# Cost-Volume-Profit Analysis

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## Assignment Content

1. Purpose of Assignment
The Case Study focuses on CVP (Cost-Volume-Profit), break-even, and margin of safety analyses which allows students to experience working through a business scenario and applying these tools in managerial decision making.

Resources

• Cost-Volume-Profit Analysis Grading Guide
• Generally Accepted Accounting Principles (GAAP), U.S. Securities and Exchange Commission (SEC)
• Tutorial help on Excel and Word functions can be found on the Microsoft Office website. There are also additional tutorials via the web offering support for Office products.
• Scenario: Mary Willis is the advertising manager for Bargain Shoe Store. She is currently working on a major promotional campaign. Her ideas include the installation of a new lighting system and increased display space that will add \$24,000 in fixed costs to the \$270,000 in fixed costs currently spent. In addition, Mary is proposing a 5% price decrease (\$40 to \$38) will produce a 20% increase in sales volume (20,000 to 24,000). Variable costs will remain at \$24 per pair of shoes. Management is impressed with Mary’s ideas but concerned about the effects these changes will have on the break-even point and the margin of safety.

Assignment Steps
Complete the following:

• Compute the current break-even point in units, and compare it to the break-even point in units if Mary’s ideas are used.
• Compute the margin of safety ratio for current operations and after Mary’s changes are introduced (Round to nearest full percent).
• Prepare a CVP (Cost-Volume-Profit) income statement for current operations and after Mary’s changes are introduced.
• Prepare a maximum 750-word informal memo to management addressing Mary’s suggested changes.
• Explain whether Mary’s changes should be adopted. Why or why not? Analyze the above information (three bullet points above) and use this information to support your suggestion.
• Show your work in Microsoft Word or Excel.

Complete calculations/computations using Microsoft Word or Excel.

• APA Format,
• No Plagiarism.

Cost-Volume-Profit

CHAPTER PREVIEW

As the Feature Story indicates, to manage any size business you must understand how costs respond to changes in sales volume and the effect of costs and revenues on profits. A prerequisite to understanding cost‐volume‐profit (CVP) relationships is knowledge of how costs behave. In this chapter, we first explain the considerations involved in cost behavior analysis. Then, we discuss and illustrate CVP analysis.

Don’t Worry—Just Get Big

It wasn’t that Jeff Bezos didn’t have a good job. He was a vice president at a Wall Street firm. But, he quit his job, moved to Seattle, and started an online retailer, which he named Amazon.com. Like any good entrepreneur, Jeff strove to keep his initial investment small. Operations were run out of his garage. And, to avoid the need for a warehouse, he took orders for books and had them shipped from other distributors’ warehouses.

By its fourth month, Amazon was selling 100 books a day. In its first full year, it had \$15.7 million in sales. The next year, sales increased eightfold. Two years later, sales were \$1.6 billion.

Although its sales growth was impressive, Amazon’s ability to lose money was equally amazing. One analyst nicknamed it Amazon.bomb, while another, predicting its demise, called it Amazon.toast. Why was it losing money? The company used every available dollar to reinvest in itself. It built massive warehouses and bought increasingly sophisticated (and expensive) computers and equipment to improve its distribution system. This desire to grow as fast as possible was captured in a T‐shirt slogan at its company picnic, which read “Eat another hot dog, get big fast.” This buying binge was increasing the company’s fixed costs at a rate that exceeded its sales growth. Skeptics predicted that Amazon would soon run out of cash. It didn’t.

In the fourth quarter of 2010 (only 15 years after its world headquarters was located in a garage), Amazon reported quarterly revenues of \$12.95 billion and quarterly income of \$416 million. But, even as it announced record profits, its share price fell by 9%. Why? Because although the company was predicting that its sales revenue in the next quarter would increase by at least 28%, it predicted that its operating profit would fall by at least 2% and perhaps by as much as 34%. The company made no apologies. It explained that it was in the process of expanding from 39 distribution centers to 52. As Amazon’s finance chief noted, “You’re not as productive on those assets for some time. I’m very pleased with the investments we’re making and we’ve shown over our history that we’ve been able to make great returns on the capital we invest in.” In other words, eat another hot dog.

Sources: Christine Frey and John Cook, “How Amazon.com Survived, Thrived and Turned a Profit,” Seattle Post (January 28, 2008); and Stu Woo, “Sticker Shock Over Amazon Growth,” WallStreet Journal Online (January 28, 2011).

LEARNING OBJECTIVE 1

Explain variable, fixed, and mixed costs and the relevant range.

Cost behavior analysis  is the study of how specific costs respond to changes in the level of business activity. As you might expect, some costs change, and others remain the same. For example, for an airline company such as Southwest or United, the longer the flight, the higher the fuel costs. On the other hand, Massachusetts General Hospital’s costs to staff the emergency room on any given night are relatively constant regardless of the number of patients treated. A knowledge of cost behavior helps management plan operations and decide between alternative courses of action. Cost behavior analysis applies to all types of entities.

The starting point in cost behavior analysis is measuring the key business activities. Activity levels may be expressed in terms of sales dollars (in a retail company), miles driven (in a trucking company), room occupancy (in a hotel), or dance classes taught (by a dance studio). Many companies use more than one measurement base. A manufacturer, for example, may use direct labor hours or units of output for manufacturing costs, and sales revenue or units sold for selling expenses.

For an activity level to be useful in cost behavior analysis, changes in the level or volume of activity should be correlated with changes in costs. The activity level selected is referred to as the activity (or volume) index. The  activity index  identifies the activity that causes changes in the behavior of costs. With an appropriate activity index, companies can classify the behavior of costs in response to changes in activity levels into three categories: variable, fixed, or mixed.

VARIABLE COSTS

Variable costs  are costs that vary in total directly and proportionately with changes in the activity level. If the level increases 10%, total variable costs will increase 10%. If the level of activity decreases by 25%, variable costs will decrease 25%. Examples of variable costs include direct materials and direct labor for a manufacturer; cost of goods sold, sales commissions, and freight‐out for a merchandiser; and gasoline in airline and trucking companies. A variable cost may also be defined as a cost that remains the same per unit at every level of activity.

To illustrate the behavior of a variable cost, assume that Damon Company manufactures tablet computers that contain \$10 cameras. The activity index is the number of tablet computers produced. As Damon manufactures each tablet, the total cost of cameras used increases by \$10. As part (a) of Illustration 18-1 shows, total cost of the cameras will be \$20,000 if Damon produces 2,000 tablets, and \$100,000 when it produces 10,000 tablets. We also can see that a variable cost remains the same per unit as the level of activity changes. As part (b) of Illustration 18-1 shows, the unit cost of \$10 for the cameras is the same whether Damon produces 2,000 or 10,000 tablets.

ILLUSTRATION 18-1 Behavior of total and unit variable costs

Companies that rely heavily on labor to manufacture a product, such as Nike or Reebok, or to perform a service, such as Hilton or Marriott, are likely to have many variable costs. In contrast, companies that use a high proportion of machinery and equipment in producing revenue, such as AT&T or Duke Energy Co., may have few variable costs.

Variable costs per unit remain constant at all levels of activity.

FIXED COSTS

Fixed costs  are costs that remain the same in total regardless of changes in the activity level. Examples include property taxes, insurance, rent, supervisory salaries, and depreciation on buildings and equipment. Because total fixed costs remain constant as activity changes, it follows that fixed costs per unit vary inversely with activity: As volume increases, unit cost declines, and vice versa.

To illustrate the behavior of fixed costs, assume that Damon Company leases its productive facilities at a cost of \$10,000 per month. Total fixed costs of the facilities will remain constant at every level of activity, as part (a) of Illustration 18-2 shows. But, on a per unit basis, the cost of rent will decline as activity increases, as part (b) of Illustration 18-2 shows. At 2,000 units, the unit cost per tablet computer is \$5 (\$10,000÷2,000)\$5 (\$10,000÷2,000). When Damon produces 10,000 tablets, the unit cost of the rent is only \$1 per tablet (\$10,000÷10,000)(\$10,000÷10,000).

ILLUSTRATION 18-2 Behavior of total and unit fixed costs

The trend for many manufacturers is to have more fixed costs and fewer variable costs. This trend is the result of increased use of automation and less use of employee labor. As a result, depreciation and lease charges (fixed costs) increase, whereas direct labor costs (variable costs) decrease.

PEOPLE, PLANET, AND PROFIT INSIGHT

BrightFarms

Gardens in the Sky

Because of population increases, the United Nations’ Food and Agriculture Organization estimates that food production will need to increase by 70% by 2050. Also, by 2050, roughly 70% of people will live in cities, which means more food needs to be hauled further to get it to the consumer. To address the lack of farmable land and reduce the cost of transporting produce, some companies, such as New York‐based BrightFarms, are building urban greenhouses.

This sounds great, but do the numbers work? Some variable costs would be reduced. For example, the use of pesticides, herbicides, fuel costs for shipping, and water would all drop. Soil erosion would be a non‐issue since plants would be grown hydroponically (in a solution of water and minerals), and land requirements would be reduced because of vertical structures. But, other costs would be higher. First, there is the cost of the building. Also, any multistory building would require artificial lighting for plants on lower floors.

Until these cost challenges can be overcome, it appears that these urban greenhouses may not break even. On the other hand, rooftop greenhouses on existing city structures already appear financially viable. For example, a 15,000 square‐foot rooftop greenhouse in Brooklyn already produces roughly 30 tons of vegetables per year for local residents.

Sources: “Vertical Farming: Does It Really Stack Up?” The Economist (December 9, 2010); and Jane Black, “BrightFarms Idea: Greenhouses That Cut Short the Path from Plant to Grocery Shelf,” The Washington Post (May 7, 2013).

What are some of the variable and fixed costs that are impacted by hydroponic farming? (Go to WileyPLUS for this answer and additional questions.)

RELEVANT RANGE

In Illustration 18-1 part (a) (page 884), a straight line is drawn throughout the entire range of the activity index for total variable costs. In essence, the assumption is that the costs are linear. If a relationship is linear (that is, straight‐line), then changes in the activity index will result in a direct, proportional change in the variable cost. For example, if the activity level doubles, the cost doubles.

It is now necessary to ask: Is the straight‐line relationship realistic? In most business situations, a straight‐line relationship does not exist for variable costs throughout the entire range of possible activity. At abnormally low levels of activity, it may be impossible to be cost‐efficient. Small‐scale operations may not allow the company to obtain quantity discounts for raw materials or to use specialized labor. In contrast, at abnormally high levels of activity, labor costs may increase sharply because of overtime pay. Also, at high activity levels, materials costs may jump significantly because of excess spoilage caused by worker fatigue.

As a result, in the real world, the relationship between the behavior of a variable cost and changes in the activity level is often curvilinear, as shown in part (a) of Illustration 18-3. In the curved sections of the line, a change in the activity index will not result in a direct, proportional change in the variable cost. That is, a doubling of the activity index will not result in an exact doubling of the variable cost. The variable cost may more than double, or it may be less than double.

ILLUSTRATION 18-3 Nonlinear behavior of variable and fixed costs

Total fixed costs also do not have a straight‐line relationship over the entire range of activity. Some fixed costs will not change. But it is possible for management to change other fixed costs. For example, in some instances, salaried employees (fixed) are replaced with freelance workers (variable). Illustration 18-3, part (b), shows an example of the behavior of total fixed costs through all potential levels of activity.

Fixed costs that may be changeable include research, such as new product development, and management training programs.

For most companies, operating at almost zero or at 100% capacity is the exception rather than the rule. Instead, companies often operate over a somewhat narrower range, such as 40–80% of capacity. The range over which a company expects to operate during a year is called the  relevant range  of the activity index. Within the relevant range, as both diagrams in Illustration 18-4 show, a straight‐line relationship generally exists for both variable and fixed costs.

ILLUSTRATION 18-4 Linear behavior within relevant range

As you can see, although the linear (straight‐line) relationship may not be completely realistic, the linear assumption produces useful data for CVP analysis as long as the level of activity remains within the relevant range.

ALTERNATIVE TERMINOLOGY

The relevant range is also called the normal or practical range.

MIXED COSTS

Mixed costs  are costs that contain both a variable‐ and a fixed‐cost element. Mixed costs, therefore, change in total but not proportionately with changes in the activity level.

The rental of a U‐Haul truck is a good example of a mixed cost. Assume that local rental terms for a 17‐foot truck, including insurance, are \$50 per day plus 50 cents per mile. When determining the cost of a one‐day rental, the per day charge is a fixed cost (with respect to miles driven), whereas the mileage charge is a variable cost. The graphic presentation of the rental cost for a one‐day rental is shown in Illustration 18-5 (page 888).

ILLUSTRATION 18-5 Behavior of a mixed cost

In this case, the fixed‐cost element is the cost of having the service available. The variable‐cost element is the cost of actually using the service. Utility costs such as for electricity are another example of a mixed cost. Each month the electric bill includes a flat service fee plus a usage charge.

