8-1 a. In the contribution-margin approach, the break-even point in units is calculated using the following formula:
margin oncontributiunit expenses fixed point even-Break =
b. In the equation approach, the following profit equation is used:
−⎟⎟⎠
⎞×⎜⎜
⎝
⎛−⎟⎟
⎠
⎞×⎜⎜
⎝
⎛ units in volumesales
expense
bleunit varia
units in volumesales
price sales
unit fixed expenses 0 =
This equation is solved for the sales volume in units.
c. In the graphical approach, sales revenue and total expenses are graphed. The break-even point occurs at the intersection of the total revenue and total expense lines.
8-2 The term unit contribution margin refers to the contribution that each unit of sales makes toward covering fixed expenses and earning a profit. The unit contribution margin is defined as the sales price minus the unit variable expense.
8-3 In addition to the break-even point, a CVP graph shows the impact on total expenses, total revenue, and profit when sales volume changes. The graph shows the sales volume required to earn a particular target net profit. The firm's profit and loss areas are also indicated on a CVP graph.
8-4 The safety margin is the amount by which budgeted sales revenue exceeds break-even sales revenue.
8-5 An increase in the fixed expenses of any enterprise will increase its break-even point. In a travel agency, more clients must be served before the fixed expenses are covered by the agency's service fees.
8-6 A decrease in the variable expense per pound of oysters results in an increase in the contribution margin per pound. This will reduce the company's break-even sales volume.
8-7 The president is correct. A price increase results in a higher unit contribution margin. An increase in the unit contribution margin causes the break-even point to decline.
The financial vice president's reasoning is flawed. Even though the break-even point will be lower, the price increase will not necessarily reduce the likelihood of a loss. Customers will probably be less likely to buy the product at a higher price. Thus, the firm may be less likely to meet the lower break-even point (at a high price) than the higher break-even point (at a low price).
8-8 When the sales price and unit variable cost increase by the same amount, the unit contribution margin remains unchanged. Therefore, the firm's break-even point remains the same.
8-9 The fixed annual donation will offset some of the museum's fixed expenses. The reduction in net fixed expenses will reduce the museum's break-even point.
8-10 A profit-volume graph shows the profit to be earned at each level of sales volume.
8-11 The most important assumptions of a cost-volume-profit analysis are as follows:
(a) The behavior of total revenue is linear (straight line) over the relevant range. This behavior implies that the price of the product or service will not change as sales volume varies within the relevant range.
(b) The behavior of total expenses is linear (straight line) over the relevant range. This behavior implies the following more specific assumptions:
(1) Expenses can be categorized as fixed, variable, or semivariable.
(2) Efficiency and productivity are constant.
(c) In multiproduct organizations, the sales mix remains constant over the relevant range.
(d) In manufacturing firms, the inventory levels at the beginning and end of the period are the same.
8-12 Operating managers frequently prefer the contribution income statement because it separates fixed and variable costs. This format makes cost-volume-profit relationships more readily discernible.
8-13 The gross margin is defined as sales revenue minus all variable and fixed manufacturing expenses. The total contribution margin is defined as sales revenue minus all variable expenses, including manufacturing, selling, and administrative expenses.
8-14 East Company, which is highly automated, will have a cost structure dominated by fixed costs. West Company's cost structure will include a larger proportion of variable costs than East Company's cost structure.
A firm's operating leverage factor, at a particular sales volume, is defined as its total contribution margin divided by its net income. Since East Company has proportionately higher fixed costs, it will have a proportionately higher total contribution margin. Therefore, East Company's operating leverage factor will be higher.
8-15 When sales volume increases, Company X will have a higher percentage increase in profit than Company Y. Company X's higher proportion of fixed costs gives the firm a higher operating leverage factor. The company's percentage increase in profit can be found by multiplying the percentage increase in sales volume by the firm's operating leverage factor.
8-16 The sales mix of a multiproduct organization is the relative proportion of sales of its products.
