1

CVP Analysis Q&A

PROBLEM

COST VOLUME PROFIT ANALYSIS

QUESTION
Angie Silva has recently opened The Sandal Shop in Brisbane, Australia, a store that specializes
in fashionable sandals. Angie has just received a degree in business and she is anxious to apply
the principles she has learned to her business. In time, she hopes to open a chain of sandal shops.
As a first step, she has prepared the following analysis for her new store:

Selling price per pair of sandals ............... $50.00

Variable expenses per pair of sandals ...... 30.00
Contribution margin per pair of sandals .. $20.00

Fixed expenses per year:

Building rental....................................... $18,000
Equipment depreciation ........................ 6,000
Selling ................................................... 32,000
Administrative....................................... 34,000
Total fixed expenses................................. $90,000

Required:
1. How many pairs of sandals must be sold each year to break even? What does this represent in
total dollar sales?
2. Angie has decided that she must earn at least $25,000 the first year to justify her time and
effort. How many pairs of sandals must be sold to reach this target profit?
3. Angie now has one salesperson working in the store-one part time. It will cost her an
additional $12,000 per year to convert the part-time position to a full-time position. Angie
believes that the change would bring in an additional $80,000 in sales each year. Should she
convert the position? Use the incremental approach (do not prepare an income statement).
4. Refer to the original data. During the first year, the store sold 5,250 pairs of sandals and
reported the following operating results:

Sales (5,250 pairs) ................................. $262,500

Less variable expenses .......................... 157,500
Contribution margin .............................. 105,000
Less fixed expenses............................... 90,000
Net operating income ............................ $ 15,000

a. What is the store’s degree of operating leverage?

b. Angie is confident that with a more intense sales effort and with a more creative
advertising program she can increase sales by 10% next year. What would be the
expected percentage increase in net operating income? Use the degree of operating
leverage to compute your answer.

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CVP Analysis Q&A

CHECK FIGURE (1) Break-even: 4,500 pairs (4a) Leverage: 7.00

SOLUTION

1. Sales = Variable expenses + Fixed expenses + Profits

$50.00Q = $30.00Q + $90,000 + $0
$20.00Q = $90,000
Q= $90,000 ÷ $20.00 per pair
Q= 4,500 pairs
4,500 pairs × $50.00 per pair = $225,000 in sales

Alternative solution:
Fixed expenses $90,000
= = 4,500 pairs
CM per unit $20.00 per pair
Fixed expenses $90,000
= = $225,000 in sales
CM ratio 0.40
2. Cost-volume-profit graph:

$400,000

$350,000
Break-Even Point: Total
$300,000 4,500 pairs sold or Sales
$225,000 in total sales
$250,000 Total
Total Sales

Expenses
$200,000

$150,000
Total
$100,000 Fixed
Expenses
$50,000

$0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000
Number of Pairs of Sandals Sold
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CVP Analysis Q&A

Problem 6-9A (continued)

3. Sales = Variable expenses + Fixed expenses + Profits

$50.00Q = $30.00Q + $90,000 + $25,000
$20.00Q = $115,000
Q= $115,000 ÷ $20.00 per pair
Q= 5,750 pairs
Alternative solution:
Fixed expenses + Target profit $90,000 + $25,000
= = 5,750 pairs
Unit contribution margin $20.00 per pair

4. Incremental contribution margin:

$80,000 increased sales × 40% CM ratio ....................................... $32,000
Incremental fixed salary cost............................................................. 12,000
Increased net operating income ......................................................... $20,000
Yes, the position should be converted to a full-time basis.

5. a. Contribution margin $105,000

=
Net operating income $15,000

= 7.00 (Degree of operating leverage)

b. 7.00 × 10% sales increase = 70% increase in net income. Thus, net operating income next
year would be: $15,000 + ($15,000 × 70%) = $25,500. Note that the operating leverage
focuses on the increase in income resulting from the increase in sales.

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CVP Analysis Q&A

CVP IN A MULTI PRODUCT SCENARIO

QUESTION

Yurus Manufacturing Company produces two products, X and Y. The following

information is presented for both products:
X Y
Selling price per unit $36 $24
Variable cost per unit 28 12

Total fixed costs are $234,000.

Required:

a. Calculate the contribution margin for each product.

b. Calculate breakeven point in units of both X and Y if the sales mix is 3 units of X
for every unit of Y.
c. Calculate breakeven volume in total dollars if the sales mix is 2 units of X for every
3 units of Y.

SOLUTION
a.
X: $36 - $28 = $8
Y: $24 - $12 = $12

b.
(3 x $8) + (1 x $12) = $36
$234,000/$36 = 6,500 units
X: 6,500 x 3 = 19,500 units
Y: 6,500 x 1 = 6,500 units
c.
(2 x $8) + (3 x $12) = $52
$234,000/$52 = 4,500 units
X: 4,500 x 2 = 9,000 x $36 = $324,000
Y: 4,500 x 3 = 13,500 x $24 = $324,000
Total dollar sales = $648,000

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CVP Analysis Q&A

CHOOSING YOUR COST STRUCTURE

QUESTION
. Query Company sells pillows for $25.00 each. The manufacturing cost, all variable, is
$10 per pillow. The company is planning on renting an exhibition booth for both display
and selling purposes at the annual crafts and art convention. The convention coordinator
allows three options for each participating company. They are:
1. paying a fixed booth fee of $5,010, or
2. paying an $4,000 fee plus 10% of revenue made at the convention, or
3. paying 20% of revenue made at the convention.

Required:
a. Compute the breakeven sales in pillows of each option.
b. Which option should Query Company choose, assuming sales are expected to be 800
pillows?

SOLUTION
a.
Option 1 N = Breakeven in pillows
$25N - $10N - $5,010 = 0
$15N - $5,010 = 0
N = $5,010/$15 = 334 pillows

Option 2 N = Breakeven in pillows

$25N - $10N - 0.10($25N) - $4,000 = 0
$12.5N - $4,000 = 0
N = $4,000/$12.5 = 320 pillows

Option 3 N = Breakeven in pillows

$25N - $10N - 0.20($25N) = 0
$10N - $0 = 0
N = $0/$10 = 0 pillows

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CVP Analysis Q&A

b. Option 1 profit for 800 pillows = $15 x 800 - $5,010 = $6,990

Option 2 profit for 800 pillows = $12.5 x 800 - $4,000 = $6,000
Option 3 profit for 800 pillows = $10 x 800 = $8,000
Option 3 is the best choice.

