CHAPTER 2

PROFIT PLANNING

2-1 Assumptions and Misconceptions about CVP Analysis

General Note to the Instructor: This question can prove difficult

because it requires not only considerable understanding of the concepts
introduced in Chapter 2 but also some anticipation of concepts introduced in
Chapter 3. The purposes of the questions are to stimulate discussion of the
uses and limitations of CVP analysis and to counter the natural student
skepticism regarding the applicability of basic concepts in light of the
factors that make it impossible to portray the practicalities of business
operations in the simple forms offered by theoretical analysis.

The points to be made are that, the uncertainties of the real world
notwithstanding, managers must plan and take actions and that any actions
managers take implicitly reflect some assumptions about the future. For
example, a store owner must set some prices, and the action of setting a
price reflects some expectations about volume and costs. Similarly, a manager
must decide not only whether or not to advertise but also, if some
advertising is to be done, how much is reasonable. A manager must also
decide how many employees to have as well as a host of other matters. CVP
analysis, though far from a cure-all, provides a reasonable basis for
planning.

1. CVP analysis answers "what if" and "what must we do to achieve"

questions. It is a planning tool and helps managers see what should occur
given certain estimates of the values of important variables. All of the
classmate's statements are true; but they relate to facts that can only be
known after the manager is required to decide what to do. A manager must
decide what to do on the basis of estimates because the future is not known.

The emphasis in CVP analysis is not on past costs nor on current costs,
but rather on the costs that can be expected in the future. A manager must
make some estimates of the expected pattern of increases of costs and prices,
and it is those estimates of expected patterns that form the basis for
successful use of CVP analysis. Plans can be made by month, or for the
entire year, or for some period of time in between those two extremes. The
point is that planning relates to the future. It is probably impossible to
overemphasize this point.

2. Note to the Instructor: The depth of the answer to be expected on this

question depends on the depth of the students' knowledge and understanding of
microeconomics. In any case it is important to emphasize that basic study in
microeconomic theory assumes that managers of a firm have information that is
not, in fact, automatically available to them.

2-1
 The typical demand curve for a particular product has a negative slope.
But CVP analysis is not concerned so much with the relationship between price
and quantity demanded as it is with the likely results of a particular price
and, implicitly, a set of other variables such as advertising expenditures.
CVP analysis does not purport to answer the question, "How many will we sell
at this price?" Rather it answers questions about profits at given levels of
volume and price. CVP analysis is a planning tool.

Note also that the idea of relevant range is important here. A cost
structure (mix of variable and fixed costs) holds over a range of volume
levels for a single firm regardless of the sales price of the product. (To
emphasize the points of difference between microeconomic theory and break-
even analysis, note also that the long-run cost curves used for the former do
not assume the same cost structures at each level of volume.)

3. Again, CVP analysis is a planning tool and utilizes the best information
available at a given point in time when planning must take place. If a
manager knows (or considers it probable) that certain costs will change, his
CVP analysis should take such knowledge into consideration, for that analysis
is, by virtue of its being a planning tool, future oriented.

4. The possibility of reduced prices does not reduce the usefulness of CVP
analysis but only changes the manner in which the analysis is carried out.
There are several ways to handle the problem proposed by some sales at
reduced prices. One way is to integrate into the calculation of contribution
margin percentage the effects of sales at reduced prices. Another is to
estimate separately the contribution margins from sales at regular prices and
sales at reduced prices. In either case, the critical concern is the
quantity of merchandise that the manager believes will have to be sold at
reduced prices.

2-2 Effects of Events

1. The slope of the revenue line will increase.

2. The slope of the total cost line will increase, but the intercept will
remain the same.

3. The graph will not change, but the expected volume will be higher.

2-3 Effects of Keeping Up With Technology

The statement describes a typical situation in a retailing company

dependant upon technology. Amazon.com will face large and continued fixed
costs expenditures to support its marketing and promotion, product
development and technology, and operating infrastructure development.
Amazon.com’s variable costs are primarily the cost of the merchandise (books,
audio, and video) sold. To achieve profitability, Amazon.com must emphasize
revenue growth.

2-2
2-4 Income Statement and CVP Analysis (10-15 minutes)

1.
Sales $480,000
Variable costs 360,000
Contribution margin 120,000
Fixed costs 80,000
Income $ 40,000

2. (a) 40,000 units $80,000/($8 - $6)

(b) $320,000, $8 x 40,000, or $80,000/[($8 - $6)/$8]

Note to the Instructor: We can calculate required volumes incrementally,

either in units or dollars, by dividing the existing income or loss by the
contribution margin (per unit or percentage) and subtracting that from
existing sales. For break-even units, the calculations are as follows:

Income $ 40,000
Divided by contribution margin per unit ($8 - $6) $2
Equals decrease in unit sales to reach break-even point 20,000
Subtracted from current unit volume 60,000
Equals break-even unit sales 40,000

3. (a) 100,000 units $80,000/[($8 - $6) - (15% x $8)]

= $80,000/($2 - $1.20)
(b) $800,000 100,000 x $8, or $80,000/(25% - 15%).
The contribution margin percentage of 25% is ($8 - $6)/$8.

An income statement shows,

Sales $800,000
Variable costs 600,000
Contribution margin 200,000
Fixed costs 80,000
Income $120,000 15% x $800,000

4. $8.67 rounded

Desired profit ($40,000 x 2) $ 80,000

Plus fixed costs 80,000
Equals required contribution margin $160,000
Divided by volume 60,000 units
Equals required per-unit contribution margin $ 2.67
Plus per-unit variable cost 6.00
Equals required selling price $ 8.67

2-5 Income Statement and CVP Analysis (10-15 minutes)

1. Sales $800,000
Variable costs at 40% 320,000
Contribution margin 480,000
Fixed costs 450,000
Income $ 30,000

2. $750,000 $450,000/(100% - 40%)

2-3
3. $850,000 [$450,000 + (2 x $30,000)]/(100% - 40%) = $510,000/60%

You might wish to show that this part can also be solved by finding the
increase in sales required to increase profit by $30,000. That is $50,000
($30,000/60%). Adding $50,000 to existing sales of $800,000 gives $850,000.

2-6 Income Statement and CVP Analysis with Taxes (15-20 minutes)

1. Sales $480,000
Variable costs 360,000
Contribution margin 120,000
Fixed costs 80,000
Income before taxes 40,000
Income taxes at 30% 12,000
Income $ 28,000

2.
Desired income (2 x $28,000) $ 56,000
Divided by 70% = required pretax income $ 80,000
Plus fixed costs 80,000
Equals required contribution margin $160,000
Divided by unit contribution margin $2
(a) Equals unit sales required 80,000
Times unit price $8
(b) Equals sales dollars required $640,000

Note to the Instructor: An alternative calculation is to divide the

required contribution margin by the contribution margin percentage.
Required contribution margin $160,000
Divided by contribution margin percentage 25%
Equals sales dollars required $640,000

3. $8.67 rounded This is the same question and answer as requirement 4 of

2-4. Income taxes do not affect pretax profit calculations or breakeven
calculations.

Desired pretax profit ($40,000 x 2) $ 80,000

Plus fixed costs 80,000
Equals required contribution margin $160,000
Divided by volume 60,000
Equals required per-unit contribution margin $ 2.67
Plus variable cost 6.00
Equals required price $ 8.67

Note to the Instructor: The $8.67 price also doubles the after-tax
profit. We asked the assignment in this way to highlight that doubling
pretax profit is equivalent to doubling after-tax profit.

2-4
2-7 Income Statement and CVP Analysis with Taxes (15-20 minutes)

1.