The weighted-average unit contribution margin is the average of the unit contribution margins for a firm's several products, with each product's contribution margin weighted by the relative proportion of that product's sales.
8-17 The car rental agency's sales mix is the relative proportion of its rental business associated with each of the three types of automobiles: subcompact, compact, and full-size. In a multi-product CVP analysis, the sales mix is assumed to be constant over the relevant range of activity.
8-18 Cost-volume-profit analysis shows the effect on profit of changes in expenses, sales prices, and sales mix. A change in the hotel's room rate (price) will change the hotel's unit contribution margin. This contribution-margin change will alter the relationship between volume and profit.
8-19 Budgeting begins with a sales forecast. Cost-volume-profit analysis can be used to determine the profit that will be achieved at the budgeted sales volume. A CVP analysis also shows how profit will change if the sales volume deviates from budgeted sales.
Cost-volume-profit analysis can be used to show the effect on profit when variable or fixed expenses change. The effect on profit of changes in variable or fixed advertising expenses is one factor that management would consider in making a decision about advertising.
8-20 The low-price company must have a larger sales volume than the high-price company. By spreading its fixed expense across a larger sales volume, the low-price firm can afford to charge a lower price and still earn the same profit as the high-price company. Suppose, for example, that companies A and B have the following expenses, sales prices, sales volumes, and profits.
Company A Company B
Sales revenue: 350 units at $10............................................... 100 units at $20............................................... Variable expenses: 350 units at $6................................................. 100 units at $6................................................. Contribution margin ............................................. Fixed expenses..................................................... Profit ......................................................................
$3,500 2,100 $1,400 1,000 $ 400
$2,000 600 $1,400 1,000 $ 400
8-21 The statement makes three assertions, but only two of them are true. Thus the statement is false. A company with an advanced manufacturing environment typically will have a larger proportion of fixed costs in its cost structure. This will result in a higher break-even point and greater operating leverage. However, the firm's higher break-even point will result in a reduced safety margin.
8-22 Activity-based costing (ABC) results in a richer description of an organization's cost behavior and CVP relationships. Costs that are fixed with respect to sales volume may not be fixed with respect to other important cost drivers. An ABC system recognizes these nonvolume cost drivers, whereas a traditional costing system does not.
Revenue 1 $360,000 $120,000 $240,000 $90,000 $150,000 $135,000 a 2 55,000 11,000 44,000 25,000 19,000 31,250b 3 320,000 c 80,000 240,000 60,000 180,000 80,000 4 160,000 130,000 30,000 30,000d -0- 160,000 Explanatory notes for selected items: a$135,000 = $90,000 ÷ (2/3), where 2/3 is the contribution-margin ratio. b$31,250 = $25,000/.80, where .80 is the contribution-margin ratio. cBreak-even sales revenue ................................................................................ $80,000 Fixed expenses.................................................................................................. 60,000 Variable expenses ............................................................................................. $20,000 Therefore, variable expenses are 25 percent of sales revenue. When variable expenses amount to $80,000, sales revenue is $320,000. d$160,000 is the break-even sales revenue, so fixed expenses must be equal to the contribution margin of $30,000 and profit must be zero.
increase percentage incomenet in increase Percentage
= 12% × 4.35 = 52.2%
4. Most operating managers prefer the contribution income statement for answering this
type of question. The contribution format highlights the contribution margin and separates fixed and variable expenses.
EXERCISE 8-29 (30 MINUTES)
Answers will vary on this question, depending on the airline selected as well as the year of the inquiry. In a typical year, most airlines report a breakeven load factor of around 65 percent.