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MA (CASES) CVP ANALYSIS

GMBA SBR – CVP Analysis - The Fashion Shoe Company

PROBLEM 6-3A CVP Analysis; Graphing

CHECK FIGURE (1) 13,000 pairs of shoes (3) $7,500 net operating loss

The Fashion Shoe Company operates a chain of women’s shoe shops around the country. The
shops carry many styles of shoes that are all sold at the same price. Sales personnel in the shops
are paid a substantial commission on each pair of shoes sold (in addition to a small basic salary)
in order to encourage them to be aggressive in their sales efforts.
The following cost and revenue data relate to Shop 48 and are typical of one of the
company’s many outlets:

Per Pair of Shoes

Selling price ..................... $40.00

Variable expenses:
Invoice cost ................... $23.00
Sales commission .......... 2.00
Total variable expenses .... $25.00

Fixed expenses: Annual

Advertising.................... $ 45,000
Rent ............................... 30,000
Salaries .......................... 120,000
Total fixed expenses ........ $195,000

Required:

1. Calculate the annual break-even point in dollar sales and in unit sales for Shop 48.
2. Prepare a CVP graph showing cost and revenue data for Shop 48 from a zero level of activity
up to 20,000 pairs of shoes sold each year. Clearly indicate the break-even point on the
graph.
3. If 12,500 pairs of shoes are sold in a year, what would be Shop 48’s net operating income or
loss?
4. The company is considering paying the store manager of Shop 48 an incentive commission
of $1.00 per pair of shoes (in addition to the salesperson’s commission). If this change is
made, what will be the new break-even point in dollar sales and in unit sales?
5. Refer to the original data. As an alternative to (4) above, the company is considering paying
the store manager a $0.25 commission on each pair of shoes sold in excess of the break-even
point. If this change is made, what will be the shop’s net operating income or loss if 15,000
pairs of shoes are sold?
6. Refer to the original data. The company is considering eliminating sales commissions
entirely in its shops and increasing fixed salaries by $17,500 annually. If this change is made,
what will be the new break-even point in dollar sales and in unit sales for Shop 48? Would
you recommend that the change be made? Explain.

1 © The McGraw-Hill Companies, Inc., 2002. All rights reserved.

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MA (CASES) CVP ANALYSIS

GMBA SBR – CVP Analysis - Island Novelties, Inc

PROBLEM 6-8A Sales Mix; Break-Even Analysis; Margin of Safety

CHECK FIGURE
(1b) Break-even: $675,000
(2b) Margin of safety: 21.0%

Island Novelties, Inc., of Palau makes two products, Hawaiian Fantasy and Tahitian Joy. Present
revenue, cost, and sales data on the two products follow:

Hawaiian Tahitian
Fantasy Joy
Selling price per unit ............ $20.00 $25.00
Variable expenses per unit ... $14.00 $10.00
Number of units sold
annually ............................. 25,000 10,000

Fixed expenses total $270,000 per year. The Republic of Palau uses the US dollar as its currency.

Required:

1. Assuming the sales mix given above, do the following:

a. Prepare a contribution income statement showing both dollar and percent columns for
each product and for the company as a whole.
b. Compute the break-even point in dollars for the company as a whole and the margin of
safety in both dollars and percent.
2. The company has just developed a new product, Samoan Delight. Assume that the company
could sell 12,000 units at $17.50 each. The variable expenses would be $14.00 each. The
company’s fixed expenses would not change.
a. Prepare another contribution income statement, including sales of Samoan Delight (sales
of the other two products would not change). Carry percentage computations to one
decimal place.
b. Compute the company’s new break-even point in dollars and the new margin of safety in
both dollars and percent.
3. The president of the company examines your figures and says, “There’s something strange
here. Our fixed costs haven’t changed and you show greater total contribution margin if we
add the new product, but you also show our break-even point going up. With greater
contribution margin, the break-even point should go down, not up. You’ve made a mistake
somewhere.” Explain to the president what has happened.

2 © The McGraw-Hill Companies, Inc., 2002. All rights reserved.

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MA (CASES) CVP ANALYSIS

INDICATIVE SOLUTIONS

3 © The McGraw-Hill Companies, Inc., 2002. All rights reserved.

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MA (CASES) CVP ANALYSIS

Problem 6-3A

1. Sales = Variable expenses + Fixed expenses + Profits

$40.00Q = $25.00Q + $195,000 + $0
$15.00Q = $195,000
Q= $195,000 ÷ $15.00 per pair
Q= 13,000 pairs
13,000 pairs × $40.00 per pair = $520,000 in sales.
Alternatively:
Fixed expenses $195,000
= = 13,000 pairs
CM per unit $15.00 per pair
Fixed expenses $195,000
= = $520,000 in sales
CM ratio 0.375

4 © The McGraw-Hill Companies, Inc., 2002. All rights reserved.

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MA (CASES) CVP ANALYSIS

Problem 6-3A (continued)

2. Cost-volume-profit graph.

$900

$800
Total Sales Revenue
$700 Break-Even Point:
13,000 pairs of shoes or
$600 $520,000 in total sales

$500 Total Expenses

$400

$300

$200 Total Fixed

Expenses
$100

$0
00

00

00

00

00
0

0
0

50

00

50

,0

,5

,0

,5

,0
2,

5,

7,

10

12

15

17

20

5 © The McGraw-Hill Companies, Inc., 2002. All rights reserved.

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MA (CASES) CVP ANALYSIS

Problem 6-3A (continued)

3. The simplest approach is:
Break-even sales ................................................... 13,000 pairs
Actual sales ........................................................... 12,500 pairs
Sales short of break-even ...................................... 500 pairs

500 pairs × $15.00 contribution margin per pair = $7,500 loss

Alternative solution:
Sales (12,500 pairs × $40.00 per pair) ........................................... $500,000
Less variable expenses
(12,500 pairs × $25.00 per pair) ................................................. 312,500
Contribution margin....................................................................... 187,500
Less fixed expenses ....................................................................... 195,000
Net operating loss .......................................................................... $ (7,500)

4. The variable expenses will now be $26.00 per pair, and the contribution
margin will be $14.00 per pair.
Sales = Variable expenses + Fixed expenses + Profits
$40.00Q = $26.00Q + $195,000 + $0
$14.00Q = $195,000
Q= $195,000 ÷ $14.00 per pair
Q= 13,929 pairs
13,929 pairs × $40.00 per pair = $557,143 in sales
Alternative solution:
Fixed expenses $195,000
= = 13,929 pairs
CM per unit $14.00 per pair
Fixed expenses $195,000
= = $557,143 in sales
CM ratio 0.350

6 © The McGraw-Hill Companies, Inc., 2002. All rights reserved.