DO IT! 1

Types of Costs

Helena Company reports the following total costs at two levels of production.

 10,000 Units 20,000 Units Direct materials \$20,000 \$40,000 Maintenance 8,000 10,000 Direct labor 17,000 34,000 Indirect materials 1,000 2,000 Depreciation 4,000 4,000 Utilities 3,000 5,000 Rent 6,000 6,000

Classify each cost as variable, fixed, or mixed.

Action Plan

Recall that a variable cost varies in total directly and proportionately with each change in activity level.

Recall that a fixed cost remains the same in total with each change in activity level.

Recall that a mixed cost changes in total but not proportionately with each change in activity level.

SOLUTION

Direct materials, direct labor, and indirect materials are variable costs.

Depreciation and rent are fixed costs.

Maintenance and utilities are mixed costs.

Related exercise material: BE18-1, BE18-2, E18-1, E18-2, E18-4, E18-6, and DO IT! 18-1.

LEARNING OBJECTIVE 2

Apply the high‐low method to determine the components of mixed costs.

For purposes of cost‐volume‐profit analysis, mixed costs must be classified into their fixed and variable elements. How does management make the classification? One possibility is to determine the variable and fixed components each time a mixed cost is incurred. But because of time and cost constraints, this approach is rarely followed. Instead, the usual approach is to collect data on the behavior of the mixed costs at various levels of activity. Analysts then identify the fixed‐ and variable‐cost components. Companies use various types of analysis. One type of analysis, called the high‐low method, is discussed next.

HIGH‐LOW METHOD

The  high‐low method  uses the total costs incurred at the high and low levels of activity to classify mixed costs into fixed and variable components. The difference in costs between the high and low levels represents variable costs, since only the variable‐cost element can change as activity levels change.

The steps in computing fixed and variable costs under this method are as follows.

1. Determine variable cost per unit from the following formula.

Change in Total Costs÷High minus Low Activity Level=Variable Cost per UnitChange in Total Costs÷High minus Low Activity Level=Variable Cost per Unit

ILLUSTRATION 18-6 Formula for variable cost per unit using high‐low method

To illustrate, assume that Metro Transit Company has the following maintenance costs and mileage data for its fleet of buses over a 6‐month period.

 Month Miles Driven Total Cost January 20,000 \$30,000 February 40,000 48,000 March 35,000 49,000 April 50,000 \$63,000 May 30,000 42,000 June 43,000 61,000

ILLUSTRATION 18-7 Assumed maintenance costs and mileage data

The high and low levels of activity are 50,000 miles in April and 20,000 miles in January. The maintenance costs at these two levels are \$63,000 and \$30,000, respectively. The difference in maintenance costs is \$33,000 (\$63,000−\$30,000)\$33,000 (\$63,000−\$30,000), and the difference in miles is 30,000 (50,000−20,000)30,000 (50,000−20,000). Therefore, for Metro Transit, variable cost per unit is \$1.10, computed as follows.

\$33,000÷30,000=\$1.10\$33,000÷30,000=\$1.10

2. Determine the fixed costs by subtracting the total variable costs at either the high or the low activity level from the total cost at that activity level.

For Metro Transit, the computations are shown in Illustration 18-8.

ILLUSTRATION 18-8 High‐low method computation of fixed costs

Maintenance costs are therefore \$8,000 per month of fixed costs plus \$1.10 per mile of variable costs. This is represented by the following formula:

Maintenance costs=\$8,000+(\$1.10×Miles driven)Maintenance costs=\$8,000+(\$1.10×Miles driven)

For example, at 45,000 miles, estimated maintenance costs would be \$8,000 fixed and \$49,500 variable (\$1.10×45,000)(\$1.10×45,000) for a total of \$57,500.

The graph in Illustration 18-9 plots the 6‐month data for Metro Transit Company. The red line drawn in the graph connects the high and low data points, and therefore represents the equation that we just solved using the high‐low method. The red, “high‐low” line intersects the y‐axis at \$8,000 (the fixed‐cost level), and it rises by \$1.10 per unit (the variable cost per unit). Note that a completely different line would result if we chose any two of the other data points. That is, by choosing any two other data points, we would end up with a different estimate of fixed costs and a different variable cost per unit. Thus, from this scatter plot, we can see that while the high‐low method is simple, the result is rather arbitrary. A better approach, which uses information from all the data points to estimate fixed and variable costs, is called regression analysis. A discussion of regression analysis is provided in a supplement on the book’s companion website.

ILLUSTRATION 18-9 Scatter plot for Metro Transit Company

MANAGEMENT INSIGHT

Tempur Sealy International

Skilled Labor Is Truly Essential

Bloomberg/Getty Images

The recent recession had devastating implications for employment. But one surprise was that for some manufacturers, the number of jobs lost was actually lower than in previous recessions. One of the main explanations for this was that in the years preceding the recession, many companies, such as Tempur Sealy International, adopted lean manufacturing practices. This meant that production relied less on large numbers of low‐skilled workers and more on machines and a few highly skilled workers. As a result of this approach, a single employee supports far more dollars in sales. Thus, it requires a larger decline in sales before an employee would need to be laid‐off in order for the company to continue to break even. Also, because the employees are highly skilled, employers are reluctant to lose them. Instead of lay‐offs, many manufacturers now resort to cutting employees’ hours when necessary.

Source: Timothy Aeppel and Justin Lahart, “Lean Factories Find It Hard to Cut Jobs Even in a Slump,” Wall Street Journal Online (March 9, 2009).

Would you characterize labor costs as being a fixed cost, a variable cost, or something else in this situation? (Go to WileyPLUS for this answer and additional questions.)

IMPORTANCE OF IDENTIFYING VARIABLE AND FIXED COSTS

Why is it important to segregate mixed costs into variable and fixed elements? The answer may become apparent if we look at the following four business decisions.

1. If American Airlines is to make a profit when it reduces all domestic fares by 30%, what reduction in costs or increase in passengers will be required?

Answer: To make a profit when it cuts domestic fares by 30%, American Airlines will have to increase the number of passengers or cut its variable costs for those flights. Its fixed costs will not change.

2. If Ford Motor Company meets workers’ demands for higher wages, what increase in sales revenue will be needed to maintain current profit levels?

Answer: Higher wages at Ford Motor Company will increase the variable costs of manufacturing automobiles. To maintain present profit levels, Ford will have to cut other variable costs or increase the price of its automobiles.

3. If United States Steel Corp.’s program to modernize plant facilities through significant equipment purchases reduces the work force by 50%, what will be the effect on the cost of producing one ton of steel?

Answer: The modernizing of plant facilities at United States Steel Corp. changes the proportion of fixed and variable costs of producing one ton of steel. Fixed costs increase because of higher depreciation charges, whereas variable costs decrease due to the reduction in the number of steelworkers.

4. What happens if Kellogg’s increases its advertising expenses but cannot increase prices because of competitive pressure?

Answer: Sales volume must be increased to cover the increase in fixed advertising costs.

DO IT! 2

High‐Low Method

Byrnes Company accumulates the following data concerning a mixed cost, using units produced as the activity level.

 Units Produced Total Cost March 9,800 \$14,740 April 8,500 13,250 May 7,000 11,100 June 7,600 12,000 July 8,100 12,460

(a) Compute the variable‐cost and fixed‐cost elements using the high‐low method.

(b) Estimate the total cost if the company produces 8,000 units.

Action Plan

Determine the highest and lowest levels of activity.

Compute variable cost per unit as Change in total costs÷(High−low activity level)=Variable cost per unitChange in total costs÷(High−low activity level)=Variable cost per unit.

Compute fixed cost as Total cost−(Variable cost per unit×Units produced)=Fixed costTotal cost−(Variable cost per unit×Units produced)=Fixed cost.

SOLUTION

(a) Variable cost: (\$14,740−\$11,100)÷(9,800−7,000)=\$1.30 per unit(\$14,740−\$11,100)÷(9,800−7,000)=\$1.30 per unit

Fixed cost: \$14,740−\$12,740*=\$2,000\$14,740−\$12,740*=\$2,000 or \$11,100−\$9,100**=\$2,000\$11,100−\$9,100**=\$2,000

* \$1.30×9,800 units\$1.30×9,800 units

** \$1.30×7,000 units\$1.30×7,000 units

(b) Total cost to produce 8,000 units: \$2,000+\$10,400 (\$1.30×8,000 units)=\$12,400\$2,000+\$10,400 (\$1.30×8,000 units)=\$12,400

Related exercise material: BE18-3, BE18-4, BE18-5, E18-3, E18-5, and DO IT! 18-2.

LEARNING OBJECTIVE 3

Prepare a CVP income statement to determine contribution margin.

Cost‐volume‐profit (CVP) analysis  is the study of the effects of changes in costs and volume on a company’s profits. CVP analysis is important in profit planning. It also is a critical factor in such management decisions as setting selling prices, determining product mix, and maximizing use of production facilities.

BASIC COMPONENTS

CVP analysis considers the interrelationships among the components shown in Illustration 18-10.

ILLUSTRATION 18-10 Components of CVP analysis

The following assumptions underlie each CVP analysis.

1. The behavior of both costs and revenues is linear throughout the relevant range of the activity index.

2. Costs can be classified accurately as either variable or fixed.

3. Changes in activity are the only factors that affect costs.

4. All units produced are sold.

5. When more than one type of product is sold, the sales mix will remain constant. That is, the percentage that each product represents of total sales will stay the same. Sales mix complicates CVP analysis because different products will have different cost relationships. In this chapter, we assume a single product. In Chapter 19, however, we examine the sales mix more closely.

When these assumptions are not valid, the CVP analysis may be inaccurate.

CVP INCOME STATEMENT

Because CVP is so important for decision‐making, management often wants this information reported in a  cost‐volume‐profit (CVP) income statement  format for internal use. The CVP income statement classifies costs as variable or fixed and computes a contribution margin.  Contribution margin (CM)  is the amount of revenue remaining after deducting variable costs. It is often stated both as a total amount and on a per unit basis.

We will use Vargo Video Company to illustrate a CVP income statement. Vargo Video produces a high‐definition digital camcorder with 15× optical zoom and a wide‐screen, high‐resolution LCD monitor. Relevant data for the camcorders sold by this company in June 2017 are as follows.

 Unit selling price of camcorder \$500 Unit variable costs \$300 Total monthly fixed costs \$200,000 Units sold 1,600

ILLUSTRATION 18-11 Assumed selling and cost data for Vargo Video

The CVP income statement for Vargo therefore would be reported as follows.

 VARGO VIDEO COMPANY CVP Income Statement For the Month Ended June 30, 2017 Total Sales (1,600 camcorders) \$ 800,000 Variable costs 480,000 Contribution margin 320,000 Fixed costs 200,000 Net income \$120,000

ILLUSTRATION 18-12 CVP income statement, with net income

A traditional income statement and a CVP income statement both report the same net income of \$120,000. However, a traditional income statement does not classify costs as variable or fixed, and therefore it does not report a contribution margin. In addition, sometimes per unit amounts and percentage of sales amounts are shown in separate columns on a CVP income statement to facilitate CVP analysis. Homework assignments specify which columns to present.

In the applications of CVP analysis that follow, we assume that the term “cost” includes all costs and expenses related to production and sale of the product. That is, cost includes manufacturing costs plus selling and administrative expenses.

DECISION TOOLS

The unit contribution margin indicates by how much every unit sold will increase income.

Unit Contribution Margin

The formula for  unit contribution margin  and the computation for Vargo Video are as follows.

Unit Selling Price−Unit Variable Costs=Unit Contribution Margin\$500−\$300=\$200Unit Selling Price−Unit Variable Costs=Unit Contribution Margin\$500−\$300=\$200

ILLUSTRATION 18-13 Formula for unit contribution margin

Unit contribution margin indicates that for every camcorder sold, the selling price exceeds the variable costs by \$200. Vargo generates \$200 per unit sold to cover fixed costs and contribute to net income. Because Vargo has fixed costs of \$200,000, it must sell 1,000 camcorders (\$200,000÷\$200)(\$200,000÷\$200) to cover its fixed costs.

At the point where total contribution margin exactly equals fixed costs, Vargo will report net income of zero. At this point, referred to as the  break‐even point , total costs (variable plus fixed) exactly equal total revenue. Illustration 18-14 shows Vargo’s CVP income statement at the point where net income equals zero. It shows a contribution margin of \$200,000, and a unit contribution margin of \$200 (\$500−\$300)\$200 (\$500−\$300).