$99,00048,5001$ $99,000 of incomenet target earn torequired volumeSales
=
+=
This means that the shop will need to sell the following volume of each type of bicycle to earn the target net income: High-quality............................................................................ 225 (750 × .30) Medium-quality ...................................................................... 525 (750 × .70)
1. Break-even point in units, using the equation approach: $24X – ($15 + $3)X – $1,800,000 = 0 $6X = $1,800,000 X = $6
$1,800,000
= 300,000 units 2. New projected sales volume = 400,000 × 110% = 440,000 units
Net income = (440,000)($24 – $18) – $1,800,000
= (440,000)($6) – $1,800,000
= $2,640,000 – $1,800,000 = $840,000 3. Target net income = $600,000 (from original problem data) New disk purchase price = $15 × 130% = $19.50 Volume of sales dollars required: Volume of sales dollars required
0$38,400,00
.0625$2,400,000
$24$3 $19.50 $24
$600,000 $1,800,000
ratio margin-oncontributiprofitnet target expenses fixed
PROBLEM 8-37 (30 MINUTES) 1. Unit contribution margin:
Sales price………………………………… $32.00 Less variable costs:
Sales commissions ($32 x 5%)…… $ 1.60 System variable costs……………… 8.00 9.60
Unit contribution margin……………….. $22.40
Break-even point = fixed costs ÷ unit contribution margin = $1,971,200 ÷ $22.40 = 88,000 units
2. Model A is more profitable when sales and production average 184,000 units.
Model A Model B Sales revenue (184,000 units x $32.00)……... $5,888,000 $5,888,000 Less variable costs:
Sales commissions ($5,888,000 x 5%)… $ 294,400 $ 294,400 System variable costs:……………………
184,000 units x $8.00…………………. 1,472,000 184,000 units x $6.40…………………. 1,177,600
Total variable costs……………………….. $1,766,400 $1,472,000 Contribution margin…………………………... $4,121,600 $4,416,000 Less: Annual fixed costs…………………….. 1,971,200 2,227,200 Net income……………………………………… $2,150,400 $2,188,800
3. Annual fixed costs will increase by $180,000 ($900,000 ÷ 5 years) because of
straight-line depreciation associated with the new equipment, to $2,407,200 ($2,227,200 + $180,000). The unit contribution margin is $24 ($4,416,000 ÷ 184,000 units). Thus:
Required sales = (fixed costs + target net profit) ÷ unit contribution margin = ($2,407,200 + $1,912,800) ÷ $24 = 180,000 units
4. Let X = volume level at which annual total costs are equal $8.00X + $1,971,200 = $6.40X + $2,227,200 $1.60X = $256,000 X = 160,000 units
Loss of contribution margin at Mall Store ...................................................... $(108,000) Savings of fixed cost at Mall Store (75%) ....................................................... 90,000 Loss of contribution margin at Downtown Store (10%) ................................ (14,400) Total decrease in operating income................................................................ $ (32,400)
2. Promotional campaign:
Increase in contribution margin (10%)............................................................ $10,800 Increase in monthly promotional expenses ($180,000/12)............................ (15,000) Decrease in operating income ......................................................................... $(4,200)
3. Elimination of items sold at their variable cost:
We can restate the November 20x4 data for the Mall Store as follows: Mall Store Items Sold at
Their Variable Cost
Other Items Sales .................................................................................... $180,000* $180,000* Less: variable expenses .................................................... 180,000 72,000 Contribution margin ........................................................... $ -0- $108,000 If the items sold at their variable cost are eliminated, we have: Decrease in contribution margin on other items (20%)............................... $(21,600) Decrease in fixed expenses (15%)................................................................. 18,000 Decrease in operating income ....................................................................... $ (3,600)
*$180,000 is one half of the Mall Store's dollar sales for November 20x4.
PROBLEM 8-39 (40 MINUTES) 1. Sales mix refers to the relative proportion of each product sold when a company
sells more than one product. 2. (a) Yes. Plan A sales are expected to total 65,000 units (19,500 + 45,500), which
compares favorably against current sales of 60,000 units.
(b) Yes. Sales personnel earn a commission based on gross dollar sales. As the following figures show, Cold King sales will comprise a greater proportion of total sales under Plan A. This is not surprising in light of the fact that Cold King has a higher selling price than Mister Ice Cream ($43 vs. $37).
PROBLEM 8-39 (CONTINUED) (d) No. The company would be less profitable under the new plan.