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MA (CASES) CVP ANALYSIS

Problem 6-3A (continued)

5. The simplest approach is:
15,000 pairs
Actual sales ....................................................................
Break-even sales ............................................................. 13,000 pairs
Excess over break-even sales ......................................... 2,000 pairs
2,000 pairs × $14.75 per pair* = $29,500 profit
*$15.00 present contribution margin – $0.25 commission = $14.75

Alternative solution:
Sales (15,000 pairs × $40.00 per pair)............................................................... $600,000
Less variable expenses (13,000 pairs × $25.00 per pair; 2,000 pairs × $25.25
per pair).......................................................................................................... 375,500
Contribution margin .......................................................................................... 224,500
Less fixed expenses ........................................................................................... 195,000
Net operating income ........................................................................................ $ 29,500

6. The new variable expenses will be $23.00 per pair.

Sales = Variable expenses + Fixed expenses + Profits
$40.00Q = $23.00Q + $212,500 + $0
$17.00Q = $212,500
Q= $212,500 ÷ $17.00 per pair
Q= 12,500 pairs
12,500 pairs × $40.00 per pair = $500,000 in sales.

Although the change will lower the break-even point from 13,000 pairs
to 12,500 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.

7 © The McGraw-Hill Companies, Inc., 2002. All rights reserved.

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MA (CASES) CVP ANALYSIS

Problem 6-8A

1. a. Hawaiian Fantasy Tahitian Joy Total

Amount % Amount % Amount %
Sales .......................................................... $500,000 100.0 $250,000 100.0 $750,000 100.0
Less variable expenses.............................. 350,000 70.0 100,000 40.0 450,000 60.0
Contribution margin ................................. $150,000 30.0 $150,000 60.0 300,000 40.0
Less fixed expenses .................................. 270,000
Net income................................................ $ 30,000

b.
Fixed expenses $270,000
= = $675,000 in sales
CM ratio 0.400
Margin of safety:
Margin of safety=Actual sales - Break-even sales

$750,000 - $675,000= $75,000

Margin of safety in percentage= Margin of safety in dollars

Actual sales
$75,000
= 10.0%
$750,000

8 © The McGraw-Hill Companies, Inc., 2002. All rights reserved.

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MA (CASES) CVP ANALYSIS

Problem 6-8A (continued)

2. a. Hawaiian Fantasy Tahitian Joy Samoan Delight Total

Amount % Amount % Amount % Amount %
Sales ............................................... $500,000 100.0 $250,000 100.0 $210,000 100.0 $960,000 100.0
Less variable expenses ................... 350,000 70.0 100,000 40.0 168,000 80.0 618,000 64.4
Contribution margin ....................... $150,000 30.0 $150,000 60.0 $ 42,000 20.0 342,000 35.6
Less fixed expenses ........................ 270,000
Net income ..................................... $ 72,000

9 © The McGraw-Hill Companies, Inc., 2002. All rights reserved.

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MA (CASES) CVP ANALYSIS

Problem 6-8A (continued)

b.
Fixed expenses $270,000
= = $758,427
CM ratio 0.356
Margin of safety:
Margin of safety=Actual sales - Break-even sales
$960,000 - $758,427 = $201,573

Margin of safety in percentage= Margin of safety in dollars

Actual sales
$201,573
= 21.0%
$960,000

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 40.0% to 35.6% with the addition of the third product.
This product (Samoan Delight) has a CM ratio of only 20.0%, 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 manager
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 $75,000 to $201,573 or from 10.0% to 21.0%.
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.

Further circulation is prohibited.

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QUESTION.

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ANSWER 1

Problem 6-22 (60 minutes)

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:

Profit = Unit CM × Q − Fixed expenses
$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

Alternative solution:
Unit sales to = Fixed expenses
break even Unit contribution margin

$180,000
= = 20,000 units
$9.00

Dollar sales to = Fixed expenses

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).

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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

4. Profit = Unit CM × Q − Fixed expenses

$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

Alternative solution:
Unit sales to attain = Target profit + Fixed expenses
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%

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CVP Analysis Q&A

The new break-even point would be:

Unit sales to = Fixed expenses
break even Unit contribution margin

$180,000 + $72,000
=
$12.00
= 21,000 units

Dollar sales to = Fixed expenses

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

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CVP Analysis Q&A

Problem 6-22 (continued)

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).

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CVP Analysis Q&A

QUESTION
177.Belli-Pitt, Inc, produces a single product. The results of the company's operations for a
typical month are summarized in contribution format as follows:

Sales................................... $540,000
Variable expenses .............. 360,000
Contribution margin .......... 180,000
Fixed expenses .................. 120,000
Net operating income ........ $ 60,000

The company produced and sold 120,000 kilograms of product during the month.
There were no beginning or ending inventories.

Required:

a. Given the present situation, compute

1. The break-even sales in kilograms.
2. The break-even sales in dollars.
3. The sales in kilograms that would be required to produce net operating income
of $90,000.
4. The margin of safety in dollars.

b. An important part of processing is performed by a machine that is currently being

leased for $20,000 per month. Belli-Pitt has been offered an arrangement whereby
it would pay $0.10 royalty per kilogram processed by the machine rather than the
monthly lease.
1. Should the company choose the lease or the royalty plan?
2. Under the royalty plan compute break-even point in kilograms.
3. Under the royalty plan compute break-even point in dollars.
4. Under the royalty plan determine the sales in kilograms that would be required
to produce net operating income of $90,000.

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CVP Analysis Q&A

Answer :
a. Per kg.
Sales ................................ $4.50 100.0%
Variable expense ............. 3.00 66.7%
Contribution margin ........ $1.50 33.3%

1. Sales = Variable expenses + Fixed expenses + Target profit

$4.50Q = $3.00Q + $120,000 + $0
$1.50Q = $120,000
Q = $120,000 ÷ $1.50 per unit = 80,000 units

2. 80,000 units × $4.50 per unit = $360,000

3. Sales = Variable expenses + Fixed expenses + Target profit

$4.50Q = $3.00Q + $120,000 + $90,000
$1.50Q = $210,000
Q = $210,000 ÷ $1.50 per unit = 140,000 units

4. Margin of safety = Sales − Sales at breakeven = $540,000 − $360,000

= $180,000

b.
1. As Is Proposed
Per Unit Amount Per Unit Amount
Sales ................................ $540,000 $4.50 $540,000 $4.50
Variable expense ............. 360,000 3.00 372,000 3.10
Contribution margin........ 180,000 1.50 168,000 1.40
Fixed expense ................. 120,000 1.00 100,000 0.83
Net operating income ...... $ 60,000 $0.50 $ 68,000 $0.57

Since net operating income increases by $8,000 the royalty is a good plan,
provided sales remains at the same level.

