,500 should drop to the bottom line as increased net
operating income.
This answer assumes no change in selling prices, variable costs per
unit, fixed expense, or sales mix.

Total Per Unit

1. Sales (20,000 units × 1.15 = 23,000 units)..... $345,000 $ 15.00
Variable expenses ......................................... 207,000 9.00
Contribution margin ...................................... 138,000 $ 6.00
Fixed expenses ............................................. 70,000
Net operating income .................................... $ 68,000
2. Sales (20,000 units × 1.25 = 25,000 units)..... $337,500 $13.50

Fixed expenses ............................................. 70,000

Fixed expenses ............................................. 90,000

Fixed expenses ............................................. 70,000

1. Variable expenses: $40 × (100% – 30%) = $28
2. The break-even points in unit sales (Q) and dollar sales are computed as
follows:
Selling price .......................... $40 100%

Variable expenses ................. 28 70%
Contribution margin .............. $12 30%
$0 = $12 × Q − $180,000
$12Q = $180,000
Q= $180,000 ÷ $12
Q= 15,000 units
In dollar sales: 15,000 units × $40 per unit = $600,000
Alternative solution:
$0 = 0.30 × Sales − $180,000
0.30 × Sales = $180,000
Sales = $180,000 ÷ 0.30
Sales = $600,000
In unit sales: $600,000 ÷ $40 per unit = 15,000 units
3. The unit sales and dollar sales needed to attain the target profit are
computed as follows:

$60,000 = $12 × Q − $180,000
$12Q = $60,000 + $180,000
$12Q = $240,000
Q = $240,000 ÷ $12
Q = 20,000 units

$60,000 = 0.30 × Sales − $180,000
0.30 × Sales = $240,000
Sales = $240,000 ÷ 0.30
Sales = $800,000
4. The new break-even points in unit sales and dollar sales are computed
as follows:
The company’s new cost/revenue relation will be:

Selling price .............................. $40 100%
Variable expenses ($28 – $4) ..... 24 60%
Contribution margin ................... $16 40%
$0 = ($40 − $24) × Q − $180,000
$16Q = $180,000
Q = $180,000 ÷ $16 per unit
Q = 11,250 units
$0 = 0.40 × Sales − $180,000
0.40 × Sales = $180,000
Sales = $180,000 ÷ 0.40
Sales = $450,000

4. The dollar sales required to attain the target profit is computed as
follows:

$60,000 = 0.40 × Sales − $180,000
0.40 × Sales = $240,000
Sales = $240,000 ÷ 0.40
Sales = $600,000

1.
Per
Total Unit
Sales (15,000 games) ......... $300,000 $20
Variable expenses .............. 90,000 6
Contribution margin ............ 210,000 $14
Fixed expenses................... 182,000
Net operating income ......... $ 28,000
The degree of operating leverage is:

Degree of operating = Contribution margin
leverage Net operating income
$210,000
= = 7.5
$28,000
2. a. Sales of 18,000 games represent a 20% increase over last year’s
sales. Because the degree of operating leverage is 7.5, net operating
income should increase by 7.5 times as much, or by 150% (7.5 ×
20%).
b. The expected total dollar amount of net operating income for next
year would be:
Last year’s net operating income ...................... $28,000
Expected increase in net operating income next
year (150% × $28,000) ................................ 42,000
Total expected net operating income ................ $70,000

1. The contribution margin per person would be:
Price per ticket ..................................... $35
Variable expenses:
Dinner............................................... $18
Favors and program ........................... 2 20
Contribution margin per person ............. $15
The fixed expenses of the dinner-dance total $6,000 (= $2,800 + $900
+ $1,000 + $1,300). The break-even point would be:
$0 = ($35 − $20) × Q − $6,000
$0 = ($15) × Q − $6,000
$15Q = $6,000
Q = $6,000 ÷ $15
Q = 400 persons; or, at $35 per person, $14,000
Unit sales to = Fixed expenses
break even Unit contribution margin
$6,000
= = 400 persons
$15
or, at $35 per person, $14,000.
2. Variable cost per person ($18 + $2) ................. $20

Fixed cost per person ($6,000 ÷ 300 persons) .. 20
Ticket price per person to break even ............... $40

3. Cost-volume-profit graph:
$20,000
Total Sales
$18,000
Break-even point: Total
$16,000 400 persons or Expenses
$14,000 total sales
$14,000
$12,000
Total Sales
$10,000
$8,000
$6,000 Total
Fixed
$4,000 Expenses
$2,000
$0
0 100 200 300 400 500 600 700
Number of Persons

1. Profit = Unit CM × Q − Fixed expenses

$0 = ($50 − $32) × Q − $108,000
$0 = ($18) × Q − $108,000
$18Q = $108,000
Q = $108,000 ÷ $18
Q = 6,000 stoves, or at $50 per stove, $300,000 in sales
$108,000
= = 6,000 stoves
$18.00 per stove
or at $50 per stove, $300,000 in sales.
2. An increase in variable expenses as a percentage of the selling price

would result in a higher break-even point. If variable expenses increase
as a percentage of sales, then the contribution margin will decrease as a
percentage of sales. With a lower CM ratio, more stoves would have to
be sold to generate enough contribution margin to cover the fixed costs.
3. Present: Proposed:
8,000 Stoves 10,000 Stoves*
Total Per Unit Total Per Unit
Sales ............................ $400,000 $50 $450,000 $45 **
Variable expenses.......... 256,000 32 320,000 32
Contribution margin ....... 144,000 $18 130,000 $13
Fixed expenses.............. 108,000 108,000
Net operating income .... $ 36,000 $ 22,000
*8,000 stoves × 1.25 = 10,000 stoves
**$50 × 0.9 = $45
As shown above, a 25% increase in volume is not enough to offset a
10% reduction in the selling price; thus, net operating income
decreases.


$35,000 = ($45 − $32) × Q − $108,000
$35,000 = ($13) × Q − $108,000
$13 × Q = $143,000
Q = $143,000 ÷ $13
Q = 11,000 stoves
Unit sales to attain = Target profit + Fixed expenses
target profit Unit contribution margin
$35,000 + $108,000
=
$13
= 11,000 stoves


$0 = ($30 − $12) × Q − $216,000
$0 = ($18) × Q − $216,000
$18Q = $216,000
Q = $216,000 ÷ $18
Q = 12,000 units, or at $30 per unit, $360,000
Unit sales = Fixed expenses
to break even Unit contribution margin
$216,000
= = 12,000 units
$18
or at $30 per unit, $360,000
2. The contribution margin is $216,000 because the contribution margin is

equal to the fixed expenses at the break-even point.
3. The unit sales to attain the target profit is computed as follows:
Units sold to attain = Target profit + Fixed expenses

$90,000 + $216,000
=
$18
= 17,000 units
Total Unit
Sales (17,000 units × $30 per unit) ....... $510,000 $30
Variable expenses
(17,000 units × $12 per unit) ............. 204,000 12
Contribution margin ............................. 306,000 $18
Fixed expenses .................................... 216,000
Net operating income ........................... $ 90,000

4. Margin of safety in dollar terms:
Margin of safety = Total sales - Break-even sales
in dollars
= $450,000 - $360,000 = $90,000

Margin of safety in percentage terms:
Margin of safety = Margin of safety in dollars
percentage Total sales
$90,000
= = 20%
$450,000
5. The CM ratio is 60% [= ($30 – $12) ÷ $30].
Expected total contribution margin: ($500,000 × 60%) .. $300,000

Present total contribution margin: ($450,000 × 60%) .... 270,000
Increased contribution margin....................................... $ 30,000
$50,000 incremental sales × 60% CM ratio = $30,000
Given that the company’s fixed expenses will not change, monthly net
operating income will also increase by $30,000.