Sales $800,000
Variable costs 320,000
Contribution margin 480,000
Fixed costs 450,000
Income before taxes 30,000
Income taxes at 40% 12,000
Income $ 18,000

2.
Desired income (2 x $18,000 above) $ 36,000
Divided by (100% - 40%) 60%
Equals required pre-tax income 60,000
Plus fixed costs 450,000
Equals required contribution margin $510,000
Divided by contribution margin percentage 60%
Equals sales required $850,000

2-8 Basic CVP Analysis (20-25 minutes)

1. (a) 33,334 units (rounded) $600,000/($30 - $12) = $600,000/$18

(b) $1,000,000 $600,000/($18/$30) = $600,000/60%, or 33,334 x $30

2. (a) 40,000 units ($600,000 + $120,000)/$18

(b) $1,200,000 ($600,000 + $120,000)/60%, or 40,000 x $30

3. (a) 41,667 (rounded) $600,000/($18 - [12% x $30]) = $600,000/$14.40

(b) $1,250,00 $600,000/(60% - 12%) = $600,000/48%, or 41,667 x $30

4. $35.33 rounded
Sales - variable costs - fixed costs = profit
S - (30,000 x $12) - $600,000 = $100,000
S - $360,000 - $600,000 = $100,000
S = $1,060,000
Price = $1,060,000/30,000 = $35.33

5. $35.93 rounded
Sales - variable costs - fixed costs = profit
S - 30,000 x $9 - 10%S - $600,000 = $100,000
S - $270,000 - 10%S - $600,000 = $100,000
90%S = $970,000
S = $1,077,778
Price = $1,077,078/30,000 = $35.93 (rounded)

Note to the Instructor: This basic exercise makes the point that CVP
analysis and other techniques can yield impossible answers, here fractions of
units or pennies. Some students believe that if their answer is not a whole
number, they must have done something wrong. (This feeling is especially
prevalent during examinations.)

2-9 Basic CVP Relationships, with Income Taxes (15-20 minutes)

2-5
1. (a) 266,667 units ($3,000,000 + [$600,000/60%])/($40 - $25) =
$4,000,000/$15

(b) $10,666,667
Total required contribution margin (part a) $4,000,000
Divided by contribution margin percentage ($40 - $25)/$40 37.5%
Or, 266,667 x $40

2. $38.333

Required contribution margin (part 1) $4,000,000

Divided by units 300,000
Required contribution margin per unit $ 13.333
Plus variable cost 25.000
Required price $ 38.333

3. $38.15 rounded
Sales - variable costs - fixed costs = pretax profit
S - (300,000 x $21) - 10%S - $3,000,000 = $1,000,000
90%S = $10,300,000
S = $11,444,444
Price = $11,444,444/300,000 = $38.15 rounded

2-10 Relationships Among Variables (20-30 minutes)

1. To work this part it is necessary to start with the second blank.

(d) $78,000, $28,000 + $50,000

(c) 2,600 units ($78,000/$30 contribution margin per unit)

Contribution margin per unit ($50 x 60%) $30
Contribution margin in total, from part (d) $78,000

2. (b) 75% (100% - contribution margin of 25%)

Contribution margin per unit ($60,000/3,000) $20
Contribution margin percentage ($20/$80) 25%

(e) $80,000, (loss of $20,000 after deducting fixed costs from a

contribution margin of $60,000)

3. Again, it is necessary to start with the second blank.

(d) $75,000, $25,000 + $50,000

(b) 80% (100% - contribution margin percentage of 20%)

Contribution margin per unit ($75,000/15,000) $5
Contribution margin percentage ($5/$25) 20%

2-6
2-11 Relationships Among Variables (15-20 minutes)

1. $8 selling price $6 + ($2,000/1,000)

$800 fixed costs $2,000 - $1,200

2. 2,000 units sold $4,000/($5 - $3)

$2,500 income $4,000 - $1,500

3. $10 selling price $6 + ($16,000/4,000)

$8,000 income $16,000 - $8,000

2-12 CVP Graph (10-15 minutes)

1. $6,000

2. $2,000, which is the answer at all levels of sales.

3. $4,000, the difference between $6,000 total costs at the 4,000-unit

(break-even) level minus $2,000 fixed costs. You do not need variable cost
per unit to solve this part.

4. $1.00, $4,000/4,000 from the previous part. Or, read the value of total
cost at any level above zero sales, subtract fixed costs of $2,000, and
divide by unit sales.

5. $1.00, same as in part 4. This question emphasizes the point that

variable cost per unit remains constant throughout the relevant range.

6. $1.50, $6,000 sales divided by 4,000 units at the break-even point.

7. $1,500, $0.50 contribution margin ($1.50 - $1.00) times 3,000 units.

8. $500 loss, $1,500 contribution margin (part 7) minus $2,000 fixed costs.

9. $500 profit, which is contribution margin of $2,500 (500 x $0.50) less

fixed costs of $2,000.

10. 5,000 units. This is $2,500 fixed costs divided by $0.50 contribution
margin per unit.

2-13 Basic Sales Mix (10 minutes)

1. 34% 12% + 7% + 15%

Produce Meat/Dairy Canned Goods

Contribution margin percentage 40% 35% 30%

Sales mix percentage 30% 20% 50%
Weighted-average contribution margin 12% 7% 15%

2. $2,000,000 $680,000/34%

3. $2,617,647 ($680,000 + $210,000)/34%

2-7
2-14 Improving Sales Mix (15-20 minutes)

1. 62% 20% + 18% + 24%

Termites Lawn Pests Interior Pests

Contribution margin percentage 50% 60% 80%

Sales mix percentage * 40% 30% 30%
Weighted-average 20% 18% 24%

* $160,000/$400,000; $120,000/$400,000, $120,000/$400,000

Alternatively, some students will solve for total contribution margin by

carrying out the multiplication of CM% by budgeted sales, then adding the
sales and contribution margins. This part tests to see whether students
understand the concept of sales mix by presenting the information in a
different form from that in the text.

2. $98,000
Contribution margin, $400,000 x 62% $248,000
Fixed costs 150,000
Profit $ 98,000

3. (a) 68% 10% + 18% + 40%

Termites Lawn pests Interior pests

Contribution margin percentage 50% 60% 80%

Sales mix percentage 20% 30% 50%
Weighted-average 10% 18% 40%

(b) $122,000
Contribution margin ($400,000 x 68%) $272,000
Fixed costs 150,000
Profit $122,000

Note to the Instructor: This exercise demonstrates that sales mix

affects profit (through its effect on the contribution margin percentage).
Thus, even though selling prices, the percentages of variable cost to price,
total fixed costs, and total sales dollars remained constant, the shift in
sales mix resulted in a six percentage point increase in the weighted-average
contribution margin percentage and a corresponding six percentage point
increase in return on sales, an additional $24,000 profit.

2-15 Margin of Safety (5-10 minutes)

2,250 units, or $202,500 (2,250 x $90), as computed below.

Expected sales, in units 16,000

Fixed costs $275,000
Contribution margin, $90 - $52 - (20% x $90) $ 20
Breakeven point 13,750
Margin of safety, in units 2,250

2-16 Alternative CVP Graph (continuation of 2-15) (10-15 minutes)

2-8
Per-unit contribution margin under the alternative is $26.50 [$90 - $41 -
(25% x $90)] and the break-even point is 12,264 units ($325,000 fixed costs/
$26.50), which is 1,486 less than before.

300,000

200,000

100,000

0
- 5,000 10,000 15,000 20,000
-100,000

-200,000

-300,000

-400,000

The graph highlights the desirability of the change. Profit is higher under
the alternative once volume reaches 7,692 units ($50,000 difference in fixed
costs divided by $6.50 difference in contribution margin). Because the
company expects sales of 16,000 units, unless the new production/marketing
strategies will reduce volume, the alternative dominates the existing case.