2. Sales = Variable expenses + Fixed expenses + Target profit

$4.50Q = $3.10Q + $100,000 + $0
$1.40Q = $100,000
Q = $100,000 ÷ $1.40 per unit = 71,429 units

3. 71,429 units × $4.50 unit = $321,429

4. Sales = Variable expenses + Fixed expenses + Target profit

$4.50Q = $3.10Q + $100,000 + $90,000
$1.40Q = $190,000
Q = $190,000 ÷ $1.40 per unit = 135,714 units

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MA / CVP ANALYSIS iLearn (iL) Ltd

COST VOLUME PROFIT ANALYSIS

QUESTION

The iLearn (iL) Ltd. Company has developed a new product called iSMART for children.
Following estimates have been made about the product for the coming year;

Fixed Costs per annum $60,000

Unit selling Price $20
Unit Variable Cost $10
Existing sales 8,000 units
Relevant range of output 4,000 - 12,000 units

Using the data above, we can now answer the following independent (unrelated) questions:

(a) What is the output (units / $) at which the iLearn (iL) Ltd breaks even (i.e. makes neither
a profit nor a loss)?
(b) What is the current margin of safety in units / $?
(c) How many units must be sold to obtain $30,000 profits?
(d) What is the profit which will result from a 10% reduction in the variable costs and a
$10,000 decrease in fixed costs assuming that current unit sales can be maintained?
(e) What is the required (new) selling price to show a profit of $30,000 on sales of 6,000
units?
(f) What additional sales volume is required to meet $8,000 extra fixed charges from a
proposed plant expansion?

ANSWER 1
A BEP = 6000 UNITS OR $120000
B MARGIN OF SAFETY = 2000 UNITS OR $40000
C Required Sales = 9000 units
D $38,000
E $25 per unit
f 800 units additional sales

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MA / CVP ANALYSIS iLearn (iL) Ltd

Workings

Part 1 Part 3
Units 6000 1 9000 1
$ $ $ $
Sales 120000 20 20
Less Variable Cost 10 10

= Contribution 60000 10 90000 10

Less Fixed Cost 60000 60000

= Profit 0 30000

Part 4 Part 5
Units 8000 1 6000 1
$ $ $ $
Sales 20 25
Less Variable Cost 9 10

= Contribution 88000 11 90000 15

Less Fixed Cost 50000 60000

= Profit 38000 30000

Part 2
Units
Given sales 8000
Break even sales 6000
Margin of safety - units 2000
Margin of safety $ 40000

Part 6
Additional contribution $ 8000 To cover increased fixed cost
Per unit contribution $ 10
Additional units 800

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CVP Analysis Q&A

QUESTION
Juices R Us sells bottles of freshly squeezed juice to small convenience stores throughout
Melbourne. Its latest income statement for the last 12 months is as follows:
Juices R Us
Income statement
Sales (100 000 bottles × $5) $500 000
Less: Variable cost of sales (100 000 300 000
*
bottles × $3)
Gross profit $200 000
Less: Fixed expenses
Advertising $10 000
Manager’s salary $50 000
Occupancy and admin 20 000 80 000#
Profit $120 000
*
all variable cost
#
all fixed costs

Required
a. Calculate the contribution margin and contribution margin ratio per juice bottle.
b. Calculate the number of juice bottles to break even in both units and sales dollars.
c. The company expects to sell 115 000 units in the coming year.
(i) What is the margin of safety in units and $ at this level of activity?
(ii) How much profit will the business make for the year if its estimated level
of activity is accurate?
d. The company estimates that if it reduced the selling price by $0.30 per bottle, spent an
additional $20 000 on advertising for the year, and improved the appearance of the juice
bottle (at an extra cost of $0.15 per bottle), sales for the year would rise to 155 000 units.
Using supporting calculations, advise whether the company should make these changes or
retain the existing revenue and cost structure and go with the 115 000 units sales plan.
e. Use original data. Juices R Us could avoid the manager’s salary costs by paying her $1.00
for every bottle sold. In what circumstances would Juices R Us benefit from switching to this
arrangement?

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CVP Analysis Q&A

ANSWER A1
Juices R Us sells bottles of freshly squeezed juice to small convenience stores throughout
Melbourne. Its latest income statement for the last 12 months is as follows:
Juices R Us
Income statement
Sales (100 000 bottles × $5) $500 000
Less: Cost of sales (100 000 bottles × $3)* 300 000
Gross profit $200 000
Less: Other expenses
Advertising $10 000
Manager’s salary $50 000
Occupancy and admin 20 000 80 000#
Profit $120 000
*
all variable cost
#
all fixed costs

Required
a. Calculate the contribution margin per juice bottle.

SP $5
VC $3
CM $2 per bottle

b. Calculate the number of juice bottles to break even in both units and sales
dollars.

Units - $80000/ $2 = 40000 bottles

Sales dollars - $80000 / ($3/$5) = $200 000
Proof 40000 bottles x $5 = $200000

c. The company expects to sell 115 000 units in the coming year.
(i) What is the margin of safety at this level of activity?

115000 sales less breakeven 40000 units = 75000 bottles margin of safety

(ii) How much profit will the business make for the year if its estimated level
of activity is accurate?

75000 bottles x $2 contribution margin = $150000

d. The company estimates that if it reduced the selling price by $0.30 per bottle,
spent an additional $20 000 on advertising for the year, and improved the
appearance of the juice bottle (at an extra cost of $0.15 per bottle), sales for the
year would rise to 155 000 units. Using supporting calculations, advise whether
the company should make these changes or retain the existing revenue and cost
structure and go with the 115 000 units sales plan.

Revised contribution margin

SP $4.70
VC $3.15
CM $1.55

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CVP Analysis Q&A

Revised breakeven = $100000/$1.55 = 64516 bottles

Therefore if sales are 115,000 bottles profit will be #140 250.20 (155000 = 64516 * $1.55)
It will be best to maintain the current plan if sales are only expected to be 155000 units as
higher profits can be generated on 115000 units of sales with the existing revenue/cost
structure

e. Juices R Us could avoid the manager’s salary costs by paying her $1.00 for every
bottle sold. In what circumstances would Juices R Us benefit from switching to
this arrangement? (Revert to original cost scenario.)

Point of indifference = $50 000 / $1 = 50000 bottles

At this level total costs are the same for both options, however, above 50000 bottles a fixed
salary will be preferred as each additional sale will generate a higher profit due to the higher
contribution margin; however, if sales fall below 50000 bottles then the variable salary will
be preferred .

(suggest students prepare an income statement for the following sales levels to reinforce this
concept – sales levels of 49999, 50000 and 50001)

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MA / CVP ANALYSIS Island Novelties

CVP Analysis - Island Novelties, Inc

PROBLEM 6-8A Sales Mix; Break-Even Analysis; Margin of Safety

CHECK FIGURE
(1b) Break-even: $675,000
(2b) Margin of safety: 21.0%

Island Novelties, Inc., of Palau makes two products, Hawaiian Fantasy and Tahitian Joy. Present
revenue, cost, and sales data on the two products follow:

Hawaiian Tahitian
Fantasy Joy
Selling price per unit ........... $20.00 $25.00
Variable expenses per unit .. $14.00 $10.00
Number of units sold
annually ............................ 25,000 10,000

Fixed expenses total $270,000 per year. The Republic of Palau uses the US dollar as its currency.