 VARGO VIDEO COMPANY CVP Income Statement For the Month Ended June 30, 2017 Total Per Unit Sales (1,000 camcorders) \$  500,000 \$ 500 Variable costs 300,000 300 Contribution margin 200,000 \$200 Fixed costs 200,000 Net income \$  –0–

ILLUSTRATION 18-14 CVP income statement, with zero net income

It follows that for every camcorder sold above the break‐even point of 1,000 units, net income increases by the amount of the unit contribution margin, \$200. For example, assume that Vargo sold one more camcorder, for a total of 1,001 camcorders sold. In this case, Vargo reports net income of \$200, as shown in Illustration 18-15.

 VARGO VIDEO COMPANY CVP Income Statement For the Month Ended June 30, 2017 Total Per Unit Sales (1,001camcorders) \$500,500 \$500 Variable costs 300,300 300 Contribution margin 200,200 \$200 Fixed costs 200,000 Net income \$    200

ILLUSTRATION 18-15 CVP income statement, with net income and per unit data

Contribution Margin Ratio

Some managers prefer to use a contribution margin ratio in CVP analysis. The contribution margin ratio is the contribution margin expressed as a percentage of sales, as shown in Illustration 18-16.

 VARGO VIDEO COMPANY CVP Income Statement For the Month Ended June 30, 2017 Total Per Unit Sales (1,001 camcorders) \$500,500 100% Variable costs 300,300 60 Contribution margin 200,200 40% Fixed costs 200,000 Net income \$    200

ILLUSTRATION 18-16 CVP income statement, with net income and percent of sales data

DECISION TOOLS

The contribution margin ratio indicates by how much every dollar of sales will increase income.

Alternatively, the  contribution margin ratio  can be determined by dividing the unit contribution margin by the unit selling price. For Vargo Video, the ratio is as follows.

Unit Contribution Margin÷Unit Selling Price=Contribution Margin Ratio\$200÷\$500=40%Unit Contribution Margin÷Unit Selling Price=Contribution Margin Ratio\$200÷\$500=40%

ILLUSTRATION 18-17 Formula for contribution margin ratio

The contribution margin ratio of 40% means that Vargo generates 40 cents of contribution margin with each dollar of sales. That is, \$0.40 of each sales dollar (40%×\$1)(40%×\$1) is available to apply to fixed costs and to contribute to net income.

This expression of contribution margin is very helpful in determining the effect of changes in sales on net income. For example, if Vargo’s sales increase \$100,000, net income will increase \$40,000 (40%×\$100,000)\$40,000 (40%×\$100,000). Thus, by using the contribution margin ratio, managers can quickly determine increases in net income from any change in sales.

We can also see this effect through a CVP income statement. Assume that Vargo’s current sales are \$500,000 and it wants to know the effect of a \$100,000 (200‐unit) increase in sales. Vargo prepares a comparative CVP income statement analysis as follows.

 VARGO VIDEO COMPANY CVP Income Statements For the Month Ended June 30, 2017 No Change With Change Total Per Unit Percent of Sales Total Per Unit Percent of Sales Sales \$ 500,000 \$500 100% \$600,000 \$500 100% Variable costs 300,000 300 60 360,000 300 60 Contribution margin 200,000 \$200 40% 240,000 \$200 40% Fixed costs 200,000 200,000 Net income \$  –0– \$40,000

ILLUSTRATION 18-18 Comparative CVP income statements

The \$40,000 increase in net income can be calculated on either a unit contribution margin basis (200 units×\$200 per unit)(200 units×\$200 per unit) or using the contribution margin ratio times the increase in sales dollars (40%×\$100,000)(40%×\$100,000). Note that the unit contribution margin and contribution margin as a percentage of sales remain unchanged by the increase in sales.

Study these CVP income statements carefully. The concepts presented in these statements are used extensively in this and later chapters.

DO IT! 3

CVP Income Statement

Ampco Industries produces and sells a cell phone‐operated thermostat. Information regarding the costs and sales of thermostats during September 2017 are provided below.

 Unit selling price of thermostat \$85 Unit variable costs \$32 Total monthly fixed costs \$190,000 Units sold 4,000

Prepare a CVP income statement for Ampco Industries for the month of September. Provide per unit values and total values.

Action Plan

Provide a heading with the name of the company, name of statement, and period covered.

Subtract variable costs from sales to determine contribution margin. Subtract fixed costs from contribution margin to determine net income.

Express sales, variable costs and contribution margin on a per unit basis.

SOLUTION

 AMPCO INDUSTRIES CVP Income Statement For the Month Ended September 30, 2017 Total Per Unit Sales \$340,000 \$85 Variable costs 128,000 32 Contribution margin 212,000 \$53 Fixed costs 190,000 Net income \$ 22,000

Related exercise material: BE18-6, BE18-7, E18-7, and DO IT! 18-3.

LEARNING OBJECTIVE 4

Compute the break‐even point using three approaches.

A key relationship in CVP analysis is the level of activity at which total revenues equal total costs (both fixed and variable)—the break‐even point. At this volume of sales, the company will realize no income but will suffer no loss. The process of finding the break‐even point is called break‐even analysis. Knowledge of the break‐even point is useful to management when it considers decisions such as whether to introduce new product lines, change sales prices on established products, or enter new market areas.

The break‐even point can be:

1. Computed from a mathematical equation.

2. Computed by using contribution margin.

3. Derived from a cost‐volume‐profit (CVP) graph.

The break‐even point can be expressed either in sales units or sales dollars.

DECISION TOOLS

Break‐even analysis indicates the amount of sales units or sales dollars that a company needs to cover its costs.

MATHEMATICAL EQUATION

The first line of Illustration 18-19 shows a common equation used for CVP analysis. When net income is set to zero, this equation can be used to calculate the break‐even point.

Required Sales−Variable Costs−Fixed Costs=Net Income\$500Q−\$300Q−\$200,000=\$0Required Sales−Variable Costs−Fixed Costs=Net Income\$500Q−\$300Q−\$200,000=\$0

ILLUSTRATION 18-19 Basic CVP equation

As shown in Illustration 18-14 (page 893), net income equals zero when the contribution margin (sales minus variable costs) is equal to fixed costs.

To reflect this, Illustration 18-20 rewrites the equation with contribution margin (sales minus variable costs) on the left side, and fixed costs and net income on the right. We can compute the break‐even point in units by using unit selling prices and unit variable costs. The computation for Vargo Video is as follows.

 Required Sales−Variable Costs−Fixed Costs=Net Income\$500Q −\$300Q−\$200,000=\$0\$500Q −\$300Q=\$200,000+\$0\$200Q=\$200,000Required Sales−Variable Costs−Fixed Costs=Net Income\$500Q −\$300Q−\$200,000=\$0\$500Q −\$300Q=\$200,000+\$0\$200Q=\$200,000 Q=\$200,000\$200=Fixed CostsUnit Contribution MarginQ=1,000 unitswhereQ=sales volume in units\$500=selling price\$300=variable costs per unit\$200,000=total fixed costsQ=\$200,000\$200=Fixed CostsUnit Contribution MarginQ=1,000 unitswhereQ=sales volume in units\$500=selling price\$300=variable costs per unit\$200,000=total fixed costs

ILLUSTRATION 18-20 Computation of break‐even point in units

Thus, Vargo must sell 1,000 units to break even.

To find the amount of sales dollars required to break even, we multiply the units sold at the break‐even point times the selling price per unit, as shown below.

1,000×\$500=\$500,000 (break‐even sales dollars)1,000×\$500=\$500,000 (break‐even sales dollars)

CONTRIBUTION MARGIN TECHNIQUE

Many managers employ the contribution margin to compute the break‐even point.

Contribution Margin in Units

The final step in Illustration 18-20 divides fixed costs by the unit contribution margin (highlighted in red). Thus, rather than walk through all of the steps of the equation approach, we can simply employ this formula shown in Illustration 18-21.

Fixed Costs÷Unit Contribution Margin=Break-Even Point in Units\$200,000÷\$200=1,000 unitsFixed Costs÷Unit Contribution Margin=Break-Even Point in Units\$200,000÷\$200=1,000 units

ILLUSTRATION 18-21 Formula for break‐even point in units using unit contribution margin

Why does this formula work? The unit contribution margin is the net amount by which each sale exceeds the variable costs per unit. Every sale generates this much money to pay off fixed costs. Consequently, if we divide fixed costs by the unit contribution margin, we know how many units we need to sell to break even.

Contribution Margin Ratio

As we will see in the next chapter, when a company has numerous products, it is not practical to determine the unit contribution margin for each product. In this case, using the contribution margin ratio is very useful for determining the break‐even point in total dollars (rather than units). Recall that the contribution margin ratio is the percentage of each dollar of sales that is available to cover fixed costs and generate net income. Therefore, to determine the sales dollars needed to cover fixed costs, we divide fixed costs by the contribution margin ratio, as shown in Illustration 18-22.

Fixed Costs÷Contribution Margin Ratio=Break-Even Point in Dollars\$200,000÷40%=\$500,000Fixed Costs÷Contribution Margin Ratio=Break-Even Point in Dollars\$200,000÷40%=\$500,000

ILLUSTRATION 18-22 Formula for break‐even point in dollars using contribution margin ratio

To apply this formula to Vargo Video, consider that its 40% contribution margin ratio means that for every dollar sold, it generates 40 cents of contribution margin. The question is, how many dollars of sales does Vargo need in order to generate total contribution margin of \$200,000 to pay off fixed costs? We divide the fixed costs of \$200,000 by the 40 cents of contribution margin generated by each dollar of sales to arrive at \$500,000 (\$200,000÷40%)\$500,000 (\$200,000÷40%). To prove this result, if we generate 40 cents of contribution margin for each dollar of sales, then the total contribution margin generated by \$500,000 in sales is \$200,000 (\$500,000÷40%)\$200,000 (\$500,000÷40%).

SERVICE COMPANY INSIGHT

Flightserve

Charter Flights Offer a Good Deal

Digital Vision/Getty Images

The Internet is wringing inefficiencies out of nearly every industry. While commercial aircraft spend roughly 4,000 hours a year in the air, chartered aircraft are flown only 500 hours annually. That means that they are sitting on the ground—not making any money—about 90% of the time. One company, Flightserve, saw a business opportunity in that fact. For about the same cost as a first‐class ticket, Flightserve matches up executives with charter flights in small “private jets.” The executive gets a more comfortable ride and avoids the hassle of big airports. Flightserve noted that the average charter jet has eight seats. When all eight seats are full, the company has an 80% profit margin. It breaks even at an average of 3.3 full seats per flight.

Source: “Jet Set Go,” The Economist (March 18, 2000), p. 68.

How did Flightserve determine that it would break even with 3.3 seats full per flight? (Go to WileyPLUS for this answer and additional questions.)

GRAPHIC PRESENTATION

An effective way to find the break‐even point is to prepare a break‐even graph. Because this graph also shows costs, volume, and profits, it is referred to as a  cost‐volume‐profit (CVP) graph .

As the CVP graph in Illustration 18-23 shows, sales volume is recorded along the horizontal axis. This axis should extend to the maximum level of expected sales. Both total revenues (sales) and total costs (fixed plus variable) are recorded on the vertical axis.

ILLUSTRATION 18-23 CVP graph

The construction of the graph, using the data for Vargo Video, is as follows.

1. Plot the sales line, starting at the zero activity level. For every camcorder sold, total revenue increases by \$500. For example, at 200 units, sales are \$100,000. At the upper level of activity (1,800 units), sales are \$900,000. The revenue line is assumed to be linear through the full range of activity.

2. Plot the total fixed costs using a horizontal line. For the camcorders, this line is plotted at \$200,000. The fixed costs are the same at every level of activity.

3. Plot the total‐cost line. This starts at the fixed‐cost line at zero activity. It increases by the variable costs at each level of activity. For each camcorder, variable costs are \$300. Thus, at 200 units, total variable costs are \$60,000 (\$300×200)\$60,000 (\$300×200) and the total cost is \$260,000 (\$60,000+\$200,000)\$260,000 (\$60,000+\$200,000). At 1,800 units, total variable costs are \$540,000(\$300×1,800)\$540,000(\$300×1,800) and total cost is \$740,000 (\$540,000+\$200,000)\$740,000 (\$540,000+\$200,000). On the graph, the amount of the variable costs can be derived from the difference between the total‐cost and fixed‐cost lines at each level of activity.

4. Determine the break‐even point from the intersection of the total‐cost line and the sales line. The break‐even point in dollars is found by drawing a horizontal line from the break‐even point to the vertical axis. The break‐even point in units is found by drawing a vertical line from the break‐even point to the horizontal axis. For the camcorders, the break‐even point is \$500,000 of sales, or 1,000 units. At this sales level, Vargo will cover costs but make no profit.

The CVP graph also shows both the net income and net loss areas. Thus, the amount of income or loss at each level of sales can be derived from the sales and total‐cost lines.

A CVP graph is useful because the effects of a change in any element in the CVP analysis can be quickly seen. For example, a 10% increase in selling price will change the location of the sales line. Likewise, the effects on total costs of wage increases can be quickly observed.