Current Plan A Sales revenue:
Mister Ice Cream: 21,000 units x $37; 19,500 units x $37.............. $ 777,000 $ 721,500 Cold King: 39,000 units x $43; 45,500 units x $43.......................... 1,677,000 1,956,500
Total revenue ............................................................................... $2,454,000 $2,678,000 Less variable cost:
Mister Ice Cream: 21,000 units x $20.50; 19,500 units x $20.50.... $ 430,500 $ 399,750 Cold King: 39,000 units x $32.50; 45,500 units x $32.50................ 1,267,500 1,478,750 Sales commissions (10% of sales revenue) ................................... 267,800
Total variable cost ....................................................................... $1,698,000 $2,146,300 Contribution margin................................................................................ $ 756,000 $ 531,700 Less fixed cost (salaries)........................................................................ 200,000 ----___ Net income ............................................................................................... $ 556,000 $ 531,700
3. (a) The total units sold under both plans are the same; however, the sales mix
has shifted under Plan B in favor of the more profitable product as judged by the contribution margin. Cold King has a contribution margin of $10.50 ($43.00 - $32.50), and Mister Ice Cream has a contribution margin of $16.50 ($37.00 - $20.50).
(b) Plan B is more attractive both to the sales force and to the company. Salespeople earn more money under this arrangement ($274,950 vs. $200,000), and the company is more profitable ($641,550 vs. $556,000).
Current Plan B Sales revenue:
Mister Ice Cream: 21,000 units x $37; 39,000 units x $37 ............. $ 777,000 $1,443,000 Cold King: 39,000 units x $43; 26,000 units x $43 ......................... 1,677,000 1,118,000
Total revenue............................................................................... $2,454,000 $2,561,000 Less variable cost:
Mister Ice Cream: 21,000 units x $20.50; 39,000 units x $20.50 ... $ 430,500 $ 799,500 Cold King: 39,000 units x $32.50; 26,000 units x $32.50 ............... 1,267,500 845,000
Total variable cost ...................................................................... $1,698,000 $1,644,500 Contribution margin ............................................................................... $ 756,000 $ 916,500 Less: Sales force compensation:
Flat salaries ....................................................................................... 200,000 Commissions ($916,500 x 30%)....................................................... 274,950
Net income............................................................................................... $ 556,000 $ 641,550
Fixed costs……………………. 2,736,000 3,744,000 Net income……………………………. $ 288,000
CompTronics has a contribution margin of $72 [($4,032,000 - $1,008,000) ÷ 42,000
sets] and desires to increase income to $576,000 ($288,000 x 2). In addition, the current selling price is $96 ($4,032,000 ÷ 42,000 sets). Thus:
Required sales = (fixed costs + target net profit) ÷ unit contribution margin
= ($2,736,000 + $576,000) ÷ $72 = 46,000 sets, or $4,416,000 (46,000 sets x $96) 2. If operations are shifted to Mexico, the new unit contribution margin will be $74.40
($96.00 - $21.60). Thus:
Break-even point = fixed costs ÷ unit contribution margin = $2,380,800 ÷ $74.40
= 32,000 units
3. (a) CompTronics desires to have a 32,000-unit break-even point with a $72 unit contribution margin. Fixed costs must therefore drop by $432,000 ($2,736,000 - $2,304,000), as follows:
Let X = fixed costs X ÷ $72 = 32,000 units X = $2,304,000
(b) As the following calculations show, CompTronics will have to generate a contribution margin of $85.50 to produce a 32,000-unit break-even point. Based on an $96.00 selling price, this means that the company can incur variable costs of only $10.50 per unit. Given the current variable cost of $24.00 ($96.00 - $72.00), a decrease of $13.50 per unit ($24.00 - $10.50) is needed.