Required:

Assuming the sales mix given above, do the following:

a. Prepare a contribution income statement showing both dollar and percent columns for
each product and for the company as a whole.
b. Compute the break-even point in dollars for the company as a whole and the margin of
safety in both dollars and percent.

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MA / CVP ANALYSIS Island Novelties

INDICATIVE SOLUTIONS

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MA / CVP ANALYSIS Island Novelties

Problem 6-8A

a. Hawaiian Fantasy Tahitian Joy Total

Amount % Amount % Amount %
Sales .............................................. $500,000 100.0 $250,000 100.0 $750,000 100.0
Less variable expenses .................. 350,000 70.0 100,000 40.0 450,000 60.0
Contribution margin ...................... $150,000 30.0 $150,000 60.0 300,000 40.0
Less fixed expenses ....................... 270,000
Net income .................................... $ 30,000

b.
Fixed expenses $270,000
= = $675,000 in sales
CM ratio 0.400
Margin of safety:
Margin of safety=Actual sales - Break-even sales

$750,000 - $675,000= $75,000

Margin of safety in percentage= Margin of safety in dollars

Actual sales
$75,000
= 10.0%
$750,000

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MA / CVP ANALYSIS Yurus

PROBLEM

CVP IN A MULTI PRODUCT SCENARIO

QUESTION

Yurus Manufacturing Company produces two products, X and Y. The following

information is presented for both products:
X Y
Selling price per unit $36 $24
Variable cost per unit 28 12

Total fixed costs are $234,000.

Required:

a. Calculate the contribution margin for each product.

b. Calculate breakeven point in units of both X and Y if the sales mix is 3 units of X
for every unit of Y.
c. Calculate breakeven volume in total dollars if the sales mix is 2 units of X for every
3 units of Y.

SOLUTION
a.
X: $36 - $28 = $8
Y: $24 - $12 = $12

b.
(3 x $8) + (1 x $12) = $36
$234,000/$36 = 6,500 units
X: 6,500 x 3 = 19,500 units
Y: 6,500 x 1 = 6,500 units
c.
(2 x $8) + (3 x $12) = $52
$234,000/$52 = 4,500 units
X: 4,500 x 2 = 9,000 x $36 = $324,000
Y: 4,500 x 3 = 13,500 x $24 = $324,000
Total dollar sales = $648,000

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CVP Analysis Q&A

QUESTION

Due to erratic sales of its sole product—a high-capacity battery for laptop computers—DRJ,
Inc., has been experiencing difficulty for some time. The company’s contribution format
income statement (original data) for the most recent month is given below:

Sales (20,000 units × $25.00 per unit) ............. $500,000

Less variable expenses ..................................... 300,000
Contribution margin ......................................... 200,000
Less fixed expenses .......................................... 220,000
Net operating loss ............................................. $ (20,000)

Required:

a. Compute the company’s CM ratio and its break-even point in both units and dollars.
b. The president believes that a $15,000 increase in the monthly advertising budget,
combined with an intensified effort by the sales staff, will result in a $100,000 increase in
monthly sales. If the president is right, what will be the effect on the company’s monthly
net operating income or loss?
c. Refer to the original data. The sales manager is convinced that a 10% reduction in the
selling price, combined with an increase of $10,000 in the monthly advertising budget,
will cause unit sales to increase by 20%. What will the new contribution format income
statement look like if these changes are adopted?
d. Refer to the original data. The Marketing Department thinks that a fancy new package for
the laptop computer battery would help sales. The new package would increase packaging
costs by 25 cents per unit. Assuming no other changes, how many units would have to be
sold each month to earn a profit of $33,500?
e. Refer to the original data. By automating certain operations, the company could reduce
variable costs by $2.00 per unit. However, fixed costs would increase by $41,000 each
month.
i. Compute the new CM ratio and the new break-even point in both units and dollars.
ii. Assume that the company expects to sell 22,500 units next month. Prepare two
contribution format income statements, one assuming that operations are not
automated and one assuming that they are. (Show data on a per unit and percentage
basis, as well as in total, for each alternative.)
iii. Would you recommend that the company automate its operations? Explain.

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CVP Analysis Q&A

Problem 6-22B (90 minutes)

1. The CM ratio is:
Total Per Unit Percent of Sales
Sales (20,000 units) ....... $500,000 $25.00 100%
Less variable expenses ... 300,000 15.00 60%
Contribution margin........ $200,000 $10.00 40%

The break-even point is:

Sales = Variable expenses + Fixed expenses + Profits
$25.00Q = $15.00Q + $220,000 + $0
$10.00Q = $220,000
Q = $220,000 ÷ $10.00 per unit
Q = 22,000 units
22,000 units × $25.00 per unit = $550,000 in sales.

Alternative solution:
Break-even point = Fixed expenses
in unit sales Unit contribution margin

$220,000
= = 22,000 units
$10.00 per unit

Break-even point = Fixed expenses

in sales dollars CM ratio
$220,000
= = $550,000 in sales
0.40

2. Incremental contribution margin:

$100,000 increased sales × 0.40 CM ratio .......... $40,000
Less increased advertising cost ............................ 15,000
Increase in monthly net operating income ............ $25,000
Since the company is now showing a loss of $20,000 per month, if
the changes are adopted, the loss will turn into a profit of $5,000
each month ($25,000 less $20,000 = $5,000).

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CVP Analysis Q&A

3. Sales (24,000 units @ $22.50 per unit*) ......... $540,000

Less variable expenses (24,000 units @
$15.00 per unit) ......................................... 360,000
Contribution margin ...................................... 180,000
Less fixed expenses ($220,000 + $10,000) ..... 230,000
Net operating loss ......................................... $ (50,000)
*$25.00 – ($25.00 × 0.10) = $22.50

4. Sales = Variable expenses + Fixed expenses + Profits

$25.00Q = $15.25Q* + $220,000 + $33,500
$9.75Q = $253,500
Q = $253,500 ÷ $9.75 per unit
Q = 26,000 units
*$15.00 + $0.25 = $15.25

Alternative solution:
Unit sales to attain = Fixed expenses + Target profit
target profit Unit contribution margin

$253,500
= = 26,000 units
$9.75 per unit**
**$25.00 – $15.25 = $9.75

5. a. The new CM ratio would be:

Per Unit Percent of Sales
Sales ........................... $25.00 100%
Less variable expenses . 13.00 52%
Contribution margin ..... $12.00 48%

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CVP Analysis Q&A

The new break-even point would be:

Break-even point = Fixed expenses
in unit sales Unit contribution margin
$220,000 + $41,000
= = 21,750 units
$12.00 per unit

Break-even point = Fixed expenses

in sales dollars CM ratio
$220,000 + $41,000
= = $543,750
0.48
b. Comparative income statements follow:
Not Automated Automated
Per Per
Total Unit % Total Unit %
Sales (22,500 units) . $562,500 $25.00 100% $562,500 $25.00 100%
Less variable
expenses .............. 337,500 15.00 60% 292,500 13.00 52%
Contribution margin . 225,000 $10.00 40% 270,000 $12.00 48%
Less fixed expenses . 220,000 261,000
Net operating
income ................. $ 5,000 $ 9,000

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 0.40 to
0.48). The higher CM ratio means that once the break-even point
is reached, profits will increase more rapidly than at present. If
22,500 units are sold next month, for example, the higher CM ratio
will generate $4,000 more in profits than if no changes are made.