Problem 5-19 (45 minutes)
1. Sales (15,000 units × $70 per unit) ...................... $1,050,000

Variable expenses (15,000 units × $40 per unit) ... 600,000
Contribution margin ............................................ 450,000
Fixed expenses ................................................... 540,000
Net operating loss ............................................... $ (90,000)
2. Unit sales to Fixed expenses

=
$540,000
=
$70 per unit - $40 per unit
=18,000 units
18,000 units × $70 per unit = $1,260,000 to break even
3. See the next page.
4. At a selling price of $58 per unit, the contribution margin is $18 per unit.
Therefore:
$540,000
=
$18
= 30,000 units
30,000 units × $58 per unit = $1,740,000 to break even.
This break-even point is different from the break-even point in part (2)
because of the change in selling price. With the change in selling price,
the unit contribution margin drops from $30 to $18, resulting in an
increase in the break-even point.

Problem 5-19 (continued)
3.
Unit Unit Unit Total
Selling Variable Contribution Volume Contribution Fixed Net operating
Price Expense Margin (Units) Margin Expenses income (loss)
$70 $40 $30 15,000 $450,000 $540,000 $ (90,000)
$68 $40 $28 20,000 $560,000 $540,000 $ 20,000
$66 $40 $26 25,000 $650,000 $540,000 $110,000
$64 $40 $24 30,000 $720,000 $540,000 $180,000
$62 $40 $22 35,000 $770,000 $540,000 $230,000
$60 $40 $20 40,000 $800,000 $540,000 $260,000
$58 $40 $18 45,000 $810,000 $540,000 $270,000
$56 $40 $16 50,000 $800,000 $540,000 $260,000
The maximum profit is $270,000. This level of profit can be earned by selling 45,000 units at a price
of $58 each.

1. a. Selling price ..................... $25 100%

Variable expenses ............ 15 60%
Contribution margin ......... $10 40%
$0 = $10 × Q − $210,000
$10Q = $210,000
Q = $210,000 ÷ $10
Q = 21,000 balls
$210,000
=
$10
= 21,000 balls
b. The degree of operating leverage is:
Degree of Contribution margin
=
operating leverage Net operating income
$300,000
= = 3.33 (rounded)
$90,000
2. The new CM ratio will be:

Selling price .................... $25 100%
Variable expenses ........... 18 72%
Contribution margin......... $ 7 28%
The new break-even point will be:
$0 = $7 × Q − $210,000
$7Q = $210,000
Q = $210,000 ÷ $7
Q = 30,000 balls

$210,000
=
$7
= 30,000 balls

$90,000 = $7 × Q − $210,000
$7Q = $90,000 + $210,000
Q = $300,000 ÷ $7
Q = 42,857 balls (rounded)
$90,000 + $210,000
= = 42,857 balls
$7
Thus, sales will have to increase by 12,857 balls (= 42,857 balls –
30,000 balls = 12,857 balls) to earn the same amount of net operating
income as last year. The computations above and in part (2) show the
dramatic effect that increases in variable costs can have on an
organization. The effects on Northwood Company are summarized
below:
Present Expected
Break-even point (in balls) ................................. 21,000 30,000
Sales (in balls) needed to earn a $90,000 profit .. 30,000 42,857
Note that if variable costs do increase next year, then the company will
just break even if it sells the same number of balls (30,000) as it did last
year.

4. The contribution margin ratio last year was 40%. If we let P equal the
new selling price, then:
P = $18 + 0.40P
0.60P = $18
P = $18 ÷ 0.60
P = $30
To verify:
Selling price ................... $30 100%
Variable expenses ........... 18 60%
Contribution margin ........ $12 40%
Therefore, to maintain a 40% CM ratio, a $3 increase in variable costs
would require a $5 increase in the selling price.
5. The new CM ratio would be:

Selling price ........................ $25 100%
Variable expenses................ 9* 36%
Contribution margin............. $16 64%
*$15 – ($15 × 40%) = $9
The new break-even point would be:
$0 = $16 × Q – ($210,000 × 2)
$16Q = $420,000
Q = $420,000 ÷ $16
Q = 26,250 balls
$420,000
= = 26,250 balls
$16
Although this new break-even point is greater than the company’s
present break-even point of 21,000 balls [see Part (1) above], it is less
than the break-even point will be if the company does not automate and
variable labor costs rise next year [see Part (2) above].
6. a. Profit = Unit CM × Q − Fixed expenses

$90,000 = $16 × Q − $420,000
$16Q = $90,000 + $420,000
Q = $510,000 ÷ $16
Q = 31,875 balls
= $90,000 + $420,000
$16
= 31,875 balls
Thus, the company will have to sell 1,875 more balls (31,875 –
30,000 = 1,875) than now being sold to earn a profit of $90,000 per
year. However, this is still less than the 42,857 balls that would have
to be sold to earn a $90,000 profit if the plant is not automated and
variable labor costs rise next year [see Part (3) above].
b. The contribution income statement would be:

Sales (30,000 balls × $25 per ball) .................... $750,000
Variable expenses (30,000 balls × $9 per ball) ... 270,000
Contribution margin .......................................... 480,000
Fixed expenses ................................................. 420,000
Net operating income ....................................... $ 60,000

=
$480,000
= =8
$60,000

c. This problem illustrates the difficulty faced by some companies. When
variable labor costs increase, it is often difficult to pass these cost
increases along to customers in the form of higher prices. Thus,
companies are forced to automate resulting in higher operating
leverage, often a higher break-even point, and greater risk for the
company.
There is no clear answer as to whether one should have been in favor
of constructing the new plant.

1. Product
White Fragrant Loonzain Total
Percentage of total
sales ..................... 40% 24% 36% 100%
Sales ....................... $300,000 100% $180,000 100% $270,000 100% $750,000 100%
Variable expenses .... 216,000 72% 36,000 20% 108,000 40% 360,000 48%
Contribution margin.. $ 84,000 28% $144,000 80% $162,000 60% 390,000 52% *
Fixed expenses ........ 449,280
Net operating
income (loss)......... $ (59,280)
*$390,000 ÷ $750,000 = 52%
2. Break-even sales would be:

break even CM ratio
$449,280
= = $864,000
0.52

3. Memo to the president:
Although the company met its sales budget of $750,000 for the month,
the mix of products changed substantially from that budgeted. This is
the reason the budgeted net operating income was not met, and the
reason the break-even sales were greater than budgeted. The
company’s sales mix was planned at 20% White, 52% Fragrant, and
28% Loonzain. The actual sales mix was 40% White, 24% Fragrant, and
36% Loonzain.
As shown by these data, sales shifted away from Fragrant Rice, which
provides our greatest contribution per dollar of sales, and shifted toward
White Rice, which provides our least contribution per dollar of sales.
Although the company met its budgeted level of sales, these sales
provided considerably less contribution margin than we had planned,
with a resulting decrease in net operating income. Notice from the
attached statements that the company’s overall CM ratio was only 52%,
as compared to a planned CM ratio of 64%. This also explains why the
break-even point was higher than planned. With less average
contribution margin per dollar of sales, a greater level of sales had to be
achieved to provide sufficient contribution margin to cover fixed costs.

1. The CM ratio is 30%.
Total Per Unit Percent of Sales
Sales (19,500 units) ........ $585,000 $30.00 100%
Variable expenses ........... 409,500 21.00 70%
Contribution margin......... $175,500 $ 9.00 30%
The break-even point is:

$0 = ($30 − $21) × Q − $180,000
$0 = ($9) × Q − $180,000
$9Q = $180,000
Q = $180,000 ÷ $9
Q = 20,000 units
20,000 units × $30 per unit = $600,000 in sales
$180,000
= = 20,000 units
$9.00

break even CM ratio
$180,000
= = $600,000 in sales
0.30
2. Incremental contribution margin:

$80,000 increased sales × 0.30 CM ratio ............ $24,000
Less increased advertising cost ............................ 16,000
Increase in monthly net operating income ............ $ 8,000
Since the company is now showing a loss of $4,500 per month, if the
changes are adopted, the loss will turn into a profit of $3,500 each
month ($8,000 – $4,500 = $3,500).