2-17 CVP Graph, Analysis of Changes (5-10 minutes)

Revenue Line Total Cost Line Break-even Point

1. Decrease slope No effect Increase

(shallower revenue line)
2. No effect Decrease slope Lower (decrease)
(shallower angle on
cost line)
3. No effect Higher intercept of Not determinable (the
cost line, but re- answer depends on the
duction of slope of specific numbers)
that line
4. No effect No effect No effect

5. Increase slope Increase slope Not determinable

(depends on relationship
between price and cost
changes)

Note to the Instructor: This exercise should help students understand

2-9
how changes in the basic facts of a situation will change its graphical
analysis. To emphasize that both the graphic and the contribution-margin
approaches allow conceptual analysis of break-even situations, you might wish
to review each of the above changes using the contribution-margin approach,
as follows:

1. A price decrease decreases per-unit contribution margin, which raises

the break-even point.

2. A decrease in per-unit variable cost increases per-unit contribution

margin, which lowers the break-even point.

3.
A decrease in per-unit variable cost increases per-unit contribution
margin and therefore reduces the break-even point. An increase in
fixed costs increases the break-even point, so the effect of the two
events cannot be determined without knowing the numerical amounts.

4. Since price, per-unit variable costs, and total fixed costs do not
change, the break-even point remains the same. The company's profit
will be lower than expected, but break-even remains the same.

5. An increase in selling price increases contribution margin, thus

lowering the break-even point; but an increase in per-unit variable
cost decreases contribution margin, thus raising the break-even
point.
The ultimate effect on the break-even point depends on the relative
magnitudes of the changes in the two factors.

2-18 Converting an Income Statement (20 minutes)

1. Sales $400,000
Variable costs:
Cost of goods sold $240,000
Commissions ($400,000 x 10%) 40,000
Total variable costs 280,000
Contribution margin 120,000
Fixed costs:
Salaries ($71,000 - $40,000) 31,000
Utilities 10,000
Rent 15,000
Other 25,000
Total fixed costs 81,000
Income $ 39,000

2. (a) 10,800 units $81,000/$7.50 Volume is $400,000/$25 = 16,000, so

contribution margin is $120,000/16,000 = $7.50

(b) $270,000 10,800 x $25 or $81,000/30% (30% = $120,000/$400,000)

2-10
3. $26 Cost of goods sold is $15 per unit ($240,000/16,000). Adding the
commission of 10% of price gives
sales - variable costs - fixed costs = profit
S - (15,000 x $15) - 10%S - $81,000 = $45,000
90%S = $351,000
S = $390,000
Price = $390,000/15,000 = $26

2-19 Target Costing (10 minutes)

1. $14,000,000

Revenue (200,000 x $100) $20,000,000

Target profit 6,000,000
Total allowable cost $14,000,000

2. $25, $5,000,000 allowable variable cost divided by 200,000 units

Total allowable cost $14,000,000

Estimated fixed cost 9,000,000
Allowable total variable cost $ 5,000,000

2-20 Profit Planning (20-25 minutes)

The following preliminary calculations will be helpful.

Selling price $35.00

Cost of goods sold:
Cost of sales $800,000
Divided by number of units sold 40,000
Equals unit cost of sales $20.00
Plus increase expected 1.50
Equals new unit cost of sales in 21.50
Selling costs:
Selling costs, per unit $2.00
Plus expected increase 0.10
Equals new unit selling cost 2.10
Total variable cost per unit 23.60
Contribution margin per unit $11.40

1. Zaldec Company
Income Statement

Sales, 48,000 (40,000 units x 120%) x $35 $1,680,000

Variable costs:
Cost of goods sold (48,000 x $21.50) $1,032,000
Selling costs (48,000 x $2.10) 100,800 1,132,800
Contribution margin (48,000 x $11.40) 547,200
Fixed costs:
Selling* $310,000
Administrative ($190,000 + $30,000) 220,000 530,000
Income $ 17,200

*Fixed costs $350,000 - (40,000 x $2) $270,000

2-11
 Expected increase 40,000
Fixed costs, new $310,000

2. 51,754 units rounded ($60,000 + $530,000)/$11.40 = $590,000/$11.40

3. $35.89 rounded, $1,722,800 total revenue divided by 48,000 units

sales = variable costs + fixed costs + profit
S = (48,000 x $23.60) + $530,000 + $60,000
S = $1,722,800

2-21 Basic Income Taxes (15-20 minutes)

1. $109,200
Sales (12,000 x $120) $1,440,000
Variable costs:
Manufacturing (12,000 x $72) $864,000
Commission ($1,440,000 x 10%) 144,000 1,008,000
Contribution margin 432,000
Fixed costs 250,000
Income before taxes 182,000
Income taxes (40%) 72,800
Net income $ 109,200

2. 12,500 units
Desired after-tax profit $120,000
Divided by (1 - tax rate of 40%) .60
Required pre-tax profit 200,000
Plus, fixed costs 250,000
Equals required contribution margin for target profit 450,000
Divided by contribution margin per unit:
Selling price $120
Variable manufacturing cost ( 72)
Commission (10% of selling price) (12) $36
Equals volume required for target profit 12,500
units

3. About $123.43
Sales - variable costs - fixed costs = profit
S - [(11,000 x $72) - 10%S] - $250,000 = $180,000
90%S = $1,222,000
S = $1,357,778
Price = $1,357,778/11,000 = $123.43 (rounded)

2-12
2-22 Basic Sales Mix (20 minutes)

1. 60% weighted-average contribution margin, $400,000 monthly sales.

Allergy-free Cleansaway
Selling price $18 $24
Variable cost 9 6
Contribution margin $ 9 $18
Contribution margin percentage 50% 75%
Sales mix, in dollars 60% 40%
Weighted contribution margin 30% + 30% = 60%

Required sales = ($180,000 + $60,000)/60% = $400,000

Allergy-free Cleansaway

Sales, 60%, 40% $240,000 $160,000

Divided by selling price $18 $24
Units sold (rounded) 13,333 6,667 20,000

Thus, the company could also express the mix percentage in units as 2/3
Allergy-free, 1/3 Cleansaway. Again, we have a fractional answer, indicating
that the company cannot really earn $60,000 under the stated conditions.

2. $13.50 weighted-average unit contribution margin, 17,778 units

Allergy-free Cleansaway
Contribution margin $9 $ 18
Sales mix, in units 50% 50%
Weighted-average contribution margin $4.50 + $9.00 = $13.50

Required sales = $240,000/$13.50 = 17,778, 8,889 of each

Dollar sales = 8,889 x $18, 8,889 x $24 = $160,002 + $213,336 = $373,338

The reason that unit sales here are much lower than the unit sales required
in requirement 1, where the mix was expressed in dollars is that the implied
unit mix of 2/3, 1/3 in requirement 1 is leaner than the 50/50 given here.
Therefore, the company needs to sell less total product to earn the same
profit. The same reasoning applies to the dollar sales differences.

Some students do not understand that the way you express mix, units or
dollars, depends on circumstances. A department store manager would never
try to express mix in units because units range from handkerchiefs to
refrigerators. An auto dealer would be very comfortable using units to
express mix.

2-13
3. Profit rises by $12,000, to $72,000.