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CVP Analysis Q&A

The greatest risk of automating is that future sales may drop back
down to present levels (only 20,000 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; 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
$15.00Q + $220,000 = $13.00Q + $261,000
$2.00Q = $41,000
Q = $41,000 ÷ $2.00 per unit
Q = 20,500 units
If more than 20,500 units are sold in a month, the proposed plan
will yield the greater profits; if less than 20,500 units are sold in a
month,

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MA / CVP ANALYSIS Feather Friends

CVP Analysis - Feather Friends

Feather Friends, Inc., makes a high-quality wooden birdhouse that sells for $15.00 per unit.
Variable costs are $4.50 per unit, and fixed costs total $135,000 per year.

Required:

Answer the following independent questions:

1. What is the product’s CM ratio?
2. Use the CM ratio to determine the break-even point in sales dollars.
3. Due to an increase in demand, the company estimates that sales will increase by $56,250
during the next year. By how much should net operating income (or net operating loss)
change, assuming that fixed costs do not change?
4. Assume that the operating results for last year were:

Sales ................................ $300,000

Less variable expenses .... 90,000
Contribution margin ........ 210,000
Less fixed expenses ......... 135,000
Net operating income ...... $ 75,000

a. Compute the degree of operating leverage at the current level of sales.

b. The president expects sales to increase by 25% next year. By what percentage should net
operating income increase?
5. Refer to the original data. Assume that the company sold 16,500 units last year. The sales
manager is convinced that a 5% reduction in the selling price, combined with a $22,500
increase in advertising, would cause annual sales in units to increase by one-third. Prepare
two contribution income statements, one showing the results of last year’s operations and one
showing the results of operations if these changes are made. Would you recommend that the
company do as the sales manager suggests?
6. Refer to the original data. Assume again that the company sold 16,500 units last year. The
president does not want to change the selling price. Instead, he wants to increase the sales
commission by $0.75 per unit. He thinks that this move, combined with some increase in
advertising, would increase annual sales by 20%. By how much could advertising be
increased with profits remaining unchanged? Do not prepare an income statement; use the
incremental analysis approach.

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MA / CVP ANALYSIS Feather Friends

INDICATIVE SOLUTIONS

ANSWERS

Units $ % Times

1 CM Ratio 70%

2 BEP 12857 $192,857

3 Profit increase by $39,375

4a DOL times 2.8

4b Profit increase by 70%

5 Profit increase to $57,000

Profit increase by $18,750

6 Advert can increase by $19,800

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MA / CVP ANALYSIS Feather Friends

INDICATIVE SOLUTION

1.
Sales price ........................................... $15.00 100%
Less variable expenses ........................ 4.50 30%
Contribution margin ............................ $10.50 70%

2. Fixed expenses $135,000

= = $192,857 sales to break even.
CM ratio 0.70

3. $56,250 increased sales × 0.70 CM ratio = $39,375 increased

contribution margin. Since the fixed costs will not change, net operating
income should also increase by $39,375.

4. a.
Contribution margin
Degree of Operating Leverage =
Net operating income
$210,000
= = 2.80
$75,000

b. 2.80 × 25% = 70% increase in net operating income.

5. Last Year: Proposed:

16,500 units 22,000 units*
Amount Per Unit Amount Per Unit
Sales ..................................................... $247,500 $15.00 $313,500 $14.25 **
Less variable expenses ......................... 74,250 4.50 99,000 4.50
Contribution margin ............................. 173,250 $10.50 214,500 $ 9.75
Less fixed expenses ............................. 135,000 157,500
Net operating income ........................... $ 38,250 $ 57,000

*16,500 units + 5,500 units = 22,000 units

**$15.00 per unit × 0.95 = $14.25 per unit
Yes, the changes should be made.

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MA / CVP ANALYSIS Feather Friends

6. Expected total contribution margin:

16,500 units × 1.20 × $9.75 per unit* ............................................................................... $193,050
Present total contribution margin:
16,500 units × $10.50 per unit........................................................................................... 173,250
Incremental contribution margin, and the amount by which advertising can be increased
with net operating income remaining unchanged .............................................................. $ 19,800

*$15.00 – ($4.50 + $0.75) = $9.75

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CVP Analysis Q&A

QUESTION

(6 marks * 5 = 30 marks)

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CVP Analysis Q&A

ANSWER A1

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 50
CVP Analysis Q&A

ANSWER A1

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CVP Analysis Q&A

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CVP Analysis Q&A

QUESTION 1 – 50 marks - This is a compulsory question.

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CVP Analysis Q&A

Answer 1 2-47 (40-50 min.)

1. Several variations of the following general approach are possible:

Let N = Unit Sales.

Sales - Variable expenses - Fixed expenses = Profit
$5N – $4.1N – ($3,000 + $4,000 + $3,000) = $500
$.9N - $10,000 = $500
N = $10,500 ÷ $.9 = 11,666.67 glasses of beer

Check: Sales (11,666.67 × $5) $58,333

Variable expenses (11,666.67 × $4.1) 47,833
Contribution margin 10,500
Fixed expenses 10,000
Profit $ 500

2. $5N – $4.1N - $10,000 = .05 × ($5N)

N = $10,000 ÷ ($.9 - $.25) = 15,385 glasses of beer

3. Fixed Cost ÷ (Sales price – cost of meat – cost of buns – cost of other ingredients) = # of
hamburgers
$1,560 ÷ ($1.24 - $.40 - $.12 - $.12) = 2,600 hamburgers

4. (3,000 × $.60) + (4,800 × $.90) - $1,560 = $1,800 + $4,320 - $1,560 = $4,560 added profit

5. $1,560 ÷ ($.60 + $.90) = 1,040 new customers are needed to breakeven on the new business.