3. Sales (39,000 units @ $27.00 per unit*) ......... $1,053,000

Variable expenses
(39,000 units @ $21.00 per unit)................. 819,000
Contribution margin ...................................... 234,000
Fixed expenses ($180,000 + $60,000) ........... 240,000
Net operating loss ......................................... $ (6,000)
*$30.00 – ($30.00 × 0.10) = $27.00

$9,750 = ($30.00 − $21.75) × Q − $180,000
$9,750 = ($8.25) × Q − $180,000
$8.25Q = $189,750
Q = $189,750 ÷ $8.25
Q = 23,000 units
*$21.00 + $0.75 = $21.75
target profit CM per unit
$9,750 + $180,000
=
$8.25**
= 23,000 units
**$30.00 – $21.75 = $8.25
5. a. The new CM ratio would be:

Per Unit Percent of Sales
Sales ............................ $30.00 100%
Variable expenses ......... 18.00 60%
Contribution margin ...... $12.00 40%

The new break-even point would be:
$180,000 + $72,000
=
$12.00
= 21,000 units

break even CM ratio
$180,000 + $72,000
=
0.40
= $630,000
b. Comparative income statements follow:

Not Automated Automated
Per Per
Total Unit % Total Unit %
Sales (26,000
units).............. $780,000 $30.00 100 $780,000 $30.00 100
Variable
expenses ........ 546,000 21.00 70 468,000 18.00 60
Contribution
margin ............ 234,000 $ 9.00 30 312,000 $12.00 40
Fixed expenses .. 180,000 252,000
Net operating
income ........... $ 54,000 $ 60,000

c. Whether or not the company should automate its operations depends
on how much risk the company is willing to take and on prospects for
future sales. The proposed changes would increase the company’s
fixed costs and its break-even point. However, the changes would
also increase the company’s CM ratio (from 0.30 to 0.40). The higher
CM ratio means that once the break-even point is reached, profits will
increase more rapidly than at present. If 26,000 units are sold next
month, for example, the higher CM ratio will generate $6,000 (=
$60,000 – $54,000) more in profits than if no changes are made.
The greatest risk of automating is that future sales may drop back
down to present levels (only 19,500 units per month), and as a
result, losses will be even larger than at present due to the
company’s greater fixed costs. (Note the problem states that sales
are erratic from month to month.) In sum, the proposed changes will
help the company if sales continue to trend upward in future months;
the changes will hurt the company if sales drop back down to or near
present levels.
Note to the Instructor: Although it is not asked for in the problem,

if time permits you may want to compute the point of indifference
between the two alternatives in terms of units sold; i.e., the point
where profits will be the same under either alternative. At this point,
total revenue will be the same; hence, we include only costs in our
equation:
Let Q = Point of indifference in units sold
$21.00Q + $180,000 = $18.00Q + $252,000
$3.00Q = $72,000
Q = $72,000 ÷ $3.00
Q = 24,000 units
If more than 24,000 units are sold in a month, the proposed plan will
yield the greater profits; if less than 24,000 units are sold in a month,
the present plan will yield the greater profits (or the least loss).

1. The CM ratio is 60%:
Sales price ...................... $20.00 100%

Variable expenses ........... 8.00 40%
Contribution margin ........ $12.00 60%
2. Dollar sales to Fixed expenses

=
break even CM ratio
$180,000
=
0.60
= $300,000
3. $75,000 increased sales × 0.60 CM ratio = $45,000 increased

contribution margin. Because the fixed costs will not change, net
operating income should also increase by $45,000.
4a. The degree of operating leverage is calculated as follows:

=
$240,000
=
$60,000
=4
4b. 4 × 20% = 80% increase in net operating income. In dollars, this
increase would be 80% × $60,000 = $48,000.

5. This year’s net operating income is computed as follows:
Sales (25,000 units × $18 per unit) .................... $450,000

Variable expenses (25,000 units × $8 per unit) ... 200,000
Contribution margin .......................................... 250,000
Fixed expenses ($180,000 + $30,000)................ 210,000
Net operating income ........................................ $ 40,000
The sales manager’s suggestions should not be implemented because

they will lower net operating income by $20,000 (= $60,000 – $40,000).
6. Expected total contribution margin:

20,000 units × 1.25 × $11.00 per unit* ........................ $275,000
Present total contribution margin .................................... 240,000
Incremental contribution margin, and the amount by
which advertising can be increased with net operating
income remaining unchanged....................................... $ 35,000
*$20.00 – ($8.00 + $1.00) = $11.00

The key to solving the requirements of this problem is understanding that
the sweatshirts represent a step-fixed cost. They cannot be purchased at a
cost of $8 each. They must be bought in batches of 75 sweatshirts at a
cost of $600 per batch (75 sweatshirts × $8 per shirt = $600 per batch).
1. A good starting point for solving this problem is to compute the profit
from buying and selling one batch of 75 sweatshirts:
Sales (75 shirts × $13.50) ........................ $1,012.50

Variable expenses (75 shirts × $1.50) ....... 112.50
Contribution margin ................................. 900.00
Step-fixed expense ($600 × 1 batch) ........ 600.00
Net operating income ............................... $ 300.00
If the profit from selling one batch of 75 sweatshirts is $300, then the
profit from selling four batches of 75 sweatshirts, or 300 sweatshirts in
total, will equal the target profit of $1,200 ($300 per batch × 4 batches
= $1,200).
Unit sales of 300 sweatshirts corresponds with dollar sales of $4,050 (=

300 sweatshirts × $13.50).
2. The contribution margin per sweatshirt is:

Selling price ......................................... $13.50
Variable expenses ................................ 1.50
Contribution margin.............................. $12.00
The fixed cost associated with buying 75 sweatshirts is $600; therefore,
the break-even point would be 50 sweatshirts computed as follows:
50 sweatshirts × $13.50 per sweatshirt = $675 in total sales

3. Purchasing four batches of sweatshirts, or a total of 300 sweatshirts,
yields a profit of $1,200. If Hooper purchased and sold five batches of
sweatshirts, or a total of 375 sweatshirts, he would earn a profit of
$1,500 ($1,200 + $300). Since the target profit of $1,320 is between
$1,200 and $1,500, Hooper will need to attain a sales volume between
300 and 375 sweatshirts to achieve his target profit.
Given that the selling price per unit $13.50, the variable cost per unit is
$1.50, the target profit is $1,320, and the step-fixed cost in this scenario
is $3,000 (5 batches × $600 per batch) The correct answer of 360
sweatshirts is calculated as follows:

$1,320 = ($13.50 − $1.50) × Q − $3,000
$1,320 = ($12) × Q − $3,000
$12Q = $4,320
Q = $4,320 ÷ $12
Q = 360 sweatshirts

1. The break-even point is calculated as follows:

$0 = ($3 − $1) × Q − $22,000
$0 = ($2) × Q − $22,000
$2Q = $22,000
Q = $22,000 ÷ $2
Q = 11,000 units
2a. If Neptune produces and sells 18,000 units, it will earn net operating
income of $14,000, calculated as follows:
Sales (18,000 units × $3.0) ...................... $54,000

Variable expenses (18,000 units × $1.00) .. 18,000
Contribution margin ................................. 36,000
Fixed expenses ........................................ 22,000
Net operating income ............................... $14,000
2b. If Neptune buys 18,000 units from its supplier and then resells them, it
will earn net operating income of $7,500, calculated as follows:
Sales (18,000 units × $3.00)..................... $54,000