DO IT! 4

Break‐Even Analysis

Lombardi Company has a unit selling price of \$400, variable costs per unit of \$240, and fixed costs of \$180,000. Compute the break‐even point in units using (a) a mathematical equation and (b) unit contribution margin.

Action Plan

Apply the formula: Sales−Variable costs−Fixed costs=Net incomeSales−Variable costs−Fixed costs=Net income.

Apply the formula: Fixed costs÷Unit contribution margin=Break‐even point in unitsFixed costs÷Unit contribution margin=Break‐even point in units.

SOLUTION

(a) The equation is \$400Q−\$240Q−\$180,000=\$0;(\$400Q−\$240Q)=\$180,000\$400Q−\$240Q−\$180,000=\$0;(\$400Q−\$240Q)=\$180,000. The break‐even point in units is 1,125.

(b) The unit contribution margin is \$160 (\$400−\$240)\$160 (\$400−\$240). The formula therefore is \$180,000÷\$160\$180,000÷\$160, and the break‐even point in units is 1,125.

Related exercise material: BE18-8, BE18-9, E18-8, E18-9, E18-10, E18-11, E18-12, E18-13, E18-16, and DO IT! 18-4..

LEARNING OBJECTIVE 5

Determine the sales required to earn target net income and determine margin of safety.

TARGET NET INCOME

Rather than simply “breaking even,” management usually sets an income objective often called  target net income . It then determines the sales necessary to achieve this specified level of income. Companies determine the sales necessary to achieve target net income by using one of the three approaches discussed earlier.

Mathematical Equation

We know that at the break‐even point no profit or loss results for the company. By adding an amount for target net income to the same basic equation, we obtain the following formula for determining required sales.

Required Sales−Variable Costs−Fixed Costs=Target Net IncomeRequired Sales−Variable Costs−Fixed Costs=Target Net Income

ILLUSTRATION 18-24 Formula for required sales to meet target net income

Recall that once the break‐even point has been reached so that fixed costs are covered, each additional unit sold increases net income by the amount of the unit contribution margin. We can rewrite the equation with contribution margin (required sales minus variable costs) on the left‐hand side, and fixed costs and target net income on the right. Assuming that target net income is \$120,000 for Vargo Video, the computation of required sales in units is as shown in Illustration 18-25 (page 900).

 Required Sales−Variable Costs−Fixed Costs=Target Net Income\$500Q−\$300Q−\$200,000=\$120,000\$500Q−\$300Q=\$200,000+\$120,000Required Sales−Variable Costs−Fixed Costs=Target Net Income\$500Q−\$300Q−\$200,000=\$120,000\$500Q−\$300Q=\$200,000+\$120,000 \$200Q=\$200,000+120,000Q=\$200,000+120,000\$200=Fixed Costs+Target Net IncomeUnit Contribution MarginQ=1,600whereQ=sales volume\$500=selling price\$300=variable costs per unit\$200,000=total fixed costs\$120,000=target net income\$200Q=\$200,000+120,000Q=\$200,000+120,000\$200=Fixed Costs+Target Net IncomeUnit Contribution MarginQ=1,600whereQ=sales volume\$500=selling price\$300=variable costs per unit\$200,000=total fixed costs\$120,000=target net income

ILLUSTRATION 18-25 Computation of required sales

Vargo must sell 1,600 units to achieve target net income of \$120,000. The sales dollars required to achieve the target net income is found by multiplying the units sold by the unit selling price [(1,600×\$500)=\$800,000][(1,600×\$500)=\$800,000].

Contribution Margin Technique

As in the case of break‐even sales, we can compute in either units or dollars the sales required to meet target net income. The formula to compute required sales in units for Vargo Video using the unit contribution margin can be seen in the final step of the equation approach in Illustration 18-25 (shown in red). We simply divide the sum of fixed costs and target net income by the unit contribution margin. Illustration 18-26 shows this for Vargo.

(Fixed Costs+Target Net Income)÷Unit Contribution Margin=Required Sales in Units(\$200,000+\$120,000)÷\$200=1,600 units(Fixed Costs+Target Net Income)÷Unit Contribution Margin=Required Sales in Units(\$200,000+\$120,000)÷\$200=1,600 units

ILLUSTRATION 18-26 Formula for required sales in units using unit contribution margin

To achieve its desired target net income of \$120,000, Vargo must sell 1,600 camcorders.

The formula to compute the required sales in dollars for Vargo using the contribution margin ratio is shown below.

(Fixed Costs+Target Net Income)÷Contribution Margin Ratio=Required Sales in Dollars(\$200,000+\$120,000)÷40%=\$800,000(Fixed Costs+Target Net Income)÷Contribution Margin Ratio=Required Sales in Dollars(\$200,000+\$120,000)÷40%=\$800,000

ILLUSTRATION 18-27 Formula for required sales in dollars using contribution margin ratio

To achieve its desired target net income of \$120,000, Vargo must generate sales of \$800,000.

Graphic Presentation

We also can use the CVP graph in Illustration 18-23 (on page 898) to find the sales required to meet target net income. In the profit area of the graph, the distance between the sales line and the total‐cost line at any point equals net income. We can find required sales by analyzing the differences between the two lines until the desired net income is found.

For example, suppose Vargo Video sells 1,400 camcorders. Illustration 18-23 shows that a vertical line drawn at 1,400 units intersects the sales line at \$700,000 and the total‐cost line at \$620,000. The difference between the two amounts represents the net income (profit) of \$80,000.

MARGIN OF SAFETY

Margin of safety  is the difference between actual or expected sales and sales at the break‐even point. It measures the “cushion” that a particular level of sales provides. It tells us how far sales could fall before the company begins operating at a loss. The margin of safety is expressed in dollars or as a ratio.

The formula for stating the margin of safety in dollars is actual (or expected) sales minus break‐even sales. Assuming that actual (expected) sales for Vargo Video are \$750,000, the computation is as follows.

Actual (Expected) Sales−Break-Even Sales=Margin of Safety in Dollars\$750,000−\$500,000=\$250,000Actual (Expected) Sales−Break-Even Sales=Margin of Safety in Dollars\$750,000−\$500,000=\$250,000

ILLUSTRATION 18-28 Formula for margin of safety in dollars

Vargo’s margin of safety is \$250,000. Its sales could fall \$250,000 before it operates at a loss.

The margin of safety ratio is the margin of safety in dollars divided by actual (or expected) sales. Illustration 18-29 shows the formula and computation for determining the margin of safety ratio.

Margin of Safety in Dollars÷Actual (Expected) Sales=Margin of Safety Ratio\$250,000÷\$750,000=33%Margin of Safety in Dollars÷Actual (Expected) Sales=Margin of Safety Ratio\$250,000÷\$750,000=33%

ILLUSTRATION 18-29 Formula for margin of safety ratio

This means that the company’s sales could fall by 33% before it operates at a loss.

The higher the dollars or the percentage, the greater the margin of safety. Management continuously evaluates the adequacy of the margin of safety in terms of such factors as the vulnerability of the product to competitive pressures and to downturns in the economy.

SERVICE COMPANY INSIGHT

Rolling Stones

How a Rolling Stones’ Tour Makes Money

Yael/Retna

Computations of break‐even and margin of safety are important for service companies. Consider how the promoter for the Rolling Stones’ tour used the break‐even point and margin of safety. For example, say one outdoor show should bring 70,000 individuals for a gross of \$2.45 million. The promoter guarantees \$1.2 million to the Rolling Stones. In addition, 20% of gross goes to the stadium in which the performance is staged. Add another \$400,000 for other expenses such as ticket takers, parking attendants, advertising, and so on. The promoter also shares in sales of T‐shirts and memorabilia for which the promoter will net over \$7 million during the tour. From a successful Rolling Stones’ tour, the promoter could make \$35 million!

What amount of sales dollars are required for the promoter to break even? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 5

Break‐Even, Margin of Safety, and Target Net Income

Zootsuit Inc. makes travel bags that sell for \$56 each. For the coming year, management expects fixed costs to total \$320,000 and variable costs to be \$42 per unit. Compute the following: (a) break‐even point in dollars using the contribution margin (CM) ratio; (b) the margin of safety and margin of safety ratio assuming actual sales are \$1,382,400; and (c) the sales dollars required to earn net income of \$410,000.

Action Plan

Apply the formula for the break‐even point in dollars.

Apply the formulas for the margin of safety in dollars and the margin of safety ratio.

Apply the formula for the required sales in dollars.

SOLUTION

(a) Contribution margin ratio=[(\$56−\$42)÷\$56]=25%Contribution margin ratio=[(\$56−\$42)÷\$56]=25%

Break‐even sales in dollars=\$320,000÷25%=\$1,280,000Break‐even sales in dollars=\$320,000÷25%=\$1,280,000

(b) Margin of safety=\$1,382,400−\$1,280,000=\$102,400Margin of safety=\$1,382,400−\$1,280,000=\$102,400

Margin of safety ratio=\$102,400÷\$1,382,400=7.4%Margin of safety ratio=\$102,400÷\$1,382,400=7.4%

(c) Required sales in dollars=(\$320,000+\$410,000)÷25%=\$2,920,000Required sales in dollars=(\$320,000+\$410,000)÷25%=\$2,920,000

Related exercise material: BE18-10, BE18-11, BE18-12, E18-14, E18-15, E18-17, and DO IT! 18-5.

USING DECISION TOOLS—AMAZON.COM

Amazon.com faces many situations where it needs to apply the decision tools presented in this chapter, such as calculating the break‐even point to determine a product’s profitability. Amazon’s dominance of the online retail space, selling other company’s products, is well known. But not everyone may realize that Amazon also sells its own private‐label electronics, including USB cables, mice, keyboards, and audio cables, under the brand name AmazonBasics. Assume that Amazon’s management was provided with the following information regarding the production and sales of Bluetooth keyboards for tablet computers.

 Cost Schedules Variable costs Direct labor per keyboard \$ 8.00 Direct materials 4.00 Variable overhead 3.00 Variable cost per keyboard \$15.00 Fixed costs Manufacturing \$ 25,000 Selling 40,000 Administrative 70,000 Total fixed costs \$135,000 Selling price per keyboard \$25.00 Sales, 2017 (20,000 keyboards) \$500,000

INSTRUCTIONS

(Ignore any income tax considerations.)

(a) What is the operating income for 2017?

(b) What is the unit contribution margin for 2017?

(c) What is the break‐even point in units for 2017?

(d) Assume that management set the sales target for the year 2018 at a level of \$550,000 (22,000 keyboards). Amazon’s management believes that to attain the sales target in 2018, the company must incur an additional selling expense of \$10,000 for advertising in 2018, with all other costs remaining constant. What will be the break‐even point in sales dollars for 2018 if the company spends the additional \$10,000?

(e) If the company spends the additional \$10,000 for advertising in 2018, what is the sales level in dollars required to equal 2017 operating income?

SOLUTION

1. (a)

 Sales \$500,000 Less: Variable costs (20,000 keyboards × \$15) 300,000 Fixed costs 135,000 Operating income \$ 65,000

2. (b)

 Selling price per keyboard \$25 Variable cost per keyboard 15 Unit contribution margin \$10

3. (c) Fixed costs÷Unit contribution margin=Break-even point in units: \$135,000÷\$10=13,500 unitsFixed costs÷Unit contribution margin=Break-even point in units: \$135,000÷\$10=13,500 units

4. (d) Fixed costs÷Contribution margin ratio=Break-even point in dollars: \$145,000∗÷40%**=\$362,500Fixed costs÷Contribution margin ratio=Break-even point in dollars: \$145,000*÷40%**=\$362,500

 *Fixed costs \$135,000 Additional advertising expense 10,000 Revised fixed costs \$145,000 **Contribution margin ratio = Unit contribution margin ÷ Unit selling price: 40% = \$10 ÷ \$25

5. (e)Required sales=(Fixed costs+Target net income)÷Contribution margin ratio\$525,000=(\$145,000+\$65,000)÷40%(e) Required sales=(Fixed costs+Target net income)÷Contribution margin ratio\$525,000=(\$145,000+\$65,000)÷40%

REVIEW AND PRACTICE

LEARNING OBJECTIVES REVIEW

1 Explain variable, fixed, and mixed costs and the relevant range. Variable costs are costs that vary in total directly and proportionately with changes in the activity index. Fixed costs are costs that remain the same in total regardless of changes in the activity index.

The relevant range is the range of activity in which a company expects to operate during a year. It is important in CVP analysis because the behavior of costs is assumed to be linear throughout the relevant range.

Mixed costs change in total but not proportionately with changes in the activity level. For purposes of CVP analysis, mixed costs must be classified into their fixed and variable elements.

2 Apply the high‐low method to determine the components of mixed costs. Determine the variable costs per unit by dividing the change in total costs at the highest and lowest levels of activity by the difference in activity at those levels. Then, determine fixed costs by subtracting total variable costs from the amount of total costs at either the highest or lowest level of activity.