A sensitivity analysis would help provide Terry with an assessment of the financial risks associated
with the new hamburger business. Suppose that Terry is confident that demand for hamburgers
would range between break-even ± 500 new customers and that expected fixed costs will not
change within this range. The contribution margin generated by each new customer is $1.50 so Terry
will realize a maximum loss or profit from the new business in the range ± $1.50 × 500 = ± $750.

Another way to assess financial risk that Terry should be aware of is the company’s operating
leverage (the ratio of fixed to variable costs). A highly leveraged company has relatively high fixed
costs and low variable costs. Such a firm is risky because small changes in volume lead to large
changes in net income. This is good when volume increases but can be disastrous when volumes
fall.

6. The additional cost of higher quality hamburger ingredients is .5 × $.64 = $.32. Any price for the
higher quality hamburgers above the current price of $1.24 plus $.32, or $1.56, will improve profits,
assuming the same number of customers purchase hamburgers.

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CVP Analysis Q&A

Question

Sattler Corporation has provided the following contribution format income statement. All
questions concern situations that are within the relevant range.

Sales (8,000 units) $480,000

Variable expenses 336,000
Contribution margin 144,000
Fixed expenses 142,200
Net operating income $1,800

Required: All questions are independent.

a. What is the contribution margin per unit? Contribution margin ratio? (8 marks)
c. If sales decline to 7,900 units, what would be the estimated net operating income? Prepare
revised income statement. (4 marks)
d. If the variable cost per unit increases by $5, spending on advertising increases by $2,000,
and unit sales increase by 3,400 units, what would be the estimated net operating income? (10
marks)
e. What is the break-even point in units & dollar sales? (8 marks)
f. Estimate how many units must be sold to achieve a target profit of $50,400. (4 marks)
g. What is the margin of safety in units, $ and percentage? (9 marks)
h. Refer to above table. Using the degree of operating leverage, what is the estimated percent
increase in net operating income of a 15% increase in sales? Prepare revised income
statement. (7 marks)

Total 50 marks

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CVP Analysis Q&A

Answer:
a.
Total contribution margin (a) $144,000
Total unit sales (b) 8,000 units
Unit contribution margin (a) ÷ (b) $18 per unit

Alternatively,

Selling price per unit ($480,000 ÷ 8,000 units) $60

Variable cost per unit ($336,000 ÷ 8,000 units) 42
Unit contribution margin $18

b. Variable expense ratio = Variable expenses ÷ Sales = $336,000 ÷ $480,000 = 70%

c.
Unit contribution margin (a) $18 per unit
Unit sales (b) 7,900 units
Contribution margin (a) × (b) $142,200
Fixed expenses 142,200
Net operating income $0

d.
Selling price $60 per unit
Variable cost per price ($42 per unit + $5 per unit) 47 per unit
Unit contribution margin (a) $13 per unit
Unit sales (8,000 units + 3,400 units) (b) 11,400 units
Contribution margin (a) × (b) $148,200
Fixed expenses ($142,200 + $2,000) 144,200
Net operating income $4,000

e. Dollar sales to break even = Fixed expenses ÷ CM ratio = $142,200 ÷ 30% = $474,000

f. Unit sales to attain a target profit = (Target profit + Fixed expenses) ÷ Unit CM
= ($50,400 + $142,200) ÷ $18 per unit = $192,600÷ $18 per unit = 10,700 units

g. Margin of safety percentage = Margin of safety in dollars ÷ Total budgeted (or actual)
sales
= $6,000 ÷ $480,000 = 1%

h. Percentage change in net operating income = Degree of operating leverage × Percentage

change in sales
= 80.0 × 15% = 1200%

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EMBA / B19/ MA EXAM

QUESTION A1 – 50 marks - This is a compulsory question.

Northwood Company manufactures basketballs. The company has a ball that sells for $25. At present,
the ball is manufactured in a small plant that relies heavily on direct labor workers. Thus, variable
expenses are high, totalling $15 per ball, of which 60% is direct labor cost.

Last year, the company sold 30,000 of these balls, with the following results:

Original Data:

Required: Show detailed supportive workings

1. Compute

(a) last year’s CM ratio and the break-even point in balls, and

(b) the degree of operating leverage at last year’s sales level. Explain what the degree of
operating leverage number means.

2. Due to an increase in labor rates, the company estimates that next year’s variable expenses will
increase by $3 per ball. If this change takes place and the selling price per ball remains constant at $25,

(a) what will be next year’s CM ratio and the break-even point in balls?

(b) If the expected change in variable expenses takes place, how many balls will have to be sold
next year to earn the same net operating income, $90,000, as last year?

(c) The president feels that the company must raise the selling price of its basketballs. If
Northwood Company wants to maintain the same CM ratio as last year (as computed in requirement
1a), what selling price per ball must it charge next year to cover the increased labor costs?

3. Refer to the original data. The company is discussing the construction of a new, automated
manufacturing plant. The new plant would slash variable expenses per ball by 40%, but it would cause
fixed expenses per year to double.

(a) If the new plant is built, what would be the company’s new CM ratio and new break-even
point in balls?

(b). If the new plant is built, how many balls will have to be sold next year to earn the same
net operating income, $90,000, as last year?

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EMBA / B19/ MA EXAM

(c). Assume the new plant is built and that next year the company manufactures and sells
30,000 balls (the same number as sold last year). Prepare a contribution format income statement and
compute and explain the degree of operating leverage.

(d). If you were a member of top management, would you have been in favor of
constructing the new plant? Explain.

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Answer 1

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

Variable expenses ......................... 15 60%
Contribution margin ...................... $10 40%
Profit = Unit CM × Q − Fixed expenses
$0 = $10 × Q − $210,000
$10Q = $210,000
Q = $210,000 ÷ $10
Q = 21,000 balls
Alternative solution:

Unit sales to = Fixed expenses

break even Unit contribution margin

$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:
Profit = Unit CM × Q − Fixed expenses
$0 = $7 × Q − $210,000
$7Q = $210,000
Q = $210,000 ÷ $7
Q = 30,000 balls

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Alternative solution:

Unit sales to = Fixed expenses

break even Unit contribution margin

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

3. Profit = Unit CM × Q − Fixed expenses

$90,000 = $7 × Q − $210,000
$7Q = $90,000 + $210,000
Q = $300,000 ÷ $7
Q = 42,857 balls (rounded)
Alternative solution:

Unit sales to attain = Target profit + Fixed expenses

target profit Unit contribution margin

$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.

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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:
Profit = Unit CM × Q − Fixed expenses
$0 = $16 × Q – ($210,000 × 2)
$16Q = $420,000
Q = $420,000 ÷ $16
Q = 26,250 balls
Alternative solution:

Unit sales to = Fixed expenses

break even Unit contribution margin

$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].