Allergy-free Cleansaway
Contribution margin percentage 50% 75%
Sales mix, in dollars 40% 60%
Weighted contribution margin 20% + 45% = 65%

Contribution margin, $400,000 x 65% $260,000

Fixed costs, $180,000 + $8,000 188,000
Profit $ 72,000

An alternative calculation that emphasizes the change in total

contribution margin accompanying a change in the weighted-average
contribution margin percentage is:

Monthly volume $400,000

times increase in weighted average contribution margin
(65% - 60%) 5%
Increase in total contribution margin 20,000
Less increased fixed costs 8,000
Increase in profit $ 12,000

2-23 Weighted-Average Contribution Margin (20 minutes)

1. Luxury, because its per-unit contribution margin is highest.

2. Necessary, because its contribution margin percentage is highest.

Necessary Frill Luxury

Selling price $10.00 $20.00 $25.00
Variable cost 4.00 12.00 12.50
Contribution margin $ 6.00 $ 8.00 $12.50
Contribution margin percentage 60% 40% 50%

3. (a) 52% 24% + 8% + 20%

Contribution margin percentage 60% 40% 50%
Sales mix, in dollars 40% 20% 40%
Weighted contribution margin 24% 8% 20%

(b) $550,000 $286,000/52%

(c) 8,800 units

Sales at the break-even point, part 3b $550,000
Times sales mix % for Luxury 40%
Sales of Luxury $220,000
Divided by selling price per unit of Luxury $25
Equals sales of Luxury at break-even 8,800

4. (a) $9 $2.40 + $1.60 + $5.00

Necessary Frill Luxury Total
Contribution margin per unit $6.00 $8.00 $12.50
Sales mix, in units 40% 20% 40%
Weighted contribution margin $2.40 $1.60 $ 5.00 $9.00

(b) 31,778 units, rounded $286,000/$9

2-14
 (c) 12,711 units, rounded 31,778 x 40%

2-24 Indifference Point (10-15 minutes)

1. Alternative #1 Alternative #2

Fixed costs $60,000 $104,000

Divided by contribution margin:
Selling price $60 $60
Variable cost 34 28
Contribution margin $26 $32
Equals break-even point, in units 2,308 rounded 3,250

2. 7,333 units We can solve this using either total costs or total
profit. Let Q = volume. Using total costs,

Alternative #1, Total Costs = Alternative #2, Total Costs

Fixed costs + variable costs = Fixed costs + variable costs
$60,000 + $34Q = $104,000 + $28Q
$ 6Q = $44,000
Q = 7,333
Using profit,

($60 - $34)Q - $60,000 = ($60 - $28)Q - $104,000

$26Q - $60,000 = $32Q - $104,000
$6Q = $44,000
Q = 7,333

Thus, if managers expect volume to exceed 7,333 units, they should prefer
alternative 2 because it will give higher profits than alternative 1 above
that volume. The reverse is true for volumes below 7,333 units.

Note to the Instructor: It is necessary to work with profit if total

costs are not the same at the volume where profits are the same. This occurs
if the selling price differs between the alternatives. Here, the selling
price is the same, but we show the technique for completeness.

2-25 Cost Structure (15 minutes)

1. $300,000 and $308,000

Hand-Fed Machine Automatic Machine

Total annual fixed costs $124,000 $168,000

Total annual variable costs:
4,000 x $44 176,000
4,000 x $35 ________ 140,000
Total annual cost $300,000 $308,000

2-15
2. 4,889 tables, Let Q = volume
Total cost with hand-fed machine = total cost with automatic machine
$44Q + $124,000 = $35Q + $168,000
$9Q = $44,000
Q = 4,889

2-26 Changes in Contribution Margin (20 minutes)

General Note to the Instructor: This assignment looks at relationships

of contribution margin per unit and contribution margin percentage. It
highlights some important points about volume, in units and in dollars,
required to achieve target profits.

1. 25,000 units ($50,000 + $50,000)/($10 - $6)

2. (a) $11
Profit $50,000
Fixed costs 50,000
Required contribution margin 100,000
Divided by volume 20,000
Required unit contribution margin $5
Plus variable cost 6
Required price $11
(b) $220,000 20,000 units x $11

3. (a) $12
Unit variable cost $ 6
Divided by variable cost percentage 50% $5/$10 from last year
Selling price $12

(b) $200,000 ($50,000 + $50,000)/50%

(c) 16,667 units, $200,000/$12

Note to the Instructor: This part could be troublesome. The key is that
the variable cost ratio is one minus the contribution margin ratio, so that
you must divide the per unit variable cost by the variable cost ratio. The
point of (b) and (c) is that maintaining the contribution margin ratio
results in needing the same dollar volume but a lower unit volume, to earn
the same profit.

2-27 Pricing and Return on Sales (25-30 minutes)

1. (a) $25,000,000 $5,000,000/20% The 20% is ($30 - $18)/$30 - 20% =

(40% - 20%)
(b) 833,333 square feet $5,000,000/[$30 - $18 - (20% x $30)] =
$5,000,000/$6, or $25,000,000 (part a)/$30

2. $27
Required contribution margin ($5,000,000 + $400,000) $5,400,000
Divided by expected volume 600,000
Required contribution margin/sq. ft $ 9
Plus variable cost 18
Required price $27

2-16
3. $21.20
Selling price
$30.00
Required contribution margin ($5,000,000 + $280,000) $5,280,000
Divided by volume 600,000
Required contribution margin/sq. ft.
8.80
Allowable variable cost
$21.20

4. $32.56
Required contribution margin $5,280,000
Divided by volume 500,000
Required contribution margin/sq. ft $10.56
Plus variable cost 22.00
Required price $32.56

Note to the Instructor: This assignment uses square feet as the measure
of volume, allowing you to remind students that volume can be expressed in
different ways. It also can be used to discuss the assumption of a constant
sales mix, which the chapter describes. The appendix covers the use of
weighted-average contribution margin in multiproduct cases. Here, the point
is that so long as the mix remains reasonably constant, it is possible to use
CVP analysis.

2-28 CVP Analysis for a Service Firm (5-10 minutes)

1. 1,838 hours ($97,000 + $50,000)/$80

2. $20 per hour, as follows

Salary, 300 x $8 $2,400
Profit 3,000
Total revenue required $5,400
divided by chargeable hours (300 - 30) 270
Required hourly rate $20

2-29 Pricing Decision—Nursery School (25-30 minutes)

1. $108 per child per month.

Fixed costs ($34,000 + $1,200 + $800) $36,000

Divided by number of children 40
Contribution margin per child per year $900
Divided by nine months 9
Contribution margin per child per month $100
Variable cost per child per month ($3 + $5) 8
Required monthly price $108

An alternative calculation, where P = price

Revenue - variable costs - fixed costs = profit
(40 x 9 x P) - [40 x 9 x ($3 + $5)] - ($34,000 + $1,200 + $800) = $0
360P - $2,880 - $36,000 = $0
360P = $38,880
P = $108

2-17
2. Approximately 43 children. (Exactly 43 children will actually yield a
small loss if all estimates are correct.) One way to make the calculation is
to determine the total annual contribution margin per child at a fee of $100
per month.

Contribution margin per month per child

($100 - variable cost of $8) $92
Number of months 9
Annual contribution margin per child $828
Break-even point ($36,000/$828) 43.48 children

2-30 Sensitivity of Variables (25-35 minutes)

1. Item (a) reduces profit the most (yielding a loss, in fact). Profits
are computed below using two approaches. The first shows an answer resulting
from the simple equation sales - variable costs - fixed costs = profit. The
second approach uses contribution margin and compares total contribution
margin with fixed costs.