3 Prepare a CVP income statement to determine contribution margin. The five components of CVP analysis are (1) volume or level of activity, (2) unit selling prices, (3) variable costs per unit, (4) total fixed costs, and (5) sales mix. Contribution margin is the amount of revenue remaining after deducting variable costs. It is identified in a CVP income statement, which classifies costs as variable or fixed. It can be expressed as a total amount, as a per unit amount, or as a ratio.

4 Compute the break‐even point using three approaches. The break‐even point can be (a) computed from a mathematical equation, (b) computed by using a contribution margin technique, and (c) derived from a CVP graph.

5 Determine the sales required to earn target net income and determine margin of safety. The general formula for required sales is Required sales −Variable costs−Fixed costs=Target net incomeRequired sales −Variable costs−Fixed costs=Target net income. Two other formulas are (1) Required sales in units=(Fixed costs+Target net income)÷Unit contribution marginRequired sales in units=(Fixed costs+Target net income)÷Unit contribution margin, and (2) Required sales in dollars=(Fixed costs+Target net income)÷Contribution margin ratioRequired sales in dollars=(Fixed costs+Target net income)÷Contribution margin ratio.

Margin of safety is the difference between actual or expected sales and sales at the break‐even point. The formulas for margin of safety are (1) Actual (expected) sales−Break‐even sales=Margin of safety in dollarsActual (expected) sales−Break‐even sales=Margin of safety in dollars, and (2) Margin of safety in dollars÷Actual (expected) sales=Margin of safety ratioMargin of safety in dollars÷Actual (expected) sales=Margin of safety ratio.

DECISION TOOLS REVIEW

 DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS What was the contribution toward fixed costs and income from each unit sold? Selling price per unit and variable cost per unit Unit contribution margin=Unit selling price−Unit variable costUnit contribution margin=Unit selling price−Unit variable cost Every unit sold will increase income by the contribution margin. What would be the increase in income as a result of an increase in sales? Unit contribution margin and unit selling price Contribution margin ratio=Unit contribution margin÷Unit selling priceContribution margin ratio=Unit contribution margin÷Unit selling price Every dollar of sales will increase income by the contribution margin ratio. At what amount of sales does a company cover its costs? Unit selling price, unit variable cost, and total fixed costs Break-even point analysis In units: Break-even point=Fixed costsUnit contribution marginBreak-even point=Fixed costsUnit contribution margin In dollars: Break-even point=Fixed costsContribution margin ratioBreak-even point=Fixed costsContribution margin ratio Below the break-even point, the company is unprofitable.

GLOSSARY REVIEW

Activity index  The activity that causes changes in the behavior of costs.

Break-even point  The level of activity at which total revenue equals total costs.

Contribution margin (CM)  The amount of revenue remaining after deducting variable costs.

Contribution margin ratio  The percentage of each dollar of sales that is available to apply to fixed costs and contribute to net income; calculated as unit contribution margin divided by unit selling price.

Cost behavior analysis  The study of how specific costs respond to changes in the level of business activity.

Cost-volume-profit (CVP) analysis  The study of the effects of changes in costs and volume on a company’s profits.

Cost-volume-profit (CVP) graph  A graph showing the relationship between costs, volume, and profits.

Cost-volume-profit (CVP) income statement  A statement for internal use that classifies costs as fixed or variable and reports contribution margin in the body of the statement.

Fixed costs  Costs that remain the same in total regardless of changes in the activity level.

High-low method  A mathematical method that uses the total costs incurred at the high and low levels of activity to classify mixed costs into fixed and variable components.

Margin of safety  The difference between actual or expected sales and sales at the break-even point.

Mixed costs  Costs that contain both a variable- and a fixed-cost element and change in total but not proportionately with changes in the activity level.

Relevant range  The range of the activity index over which the company expects to operate during the year.

Target net income  The income objective set by management.

Unit contribution margin  The amount of revenue remaining per unit after deducting variable costs; calculated as unit selling price minus unit variable costs.

Variable costs  Costs that vary in total directly and proportionately with changes in the activity level.

PRACTICE MULTIPLE-CHOICE QUESTIONS

(LO 1)

1. Variable costs are costs that:

(a) vary in total directly and proportionately with changes in the activity level.

(b) remain the same per unit at every activity level.

(c) Neither of the above.

(d) Both (a) and (b) above.

(LO 1)

2. The relevant range is:

(a) the range of activity in which variable costs will be curvilinear.

(b) the range of activity in which fixed costs will be curvilinear.

(c) the range over which the company expects to operate during a year.

(d) usually from zero to 100% of operating capacity.

(LO 2)

3. Mixed costs consist of a:

(a) variable‐cost element and a fixed‐cost element.

(b) fixed‐cost element and a controllable‐cost element.

(c) relevant‐cost element and a controllable‐cost element.

(d) variable‐cost element and a relevant‐cost element.

(LO 2)

4. Your cell phone service provider offers a plan that is classified as a mixed cost. The cost per month for 1,000 minutes is \$50. If you use 2,000 minutes this month, your cost will be:

(a) \$50.

(b) \$100.

(c) more than \$100.

(d) between \$50 and \$100.

(LO 2)

5. Kendra Corporation’s total utility costs during the past year were \$1,200 during its highest month and \$600 during its lowest month. These costs corresponded with 10,000 units of production during the high month and 2,000 units during the low month. What are the fixed and variable components of its utility costs using the high‐low method?

(a) \$0.075 variable and \$450 fixed.

(b) \$0.120 variable and \$0 fixed.

(c) \$0.300 variable and \$0 fixed.

(d) \$0.060 variable and \$600 fixed.

(LO 3)

6. Which of the following is not involved in CVP analysis?

(a) Sales mix.

(b) Unit selling prices.

(c) Fixed costs per unit.

(d) Volume or level of activity.

(LO 3)

7. When comparing a traditional income statement to a CVP income statement:

(a) net income will always be greater on the traditional statement.

(b) net income will always be less on the traditional statement.

(c) net income will always be identical on both.

(d) net income will be greater or less depending on the sales volume.

(LO 3)

8. Contribution margin:

(a) is revenue remaining after deducting variable costs.

(b) may be expressed as unit contribution margin.

(c) is selling price less cost of goods sold.

(d) Both (a) and (b) above.

(LO 3)

9. Cournot Company sells 100,000 wrenches for \$12 a unit. Fixed costs are \$300,000, and net income is \$200,000. What should be reported as variable expenses in the CVP income statement?

(a) \$700,000.

(b) \$900,000.

(c) \$500,000.

(d) \$1,000,000.

(LO 4)

10. Gossen Company is planning to sell 200,000 pliers for \$4 per unit. The contribution margin ratio is 25%. If Gossen will break even at this level of sales, what are the fixed costs?

(a) \$100,000.

(b) \$160,000.

(c) \$200,000.

(d) \$300,000.

(LO 4)

11. Brownstone Company’s contribution margin ratio is 30%. If Brownstone’s sales revenue is \$100 greater than its break‐even sales in dollars, its net income:

(a) will be \$100.

(b) will be \$70.

(c) will be \$30.

(d) cannot be determined without knowing fixed costs.

(LO 5)

12. The mathematical equation for computing required sales to obtain target net income is Required sales =

(a) Variable costs+Target net incomeVariable costs+Target net income.

(b) Variable costs+Fixed costs+Target net incomeVariable costs+Fixed costs+Target net income.

(c) Fixed costs + Target net incomeFixed costs + Target net income.

(d) No correct answer is given.

(LO 5)

13. Margin of safety is computed as:

(a) Actual sales−Break−even salesActual sales−Break−even sales.

(b) Contribution margin−Fixed costsContribution margin−Fixed costs.

(c) Break‐even sales−Variable costsBreak‐even sales−Variable costs.

(d) Actual sales − Contribution marginActual sales − Contribution margin.

(LO 5)

14. Marshall Company had actual sales of \$600,000 when break‐even sales were \$420,000. What is the margin of safety ratio?

(a) 25%.

(b) 30%.

(c) 331/3%3313%.

(d) 45%.

SOLUTIONS

1. (d) Variable costs vary in total directly and proportionately with changes in the activity level and remain the same per unit at every activity level. Choices (a) and (b) are correct, but (d) is the better and more complete answer. Since (a) and (b) are both true statements, choice (c) is incorrect.

2. (c) The relevant range is the range over which the company expects to operate during a year. The other choices are incorrect because the relevant range is the range over which (a) variable costs are expected to be linear, not curvilinear, and (b) the company expects fixed costs to remain the same. Choice (d) is incorrect because this answer does not specifically define relevant range.

3. (a) Mixed costs consist of a variable‐cost element and a fixed‐cost element, not (b) a controllable‐cost element, (c) a relevant‐cost element or a controllable‐cost element, or (d) a relevant‐cost element.

4. (d) Your cost will include the fixed‐cost component (flat service fee) which does not increase plus the variable cost (usage charge) for the additional 1,000 minutes which will increase your cost to between \$50 and \$100. Therefore, choices (a) \$50, (b) \$100, and (c) more than \$100 are incorrect.

5. (a) Variable is \$0.075 [(\$1,200−\$600)÷(10,000−2,000)]\$0.075 [(\$1,200−\$600)÷(10,000−2,000)] and fixed is \$450 [(\$1,200−(\$0.075×10,000)]\$450 [(\$1,200−(\$0.075×10,000)]. Therefore, choices (b) \$0.120 variable and \$0 fixed, (c) \$0.300 variable and \$0 fixed, and (d) \$0.060 variable and \$600 fixed are incorrect.

6. (c) Total fixed costs, not fixed costs per unit, are involved in CVP analysis. Choices (a) sales mix, (b) unit selling prices, and (d) volume or level of activity are all involved in CVP analysis.

7. (c) Net income will always be identical on both a traditional income statement and a CVP income statement. Therefore, choices (a), (b), and (d) are incorrect statements.

8. (d) Contribution margin is revenue remaining after deducting variable costs and it may be expressed on a per unit basis. Choices (a) and (b) are accurate, but (d) is a better answer. Choice (c) is incorrect because it defines gross margin, not contribution margin.

9. (a) Contribution margin is equal to fixed costs plus net income (\$300,000+\$200,000=\$500,000)(\$300,000+\$200,000=\$500,000). Since variable expenses are the difference between total sales (\$1,200,000) and contribution margin (\$500,000), \$700,000 must be the amount of variable expenses in the CVP income statement. Therefore, choices (b) \$900,000, (c) \$500,000, and (d) \$1,000,000 are incorrect.

10. (c) Unit contribution margin is \$1 (\$4×25%)\$1 (\$4×25%). Fixed costs÷Unit contribution margin=Break‐even point in unitsFixed costs÷Unit contribution margin=Break‐even point in units. Solving for fixed costs, 200,000 units×\$1 per unit=\$200,000200,000 units×\$1 per unit=\$200,000, not (a) \$100,000, (b) \$160,000, or (d) \$300,000.

11. (c) If Brownstone’s sales revenue is \$100 greater than its break‐even sales in dollars, its net income will be \$30 or (\$100×30%)(\$100×30%), not (a) \$100 or (b) \$70. Choice (d) is incorrect because net income can be determined without knowing fixed costs.

12. (b) The correct equation is Required sales=Variable costs+Fixed costs+Target net incomeRequired sales=Variable costs+Fixed costs+Target net income. The other choices are incorrect because (a) needs fixed costs added, (c) needs variable costs added, and (d) there is a correct answer given.

13. (a) Margin of safety is computed as Actual sales−Break‐even salesActual sales−Break‐even sales. Therefore, choices (b) Contribution margin−Fixed costsContribution margin−Fixed costs, (c) Break‐even sales−Variable costsBreak‐even sales−Variable costs, and (d) Actual sales−Contribution marginActual sales−Contribution margin are incorrect.

14. (b) The margin of safety ratio is computed by dividing the margin of safety in dollars of \$180,000 (\$600,000−\$420,000)\$180,000 (\$600,000−\$420,000) by actual sales of \$600,000. The result is 30% (\$180,000÷\$600,000)30% (\$180,000÷\$600,000), not (a) 25%, (c) 331/3%331/3%, or (d) 45%.

PRACTICE EXERCISES

Determine fixed and variable costs using the high‐low method and prepare graph.

(LO 1, 2)

1. The controller of Teton Industries has collected the following monthly expense data for use in analyzing the cost behavior of maintenance costs.

 Month Total  Maintenance Costs Total  Machine Hours January \$2,900 300 February 3,000 400 March 3,600 600 April 4,300 790 May 3,200 500 June 4,500 800

INSTRUCTIONS

(a) Determine the fixed‐cost and variable‐cost components using the high‐low method.

(b) Prepare a graph showing the behavior of maintenance costs, and identify the fixed‐cost and variable‐cost elements. Use 200 unit increments and \$1,000 cost increments.