Fixed expenses ........................................ 15,000
Net operating income ............................... $ 7,500

3. In this scenario, the total fixed expenses are $37,000 ($22,000 +
$15,000), the contribution margin per unit for the first 18,000 units
produced in-house is $2.00 per unit, and the contribution margin per
unit for each unit produced by the supplier is $1.25 per unit. Thus, the
break-even point of 18,800 units is computed as follows:
Fixed expenses ($22,000 + $15,000) .............. $37,000

Contribution margin from in-house production
(18,000 units × $2.00)................................. 36,000
Contribution margin that must be earned on
outsourced units to cover fixed expenses ...... $ 1,000
Contribution margin that must be earned on

outsourced units to cover fixed expenses (a) . $1,000
Contribution margin per unit from supplier (b) . $1.25
Unit sales needed from supplier to break-even
(a) ÷ (b) ..................................................... 800
The total unit sales required to break-even is 18,000 units produced in-
house plus 800 units provided by the supplier, or a total of 18,800
units.
4a. In this scenario, the total fixed expenses plus target profit is $51,000
($22,000 + $15,000 +$14,000), the contribution margin per unit for
the first 18,000 units produced in-house is $2.00 per unit, and the
contribution margin per unit for each unit produced by the supplier is
$1.25 per unit. Thus, the required unit sales is computed as follows:
Fixed expenses plus target profit ($22,000 +

$15,000 +$14,000)...................................... $51,000
(18,000 units × $2.00)................................. 36,000
Contribution margin that must be realized on
outsourced units to earn target profit............ $15,000


outsourced units to earn target profit (a) ...... $15,000
Unit sales needed from supplier to earn target
profit (a) ÷ (b) ............................................ 12,000
The total unit sales required to earn the target profit is 30,000 units,
which includes 18,000 units produced in-house plus 12,000 units
provided by the supplier.
4b. This scenario is identical to requirement 4a except the target profit

changes from $14,000 to $16,500; hence, the required unit sales is
calculated as follows:
Fixed expenses plus target profit ($22,000 +

$15,000 +$16,500)...................................... $53,500
(18,000 units × $2.00)................................. 36,000
outsourced units to earn target profit............ $17,500

outsourced units to earn target profit (a) ...... $17,500
Unit sales needed from supplier to earn target
profit (a) ÷ (b) ............................................ 14,000
The total unit sales required to earn the target profit is 32,000 units,
which includes 18,000 units produced in-house plus 14,000 units
provided by the supplier.

4c. The net operating income is computed as follows:
Sales (35,000 units × $3.00)..................... $105,000

Variable expenses (18,000 units × $1.00)
+ (17,000 units × $1.75) ....................... 47,750
Fixed expenses ($22,000 + $15,000) ........ 37,000
4d. The net operating income is computed as follows:
Sales (35,000 units × $3.00)..................... $105,000

Variable expenses (18,000 units × $1.00)
+ (800 units × $1.75) + (16,200 units ×
$1.85)................................................... 49,370
Fixed expenses ($22,000 + $15,000) ........ 37,000
5. The net operating income is computed as follows:
Sales (35,000 units × $3.00)..................... $105,000

Fixed expenses ($15,000 × 2)................... 30,000


$0 = ($30 − $18) × Q − $150,000
$0 = ($12) × Q − $150,000
$12Q = $150,000
Q = $150,000 ÷ $12
Q = 12,500 pairs
12,500 pairs × $30 per pair = $375,000 in sales
break even Unit CM
$150,000
= = 12,500 pairs
$12.00

break even CM ratio
$150,000
= = $375,000 in sales
0.40
2. See the graph on the following page.
3. The simplest approach is:

Break-even sales ....................... 12,500 pairs
Actual sales ............................... 12,000 pairs
Sales short of break-even ........... 500 pairs
500 pairs × $12 contribution margin per pair = $6,000 loss
Sales (12,000 pairs × $30.00 per pair) ..... $360,000
Variable expenses
(12,000 pairs × $18.00 per pair) ........... 216,000
Contribution margin ................................ 144,000
Fixed expenses ....................................... 150,000
Net operating loss................................... $ (6,000)

$500
Total Sales
Break-even point:
$450 Total
12,500 pairs of shoes or
Expense
$375,000 total sales
$400 s
$350
Total Sales (000s)
$300
$250
$200
Total
$150
Fixed
Expense
$100
s
$50
$0
0 2,500 5,000 7,500 10,000 12,500 15,000 17,500 20,000
Number of Pairs of Shoes Sold

4. The variable expenses will now be $18.75 per pair, and the contribution
margin will be $11.25 per pair.
$0 = ($30.00 − $18.75) × Q − $150,000
$0 = ($11.25) × Q − $150,000
$11.25Q = $150,000
Q = $150,000 ÷ $11.25
Q = 13,333 pairs (rounded)
13,333 pairs × $30.00 per pair = $400,000 in sales
break even CM per unit
$150,000
= = 13,333 pairs
$11.25

break even CM ratio
$150,000
= = $400,000 in sales
0.375
5. The simplest approach is:
Actual sales ................................ 15,000 pairs
Break-even sales......................... 12,500 pairs
Excess over break-even sales ...... 2,500 pairs
2,500 pairs × $11.50 per pair* = $28,750 profit
*$12.00 present contribution margin – $0.50 commission = $11.50

6. The new variable expenses will be $13.50 per pair.

$0 = ($30.00 − $13.50) × Q – ($150,000 + $31,500)
$0 = ($16.50) × Q − $181,500
$16.50Q = $181,500
Q = $181,500 ÷ $16.50
Q = 11,000 pairs
11,000 pairs × $30.00 per pair = $330,000 in sales
Although the change will lower the break-even point from 12,500 pairs
to 11,000 pairs, the company must consider whether this reduction in
the break-even point is more than offset by the possible loss in sales
arising from having the sales staff on a salaried basis. Under a salary
arrangement, the sales staff has less incentive to sell than under the
present commission arrangement, resulting in a potential loss of sales
and a reduction of profits. Although it is generally desirable to lower the
break-even point, management must consider the other effects of a
change in the cost structure. The break-even point could be reduced
dramatically by doubling the selling price but it does not necessarily
follow that this would improve the company’s profit.

1. a. Hawaiian Tahitian
Fantasy Joy
(20,000 units) (5,000 units) Total
Amount % Amount % Amount %
Sales .......................... $300,000 100% $500,000 100% $800,000 100%
Variable expenses ....... 180,000 60% 100,000 20% 280,000 35%
Contribution margin .... $120,000 40% $400,000 80% 520,000 65%
Fixed expenses ........... 475,800
Net operating income .. $ 44,200
b. Dollar sales to = Fixed expenses = $475,800 = $732,000

break even CM ratio 0.65
Margin of safety = Actual sales - Break-even sales
= $800,000 - $732,000 = $68,000

percentage Actual sales
$68,000
= = 8.5%
$800,000

Hawaiian Tahitian Samoan

Fantasy Joy Delight
2. a. (20,000 units) (5,000 units) (10,000 units) Total
Amount % Amount % Amount % Amount %
Sales ................. $300,000 100% $500,000 100% $450,000 100% $1,250,000 100.0%
Variable
expenses ........ 180,000 60% 100,000 20% 360,000 80% 640,000 51.2%
Contribution
margin ............ $120,000 40% $400,000 80% $ 90,000 20% 610,000 48.8%
Fixed expenses .. 475,800
Net operating
income ........... $ 134,200

b. Dollar sales to = Fixed expenses = $475,800 = $975,000
= $1,250,000 - $975,000 = $275,000

$275,000
= = 22%
$1,250,000
3. The reason for the increase in the break-even point can be traced to the
decrease in the company’s overall contribution margin ratio when the
third product is added. Note from the income statements above that this
ratio drops from 65% to 48.8% with the addition of the third product.
This product (the Samoan Delight) has a CM ratio of only 20%, which
causes the average contribution margin per dollar of sales to shift
downward.
This problem shows the somewhat tenuous nature of break-even
analysis when the company has more than one product. The analyst
must be very careful of his or her assumptions regarding sales mix,
including the addition (or deletion) of new products.
It should be pointed out to the president that even though the break-
even point is higher with the addition of the third product, the
company’s margin of safety is also greater. Notice that the margin of
safety increases from $68,000 to $275,000 or from 8.5% to 22%. Thus,
the addition of the new product shifts the company much further from
its break-even point, even though the break-even point is higher.