Let X = unit contribution margin $2,736,000 ÷ X = 32,000 units X = $85.50
3. The sales price per tub is the same regardless of the type of machine selected. Therefore, the same profit (or loss) will be achieved with the Standard and Super models at the sales volume, X, where the total costs are the same. Model
Variable Cost per Tub
Total Fixed Cost
Standard ..................................................... $2.86 $16,000 Super........................................................... 2.70 22,000
This reasoning leads to the following equation: 16,000 + 2.86X = 22,000 + 2.70X
Rearranging terms yields the following: (2.86 – 2.70)X = 22,000 – 16,000 .16X = 6,000 X = 6,000/.16 X = 37,500
Or, stated slightly differently:
Volume at which both machines produce the same profit
tubs37,500 $.16
$6,000
aldifferenticost variablealdifferenticost fixed
=
=
=
Check: the total cost is the same with either model if 37,500 tubs are sold.
Standard Super Variable cost: Standard, 37,500 × $2.86........................... $107,250 Super, 37,500 × $2.70 ................................ $101,250 Fixed cost: Standard, $16,000 ...................................... 16,000 Super, $22,000............................................ 22,000 Total cost.......................................................... $123,250 $123,250
Since the sales price for popcorn does not depend on the popper model, the sales revenue will be the same under either alternative.
PROBLEM 8-43 (35 MINUTES) 1. Plan A break-even point = fixed costs ÷ unit contribution margin
= $33,000 ÷ $33* = 1,000 units
Plan B break-even point = fixed costs ÷ unit contribution margin = $99,000 ÷ $45**
= 2,200 units
* $120 - [($120 x 10%) + $75] ** $120 - $75
2. Operating leverage refers to the use of fixed costs in an organization’s overall cost structure. An organization that has a relatively high proportion of fixed costs and low proportion of variable costs has a high degree of operating leverage.
Plan A has a higher percentage of variable costs to sales (72.5%) compared to Plan B (62.5%). Plan B’s fixed costs are 13.75% of sales, compared to Plan A’s 4.58%. Operating leverage factor = contribution margin ÷ net income Plan A: $198,000 ÷ $165,000 = 1.2 Plan B: $270,000 ÷ $171,000 = 1.58 (rounded) Plan B has the higher degree of operating leverage. 4 & 5. Calculation of profit at 5,000 units:
Plan A Plan B Sales revenue: 5,000 units x $120………………. $600,000 $600,000 Less variable costs:
Cost of purchasing product: 5,000 units x $75…………………………..
$375,000
$375,000
Sales commissions: $600,000 x 10%……... 60,000 ---- __ Total variable cost……………………….. $435,000 $375,000
PROBLEM 8-43 (CONTINUED) Plan A profitability decrease: $165,000 - $132,000 = $33,000; $33,000 ÷ $165,000 = 20% Plan B profitability decrease: $171,000 - $126,000 = $45,000; $45,000 ÷ $171,000 = 26.3% (rounded)
PneumoTech would experience a larger percentage decrease in income if it adopts Plan B. This situation arises because Plan B has a higher degree of operating leverage. Stated differently, Plan B’s cost structure produces a greater percentage decline in profitability from the drop-off in sales revenue.
Note: The percentage decreases in profitability can be computed by multiplying the percentage decrease in sales revenue by the operating leverage factor. Sales dropped from 6,000 units to 5,000 units, or 16.67%. Thus: Plan A: 16.67% x 1.2 = 20.0% Plan B: 16.67% x 1.58 = 26.3% (rounded)
6. Heavily automated manufacturers have sizable investments in plant and equipment, along with a high percentage of fixed costs in their cost structures. As a result, there is a high degree of operating leverage.
In a severe economic downturn, these firms typically suffer a significant
decrease in profitability. Such firms would be a more risky investment when compared with firms that have a low degree of operating leverage. Of course, when times are good, increases in sales would tend to have a very favorable effect on earnings in a company with high operating leverage.
*Rounded 3. Operating leverage is the extent to which a firm's operations employ fixed operating
costs. The greater the proportion of fixed costs used to produce a product, the greater the degree of operating leverage. Thus, the computer-assisted manufacturing method utilizes a greater degree of operating leverage.
The greater the degree of operating leverage, the greater the change in operating income (loss) relative to a small fluctuation in sales volume. Thus, there is a higher degree of variability in operating income if operating leverage is high.