SOLUTION

1. (a) Maintenance Costs:

\$4,500−\$2,900800−300=\$1,600500=\$3.20\$4,500−\$2,900800−300=\$1,600500=\$3.20 variable cost per machine hour

 800  Machine Hours 300 Machine Hours Total costs \$4,500 \$2,900 Less: Variable costs 800 × \$3.20 2,560 300 × \$3.20 960 Total fixed costs \$1,940 \$1,940

Thus, maintenance costs are \$1,940 per month plus \$3.20 per machine hour.

Determine contribution margin ratio, break‐even point in dollars, and margin of safety.

(LO 3, 4, 5)

2. Zion Seating Co., a manufacturer of chairs, had the following data for 2017:

 Sales 2,400 units Sales price \$40 per unit Variable costs \$15 per unit Fixed costs \$19,500

INSTRUCTIONS

(a) What is the contribution margin ratio?

(b) What is the break‐even point in dollars?

(c) What is the margin of safety in units and dollars?

(d) If the company wishes to increase its total dollar contribution margin by 40% in 2018, by how much will it need to increase its sales if all other factors remain constant?

SOLUTION

2. (a) Contribution margin ratio=Unit contribution margin÷Unit selling price (\$40−\$15)÷\$40=62.5%Contribution margin ratio=Unit contribution margin÷Unit selling price (\$40−\$15)÷\$40=62.5%

(b) Break‐even in dollars: \$19,500÷62.5%=\$31,200\$19,500÷62.5%=\$31,200

(c) Margin of safety=(2,400×\$40)−\$31,200=\$64,800 Margin of safety=(2,400×\$40)−\$31,200=\$64,800

\$64,800÷\$40=1,620 units\$64,800÷\$40=1,620 units

(d) Current contribution margin is \$40−\$15=\$25\$40−\$15=\$25

Total contribution margin is \$25×2,400=\$60,000\$25×2,400=\$60,000

40% increase in contribution margin is \$60,000×40%=\$24,000\$60,000×40%=\$24,000

Total increase in sales required is \$24,000÷62.5%=\$38,400\$24,000÷62.5%=\$38,400

PRACTICE PROBLEM

Compute break‐even point, contribution margin ratio, margin of safety, and sales for target net income.

(LO 4, 5)

Mabo Company makes calculators that sell for \$20 each. For the coming year, management expects fixed costs to total \$220,000 and variable costs to be \$9 per unit.

INSTRUCTIONS

(a) Compute break‐even point in units using the mathematical equation.

(b) Compute break‐even point in dollars using the contribution margin (CM) ratio.

(c) Compute the margin of safety percentage assuming actual sales are \$500,000.

(d) Compute the sales required in dollars to earn net income of \$165,000.

SOLUTION

(a) Required sales−Variable costs−Fixed costs=Net income\$20Q−\$9Q−\$220,000=\$0\$11Q=\$220,000Q=20,000 units(a) Required sales−Variable costs−Fixed costs=Net income\$20Q−\$9Q−\$220,000=\$0\$11Q=\$220,000Q=20,000 units

(b) Unit contribution margin=Unit selling price−Unit variable costs\$11=\$20−\$9Contribution margin ratio=Unit contribution margin÷Unit selling price55%=\$11÷\$20Break-even point in dollars=Fixed costs÷Contribution margin ratio=\$220,000÷55%=\$400,000(b) Unit contribution margin=Unit selling price−Unit variable costs\$11=\$20−\$9Contribution margin ratio=Unit contribution margin÷Unit selling price55%=\$11÷\$20Break-even point in dollars=Fixed costs÷Contribution margin ratio=\$220,000÷55%=\$400,000

(c) Margin of safety=Actual sales−Break-even salesActual sales=\$500,000−\$400,000\$500,000=20%(c) Margin of safety=Actual sales−Break-even salesActual sales=\$500,000−\$400,000\$500,000=20%

(d) Required sales−Variable costs−Fixed costs=Net income\$20Q−\$9Q−\$220,000=\$165,000\$11Q=\$385,000Q=35,000 units(d) Required sales−Variable costs−Fixed costs=Net income\$20Q−\$9Q−\$220,000=\$165,000\$11Q=\$385,000Q=35,000 units

35,000 units×\$20=\$700,000 required sales35,000 units×\$20=\$700,000 required sales

WileyPLUS

Brief Exercises, DO IT! Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

QUESTIONS

1. (a) What is cost behavior analysis?

(b) Why is cost behavior analysis important to management?

2. (a) Scott Winter asks your help in understanding the term “activity index.” Explain the meaning and importance of this term for Scott.

(b) State the two ways that variable costs may be defined.

3. Contrast the effects of changes in the activity level on total fixed costs and on unit fixed costs.

4. J. P. Alexander claims that the relevant range concept is important only for variable costs.

(a) Explain the relevant range concept.

(b) Do you agree with J. P.’s claim? Explain.

5. “The relevant range is indispensable in cost behavior analysis.” Is this true? Why or why not?

6. Adam Antal is confused. He does not understand why rent on his apartment is a fixed cost and rent on a Hertz rental truck is a mixed cost. Explain the difference to Adam.

7. How should mixed costs be classified in CVP analysis? What approach is used to effect the appropriate classification?

8. At the high and low levels of activity during the month, direct labor hours are 90,000 and 40,000, respectively. The related costs are \$165,000 and \$100,000. What are the fixed and variable costs at any level of activity?

9. “Cost‐volume‐profit (CVP) analysis is based entirely on unit costs.” Do you agree? Explain.

10. Faye Dunn defines contribution margin as the amount of profit available to cover operating expenses. Is there any truth in this definition? Discuss.

11. Marshall Company’s GWhiz calculator sells for \$40. Variable costs per unit are estimated to be \$26. What are the unit contribution margin and the contribution margin ratio?

12. “Break‐even analysis is of limited use to management because a company cannot survive by just breaking even.” Do you agree? Explain.

13. Total fixed costs are \$26,000 for Daz Inc. It has a unit contribution margin of \$15, and a contribution margin ratio of 25%. Compute the break‐even sales in dollars.

14. Peggy Turnbull asks your help in constructing a CVP graph. Explain to Peggy (a) how the break‐even point is plotted, and (b) how the level of activity and dollar sales at the break‐even point are determined.

15. Define the term “margin of safety.” If Revere Company expects to sell 1,250 units of its product at \$12 per unit, and break‐even sales for the product are \$13,200, what is the margin of safety ratio?

16. Huang Company’s break‐even sales are \$500,000. Assuming fixed costs are \$180,000, what sales volume is needed to achieve a target net income of \$90,000?

17. The traditional income statement for Pace Company shows sales \$900,000, cost of goods sold \$600,000, and operating expenses \$200,000. Assuming all costs and expenses are 70% variable and 30% fixed, prepare a CVP income statement through contribution margin.

BRIEF EXERCISES

Classify costs as variable, fixed, or mixed.

(LO 1), C

BE18-1 Monthly production costs in Dilts Company for two levels of production are as follows.

 Cost 2,000 Units 4,000 Units Indirect labor \$10,000 \$20,000 Supervisory salaries 5,000 5,000 Maintenance 4,000 6,000

Indicate which costs are variable, fixed, and mixed, and give the reason for each answer.

Diagram the behavior of costs within the relevant range.

(LO 1), AN

BE18-2 For Lodes Company, the relevant range of production is 40–80% of capacity. At 40% of capacity, a variable cost is \$4,000 and a fixed cost is \$6,000. Diagram the behavior of each cost within the relevant range assuming the behavior is linear.

Diagram the behavior of a mixed cost.

(LO 1), AN

BE18-3 For Wesland Company, a mixed cost is \$15,000 plus \$18 per direct labor hour. Diagram the behavior of the cost using increments of 500 hours up to 2,500 hours on the horizontal axis and increments of \$15,000 up to \$60,000 on the vertical axis.

Determine variable‐ and fixed‐cost elements using the high‐low method.

(LO 2), AP

BE18-4 Bruno Company accumulates the following data concerning a mixed cost, using miles as the activity level.

 Miles Driven Total Cost January 8,000 \$14,150 February 7,500 13,500 March 8,500 \$15,000 April 8,200 14,490

Compute the variable‐ and fixed‐cost elements using the high‐low method.

Determine variable‐ and fixed‐cost elements using the high‐low method.

(LO 2), AP

BE18-5 Markowis Corp. has collected the following data concerning its maintenance costs for the past 6 months.

 Units Produced Total Cost July 18,000 \$36,000 August 32,000 48,000 September 36,000 55,000 October 22,000 38,000 November 40,000 74,500 December 38,000 62,000

Compute the variable‐ and fixed‐cost elements using the high‐low method.

Determine missing amounts for contribution margin.

(LO 3), AN

BE18-6 Determine the missing amounts.

 Unit Selling Price Unit Variable Costs Unit Contribution Margin Contribution Margin Ratio 1. \$640 \$352 (a) (b) 2. \$300 (c) \$93 (d) 3. (e) (f) \$325 25%

Prepare CVP income statement.

(LO 3), AP

BE18-7 Russell Inc. had sales of \$2,200,000 for the first quarter of 2017. In making the sales, the company incurred the following costs and expenses.

 Variable Fixed Cost of goods sold \$920,000 \$440,000 Selling expenses 70,000 45,000 Administrative expenses 86,000 98,000

Prepare a CVP income statement for the quarter ended March 31, 2017.

Compute the break‐even point.

(LO 4), AP

BE18-8 Rice Company has a unit selling price of \$520, variable costs per unit of \$286, and fixed costs of \$163,800. Compute the break‐even point in units using (a) the mathematical equation and (b) unit contribution margin.

Compute the break‐even point.

(LO 4), AP

BE18-9 Presto Corp. had total variable costs of \$180,000, total fixed costs of \$110,000, and total revenues of \$300,000. Compute the required sales in dollars to break even.

Compute sales for target net income.

(LO 5), AP

BE18-10 For Flynn Company, variable costs are 70% of sales, and fixed costs are \$195,000. Management’s net income goal is \$75,000. Compute the required sales in dollars needed to achieve management’s target net income of \$75,000. (Use the contribution margin approach.)

Compute the margin of safety and the margin of safety ratio.

(LO 5), AP

BE18-11 For Astoria Company, actual sales are \$1,000,000, and break‐even sales are \$800,000. Compute (a) the margin of safety in dollars and (b) the margin of safety ratio.

Compute the required sales in units for target net income.

(LO 5), AP

BE18-12 Deines Corporation has fixed costs of \$480,000. It has a unit selling price of \$6, unit variable costs of \$4.40, and a target net income of \$1,500,000. Compute the required sales in units to achieve its target net income.

DO IT!

EXERCISES

Classify types of costs.

(LO 1), C

DO IT! 18-1 Amanda Company reports the following total costs at two levels of production.

 5,000 Units 10,000 Units Indirect labor \$ 3,000 \$ 6,000 Property taxes 7,000 7,000 Direct labor 28,000 56,000 Direct materials 22,000 44,000 Depreciation 4,000 4,000 Utilities 5,000 8,000 Maintenance 9,000 11,000

Classify each cost as variable, fixed, or mixed.

Compute costs using high‐low method and estimate total cost.

(LO 2), AP

DO IT! 18-2 Westerville Company accumulates the following data concerning a mixed cost, using units produced as the activity level.

 Units Produced Total Cost March 10,000 \$18,000 April 9,000 16,650 May 10,500 18,580 June 8,800 16,200 July 9,500 17,100

(a) Compute the variable‐ and fixed‐cost elements using the high‐low method.

(b) Estimate the total cost if the company produces 9,200 units.

Prepare CVP income statement.

(LO 3), AP

DO IT! 18-3 Cedar Grove Industries produces and sells a cell phone‐operated home security control. Information regarding the costs and sales of security controls during May 2017 are provided below.

 Unit selling price of security control \$45 Unit variable costs \$22 Total monthly fixed costs \$120,000 Units sold 8,000

Prepare a CVP income statement for Cedar Grove Industries for the month of May. Provide per unit values and total values.

Compute break‐even point in units.

(LO 4), AP

DO IT! 18-4 Snow Cap Company has a unit selling price of \$250, variable costs per unit of \$170, and fixed costs of \$160,000. Compute the break‐even point in units using (a) the mathematical equation and (b) unit contribution margin.

Compute break‐even point, margin of safety ratio, and sales for target net income.

(LO 4, 5), AP

DO IT! 18-5 Presto Company makes radios that sell for \$30 each. For the coming year, management expects fixed costs to total \$220,000 and variable costs to be \$18 per unit.

(a) Compute the break‐even point in dollars using the contribution margin (CM) ratio.

(b) Compute the margin of safety ratio assuming actual sales are \$800,000.

(c) Compute the sales dollars required to earn net income of \$140,000.

EXERCISES

Define and classify variable, fixed, and mixed costs.

(LO 1), C

E18-1 Bonita Company manufactures a single product. Annual production costs incurred in the manufacturing process are shown below for two levels of production.