1. April's Income Statement:
Standard Deluxe Pro To

Amount % Amount % Amount % Amoun
Sales ............................ $80,000 100 $60,000 100 $450,000 100 $590,00
Variable expenses:
Production.................. 44,000 55 27,000 45 157,500 35 228,50
Selling........................ 4,000 5 3,000 5 22,500 5 29,50
Total variable expenses .. 48,000 60 30,000 50 180,000 40 258,00
Contribution margin....... $32,000 40 $30,000 50 $270,000 60 332,00
Fixed expenses:
Production .................. 120,00
Advertising ................. 100,00
Administrative ............. 50,00
Total fixed expenses ...... 270,00
Net operating income .... $ 62,00

May's Income Statement:
Standard Deluxe Pro
Amount % Amount % Amount % Amo
Sales ........................... $320,000 100 $60,000 100 $270,000 100 $650
Variable expenses:
Production ................. 176,000 55 27,000 45 94,500 35 297
Selling ....................... 16,000 5 3,000 5 13,500 5 32
Total variable expenses . 192,000 60 30,000 50 108,000 40 330
Contribution margin ...... $128,000 40 $30,000 50 $162,000 60 320
Fixed expenses:
Production ................. 120
Advertising ................ 100
Administrative............ 50
Total fixed expenses ..... 270
Net operating income ... $ 50

2. The sales mix has shifted over the last month from a greater
concentration of Pro rackets to a greater concentration of Standard
rackets. This shift has caused a decrease in the company’s overall CM
ratio from 56.3% in April to only 49.2% in May. For this reason, even
though total sales (both in units and in dollars) is greater, net operating
income is lower than last month in the division.
3. The break-even in dollar sales can be computed as follows:
4. May’s break-even point has gone up. The reason is that the division’s
overall CM ratio has declined for May as stated in (2) above. Unchanged
fixed expenses divided by a lower overall CM ratio would yield a higher
break-even point in sales dollars.
5. Standard Pro
Increase in sales .................................. $20,000 $20,000
Multiply by the CM ratio ........................ × 40% × 60%
Increase in net operating income* ........ $ 8,000 $12,000
*Assuming that fixed costs do not change.

1. The income statements would be:
Present
Amount Per Unit %
Sales ......................... $450,000 $30 100%
Variable expenses ...... 315,000 21 70%
Contribution margin ... 135,000 $ 9 30%
Fixed expenses .......... 90,000
Net operating income . $ 45,000
Proposed
Amount Per Unit %
Sales ......................... $450,000 $30 100%
Variable expenses* .... 180,000 12 40%
Contribution margin ... 270,000 $18 60%
Fixed expenses .......... 225,000
Net operating income . $ 45,000
*$21 – $9 = $12
2. a. Degree of operating leverage:

Present:
=
$135,000
= =3
$45,000
Proposed:
=
$270,000
= =6
$45,000

b. Dollar sales to break even:
Present:
break even CM ratio
$90,000
= = $300,000
0.30
Proposed:
break even CM ratio
$225,000
= = $375,000
0.60
c. Margin of safety:
Present:
= $450,000 - $300,000 = $150,000

$150,000
= = 33.33%
$450,000
Proposed:
= $450,000 - $375,000 = $75,000

$75,000
= = 16.67%
$450,000

3. The major factor would be the sensitivity of the company’s operations to
cyclical movements in the economy. Because the new equipment will
increase the CM ratio, in years of strong economic activity, the company
will be better off with the new equipment. However, in economic
recession, the company will be worse off with the new equipment. The
fixed costs of the new equipment will cause losses to be deeper and
sustained more quickly than at present. Thus, management must decide
whether the potential for greater profits in good years is worth the risk
of deeper losses in bad years.
4. No information is given in the problem concerning the new variable

expenses or the new contribution margin ratio. Both of these items must
be determined before the new break-even point can be computed. The
computations are:
New variable expenses:
Profit = (Sales − Variable expenses) − Fixed expenses
$54,000** = ($585,000* − Variable expenses) − $180,000
Variable expenses = $585,000 − $180,000 − $54,000
= $351,000
*New level of sales: $450,000 × 1.30 = $585,000
**New level of net operating income: $45,000 × 1.2 = $54,000
New CM ratio:
Sales ................................ $585,000 100%
Variable expenses.............. 351,000 60%
Contribution margin........... $234,000 40%
With the above data, the new break-even point can be computed:
Dollar sales to = Fixed expenses = $180,000 = $450,000

The greatest risk is that the increases in sales and net operating income
predicted by the marketing manager will not happen and that sales will
remain at their present level. Note that the present level of sales is
$450,000, which is equal to the break-even level of sales under the new
marketing method. Thus, if the new marketing strategy is adopted and
sales remain unchanged, profits will drop from the current level of
$45,000 per month to zero.
It would be a good idea to compare the new marketing strategy to the
current situation more directly. What level of sales would be needed
under the new method to generate at least the $45,000 in profits the
company is currently earning each month? The computations are:
Dollar sales to = Target profit + Fixed expenses
attain target profit CM ratio
$45,000 + $180,000
=
0.40
= $562,500 in sales each month
Thus, sales would have to increase by at least 25% ($562,500 is 25%
higher than $450,000) in order to make the company better off with the
new marketing strategy than with the current situation. This appears to
be extremely risky.


$0 = ($40 − $16) × Q − $60,000
$0 = ($24) × Q − $60,000
$24Q = $60,000
Q = $60,000 ÷ $24
Q = 2,500 pairs, or at $40 per pair, $100,000 in sales
Unit sales to = Fixed expenses = $60,000 = 2,500 pairs
break even CM per unit $24.00
Dollar sales to = Fixed expenses = $60,000 = $100,000
2. See the graphs at the end of this solution.

$18,000 = $24 × Q − $60,000
$24Q = $18,000 + $60,000
Q = $78,000 ÷ $24
Q = 3,250 pairs
$18,000 + $60,000
= = 3,250 pairs
$24.00
4. Incremental contribution margin:

$25,000 increased sales × 60% CM ratio ..... $15,000
Incremental fixed salary cost ......................... 8,000
Increased net income .................................... $ 7,000
Yes, the position should be converted to a full-time basis.

5. a. Degree of Contribution margin $72,000
= = =6
operating leverage Net operating income $12,000
b. 6 × 50% sales increase = 300% increase in net operating income.

Thus, net operating income next year would be: $12,000 + ($12,000
× 300%) = $48,000.
$200
Total Sales
$180
$160
$140 Break-even point:

Total
Total Sales (000s)
2,500 pairs of sandals or Expense

$120 $100,000 total sales s
$100
$80
Total
$60 Fixed
Expense
$40 s
$20
$0
0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000
Number of Pairs of Sandals Sold

Profit graph:
Profit Graph
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000 Break-even point:
$5,000 2,500 sandals
$0
-$5,000
-$10,000
Profit
-$15,000
-$20,000
-$25,000
-$30,000
-$35,000
-$40,000
-$45,000
-$50,000
-$55,000
-$60,000
0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000
Sales Volume in Units

1. (1) Dollars
(2) Volume of output, expressed in units, % of capacity, sales,
or some other measure
(3) Total expense line
(4) Variable expense area
(5) Fixed expense area
(6) Break-even point
(7) Loss area
(8) Profit area
(9) Sales line

2. a. Line 3: Remain unchanged.