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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
Alternative solution:
Unit sales to attain = Target profit + Fixed expenses
target profit Unit contribution margin

= $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

Degree of Contribution margin

=
operating leverage Net operating income
$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.

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CVP Analysis Q&A

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CVP Analysis Q&A

QUESTION 1

Morton Company’s contribution format income statement for last month is given below:

The industry in which Morton Company operates is quite sensitive to cyclical movements in the
economy. Thus, profits vary considerably from year to year according to general economic
conditions. The company has a large amount of unused capacity and is studying ways of improving
profits.

Required:

1. New equipment has come onto the market that would allow Morton Company to automate
a portion of its operations. Variable expenses would be reduced by $9 per unit. However,
fixed expenses would increase to a total of $225,000 each month. Prepare two contribution
format income statements, one showing present operations and one showing how
operations would appear if the new equipment is purchased. Comment on key changes.

2. Refer to the income statements in (1). For the present operations and the proposed new
operations, compute and explain

(a) the degree of operating leverage,

(b) the break-even point in dollar sales, and

(c) the margin of safety in dollars and the margin of safety percentage.

3. Refer again to the data in (1). As a manager, discuss any 4 key or significant factors would be
in deciding whether to purchase the new equipment? (Assume that enough funds are
available to make the purchase.)

4. Refer to the original data. Rather than purchase new equipment, the marketing manager
argues that the company’s marketing strategy should be changed. Rather than pay sales
commissions, which are currently included in variable expenses, the company would pay
salespersons fixed salaries and would invest heavily in advertising. The marketing manager
claims this new approach would increase unit sales by 30% without any change in selling
price; the company’s new monthly fixed expenses would be$180,000; and its net operating
income would increase by 20%.

(a) Compute the company’s break-even point in dollar sales under the new marketing
strategy.

(b) Do you agree with the marketing manager’s proposal? Why?

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CVP Analysis Q&A

ANSWER 1
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:
Degree of Contribution margin
=
operating leverage Net operating income

$135,000
= =3
$45,000
Proposed:
Degree of Contribution margin
=
operating leverage Net operating income
$270,000
= =6
$45,000
b. Dollar sales to break even:

Present:
Dollar sales to = Fixed expenses
break even CM ratio
$90,000
= = $300,000
0.30
Proposed:

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CVP Analysis Q&A

Dollar sales to = Fixed expenses

break even CM ratio
$225,000
= = $375,000
0.60
c. Margin of safety:

Present:
Margin of safety = Actual sales - Break-even sales

= $450,000 - $300,000 = $150,000

Margin of safety = Margin of safety in dollars

percentage Actual sales
$150,000
= = 33.33%
$450,000
Proposed:
Margin of safety = Actual sales - Break-even sales
= $450,000 - $375,000 = $75,000

Margin of safety = Margin of safety in dollars

percentage Actual sales
$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

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CVP Analysis Q&A

*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
break even CM ratio 0.40
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.

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Question
Laraia Corporation has provided the following contribution format income statement. All
questions concern situations that are within the relevant range.

Sales (3,000 units) $150,000

Variable expenses 90,000
Contribution margin 60,000
Fixed expenses 48,000
Net operating income $12,000

Required:
a. What is the contribution margin per unit? What is the contribution margin ratio? (5 marks)
b. If sales increase to 3,050 units, what would be the estimated increase in net operating
income? (5 marks)
c. If sales decline to 2,900 units, what would be the estimated net operating income? (5
marks)
d. If the selling price increases by $4 per unit and the sales volume decreases by 200 units,
what would be the estimated net operating income? (5 marks)
e. If the variable cost per unit increases by $5, spending on advertising increases by $3,000,
and unit sales increase by 450 units, what would be the estimated net operating income? (5
marks)
f. What is the break-even point in unit sales? What is the break-even point in dollar sales? (5
marks)
g. Estimate how many units must be sold to achieve a target profit of $54,000. (5 marks)
h. What is the margin of safety in dollars? What is the margin of safety percentage? (5 marks)
i. What is the degree of operating leverage? (5 marks)
j. Using the degree of operating leverage, what is the estimated percent increase in net
operating income of a 15% increase in sales? (5 marks)

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CVP Analysis Q&A

Answer:
a.
Total contribution margin (a) $60,000
Total unit sales (b) 3,000 units
Unit contribution margin (a) ÷ (b) $20 per unit

Alternatively,

Selling price per unit ($150,000 ÷ 3,000 units) $50

Variable cost per unit ($90,000 ÷ 3,000 units) 30
Unit contribution margin $20

b. CM ratio = Contribution margin ÷ Sales = $60,000 ÷ $150,000 = 40%

c. Variable expense ratio = Variable expenses ÷ Sales = $90,000 ÷ $150,000 = 60%

d. The increase in net operating income would be the increased contribution margin because
fixed expenses are not affected.

Unit contribution margin (a) $20 per unit

Increased unit sales (b) 50 units
Increase in net operating income (a) × (b) $1,000

e.
Unit contribution margin (a) $20 per unit
Unit sales (b) 2,900 units
Contribution margin (a) × (b) $58,000
Fixed expenses 48,000
Net operating income $10,000

f.
Selling price ($50 per unit + $4 per unit) $54 per unit
Variable cost per price 30 per unit
Unit contribution margin (a) $24 per unit
Unit sales (b) 2,800 units
Contribution margin (a) × (b) $67,200
Fixed expenses 4 8,000
Net operating income $19,200

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CVP Analysis Q&A

g.
Selling price $50 per unit
Variable cost per price ($30 per unit + $5 per unit) 35 per unit
Unit contribution margin (a) $15 per unit
Unit sales (3,000 units + 450 units) (b) 3,450 units
Contribution margin (a) × (b) $51,750
Fixed expenses ($48,000 + $3,000) 51,000
Net operating income $750

h. Unit sales to break even = Fixed expenses ÷ Unit CM = $48,000 ÷ $20 per unit = 2,400
units

i. Dollar sales to break even = Fixed expenses ÷ CM ratio = $48,000 ÷ 40% = $120,000

j. Unit sales to attain a target profit = (Target profit + Fixed expenses) ÷ Unit CM
= ($54,000 + $48,000) ÷ $20 per unit = $102,000÷ $20 per unit = 5,100 units

k. Margin of safety in dollars = Total budgeted (or actual) sales - Break-even sales
= $150,000 − $120,000 = $30,000

l. Margin of safety percentage = Margin of safety in dollars ÷ Total budgeted (or actual) sales
= $30,000 ÷ $150,000 = 20%

m. Degree of operating leverage = Contribution margin ÷ Net operating income

= $60,000 ÷ $12,000 = 5.0

n. Percentage change in net operating income = Degree of operating leverage × Percentage

change in sales
= 5.0 × 15% = 75%

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