4. Management should employ the computer-assisted manufacturing method if annual sales are expected to exceed 311,111 units and the labor-intensive manufacturing method if annual sales are not expected to exceed 311,111 units.
5. Zodiac’s management should consider many other business factors other than
operating leverage before selecting a manufacturing method. Among these are: • Variability or uncertainty with respect to demand quantity and selling price.
• The ability to produce and market the new product quickly.
• The ability to discontinue production and marketing of the new product while incurring the least amount of loss.
1. In order to break even, during the first year of operations, 10,220 clients must visit the law office being considered by Steven Clark and his colleagues, as the following calculations show.
$292X = $2,983,960 X = 10,220 clients (rounded) *Revenue calculation:
$60X represents the $60 consultation fee per client. ($4,000 × .2X × .30) represents
the predicted average settlement of $4,000, multiplied by the 20% of the clients whose judgments are expected to be favorable, multiplied by the 30% of the judgment that goes to the firm.
To: Vice President for Manufacturing, Saturn Game Company
From: I.M. Student, Controller
Subject: Activity-Based Costing
The $300,000 cost that has been characterized as fixed is fixed with respect to sales volume. This cost will not increase with increases in sales volume. However, as the activity-based costing analysis demonstrates, these costs are not fixed with respect to other important cost drivers. This is the difference between a traditional costing system and an ABC system. The latter recognizes that costs vary with respect to a variety of cost drivers, not just sales volume.
2. New break-even point if automated manufacturing equipment is installed:
Sales price....................................................................................................... $52 Costs that are variable (with respect to sales volume): Unit variable cost (.8 × $750,000 ÷ 25,000)............................................ 24 Unit contribution margin ............................................................................... $28 Costs that are fixed (with respect to sales volume): Setup (300 setups at $100 per setup)............................................ $ 30,000 Engineering (800 hours at $56 per hour) ...................................... 44,800 Inspection (100 inspections at $90 per inspection)..................... 9,000 General factory overhead............................................................... 332,200 Total............................................................................................ $416,000 Fixed selling and administrative costs ............................................... 60,000 Total costs that are fixed (with respect to sales volume) ........... $476,000
3. Sales (in units) required to show a profit of $280,000: Number of sales units required
to earn target net profit
units 27,000 $28
$280,000 $476,000 margin oncontributiunit
profitnet target cost fixed
=
+=
+=
4. If management adopts the new manufacturing technology: (a) Its break-even point will be higher (17,000 units instead of 15,000 units). (b) The number of sales units required to show a profit of $280,000 will be lower
(27,000 units instead of 29,000 units). (c) These results are typical of situations where firms adopt advanced manufacturing
equipment and practices. The break-even point increases because of the increased fixed costs due to the large investment in equipment. However, at higher levels of sales after fixed costs have been covered, the larger unit contribution margin ($28 instead of $20) earns a profit at a faster rate. This results in the firm needing to sell fewer units to reach a given target profit level.
5. The controller should include the break-even analysis in the report. The Board of Directors needs a complete picture of the financial implications of the proposed equipment acquisition. The break-even point is a relevant piece of information. The controller should accompany the break-even analysis with an explanation as to why the break-even point will increase. It would also be appropriate for the controller to point out in the report that the advanced manufacturing equipment would require fewer sales units at higher volumes in order to achieve a given target profit, as in requirement (3) of this problem.
To withhold the break-even analysis from the controller's report would be a violation of the following ethical standards:
(a) Competence: Prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable information.
(b) Integrity: Communicate unfavorable as well as favorable information and professional judgments or opinions.
(c) Objectivity: Communicate information fairly and objectively. Disclose fully all relevant information that could reasonably be expected to influence an intended user's understanding of the reports, comments, and recommendations presented.