Line 9: Have a steeper slope.
Break-even point: Decrease.
b. Line 3: Have a flatter slope.
Line 9: Remain unchanged.
Break-even point: Decrease.
c. Line 3: Shift upward.
Break-even point: Increase.
d. Line 3: Remain unchanged.
Break-even point: Remain unchanged.
e. Line 3: Shift downward and have a steeper slope.
Break-even point: Probably change, but the direction is uncertain.
f. Line 3: Have a steeper slope.
Line 9: Have a steeper slope.
Break-even point: Remain unchanged in terms of units; increase
in terms of total dollars of sales.
g. Line 3: Shift upward.
Break-even point: Increase.
h. Line 3: Shift upward and have a flatter slope.
Break-even point: Probably change, but the direction is uncertain.

Case 5-32 (75 minutes)
Before proceeding with the solution, it is helpful first to restructure the data into contribution format for
each of the three alternatives. (The data in the statements below are in thousands.)
15% Commission 20% Commission Own Sales Force
Sales .......................................... $16,000 100% $16,000 100% $16,000.00 100.0%
Variable expenses:
Manufacturing .......................... 7,200 7,200 7,200.00
Commissions (15%, 20%, 7.5%) 2,400 3,200 1,200.00
Total variable expenses ................ 9,600 60% 10,400 65% 8,400.00 52.5%
Contribution margin..................... 6,400 40% 5,600 35% 7,600.00 47.5%
Fixed expenses:
Manufacturing overhead ............ 2,340 2,340 2,340.00
Marketing ................................. 120 120 2,520.00 *
Administrative .......................... 1,800 1,800 1,725.00 **
Interest .................................... 540 540 540.00
Total fixed expenses .................... 4,800 4,800 7,125.00
Income before income taxes ........ 1,600 800 475.00
Income taxes (30%) .................... 480 240 142.50
Net income ................................. $ 1,120 $ 560 $ 332.50
*$120,000 + $2,400,000 = $2,520,000
**$1,800,000 – $75,000 = $1,725,000

Case 5-32 (continued)
1. When the income before taxes is zero, income taxes will also be zero
and net income will be zero. Therefore, the break-even calculations can
be based on the income before taxes.
a. Break-even point in dollar sales if the commission remains 15%:

Dollar sales to = Fixed expenses = $4,800,000 = $12,000,000
b. Break-even point in dollar sales if the commission increases to 20%:
c. Break-even point in dollar sales if the company employs its own sales
force:
2. In order to generate a $1,120,000 net income, the company must

generate $1,600,000 in income before taxes. Therefore,
Dollar sales to = Target income before taxes + Fixed expenses
attain target CM ratio
$1,600,000 + $4,800,000
=
0.35
$6,400,000
= = $18,285,714
0.35
3. To determine the volume of sales at which net income would be equal

under either the 20% commission plan or the company sales force plan,
we find the volume of sales where costs before income taxes under the
two plans are equal. See the next page for the solution.

Case 5-32 (continued)
X = Total sales revenue

0.65X + $4,800,000 = 0.525X + $7,125,000
0.125X = $2,325,000
X = $2,325,000 ÷ 0.125
X = $18,600,000
Thus, at a sales level of $18,600,000 either plan would yield the same
income before taxes and net income. Below this sales level, the
commission plan would yield the largest net income; above this sales
level, the sales force plan would yield the largest net income.
4. a., b., and c.

15% 20% Own
Commission Commission Sales Force
Contribution margin (Part 1) (a) ..... $6,400,000 $5,600,000 $7,600,000
Income before taxes (Part 1) (b) .... $1,600,000 $800,000 $475,000
Degree of operating leverage:
(a) ÷ (b) .................................... 4 7 16
5. We would continue to use the sales agents for at least one more year,
and possibly for two more years. The reasons are as follows:
First, use of the sales agents would have a less dramatic effect on
net income.
Second, use of the sales agents for at least one more year would
give the company more time to hire competent people and get the
sales group organized.
Third, the sales force plan doesn’t become more desirable than the
use of sales agents until the company reaches sales of $18,600,000 a
year. This level probably won’t be reached for at least one more year,
and possibly two years.
Fourth, the sales force plan will be highly leveraged since it will
increase fixed costs (and decrease variable costs). One or two years
from now, when sales have reached the $18,600,000 level, the
company can benefit greatly from this leverage. For the moment,
profits will be greater and risks will be less by staying with the
agents, even at the higher 20% commission rate.

Appendix 5A
Analyzing Mixed Costs
Exercise 5A-1 (20 minutes)
1. Occupancy- Electrical
Days Costs
High activity level (August) .. 2,406 $5,148
Low activity level (October) . 124 1,588
Change............................... 2,282 $3,560
Variable cost = Change in cost ÷ Change in activity
= $3,560 ÷ 2,282 occupancy-days
= $1.56 per occupancy-day
Total cost (August)..................................................... $5,148
Variable cost element
($1.56 per occupancy-day × 2,406 occupancy-days) . 3,753
Fixed cost element ..................................................... $1,395
2. Electrical costs may reflect seasonal factors other than just the variation
in occupancy days. For example, common areas such as the reception
area must be lighted for longer periods during the winter than in the
summer. This will result in seasonal fluctuations in the fixed electrical
costs.
Additionally, fixed costs will be affected by the number of days in a
month. In other words, costs like the costs of lighting common areas are
variable with respect to the number of days in the month, but are fixed
with respect to how many rooms are occupied during the month.
Other, less systematic, factors may also affect electrical costs such
as the frugality of individual guests. Some guests will turn off lights
when they leave a room. Others will not.
1. and 2.
The scattergraph plot and least-squares regression estimates of fixed and

variable costs using Microsoft Excel are shown below:
The intercept provides the estimate of the fixed cost element, $1,378 per
month, and the slope provides the estimate of the variable cost element,
$4.04 per rental return. Expressed as an equation in the form Y = a + bX,
the relation between car wash costs and rental returns is
Y = $1,378 + $4.04X
where X is the number of rental returns.
Note that the R2 is approximately 0.90, which is quite high, and
indicates a strong linear relationship between car wash costs and rental
returns.

1. Kilometers Total Annual

Driven Cost*
High level of activity ......................... 105,000 $11,970
Low level of activity .......................... 70,000 9,380
Change............................................ 35,000 $ 2,590
* 105,000 kilometers × $0.114 per kilometer = $11,970
70,000 kilometers × $0.134 per kilometer = $9,380
Variable cost per kilometer:

Change in cost $2,590
= =$0.074 per kilometer
Change in activity 35,000 kilometers
Fixed cost per year:
Total cost at 105,000 kilometers ..................... $11,970
Less variable portion:
105,000 kilometers × $0.074 per kilometer .. 7,770
Fixed cost per year ........................................ $ 4,200
2. Y = $4,200 + $0.074X
3. Fixed cost ......................................................... $ 4,200

Variable cost:
80,000 kilometers × $0.074 per kilometer ........ 5,920
Total annual cost ............................................... $10,120
1. The scattergraph appears below:
$3,000
$2,500
Shipping Expense
$2,000
$1,500
$1,000
$500
$0
0 2 4 6 8 10
Units Shipped
Yes, there is an approximately linear relationship between the number of

units shipped and the total shipping expense.