(a) ($75,000) (50,000 x $25 x 90%) - ($18 x 50,000) - $300,000 or

[50,000 x ($22.50 - $18)] - $300,000

(b) ($40,000) (50,000 x $25) - (50,000 x $18 x 110%) - $300,000 or

[50,000 x ($25 - $19.80)] - $300,000

(c) $20,000 (50,000 x $25) - (50,000 x $18) - ($300,000 x 110%) or

[50,000 x ($25 - $18)] - $330,000

(d) $15,000 (50,000 x 90% x $25) - (50,000 x 90% x $18) - $300,000 or

[45,000 x ($25 - $18)] - $300,000

2. Item (a) produces the largest profit.

(a) $175,000 (50,000 x $25 x 110%) - (50,000 x $18) - $300,000 or

50,000 x ($27.50 - $18) - $300,000

(b) $140,000 (50,000 x $25) - (50,000 x $18 x 90%) - $300,000 or

[50,000 x ($25 - $16.20)] - $300,000

(c) $85,000 (50,000 x 110% x $25) - (50,000 x 110% x $18) - $300,000 or

[55,000 x ($25 - $18)] - $300,000

(d) $80,000 (50,000 x $25) - (50,000 x $18) - ($300,000 x 90%) or

[50,000 x ($25 - $18)] - $270,000

3. 77,778 units, rounded, an increase of 55.6%

Profit at planned volume and original price
[50,000 x ($25 - $18)] - $300,000 $50,000
Required volume at reduced price:
($300,000 + $50,000)/($22.50 - $18) 77,778

4. $5, the same as the increase in selling price ($25 x 20% = $5).

2-18
 Note to the Instructor: This problem illustrates the sequence and
degree of sensitivity in a particular case. However, some of the
relationships will usually hold in other cases. So long as price exceeds
variable cost, profit will be more sensitive to changes in price than to
equal percentage changes in variable cost. Also, changes in price will have
greater effects on income than will equal percentage changes in volume. (In
both cases revenue increases by the given percentage, but with the price
change total variable costs remain the same, unless all variable costs are a
constant percentage of sales.) The effects of changes in fixed costs are
probably less than those of the others. Only if fixed costs are extremely
high will changes in them have greater effects on profit than will equal
percentage changes in other variables.

2-31 CVP Analysis--Changes in Variables (20 minutes)

March April

Sales $200,000 $222,000

Total variable costs $130,000 $154,200

Less commission at 10% of sales 20,000 22,200
Purchase cost of goods sold $110,000 $132,000
Divided by purchase cost per unit $11 $11
Equals unit sales 10,000 12,000
Divided into sales (above) equals price per unit $20 $18.50

Total variable cost, from above $130,000 $154,200

Divided by units of sales, as above 10,000 12,000
Equals variable cost per unit $13 $12.85

Note to the Instructor: This rather difficult problem makes an

important point. The key is to recognize that the two components of variable
cost (purchase price and sales commission) do not both vary with the same
factor. It is necessary to separate the two components of variable cost.
Some instructors might prefer to assign this problem with Chapter 3, rather
than attack it as a complication of Chapter 2. Note also that the company
sold 20% more units in April than in March, but earned less profit because of
the reduced selling price. Some students believe that increasing sales
automatically increases income, failing to realize that variable costs
increase as sales increase.

2-32 Changes in Cost Structure (20 minutes)

1. 40,000 units $48,000/$1.20

2. $24,000 increase
Reduced variable costs ($1.20 x 60,000) $72,000
Increase in fixed costs 48,000
Increase in income $24,000

3. More likely, because the cost would then be avoidable at any time. If
volume fell, the machine could be returned and production performed as
before, assuming no changeover cost in returning to the old method.

2-19
2-33 CVP Analysis on New Business (15 minutes)

1. 208,333 ($650,000 + $450,000 + $150,000)/($12 - $6), or $1,250,000/$6

2. $12.25 $1,250,000/200,000 + $6, or $6.25 + $6

3. $0.25 reduction to $5.75. The $6.25 from requirement 2 is still the

required contribution margin. The $6.25 is $0.25 over the original $6 ($12 -
$6) so variable cost must be reduced by $0.25.

This reasoning illustrates the point that contribution margin is the

critical figure, not price or variable cost alone. The assignment also shows
the use of CVP analysis for a single product, rather than for an entire one-
product company.

Alternatively,

$150,000 = [($12 - V) x 200,000] - $1,100,000

$1,250,000 = $2,400,000 - 200,000V
200,000V = $1,150,000
V = $5.75

2-34 CVP Analysis for a Hospital (15-20 minutes)

1. An increase of $5,200 per month.

Sales (200 per month x $65) $13,000

Variable costs (200 x $10) 2,000
Contribution margin 11,000
Fixed costs ($2,200 + $3,600) 5,800
Additional income $ 5,200

2. $39
Sales - variable costs - fixed costs = profit
S - $2,000 - $5,800 = $0
S = $7,800
Price = $7,800/200

As proof:

Sales (200 x $39) $7,800

Variable costs (200 x $10) 2,000
Contribution margin 5,800
Fixed costs 5,800
Additional income $ 0

2-20
2-35 CVP in a Service Business (10-15 minutes)

1. $200,000

Hours generated internally, 15 x 2,000 30,000

Hours from freelancers, 80,000 - 30,000 50,000
Total hours 80,000

Revenues at $40 per hour $3,200,000

Variable cost, 50,000 x $25 1,250,000
Contribution margin 1,950,000
Fixed costs 1,750,000
Profit $ 200,000

2. 56,667

Fixed costs plus desired profit ($1,750,000 + $300,000)

$2,050,000 Revenue from internal billing, 30,000 x $40 (no variable cost)
1,200,000 Contribution needed from free-lancers
850,000 Required hours, $850,000/($40 - $25)
56,667

Or, to increase profit by $100,000 from $200,000 to $300,000 requires 6,667

additional hours, which is $100,000/$15 contribution per hour.

2-36 Developing CVP Information (25-30 minutes)

April May

Sales $100,000 $80,000

Variable costs:
Cost of sales (40% of sales) $40,000 $32,000
Commissions (20% of sales) 20,000 16,000
Supplies (2% of sales) 2,000 1,600
Total variable costs (62% of sales) 62,000 49,600
Contribution margin (38% of sales) 38,000 30,400
Fixed costs:
Rent $ 1,200 $ 1,200
Salaries* 14,500 14,500
Insurance 1,100 1,100
Utilities 1,500 1,500
Miscellaneous 6,000 6,000
Total fixed costs 24,300 24,300
Income $13,700 $ 6,100

*Calculation of fixed cost of salaries:

Salaries, wages commissions for April $34,500
Less variable cost of commissions:
April sales $100,000
Commission percentage 20%
Commissions for April 20,000
Fixed portion of payroll $14,500

Note to the Instructor: This assignment offers the opportunity to

illustrate the greater usefulness of contribution margin format income

2-21
statements, as well as to discuss the notion of fixed and variable costs
being in the same account (salaries, wages, and commissions).

2-37 Margin of Safety (25 minutes)

1. Margins of safety in dollars

Model 440 Model 1200

Expected sales $200,000 $250,000

Sales at break-even point:
$59,000/40% 147,500
$120,000/60% 200,000
Margins of safety $ 52,500 $ 50,000

Margins of safety as percentages

Model 440, 26.25%, $52,500/$200,000

Model 1200, 20%, $50,000/$250,000

2. With a higher margin of safety on Model 440, most students will conclude
that it should be introduced despite its lower expected profitability. There
is no correct answer because there are no reasonably objective data regarding
the probabilities of the expected sales not materializing.

The decision should hinge on whether the expected difference in profits

of $9,000 ($30,000 - $21,000) is significant enough to offset the greater
risk that attends Model 1200.

Some factors that bear on the decision follow.

(a). The current state of the company and its expected state without
considering the new possibilities. If the company expects high profitability
from its other lines, it might be more willing to take the greater risk
involved with the Model 1200. A company experiencing low profitability and
expecting it to continue, might be more likely to take the apparently surer
thing, the Model 440. It could go the other way, as well. A company with
relatively low expected profitability might be more willing to take some
risks to get back into a more favorable situation.

(b). The extent to which the fixed costs are avoidable. If virtually
all fixed costs could be avoided if the wallet turned out to be a poor
seller, there might be more willingness to bring out the Model 1200. The
less the avoidability of fixed costs, the more likely that a conservative
management would select the safer product.