Projected contribution margin (2,100 × $450)........................................ $945,000 Projected fixed costs ................................................................................ 495,000 Projected net income................................................................................ $450,000 3. Projected net income including foreign order: Variable cost per ton = $990,000/1,800 = $550 per ton
Sales price per ton for regular orders = $1,800,000/1,800 = $1,000 per ton
Foreign Order
Regular Sales
Sales in tons...................................................................... 1,500 1,500 Contribution margin per ton: Foreign order ($900 – $550) ....................................... × $350 Regular sales ($1,000 – $550) .................................... × $450 Total contribution margin ................................................ $525,000 $675,000
Contribution margin on foreign order........................................................ $ 525,000 Contribution margin on Regular sales....................................................... 675,000 Total contribution margin............................................................................ $1,200,000 Fixed costs.................................................................................................... 495,000 Net income .................................................................................................... $ 705,000
BUDGETED INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 20X4
Hedge Clippers
Line Trimmers
Leaf Blowers
Total
Unit selling price ............................ $84 $108 $144 Variable manufacturing cost......... $39 $ 36 $ 75 Variable selling cost....................... 15 12 18 Total variable cost.......................... $54 $ 48 $ 93 Contribution margin per unit ........ $30 $ 60 $ 51 Unit sales ........................................ × 50,000 × 50,000 × 100,000 Total contribution margin ......... $1,500,000 $3,000,000 $5,100,000 $9,600,000 Fixed manufacturing overhead..... $6,000,000Fixed selling and
administrative costs..................
1,800,000 Total fixed costs ........................ $7,800,000Income before taxes....................... $1,800,000Income taxes (40%)........................ 720,000Budgeted net income..................... $1,080,000
Variable Fixed Manufacturing .................................................................... $ 10,800 $3,510 Selling and administrative................................................. 3,600 2,880 Interest ................................................................................ 810 Costs from budgeted income statement..................... $ 14,400 $7,200 If the company employs its own sales force: Additional sales force costs ......................................... 3,600 Reduced commissions [(.15 – .10) × $24,000] ............ (1,200) Costs with own sales force............................................... $ 13,200 $10,800 If the company sells through agents: Deduct cost of sales force ............................................ (3,600) Increased commissions [(.225 – .10) × $24,000]......... 3,000 Costs with agents paid increased commissions............ $ 16,200 $7,200
2. To achieve its annual after-tax profit objective, management should select the first
alternative, where the sales price is reduced by $80 and 2,700 units are sold during the remainder of the year. This alternative results in the highest profit and is the only alternative that equals or exceeds the company’s profit objective. Calculations for the three alternatives follow.
2. Net earnings would decrease by $728,000, calculated as follows:
SUSQUEHANNA MEDICAL CENTER COMPUTATION OF LOSS FROM RENTAL OF ADDITIONAL 20 BEDS: PEDIATRICS FOR THE YEAR ENDED JUNE 30, 20X6
Increase in revenue (20 additional beds × 90 days × $360 charge per day) .................................... $ 648,000
Increase in expenses: Variable charges by medical center (20 additional beds × 90 days × $120 per day) ............................................ $ 216,000
Fixed charges by medical center ($3,480,000 ÷ 60 beds = $58,000 per bed) ($58,000 × 20 beds)......................................................................................... 1,160,000
Salaries (20,000 patient-days before additional 20 beds + 20 additional beds × 90 days = 21,800, which does not exceed 22,000 patient-days; therefore, no additional personnel are required) ......................................... -0-
Total increase in expenses...................................................................................... $1,376,000 Net change in earnings from rental of additional 20 beds ................................... $ (728,000)
Check: Sales ..................................................................... $ 20,000,000 Cost of goods sold (60% of sales)..................... 12,000,000 Gross margin ....................................................... $ 8,000,000 Selling and administrative expenses: Commissions................................................. $ 5,000,000 All other expenses (fixed) ............................ 150,000 5,150,000 Income before taxes............................................ $ 2,850,000 Income tax expense (30%).................................. 855,000 Net income ........................................................... $ 1,995,000
4. Sales dollar volume at which Lake Champlain Sporting Goods Company is indifferent:
Let X denote the desired volume of sales.