 Costs Incurred Production in Units 5,000 10,000 Production Costs Total Cost Cost/Unit Total Cost Cost/Unit Direct materials \$8,000 \$1.60 \$16,000 \$1.60 Direct labor 9,500 1.90 19,000 1.90 Utilities 2,000 0.40 3,300 0.33 Rent 4,000 0.80 4,000 0.40 Maintenance 800 0.16 1,400 0.14 Supervisory salaries 1,000 0.20 1,000 0.10

Instructions

(a) Define the terms variable costs, fixed costs, and mixed costs.

(b) Classify each cost above as either variable, fixed, or mixed.

Diagram cost behavior, determine relevant range, and classify costs.

(LO 1), C

E18-2 Shingle Enterprises is considering manufacturing a new product. It projects the cost of direct materials and rent for a range of output as shown below.

 Output in Units Rent Expense Direct Materials 1,000 \$ 5,000 \$ 4,000 2,000 5,000 7,200 3,000 8,000 9,000 4,000 8,000 12,000 5,000 8,000 15,000 6,000 8,000 18,000 7,000 8,000 21,000 8,000 8,000 24,000 9,000 10,000 29,300 10,000 10,000 35,000 11,000 10,000 44,000

Instructions

(a) Diagram the behavior of each cost for output ranging from 1,000 to 11,000 units.

(b) Determine the relevant range of activity for this product.

(c) Calculate the variable costs per unit within the relevant range.

(d) Indicate the fixed cost within the relevant range.

Determine fixed and variable costs using the high‐low method and prepare graph.

(LO 1, 2), AP

E18-3 The controller of Norton Industries has collected the following monthly expense data for use in analyzing the cost behavior of maintenance costs.

 Month Total Maintenance Costs Total Machine Hours January \$2,700 300 February 3,000 350 March 3,600 500 April 4,500 690 May 3,200 400 June 5,500 700

Instructions

(a) Determine the fixed‐ and variable‐cost components using the high‐low method.

(b) Prepare a graph showing the behavior of maintenance costs, and identify the fixed‐ and variable‐cost elements. Use 100‐hour increments and \$1,000 cost increments.

Classify variable, fixed, and mixed costs.

(LO 1), C

E18-4 Family Furniture Corporation incurred the following costs.

1. Wood used in the production of furniture.

2. Fuel used in delivery trucks.

3. Straight‐line depreciation on factory building.

4. Screws used in the production of furniture.

5. Sales staff salaries.

6. Sales commissions.

7. Property taxes.

8. Insurance on buildings.

9. Hourly wages of furniture craftsmen.

10. Salaries of factory supervisors.

11. Utilities expense.

12. Telephone bill.

Instructions

Identify the costs above as variable, fixed, or mixed.

Determine fixed and variable costs using the high‐low method and prepare graph.

(LO 1, 2), AP

E18-5 The controller of Hall Industries has collected the following monthly expense data for use in analyzing the cost behavior of maintenance costs.

 Month Total Maintenance Costs Total Machine Hours January \$2,640 3,500 February 3,000 4,000 March 3,600 6,000 April 4,500 7,900 May 3,200 5,000 June 4,620 8,000

Instructions

(a) Determine the fixed‐ and variable‐cost components using the high‐low method.

(b) Prepare a graph showing the behavior of maintenance costs and identify the fixed‐ and variable‐cost elements. Use 2,000‐hour increments and \$1,000 cost increments.

Determine fixed, variable, and mixed costs.

(LO 1), AP

E18-6 PCB Corporation manufactures a single product. Monthly production costs incurred in the manufacturing process are shown below for the production of 3,000 units. The utilities and maintenance costs are mixed costs. The fixed portions of these costs are \$300 and \$200, respectively.

 Production in Units 3,000 Production Costs Direct materials \$ 7,500 Direct labor 18,000 Utilities 2,100 Property taxes 1,000 Indirect labor 4,500 Supervisory salaries 1,900 Maintenance 1,100 Depreciation 2,400

Instructions

(a) Identify the above costs as variable, fixed, or mixed.

(b) Calculate the expected costs when production is 5,000 units.

Explain assumptions underlying CVP analysis.

(LO 3), K

E18-7 Marty Moser wants Moser Company to use CVP analysis to study the effects of changes in costs and volume on the company. Marty has heard that certain assumptions must be valid in order for CVP analysis to be useful.

Instructions

Prepare a memo to Marty Moser concerning the assumptions that underlie CVP analysis.

Compute break‐even point in units and dollars.

(LO 3, 4), AP

E18-8 All That Blooms provides environmentally friendly lawn services for homeowners. Its operating costs are as follows.

 Depreciation \$1,400 per month Advertising \$200 per month Insurance \$2,000 per month Weed and feed materials \$12 per lawn Direct labor \$10 per lawn Fuel \$2 per lawn

All That Blooms charges \$60 per treatment for the average single‐family lawn.

Instructions

Determine the company’s break‐even point in (a) number of lawns serviced per month and (b) dollars.

Compute break‐even point.

(LO 3, 4), AP

E18-9 The Palmer Acres Inn is trying to determine its break‐even point during its off‐peak season. The inn has 50 rooms that it rents at \$60 a night. Operating costs are as follows.

 Salaries \$5,900 per month Utilities \$1,100 per month Depreciation \$1,000 per month Maintenance \$100 per month Maid service \$14 per room Other costs \$28 per room

Instructions

Determine the inn’s break‐even point in (a) number of rented rooms per month and (b) dollars.

Compute contribution margin and break‐even point.

(LO 3, 4), AP

E18-10 In the month of March, Style Salon services 560 clients at an average price of \$120. During the month, fixed costs were \$21,024 and variable costs were 60% of sales.

Instructions

(a) Determine the contribution margin in dollars, per unit, and as a ratio.

(b) Using the contribution margin technique, compute the break‐even point in dollars and in units.

Compute break‐even point.

(LO 3, 4), AP

E18-11 Spencer Kars provides shuttle service between four hotels near a medical center and an international airport. Spencer Kars uses two 10‐passenger vans to offer 12 round trips per day. A recent month’s activity in the form of a cost‐volume‐profit income statement is shown below.

 Fare revenues (1,500 fares) \$36,000 Variable costs Fuel \$ 5,040 Tolls and parking 3,100 Maintenance 860 9,000 Contribution margin 27,000 Fixed costs Salaries 15,700 Depreciation 1,300 Insurance 1,000 18,000 Net income \$ 9,000

Instructions

(a) Calculate the break‐even point in (1) dollars and (2) number of fares.

(b) Without calculations, determine the contribution margin at the break‐even point.

Compute variable costs per unit, contribution margin ratio, and increase in fixed costs.

(LO 3, 4), AP

E18-12 In 2016, Manhoff Company had a break‐even point of \$350,000 based on a selling price of \$5 per unit and fixed costs of \$112,000. In 2017, the selling price and the variable costs per unit did not change, but the break‐even point increased to \$420,000.

Instructions

(a) Compute the variable costs per unit and the contribution margin ratio for 2016.

(b) Compute the increase in fixed costs for 2017.

Prepare CVP income statements.

(LO 3, 4), AP

E18-13 Billings Company has the following information available for September 2017.

 Unit selling price of video game consoles \$   400 Unit variable costs \$   280 Total fixed costs \$ 54,000 Units sold 600

Instructions

(a) Compute the unit contribution margin.

(b) Prepare a CVP income statement that shows both total and per unit amounts.

(c) Compute Billings’ break‐even point in units.

(d) Prepare a CVP income statement for the break‐even point that shows both total and per unit amounts.

Compute various components to derive target net income under different assumptions.

(LO 4, 5), AP

E18-14 Naylor Company had \$210,000 of net income in 2016 when the selling price per unit was \$150, the variable costs per unit were \$90, and the fixed costs were \$570,000. Management expects per unit data and total fixed costs to remain the same in 2017. The president of Naylor Company is under pressure from stockholders to increase net income by \$52,000 in 2017.

Instructions

(a) Compute the number of units sold in 2016.

(b) Compute the number of units that would have to be sold in 2017 to reach the stockholders’ desired profit level.

(c) Assume that Naylor Company sells the same number of units in 2017 as it did in 2016. What would the selling price have to be in order to reach the stockholders’ desired profit level?

Compute net income under different alternatives.

(LO 5), AP

E18-15 Yams Company reports the following operating results for the month of August: sales \$400,000 (units 5,000), variable costs \$240,000, and fixed costs \$90,000. Management is considering the following independent courses of action to increase net income.

1. Increase selling price by 10% with no change in total variable costs or units sold.

2. Reduce variable costs to 55% of sales.

Instructions

Compute the net income to be earned under each alternative. Which course of action will produce the higher net income?

Prepare a CVP graph and compute break‐even point and margin of safety.

(LO 4, 5), AP

E18-16 Glacial Company estimates that variable costs will be 62.5% of sales, and fixed costs will total \$600,000. The selling price of the product is \$4.

Instructions

(a) Prepare a CVP graph, assuming maximum sales of \$3,200,000. (Note: Use \$400,000 increments for sales and costs and 100,000 increments for units.)

(b) Compute the break‐even point in (1) units and (2) dollars.

(c) Assuming actual sales are \$2 million, compute the margin of safety in (1) dollars and (2) as a ratio.

Determine contribution margin ratio, break‐even point in dollars, and margin of safety.

(LO 3, 4, 5), AP

E18-17 Felde Bucket Co., a manufacturer of rain barrels, had the following data for 2016:

 Sales 2,500 units Sales price \$40 per unit Variable costs \$24 per unit Fixed costs \$19,500

Instructions

(a) What is the contribution margin ratio?

(b) What is the break‐even point in dollars?

(c) What is the margin of safety in dollars and as a ratio?

(d) If the company wishes to increase its total dollar contribution margin by 30% in 2017, by how much will it need to increase its sales if all other factors remain constant?

EXERCISES: SET B AND CHALLENGE EXERCISES

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercises: Set B and Challenge Exercises.

PROBLEMS: SET A

Determine variable and fixed costs, compute break‐even point, prepare a CVP graph, and determine net income.

(LO 1, 2, 3, 4), AN

P18-1A Vin Diesel owns the Fredonia Barber Shop. He employs four barbers and pays each a base rate of \$1,250 per month. One of the barbers serves as the manager and receives an extra \$500 per month. In addition to the base rate, each barber also receives a commission of \$4.50 per haircut.

Other costs are as follows.

 Advertising \$200 per month Rent \$1,100 per month Barber supplies \$0.30 per haircut Utilities \$175 per month plus \$0.20 per haircut Magazines \$25 per month

Vin currently charges \$10 per haircut.

(a) VC \$5

Instructions

(a) Determine the variable costs per haircut and the total monthly fixed costs.

(b) Compute the break‐even point in units and dollars.

(c) Prepare a CVP graph, assuming a maximum of 1,800 haircuts in a month. Use increments of 300 haircuts on the horizontal axis and \$3,000 on the vertical axis.

(d) Determine net income, assuming 1,600 haircuts are given in a month.

Prepare a CVP income statement, compute break‐even point, contribution margin ratio, margin of safety ratio, and sales for target net income.

(LO 3, 4, 5), AN

P18-2A Jorge Company bottles and distributes B‐Lite, a diet soft drink. The beverage is sold for 50 cents per 16‐ounce bottle to retailers, who charge customers 75 cents per bottle. For the year 2017, management estimates the following revenues and costs.

 Sales \$1,800,000 Selling expenses—variable \$70,000 Direct materials 430,000 Selling expenses—fixed 65,000 Direct labor 360,000 Administrative expenses—variable 20,000 Manufacturing overhead—variable 380,000 Administrative expenses—fixed 60,000 Manufacturing overhead—fixed 280,000

Instructions

(a) Prepare a CVP income statement for 2017 based on management’s estimates. (Show column for total amounts only.)

(b) (1) 2,700,000 units

(b) Compute the break‐even point in (1) units and (2) dollars.

(c) Compute the contribution margin ratio and the margin of safety ratio. (Round to nearest full percent.)

(c) CM ratio 30%

(d) Determine the sales dollars required to earn net income of \$180,000.

Compute break‐even point under alternative courses of action.

(LO 4), E

P18-3A Tanek Corp.’s sales slumped badly in 2017. For the first time in its history, it operated at a loss. The company’s income statement showed the following results from selling 500,000 units of product: sales \$2,500,000, total costs and expenses \$2,600,000, and net loss \$100,000. Costs and expenses consisted of the amounts shown below.

 Total Variable Fixed Cost of goods sold \$2,140,000 \$1,590,000 \$550,000 Selling expenses 250,000 92,000 158,000 Administrative expenses 210,000 68,000 142,000 \$2,600,000 \$1,750,000 \$850,000

Management is considering the following independent alternatives for 2018.