(c). The confidence in the forecasts. At this point students have not
been exposed to expected value calculations and other techniques that could
be applied, but some will see that investigation into the reliability of the
forecasts would be helpful.

2-22
2-38 Changes in Operations (25-30 minutes)

1. Extending the hours of operations appears wise. Packard can expect an

additional profit of $460 per week, computed as follows:

Revenues (2,000 x $.80 per hour) $1,600

Costs to achieve additional revenue:
Variable costs:
Additional rent on lease (10% of
additional revenue) $160
Additional city tax (5% of
additional revenue) 80
Total additional variable cost (15%) $ 240
Fixed costs:
Additional salaries for attendants $800
Additional utilities and insurance 100
Total additional fixed cost 900
Total additional costs 1,140
Increase in profit $ 460

2. About 1,324 hours

Fixed costs to be covered, from requirement 1 $ 900

Contribution margin from additional revenue
$0.80 - 15% of $0.80 (from requirement 1) $0.68
Hours required to offset additional costs ($900/$0.68) 1,323.5

Note to the Instructor: The $12,000 paid to the owner of the lot is, of
course, irrelevant because it will not change regardless of the number of
hours the parking lot remains open. Even at this early stage in the course,
most students are likely to recognize this fact and deal only with
incremental costs in their solutions, but it may be worthwhile to point out
this fact specifically in reviewing the solution.

2-39 CVP Analysis--Product Mix (35 minutes)

1. About 319,000 cases (rounded) ($600,000 + $375,000)/$3.057

Premium Regular Total

Selling price $10.50 $7.40

Variable brewing costs 5.10 4.25
Commissions, 10% of price 1.05 0.74
Total variable costs 6.15 4.99
Unit contribution margin $4.35 $2.41
Percentage in mix 1/3 2/3
Weighted-average contribution margin $1.45 + $1.607 = $3.057

2. 106,333 premium and 212,667 regular (1/3 and 2/3 of 319,000)

2-23
3. Monthly profit decreases about $7,000, so the campaign is not worthwhile.
The totals below are rounded.

Profit without campaign

Contribution margin 350,000 x $3.057 $1,069,950
Fixed costs 975,000
Profit $ 94,950

Profit with campaign

Premium Regular Total

Cases, 350,000/3 x 120%; 140,000

350,000 x 2/3 x 95% 221,700
361,700
Per case contribution margin $ 4.35 $ 2.41
Total contribution margin $609,000 $534,300 $1,143,300
Fixed costs $975,000 + $80,000 1,055,000
Profit $ 88,300

4. $3.161 (rounded) $1,143,300/361,700 It is possible to redo the analysis

from requirement 1, but unnecessary if the students understand the weighted-
average contribution margin.

5. 333,755 $1,055,000/$3.161

You might want to note that the increase in the breakeven point indicates
that the increase in fixed costs overwhelmed the increase in WACM per case.
Of course, the opposite could have happened. Moreover, we have no assurance
that the new mix would prevail at different levels of total volume. For
example, the increased advertising might get nearly all of the new and
existing customers who would to switch to premium to do so. So the company
might have to rely on increases in regular sales beyond the 361,700 case
level.

2-40 Unit Costs (20-25 minutes)

Anderson Shoe Store

Income Statement for Month

Sales (5,000 x $25) $125,000

Cost of sales (50% of sales) 62,500
Gross profit 62,500
Commissions (15% of sales) 18,750
Contribution margin 43,750
Fixed costs:
Salaries and wages $30,000
Utilities, insurance, rent 3,500 33,500
Profit $ 10,250

An alternative way to determine what would happen to income if sales

increase by 1,000 pairs is to use contribution margin of $8.75 per pair ($25
- $12.50 - $3.75 commission). Profit should rise by $8,750 if volume rises
by 1,000 pairs, and the income statement shows that.

The fallacy in Anderson's reasoning is the unit cost problem. He

2-24
assumed that the unit costs would be constant, not decline as sales
increased. Despite the great deal of attention paid to this point, it
remains a serious difficulty for many students.

2-41 CVP Analysis and Break-even Pricing-Municipal Operation (15-20

minutes)

1. A loss of $8,000

Revenues, (200 x $50) + (1,000 x $15) $25,000

Costs:
Fixed $25,000
Variable, businesses, 200 x 12 x $1.25 3,000
residences, 1,000 x 4 x $1.25 5,000 33,000
Loss $( 8,000)

2. $61.87 for businesses, $20.63 for residences, both rounded

Total revenue required, equals total cost, above $33,000

Total pickups (200 x 12) + (1,000 x 4) 6,400
Price per pickup $5.156

Business charge = per-pickup price x 12 $61.87

Residence charge = per-pickup price x 4 $20.63

Alternatively, solving for the monthly prices, let R = residence price, then
3R = business price

1,000R + (3 x 200 x R) = $33,000

1,600R = $33,000
R = $20.63

2-42 Product Profitability (35 minutes)

1. Gold is the most profitable per unit sold, because its contribution
margin per unit is highest.

2. Silver is the most profitable per dollar of sales because its

contribution margin percentage is highest.
Regular Silver Gold
Contribution margin $ 4 $12 $15
Divided by selling price $10 $20 $30
Contribution margin percentage 40% 60% 50%

3. (a) 48%
Regular Silver Gold
Contribution margin percentages 40% 60% 50%
Sales mix percentage, in dollars 40% 20% 40%
Weighted-average contribution margin 16% + 12% + 20% = 48%

(b) The break-even point is $416,667 ($200,000/48%)

(c) Volume required for a profit of $30,000 is $479,167

($200,000 + $30,000)/48%

2-25
4. (a) $400,000 ($200,000/50%)

Regular Silver Gold

Contribution margin percentages 40% 60% 50%
Sales mix percentage 30% 30% 40%
Weighted contribution margin 12% + 18% + 20% = 50%

(b) $460,000 (($200,000 + $30,000)/50%)

5. (a) $10
Regular Silver Gold
Contribution margin per unit $ 4 $12 $15
Sales mix percentage 40% 20% 40%
Weighted-average contribution margin $1.60 + $2.40 + $6.00 = $10.00

(b) 20,000 ($200,000/$10)

(c) 23,000 ($200,000 + $30,000)/$10 = $230,000/$10

2-43 Alternative Cost Behavior--A Movie Company (20 minutes)

1. $68,421,052 under the normal arrangement, $62,500,000 under the special

arrangement

Normal (N)
Fixed costs:
Drift's salary $20,000,000
Other 45,000,000
Total $65,000,000
Divided by contribution margin percentage:
Price 100%
Variable cost, 5% of the receipts-to-producer 5%
Equals contribution margin percentage 95%
Equals break-even sales in receipts-to-producer $68,421,052

Special (S)
Fixed costs:
Drift's salary ($20,000,000 x .25) $ 5,000,000
Other 45,000,000
Total $50,000,000
Divided by contribution margin percentage (100% - 20%) 80%
Equals break-even sales in receipts-to-the-producer $62,500,000

2. N S .
Total admissions $200,000,000 $200,000,000
Receipts to the producer at 40% $ 80,000,000 $ 80,000,000
Total costs:
Fixed costs, requirement 1 65,000,000 50,000,000
Variable cost-Drift's salary
5% 4,000,000
20% _ 16,000,000
Total costs 69,000,000 66,000,000
Income to the producer $11,000,000 $14,000,000

2-26
3. $100,000,000 Equate the returns to Drift under the two schemes. Let X
= receipts to the producer.