Exercise 5A-4 (continued)
2. The high-low estimates and cost formula are computed as follows:
Units Shipped Shipping Expense
High activity level (June) ..... 8 $2,700

Low activity level (July) ....... 2 1,200
Change............................... 6 $1,500
Variable cost element:
Change in expense $1,500
= =$250 per unit.
Change in activity 6 units
Fixed cost element:
Shipping expense at high activity level ....................... $2,700
Less variable cost element ($250 per unit × 8 units) .. 2,000
Total fixed cost ......................................................... $ 700
The cost formula is $700 per month plus $250 per unit shipped or
Y = $700 + $250X,
where X is the number of units shipped.
The scattergraph on the following page shows the straight line drawn
through the high and low data points.
Exercise 5A-4 (continued)
$3,000
$2,500
Shipping Expense
$2,000
$1,500
$1,000
$500
$0
0 2 4 6 8 10
Units Shipped
3. The high-low estimate of fixed costs is $210.71 (= $910.71 – $700.00)

lower than the estimate provided by least-squares regression. The high-
low estimate of the variable cost per unit is $32.14 (= $250.00 –
$217.86) higher than the estimate provided by least-squares regression.
A straight line that minimized the sum of the squared errors would
intersect the Y-axis at $910.71 instead of $700. It would also have a
flatter slope because the estimated variable cost per unit is lower than
the high-low method.
4. The cost of shipping units is likely to depend on the weight and volume
of the units shipped and the distance traveled as well as on the number
of units shipped. In addition, higher cost shipping might be necessary to
meet a deadline.

1. and 2.
The scattergraph plot and regression estimates of fixed and variable

costs using Microsoft Excel are shown below:
Note that the R2 is approximately 0.94, which means that 94% of the
variation in etching costs is explained by the number of units etched.
This is a very high R2 which indicates a very good fit.
The regression equation, in the form Y = a + bX, is as follows (where a

is rounded to nearest dollar and b is rounded to the nearest cent):
Y = $12.32 + $1.54X
3. Total expected etching cost if 5 units are processed:

Variable cost: 5 units × $1.54 per unit ...... $ 7.70
Fixed cost ............................................... 12.32
Total expected cost ................................. $20.02
Problem 5A-6 (30 minutes)
1. The scattergraph plot and regression estimates of fixed and variable

The cost formula, in the form Y = a + bX, using tons mined as the
activity base is $28,352 per quarter plus $2.58 per ton mined, or
Y = $28,352 + $2.58X
Note that the R2 is approximately 0.47, which means that only 47% of
the variation in utility costs is explained by the number of tons mined.

Problem 5A-6 (continued)
2. The scattergraph plot and regression estimates of fixed and variable

The cost formula, in the form Y = a + bX, using direct labor-hours as

the activity base is $17,000 per quarter plus $9.00 per direct labor-hour,
or:
Y = $17,000 + $9.00X
variation in utility costs is explained by direct labor-hours. This is a very
high R2 which is an indication of a very good fit.
3. The company should probably use direct labor-hours as the activity

base, since the fit of the regression line to the data is much tighter than
it is with tons mined. The R2 for the regression using direct labor-hours
as the activity base is twice as large as for the regression using tons
mined as the activity base. However, managers should look more closely
at the costs and try to determine why utilities costs are more closely tied
to direct labor-hours than to the number of tons mined.
1. Cost of goods sold................... Variable

Advertising expense ................ Fixed
Shipping expense .................... Mixed
Salaries and commissions ........ Mixed
Insurance expense .................. Fixed
Depreciation expense .............. Fixed
2. Analysis of the mixed expenses:

Salaries and
Shipping Commissions
Units Expense Expense
High level of activity ..... 5,000 $38,000 $90,000
Low level of activity ...... 4,000 34,000 78,000
Change ........................ 1,000 $ 4,000 $12,000
Variable cost element:
Fixed cost element:

Salaries and
Shipping Commissions
Expense Expense
Cost at high level of activity ... $38,000 $90,000
Less variable cost element:
5,000 units × $4 per unit .... 20,000
5,000 units × $12 per unit ... 60,000
Fixed cost element................. $18,000 $30,000

The cost formulas are:
Shipping expense:
$18,000 per month plus $4 per unit
or
Y = $18,000 + $4X
Salaries and commissions expense:

$30,000 per month plus $12 per unit
or
Y = $30,000 + $12X
3.
Morrisey & Brown, Ltd.
Income Statement
For the Month Ended September 30
Sales (5,000 units × $100 per unit) ........... $500,000
Variable expenses:
Cost of goods sold
(5,000 units × $60 per unit) ................ $300,000
Shipping expense
(5,000 units × $4 per unit) .................. 20,000
Salaries and commissions expense
(5,000 units × $12 per unit) ................ 60,000 380,000
Fixed expenses:
Advertising expense ............................... 21,000
Shipping expense .................................. 18,000
Salaries and commissions expense ......... 30,000
Insurance expense ................................ 6,000
Depreciation expense............................. 15,000 90,000
1. Maintenance cost at the 90,000 machine-hour level of activity can be

isolated as follows:
Level of Activity
60,000 MHs 90,000 MHs
Total factory overhead cost ........ $174,000 $246,000
Deduct:
Utilities cost @ $0.80 per MH*. 48,000 72,000
Supervisory salaries ................ 21,000 21,000
Maintenance cost ...................... $105,000 $153,000
*$48,000 ÷ 60,000 MHs = $0.80 per MH
2. High-low analysis of maintenance cost:

Machine- Maintenance
Hours Cost
High activity level .................... 90,000 $153,000
Low activity level ..................... 60,000 105,000
Change ................................... 30,000 $ 48,000
Variable rate:
Total fixed cost:

Total maintenance cost at the high activity level .. $153,000
Less variable cost element
(90,000 MHs × $1.60 per MH) ......................... 144,000
Fixed cost element ............................................ $ 9,000
Therefore, the cost formula for maintenance is $9,000 per month plus
$1.60 per machine-hour or
Y = $9,000 + $1.60X

3. Variable Cost per

Machine-Hour Fixed Cost
Utilities cost .................... $0.80
Supervisory salaries cost.. $21,000
Maintenance cost ............ 1.60 9,000
Total overhead cost ......... $2.40 $30,000
Thus, the cost formula would be: Y = $30,000 + $2.40X.
4. Total overhead cost at an activity level of 75,000 machine-hours:

Fixed costs ................................................. $ 30,000
Variable costs: 75,000 MHs × $2.40 per MH . 180,000
Total overhead costs ................................... $210,000
1. High-low method:
Units Shipping
Sold Expense
High activity level .............. 20,000 $210,000
Low activity level ............... 10,000 119,000
Change ............................. 10,000 $91,000
Fixed cost element:

Total shipping expense at high activity
level .................................................... $210,000
Less variable element:
20,000 units × $9.10 per unit................ 182,000
Fixed cost element .................................. $ 28,000
Therefore, the cost formula is: Y = $28,000 + $9.10X.

2. Milden Company
Budgeted Contribution Format Income Statement
For the First Quarter, Year 3
Sales (12,000 units × $100 per unit) ............ $1,200,000
Variable expenses:
Cost of goods sold
(12,000 units × $35 unit) ....................... $420,000
Sales commission (6% × $1,200,000)........ 72,000
Shipping expense
(12,000 units × $9.10 per unit) .............. 109,200
Total variable expenses................................ 601,200
Contribution margin .................................... 598,800
Fixed expenses:
Advertising expense .................................. 210,000
Shipping expense ..................................... 28,000
Administrative salaries .............................. 145,000
Insurance expense ................................... 9,000
Depreciation expense................................ 76,000
Total fixed expenses .................................... 468,000
Net operating income .................................. $ 130,800
1. and 2.
The scattergraph plot and regression estimates of fixed and variable costs
using Microsoft Excel are shown below:
The cost formula, in the form Y = a + bX, using number of sections

offered as the activity base is $3,700 per quarter plus $1,750 per section
offered, or:
Y = $3,700 + $1,750X
variation in cost is explained by the number of sections. This is a very
high R2 which indicates a very good fit.