1. Increase unit selling price 20% with no change in costs, expenses, and sales volume.

2. Change the compensation of salespersons from fixed annual salaries totaling \$150,000 to total salaries of \$60,000 plus a 5% commission on sales.

Instructions

(a) Compute the break‐even point in dollars for 2017.

(b) Compute the break‐even point in dollars under each of the alternative courses of action. (Round all ratios to nearest full percent.) Which course of action do you recommend?

(b) Alternative 1 \$2,023,810

Compute break‐even point and margin of safety ratio, and prepare a CVP income statement before and after changes in business environment.

(LO 3, 4, 5), E

P18-4A Mary Willis is the advertising manager for Bargain Shoe Store. She is currently working on a major promotional campaign. Her ideas include the installation of a new lighting system and increased display space that will add \$24,000 in fixed costs to the \$270,000 currently spent. In addition, Mary is proposing that a 5% price decrease (\$40 to \$38) will produce a 20% increase in sales volume (20,000 to 24,000). Variable costs will remain at \$24 per pair of shoes. Management is impressed with Mary’s ideas but concerned about the effects that these changes will have on the break‐even point and the margin of safety.

Instructions

(a) Compute the current break‐even point in units, and compare it to the break‐even point in units if Mary’s ideas are used.

(b) Compute the margin of safety ratio for current operations and after Mary’s changes are introduced. (Round to nearest full percent.)

(c) Prepare a CVP income statement for current operations and after Mary’s changes are introduced. (Show column for total amounts only.) Would you make the changes suggested?

(b) Current margin of safety ratio 16%

Compute contribution margin, fixed costs, break‐even point, sales for target net income, and margin of safety ratio.

(LO 3, 4, 5), AN

P18-5A Viejol Corporation has collected the following information after its first year of sales. Sales were \$1,600,000 on 100,000 units, selling expenses \$250,000 (40% variable and 60% fixed), direct materials \$490,000, direct labor \$290,000, administrative expenses \$270,000 (20% variable and 80% fixed), and manufacturing overhead \$380,000 (70% variable and 30% fixed). Top management has asked you to do a CVP analysis so that it can make plans for the coming year. It has projected that unit sales will increase by 10% next year.

Instructions

(a) Compute (1) the contribution margin for the current year and the projected year, and (2) the fixed costs for the current year. (Assume that fixed costs will remain the same in the projected year.)

(b) Compute the break‐even point in units and sales dollars for the current year.

(c) The company has a target net income of \$200,000. What is the required sales in dollars for the company to meet its target?

(d) If the company meets its target net income number, by what percentage could its sales fall before it is operating at a loss? That is, what is its margin of safety ratio?

(b) 120,000 units

Determine contribution margin ratio, break‐even point, and margin of safety.

(LO 1, 3, 5), E

P18-6A Kaiser Industries carries no inventories. Its product is manufactured only when a customer’s order is received. It is then shipped immediately after it is made. For its fiscal year ended October 31, 2017, Kaiser’s break‐even point was \$1.3 million. On sales of \$1.2 million, its income statement showed a gross profit of \$180,000, direct materials cost of \$400,000, and direct labor costs of \$500,000. The contribution margin was \$180,000, and variable manufacturing overhead was \$50,000.

Instructions

(a) Calculate the following:

(1) Variable selling and administrative expenses.

(2) Fixed manufacturing overhead.

(3) Fixed selling and administrative expenses.

(a) (2) \$70,000

(b) Ignoring your answer to part (a), assume that fixed manufacturing overhead was \$100,000 and the fixed selling and administrative expenses were \$80,000. The marketing vice president feels that if the company increased its advertising, sales could be increased by 25%. What is the maximum increased advertising cost the company can incur and still report the same income as before the advertising expenditure?

PROBLEMS: SET B AND SET C

Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problems: Set B and Set C.

CONTINUING PROBLEMS

CURRENT DESIGNS

EXCEL TUTORIAL

CD18 Bill Johnson, sales manager, and Diane Buswell, controller, at Current Designs are beginning to analyze the cost considerations for one of the composite models of the kayak division. They have provided the following production and operational costs necessary to produce one composite kayak.

Bill and Diane have asked you to provide a cost‐volume‐profit analysis, to help them finalize the budget projections for the upcoming year. Bill has informed you that the selling price of the composite kayak will be \$2,000.

Instructions

(a) Calculate variable costs per unit.

(b) Determine the unit contribution margin.

(c) Using the unit contribution margin, determine the break‐even point in units for this product line.

(d) Assume that Current Designs plans to earn \$270,600 on this product line. Using the unit contribution margin, calculate the number of units that need to be sold to achieve this goal.

(e) Based on the most recent sales forecast, Current Designs plans to sell 1,000 units of this model. Using your results from part (c), calculate the margin of safety and the margin of safety ratio.

WATERWAYS

(Note: This is a continuation of the Waterways problem from Chapters 1417.)

WP18 The Vice President for Sales and Marketing at Waterways Corporation is planning for production needs to meet sales demand in the coming year. He is also trying to determine how the company’s profits might be increased in the coming year. This problem asks you to use cost‐volume‐profit concepts to help Waterways understand contribution margins of some of its products and decide whether to mass‐produce any of them.

Go to the book’s companion website, www.wiley.com/college/kimmelto find the remainder of this problem.

EXPAND YOUR | CRITICAL THINKING

DECISION‐MAKING ACROSS THE ORGANIZATION

CT18-1 Creative Ideas Company has decided to introduce a new product. The new product can be manufactured by either a capital‐intensive method or a labor‐intensive method. The manufacturing method will not affect the quality of the product. The estimated manufacturing costs by the two methods are as follows.

 Capital‐Intensive Labor‐Intensive Direct materials \$5 per unit \$5.50 per unit Direct labor \$6 per unit \$8.00 per unit Variable overhead \$3 per unit \$4.50 per unit Fixed manufacturing costs \$2,524,000 \$1,550,000

Creative Ideas’ market research department has recommended an introductory unit sales price of \$32. The incremental selling expenses are estimated to be \$502,000 annually plus \$2 for each unit sold, regardless of manufacturing method.

Instructions

With the class divided into groups, answer the following.

(a) Calculate the estimated break‐even point in annual unit sales of the new product if Creative Ideas Company uses the:

(1) Capital‐intensive manufacturing method.

(2) Labor‐intensive manufacturing method.

(b) Determine the annual unit sales volume at which Creative Ideas Company would be indifferent between the two manufacturing methods.

(c) Explain the circumstance under which Creative Ideas should employ each of the two manufacturing methods.

E

MANAGERIAL ANALYSIS

CT18-2 The condensed income statement for the Peri and Paul partnership for 2017 is as follows.

 PERI AND PAUL COMPANY Income Statement For the Year Ended December 31, 2017 Sales (240,000 units) \$1,200,000 Cost of goods sold 800,000 Gross profit 400,000 Operating expenses Selling \$280,000 Administrative 150,000 430,000 Net loss \$  (30,000)

A cost behavior analysis indicates that 75% of the cost of goods sold are variable, 42% of the selling expenses are variable, and 40% of the administrative expenses are variable.

Instructions

(Round to nearest unit, dollar, and percentage, where necessary. Use the CVP income statement format in computing profits.)

(a) Compute the break‐even point in total sales dollars and in units for 2017.

(b) Peri has proposed a plan to get the partnership “out of the red” and improve its profitability. She feels that the quality of the product could be substantially improved by spending \$0.25 more per unit on better raw materials. The selling price per unit could be increased to only \$5.25 because of competitive pressures. Peri estimates that sales volume will increase by 25%. What effect would Peri’s plan have on the profits and the break‐even point in dollars of the partnership? (Round the contribution margin ratio to two decimal places.)

(c) Paul was a marketing major in college. He believes that sales volume can be increased only by intensive advertising and promotional campaigns. He therefore proposed the following plan as an alternative to Peri’s: (1) increase variable selling expenses to \$0.59 per unit, (2) lower the selling price per unit by \$0.25, and (3) increase fixed selling expenses by \$40,000. Paul quoted an old marketing research report that said that sales volume would increase by 60% if these changes were made. What effect would Paul’s plan have on the profits and the break‐even point in dollars of the partnership?

(d) Which plan should be accepted? Explain your answer.

E

REAL‐WORLD FOCUS

CT18-3 The Coca‐Cola Company hardly needs an introduction. A line taken from the cover of a recent annual report says it all: If you measured time in servings of Coca‐Cola, “a billion Coca‐Cola’s ago was yesterday morning.” On average, every U.S. citizen drinks 363 8‐ounce servings of Coca‐Cola products each year. Coca‐Cola’s primary line of business is the making and selling of syrup to bottlers. These bottlers then sell the finished bottles and cans of Coca‐Cola to the consumer.

In the annual report of Coca‐Cola, the information shown below was provided.

THE COCA‐COLA COMPANY Management Discussion

Our gross margin declined to 61 percent this year from 62 percent in the prior year, primarily due to costs for materials such as sweeteners and packaging.

The increases [in selling expenses] in the last two years were primarily due to higher marketing expenditures in support of our Company’s volume growth.

We measure our sales volume in two ways: (1) gallon shipments of concentrates and syrups and (2) unit cases of finished product (bottles and cans of Coke sold by bottlers).

Instructions

Answer the following questions.

(a) Are sweeteners and packaging a variable cost or a fixed cost? What is the impact on the contribution margin of an increase in the per unit cost of sweeteners or packaging? What are the implications for profitability?

(b) In your opinion, are Coca‐Cola’s marketing expenditures a fixed cost, variable cost, or mixed cost? Give justification for your answer.

(c) Which of the two measures cited for measuring volume represents the activity index as defined in this chapter? Why might Coca‐Cola use two different measures?

C  CT18-4 The May 21, 2010, edition of the Wall Street Journal includes an article by Jeffrey Trachtenberg entitled “E‐Books Rewrite Bookselling.”

Instructions

Read the article and answer the following questions.

(a) What aspect of Barnes and Noble’s current structure puts it at risk if electronic books become a significant portion of book sales?

(b) What was Barnes and Noble’s primary competitive advantage in a “paper book” world? How has this advantage been eliminated by e‐books?

(c) What event do the authors say might eventually be viewed as the big turning point for e‐books?

(d) What amount does Barnes and Noble earn on a \$25 hardcover book? How much would it likely earn on an e‐book version of the same title? What implications does this have for Barnes and Noble versus its competitors?

(e) What two mistakes does the author suggest that Barnes and Noble made that left it ill‐prepared for an e‐book environment?

COMMUNICATION ACTIVITY

CT18-5 Your roommate asks for your help on the following questions about CVP analysis formulas.

(a) How can the mathematical equation for break‐even sales show both sales units and sales dollars?

(b) How do the formulas differ for unit contribution margin and contribution margin ratio?

(c) How can contribution margin be used to determine break‐even sales in units and in dollars?

Instructions

Write a memo to your roommate stating the relevant formulas and answering each question.

E

ETHICS CASE

CT18-6 Scott Bestor is an accountant for Westfield Company. Early this year, Scott made a highly favorable projection of sales and profits over the next 3 years for Westfield’s hot‐selling computer PLEX. As a result of the projections Scott presented to senior management, the company decided to expand production in this area. This decision led to dislocations of some plant personnel who were reassigned to one of the company’s newer plants in another state. However, no one was fired, and in fact the company expanded its workforce slightly.

Unfortunately, Scott rechecked his projection computations a few months later and found that he had made an error that would have reduced his projections substantially. Luckily, sales of PLEX have exceeded projections so far, and management is satisfied with its decision. Scott, however, is not sure what to do. Should he confess his honest mistake and jeopardize his possible promotion? He suspects that no one will catch the error because PLEX sales have exceeded his projections, and it appears that profits will materialize close to his projections.

Instructions

(a) Who are the stakeholders in this situation?

(b) Identify the ethical issues involved in this situation.

(c) What are the possible alternative actions for Scott? What would you do in Scott’s position?

E

CT18-7 Cost‐volume‐profit analysis can also be used in making personal financial decisions. For example, the purchase of a new car is one of your biggest personal expenditures. It is important that you carefully analyze your options.

Suppose that you are considering the purchase of a hybrid vehicle. Let’s assume the following facts. The hybrid will initially cost an additional \$4,500 above the cost of a traditional vehicle. The hybrid will get 40 miles per gallon of gas, and the traditional car will get 30 miles per gallon. Also, assume that the cost of gas is \$3.60 per gallon.

Instructions

Using the facts above, answer the following questions.

(a) What is the variable gasoline cost of going one mile in the hybrid car? What is the variable cost of going one mile in the traditional car?

(b) Using the information in part (a), if “miles” is your unit of measure, what is the “contribution margin” of the hybrid vehicle relative to the traditional vehicle? That is, express the variable cost savings on a per‐mile basis.

(c) How many miles would you have to drive in order to break even on your investment in the hybrid car?

(d) What other factors might you want to consider?

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