N = $20,000,000 + 5%X S = $5,000,000 + 20%X

$20,000,000 + 5%X = $5,000,000 + 20%X

15%X = $15,000,000
X = $100,000,000

Note to the Instructor: Variations and extensions of this problem

appear in 2-44 and 3-26. The extension in 2-44 introduces additional
products in the form of TV and foreign distribution rights and the extension
in Chapter 3 delves further into the indifference analysis.

2-44 Multiple Products--Movie Company (Continuation of 2-43) (20-25

minutes)

Note to the Instructor: It is not easy to see that this is multiple-

product problem. It is also not easy to derive the correct percentages in
the sales mix.
1. $64,283,374 rounded, ($45,000,000 + $10,000,000)/85.56%
Theater _ TV

Mix percentage* 8/9ths 1/9th

Contribution margin percentage 85% 90%
Weighted average 75.56% + 10% = 85.56%

* TV rights are 1/8 of theater receipts, so theater receipts are 1/1.125 and
TV rights are .125/1.125.

Some students will set up a formula such as the one below.

Receipts - Fixed costs - Variable costs = Profit

R - $55,000,000 - [(.15 x 8/9 x R) + (.10 x 1/9 x R)] = $0

R - .1444R = $55,000,000
R = $64,282,374

2. $68,421,052, ($45,000,000 + $20,000,000)/95%

Note that because only one variable cost percentage applies to both
types of business, there is no need to be concerned with product mix.

3. $63,218,390 ($45,000,000 + $10,000,000)/87.0%

Theater _ TV Foreign

Mix percentage* 75.7% 9.4% 15.1%

Contribution margin percentage 85.0% 90.0% 95.0%
Weighted average 64.2% 8.5% 14.3% 87.0%

* Foreign receipts are 20% of domestic theater receipts, so theater receipts

are 1/1.325, TV rights are .125/1.325, and foreign sales are .20/1.325

Again, some students will set up a formula such as the one below.

2-27
Receipts - Fixed costs - Variable costs = Profit

R - $55,000,000 - [(.15 x .755R) + (.10 x .094R) + (.05 x .151R )] = $0

R - .130R = $55,000,000
R = $63,218,390

2-45 Conversion of Income Statement to Contribution Margin Basis (20

minutes)

1. Rudolf Company
Budgeted Income Statement

Sales (20,000 units) $300,000

Variable costs
Materials $40,000
Labor 20,000
Factory overhead 50,000
Selling and administrative 38,000
Total variable costs 148,000
Contribution margin 152,000
Fixed costs:
Factory overhead 100,000
Selling and administrative 70,000
Total fixed costs 170,000
Expected income (loss) $( 18,000)

2. About 22,369 units

Selling price per unit ($300,000/20,000 units) $15.00

Variable cost per unit of sales ($148,000/20,000 units) 7.40
Contribution margin per unit $ 7.60
Break-even point ($170,000/$7.60) 22,369 rounded

3. Other things equal, the campaign is wise because the company will go
into the black. The additional contribution of $60,800 (8,000 units at $7.60
per unit) exceeds the $30,000 advertising cost by $30,800, bringing the
company to a $12,800 profit ($18,000 loss + $30,800 additional profit).

2-46 Occupancy Rate as Measure of Volume (25-30 minutes)

1. (a) $6,000,000 $4,200,000/70%

(b) 60% $6,000,000/$100,000

2. $1,050,000 [($100,000 x 75) x 70%] - $4,200,000

3. 70% ($4,200,000 + $700,000)/($100,000 x 70%)

4. Yes, profit would increase by $40,000.

Increase in contribution margin (2 x $100,000 x 70%) $140,000

Less increased fixed costs 100,000
Increase in profit $ 40,000

2-28
 Note to the Instructor: This assignment uses a different measure of
volume. Some students will fail to see that a percentage point is 1.0, not .
01, and therefore make some calculational errors. The assignment allows
students to work with a volume measure other than the usual units of product.

2-47 Changes in Variables (20-25 minutes)

1. Sales (given) $442,800

Variable costs 259,200
Contribution margin 183,600
Fixed costs 114,000
Income (given) $ 69,600

Expected income was $46,000 on sales of $400,000. Expected contribution

margin was $160,000, 40% of sales, expected profit $46,000, so that expected
fixed costs were $114,000 ($160,000 - $46,000). Once fixed costs are known,
we can calculate contribution margin as income plus fixed costs. Total
variable costs are then $259,200, sales of $442,800 less contribution margin
of $183,600.

2. (a)
10,800 units. Unit variable costs are $24, so that $259,200/$24 =
10,800. With a 60% variable cost ratio (100% - 40% contribution
margin ratio) and volume of $400,000, expected variable costs were
$240,000, or $24 per unit (60% x $40).

(b) $41 $442,800/10,800

3. The title of the assignment suggests that changes in variables are the
source of the difference. The memo should make the following points.

Thompson's actual contribution margin percentage was 41.5% [($41 - $24)/

$41], rather than 40%. The $1 selling price increase increased both the
contribution margin per unit and the contribution margin percentage. Had we
known of the change in the selling price before the year had begun, we would
have prepared the following planned income statement.

Sales (10,000 x $41) $410,000

Variable costs (10,000 x $24) 240,000
Contribution margin 170,000
Fixed costs 114,000
Profit $ 56,000

Then, we would have told Ms. Thompson that increases in dollar sales (at the
$41 price) would increase income by 41.5% of the sales increase.
Accordingly,

Increase in sales ($442,800 - $410,000) $32,800

Increase in profit, 41.5% x $32,800 $13,600 (rounded)
Planned profit at $41 price and 10,000 units 56,000
Actual profit $69,600

We should tell Ms. Thompson that our analysis depended on the stability of
the values of price, variable cost, and fixed costs. Had we known the actual
values we could have forecast income correctly.

2-29
2-48 Cost Structure (40 minutes)

The first step is to analyze the results at the different levels.

Selected Sales Volumes

(in thousands)
Outside representatives:
Sales $600 $1,000 $1,200
Variable costs at 50% 300 500 600
Contribution margin 300 500 600
Additional fixed costs 80 80 80
Additional profit $220 $ 420 $ 520
Inside salespeople:
Sales $600 $1,000 $1,200
Variable costs at 35% 210 350 420
Contribution margin 390 650 780
Additional fixed costs 200 200 200
Additional profit $190 $ 450 $ 580

The indifference point is $800,000.

Profit with outside representatives = Profit with inside salespeople

50%S - $80,000 = 65%S - $200,000
15%S = $120,000
S = $800,000

If Wink's managers can reasonably expect sales to exceed $800,000 with

either type of sales effort, they should employ inside salespeople.

However, at least two other factors are important. First, is it likely

that sales will be the same either way? The outside representatives must
rely on commissions and might therefore be more motivated. However, because
they handle other lines, they might ease up on Wink's products if they do not
have immediate success. Even if they do push Wink products, outside reps
might sell less than Wink's own salespeople because the inside salespeople
sell nothing else and are more familiar, and more comfortable, with Wink
products. The outside reps might also have already developed customers who
could be expected to buy Wink's products, while Wink's salespeople would have
to develop customers from scratch. Thus, this problem might not be amenable
to indifference analysis because volumes could differ under the two
arrangements and indifference analysis applies when the alternatives will not
affect the variable being analyzed (volume in this case).