3. Expected total cost would be:

Fixed cost ....................................................... $ 3,700
Variable cost (8 sections × $1,750 per section) . 14,000
Total cost ........................................................ $17,700
The problem with using the cost formula from (2) to derive total cost is
that an activity level of 8 sections may lie outside the relevant range—
the range of activity within which the fixed cost is approximately $3,700
per term and the variable cost is approximately $1,750 per section
offered. These approximations appear to be reasonably accurate within
the range of 2 to 6 sections, but they may be invalid outside this range.
Case 5A-11 (60 minutes)
1. High-low method:
Hours Cost
High level of activity ....... 25,000 $99,000
Low level of activity ........ 10,000 64,500
Change .......................... 15,000 $34,500
Variable element: $34,500 ÷ 15,000 DLH = $2.30 per MH

Fixed element:
Total cost—25,000 MH .......................... $99,000
25,000 MH × $2.30 per MH ................ 57,500
Fixed element....................................... $41,500
Therefore, the cost formula is: Y = $41,500 + $2.30X
2. The scattergraph is shown below:

Y
$100,000
$95,000
$90,000
$85,000
Overhead
Costs
$80,000
$75,000
$70,000
$65,000
$60,000 X
8,000 10,000 12,000 14,000 16,000 18,000 20,000 22,000 24,000 26,000
Machine-Hours

Case 5A-11 (continued)
2. The scattergraph shows that there are two relevant ranges—one below
19,500 MH and one above 19,500 MH. The change in equipment lease
cost from a fixed fee to an hourly rate causes the slope of the regression
line to be steeper above 19,500 MH, and to be discontinuous between
the fixed fee and hourly rate points.
3. The cost formulas computed with the high-low and regression methods
are faulty since they are based on the assumption that a single straight
line provides the best fit to the data. Creating two data sets related to
the two relevant ranges will enable more accurate cost estimates.
4. High-low method:
Hours Cost
High level of activity ....... 25,000 $99,000
Low level of activity ........ 20,000 80,000
Change .......................... 5,000 $19,000
Variable element: $19,000 ÷ 5,000 MH = $3.80 per MH

Fixed element:
Total cost—25,000 MH .......................... $99,000
25,000 MH × $3.80 per MH ................ 95,000
Fixed element....................................... $4,000
Expected overhead costs when 22,500 machine-hours are used:

Variable cost: 22,500 hours × $3.80 per hour ........... $85,500
Fixed cost ............................................................... 4,000
Total cost ................................................................ $89,500
5. The high-low estimate of fixed costs is $6,090 (= $10,090 – $4,000)

lower than the estimate provided by least-squares regression. The high-
low estimate of the variable cost per machine hour is $0.27 (= $3.80 –
$3.53) higher than the estimate provided by least-squares regression. A
straight line that minimized the sum of the squared errors would
intersect the Y-axis at $10,090 instead of $4,000. It would also have a
flatter slope because the estimated variable cost per unit is lower than
the high-low method.
Solutions Manual, Appendix 5A 103
Case 5A-12 (45 minutes)
1. and 2.
The scattergraph plot and regression estimates of fixed and variable
The scattergraph reveals three interesting findings. First, it indicates the

relation between overhead expense and labor hours is approximated
reasonably well by a straight line. (However, there appears to be a slight
downward bend in the plot as the labor-hours increase—evidence of
increasing returns to scale. This is a common occurrence in practice. See
Noreen & Soderstrom, “Are overhead costs strictly proportional to
activity?” Journal of Accounting and Economics, vol. 17, 1994, pp. 255-
278.)
Second, the data points are all fairly close to the straight line. This
indicates that most of the variation in overhead expenses is explained by
labor hours. As a consequence, there probably wouldn’t be much benefit
to investigating other possible cost drivers for the overhead expenses.
Third, most of the overhead expense appears to be fixed. Maria should
ask herself if this is reasonable. Does the company have large fixed
expenses such as rent, depreciation, and salaries?
CASE 5A-12 (continued)
The cost formula, in the form Y = a + bX, using labor-hours as the

activity base is $48,126 per month plus $3.95 per labor-hour, or:
Y = $48,126 + $3.95X
variation in cost is explained by labor-hours. This is a very high R2 which
indicates a very good fit.
3. Using the least-squares regression estimate of the variable overhead
cost, the total variable cost per guest is computed as follows:
Food and beverages.............................. $15.00
Labor (0.5 hour @ $10 per hour) ........... 5.00
Overhead (0.5 hour @ $3.95 per hour) .. 1.98
Total variable cost per guest .................. $21.98
The total contribution from 180 guests paying $31 each is computed as
follows:
Sales (180 guests @ $31.00 per guest) .............. $5,580.00
Variable cost (180 guests @ $21.98 per guest) ... 3,956.40
Contribution to profit ........................................ $1,623.60
Fixed costs are not included in the above computation because there is
no indication that any additional fixed costs would be incurred as a
consequence of catering the cocktail party. If additional fixed costs were
incurred, they should also be subtracted from revenue.
4. Assuming that no additional fixed costs are incurred as a result of

catering the charity event, any price greater than the variable cost per
guest of roughly $22 would contribute to profits.

Solutions Manual, Appendix 5A 105
CASE 5A-12 (continued)
5. We would favor bidding slightly less than $30 to get the contract. Any
bid above $22 would contribute to profits and a bid at the normal price
of $31 is unlikely to land the contract. And apart from the contribution
to profit, catering the event would show off the company’s capabilities
to potential clients. The danger is that a price that is lower than the
normal bid of $31 might set a precedent for the future or it might
initiate a price war among caterers. However, the price need not be
publicized and the lower price could be justified to future clients
because this is a charity event. Another possibility would be for Maria to
maintain her normal price but throw in additional services at no cost to
the customer. Whether to compete on price or service is a delicate issue
that Maria will have to decide after getting to know the personality and
preferences of the customer.


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Chapter 5

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The margin of safety percentage is now 10%, whereas it was 20%

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The margin of safety percentage is 13% and the degree of operating

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2. The contribution margin ratio is calculated as follows:

3. The variable expense ratio is calculated as follows:

4. The increase in net operating income is calculated as follows:

5. If sales decline to 900 units, the net operating income would be

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7. The new net operating income would be computed as follows:

8. The equation method yields the break-even point in unit sales, Q, as

9. The equation method yields the dollar sales to break-even as follows:

Profit = CM ratio × Sales − Fixed expenses

The dollar sales to break-even ($15,000) can also be computed by

10. The equation method yields the target profit as follows:

11. The margin of safety in dollars is calculated as follows:

The margin of safety as a percentage of sales is calculated as follows:

12. The degree of operating leverage is calculated as follows:

13. A 5% increase in unit sales should result in a 20% increase in net

14. The degree of operating leverage is calculated as follows:

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15. A 5% increase in unit sales should result in a 35% increase in net

Degree of operating leverage (a) .............................. 7.0

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2. The revised net operating income would be:

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Fixed Expense Total Expense Total Sales Revenue

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Total contribution margin (a) . $80,000

2. The change in net operating income from an increase in total sales of

This computation can be verified as follows:

Increase in total sales (a) ......... $1,000

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2. The break-even point in dollar sales is computed as follows:

Unit sales to break even (a) ............................ 1,400

3. The new break-even point in unit sales, Q, is computed as follows:

The break-even point in dollar sales is computed as follows:

Unit sales to break even (a) ............................ 1,600

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2. One approach to solving this requirement is to compute the unit sales

Unit sales to attain the target profit (a)............ 1,625

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2. The margin of safety as a percentage of sales is as follows:

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