2-49 Opening a Law Office (25-30 minutes)

1. $1,146,520
Revenues $2,700,000
Variable costs, 18,000 x $4 72,000
Contribution margin 2,628,000
Fixed costs 1,481,480
Income $1,146,520

Revenues:
Number of clients, 50 x 360 18,000
Initial consulting fee $30

2-30
 Revenue from consulting fees $ 540,000
Revenue from judgments, 18,000 x 20% x $2,000 x 30% 2,160,000
Total revenue $2,700,000

Fixed costs:
Advertising $ 500,000
Rent, 6,000 x $28 168,000
Property insurance 22,000
Utilities 32,000
Malpractice insurance 180,000
Depreciation, $60,000/4 15,000
Wages, ($25 + $20 + $15 + $10) x 16 x 360 403,200
Fringes at 40% of wages 161,280
Total fixed costs $1,481,480

2. About 10,150 visits $1,481,480/$146 = 10,147, Expected contribution

margin per visit, $2,628,000/18,000 = $146

3. The memo should make the following points.

To: Don Masters

From: Student
Date: Today

The venture appears to be profitable, with an expected income of $1,146,250

in the first year. The breakeven point expressed as visits to the office is
10,150, which is well below the 18,000 expected visits, giving a good margin
of safety. The principal risk is that the fixed costs are high, so that any
unfavorable deviation from the expectations will have serious effects on the
expected profit. The estimate of the percentage of clients whose cases will
result in favorable judgments is an example.

2-50 A Concessionaire (35 minutes)

1. The royalty that Newkirk can pay, as a percentage of sales, and still
make a profit of $180,000 is no greater than 14.9%. A reasonable analysis
follows.
Hot Soft
Dogs Drinks Total

Selling price $1.50 $1.00 $2.50

Variable costs:
Hot dog and roll 0.46 0.46
Condiments 0.02 0.02
Soft drink and ice 0.22 0.22
Commission (20% of sales) 0.30 0.20 0.50
Total variable cost 0.78 0.42 1.20
Contribution margin $0.72 $0.58 $1.30

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Sales expected for the season:
College games, (30,000/2) x 7 105,000
Professional games, (60,000/2) x 7 210,000
Total expected sales (1 hot dog and 1 drink) 315,000
Times CM per unit $1.30
Total expected contribution margin $409,500
Fixed costs:
Cost per game $ 8,000
Number of games 14
112,000
Expected profits before royalty 297,500
Desired profit 180,000
Available to pay royalty $117,500
Sales at this level of profit (315,000 x $2.50) $787,500
Percentage of royalty to sales ($117,500/$787,500) 14.9%

An income statement at the expected rate of sales proves the above answer.

Sales (315,000 units at $2.50) $787,500

Variable costs:
Materials and sales commissions
(315,000 units at $1.20 per unit) $378,000
Royalty ($787,500 x 14.9%, rounded) 117,338
Total variable costs 495,338
Contribution margin 292,162
Fixed costs ($8,000 x 14 games) 112,000
Income (difference due to rounding) $180,162

2. With a bid of 12% royalty, expected income is $203,000.

Sales (315,000 units at $2.50) $787,500

Variable costs:
Materials and commissions, as above $378,000
Royalty ($787,500 x 12%) 94,500 472,500
Contribution margin 315,000
Fixed costs 112,000
Income $203,000

The expected profit is larger than the $180,000 stated in requirement 1,

which is consistent with the 12% royalty being smaller than the 14.9% rate
previously determined to produce a $180,000 profit.

3. (a)
Selling price per unit, hot dog and drink $2.50
Variable costs:
Originally stated $1.20
Royalty at 12% 0.30
Total variable costs 1.50
Contribution margin $1.00

Breakeven units ($112,000/$1.00) 112,000

Required attendance (112,000 x 2) 224,000

Attendance must be only 36% (224,000/630,000) of expected for Newkirk to

break even, which gives a considerable margin of safety of 64%.

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 (b)
Breakeven as percentage of expected attendance:
Expected attendance (30,000 x 7) + (60,000 x 7) 630,000
Percentage of people who must buy a unit (112,000/630,000) 17.8%

4. At a minimum, Newkirk wants the same kind of information available for

his bid for football games: the number of scheduled games, the average
attendance per game, and some idea of the estimated number of sales in terms
of average attendance. In addition, because baseball games are more
dependent upon the weather (attendance may be hurt, or the game not played at
all or cut short), he would probably want some idea of the number of games
normally canceled and the probabilities associated with that number. Sales
of soft drinks may be influenced by the weather as well as the attendance;
hence, it may not be possible to come up with an average sales per game in
the simple form available for the football season.

Note to the Instructor: We believe that the interrelationships among

the various disciplines in the business curriculum should be identified and
emphasized early and often. You might want to take this opportunity to
convey to students some indication of the ways in which statistics courses
will help them in dealing with problems such as the one proposed in
requirement 4. In fact, you can point out that some of the information
already given (average attendance, relationship between attendance and sales)
must have come from past analyses, perhaps through the use of statistical
methods or through judgment based on experience. It is characteristic of
most problems in managerial accounting to assume that a good deal of analysis
has already been done so that the major problem remaining is determining the
expected results. This is generally appropriate because the course is not
intended to cover such other matters, but we believe it is helpful to point
to the relationships with other courses wherever possible.

5. The absence of the star quarterback might well cut into attendance at
professional games. The effect of this drop in attendance on forecast
profits is obvious (a drop) but the extent of the drop in sales, and hence
profits, is debatable. This very possible contingency must be considered in
developing a bid for royalties. Thus, the answer in requirement 1 might be
an absolute maximum assuming no variation whatever from forecast conditions.
The specified royalty percentage in requirement 2 allows for some
contingencies. (This problem is an excellent example of the difficulties of
relying on forecasts, the need to allow for contingencies, and the general
problem of the business manager in having to deal with the future.)

2-33
2-51 Hockey Camp (30-40 minutes)

1. $2,755, calculated as follows.

Revenue, 90 x $225 $20,250

Variable costs:
Per-camper costs, 90 x $83* $7,470
Payment to college, $20,250 x 10% 2,025 9,495
Contribution margin 10,755
Fixed costs:
Coaches, (90/15) x $550 $3,300
Ice arena charge 1,000
Brochures, etc. 3,700 8,000
Profit $ 2,755

* Food, insurance and T-shirts, room ($50 + $15 + $18)

Note to the Instructor: We classified coaches' salaries as fixed even

though they are variable provided that campers come in multiples of 15 and
Oldcraft can predict the number of campers so that there will not be an
excess of coaches hired before the camp starts. This, of course, is one of
Oldcraft's concerns.

2. $231.67, calculated as follows.

Profit $ 4,000
Coaches, 7 x $550 * 3,850
Ice arena charge 1,000
Brochures, etc. 3,700
Variable costs per camper, 100 x $83 8,300
Required revenue net of 10% to college $20,850
divided by 90% equals total revenue required $23,167
divided by 100 campers equals price per camper $231.67

* 100/15 = 6.67, rounded up to 7. The number of coaches is deliberately not

an integer amount.

3. About 28.3%. One approach is to use the basic formula of revenue - cost =
profit and proceed as follows.

Revenue - Per-camper cost - Coaches - Ice charge - Fee = Profit

$20,250 - $7,470 - $3,300 - $1,000 - $20,250X = $2,755

$20,250X = $5,725
X = 28.3%

Another approach is to determine the percentage that $3,700 (the costs to be

assumed by the college) bears to $20,250 and add it to the 10%. Thus,
$3,700/ $20,250 = 18.3%.

4. The advantage to the college is the disadvantage to Oldcraft. If the

camp is more successful than anticipated, the college will earn more than it
otherwise would have, while Oldcraft will earn less. Of course, Oldcraft
will earn more than she would have if the camp goes as planned. She will
earn less than she would have with the $3,700 flat fee. The disadvantage to
the college is also the advantage to Oldcraft. If the camp is less

2-34
successful than anticipated, the college will have a lower fee while Oldcraft
will earn more than she otherwise would have.

Essentially, the proposed arrangement simply converts a fixed cost

(revenue) for Oldcraft (college) to a variable cost (revenue). Oldcraft
reduces her risk and gives up some potential profit, while the college does
the reverse.

2-35