Since the tax rate is the same regardless of which approach management chooses, we can find X so that the company’s before-tax income is the same under the two alternatives. (In the following equations, the contribution-margin ratios of .35 and .15, respectively, were computed in the preceding two requirements.)
.35X – $525,000 = .15X – $150,000
.20X = $375,000 X = $375,000/.20 X = $1,875,000
Thus, the company will have the same before-tax income under the two alternatives
if the sales volume is $1,875,000.
Check: Alternatives Employ
Sales Personnel
Pay 25%
Commission Sales .............................................................................. $1,875,000 $1,875,000 Cost of goods sold (60% of sales) .............................. 1,125,000 1,125,000 Gross margin ................................................................ $ 750,000 $ 750,000 Selling and administrative expenses: Commissions............................................................ 93,750* 468,750† All other expenses (fixed)........................................ 525,000 150,000 Income before taxes..................................................... $ 131,250 $ 131,250 Income tax expense (30%)........................................... 39,375 39,375 Net income .................................................................... $ 91,875 $ 91,875
CURRENT ISSUES IN MANAGERIAL ACCOUNTING ISSUE 8-56 “PLANES, TRAINS AND POLITICIANS,” BUSINESS WEEK, OCTOBER 7, 2002, P. 49, ALLAN SLOAN.
The break-even point is the volume of operating activity at which revenue and expenses are equal. Amtrak was originally established to provide a public service, namely low-cost transportation. It traditionally had a price structure that depended on tax-base funding to fund fixed infrastructure expenses. It is only in recent years that the government has acted to transition Amtrak to a self-sufficient operation. The airlines, by contrast, were from the outset privately owned, for-profit businesses. However, since the earliest days the airlines have struggled to be profitable; they are now asking for a massive subsidy to offset losses, which have accumulated because of overexpansion, huge debt, high labor costs, and the effects of September 11, 2001, along with other security issues. Now, both these industries should be encouraged to cut costs in order to break even. It is not an impossible mission; Southwest and JetBlue have both successfully achieved this goal.
ISSUE 8-57 “TO REDRESS INDUSTRY BLUES, DELTA TURNS TO SONG,” THE WALL STREET JOURNAL, JAN 29, 2003, P. A3, NICOLE HARRIS; “COSTLY RACE IN THE SKY: SAME ROUTE, SAME PLANE, YET UNITED'S FLIGHT COSTS MORE TO OPERATE THAN JETBLUE'S,” THE WALL STREET JOURNAL, SEPTEMBER 9, 2002, P. B1, SUSAN CAREY.
Labor costs are a significant proportion of any airline’s cost structure. Major airlines, such as United Airlines, have developed very high labor costs because (1) most of their staff belong to labor unions, which have strong wage and benefits negotiation power; and (2) wages tend to be tied to seniority rather than productivity. By comparison, the low cost competitors such as Jet Blue pay their air and ground crews lower wages and benefits. As a result, labor costs account for 47% of revenue at United, but just 25% at Jet Blue, allowing the latter to operated profitably. Another significant source of costs for airlines is ground crews. The larger airlines have pioneered a “hub-and-spoke” model, which allows them to increase passenger loads by funneling all flights through major hubs. By contrast, the low-cost airlines have tended to offer “point-to-point” services, which may offer lower passenger volumes, but also require smaller ground crews. The point-to-point model provides an added cost advantage to the low-cost airlines, allowing them to offer lower prices to customers.
ISSUE 8-58 “IT’S TIME TO CASH IN SOME CHIPS, BIG BLUE”, BUSINESS WEEK, JUNE 3, 2002, P. 43, SPENCER E. ANTE.
The cost structure is the relative proportion of fixed to variable costs. Because semiconductor manufacturing requires capital-intensive, high-technology, equipment, it is characterized by very high fixed costs. In organizations like these, profit is very sensitive to changes in volume. For this reason, analysts are concerned that IBM should be making significant efforts to reduce fixed costs (by shutting down manufacturing lines) rather than making minor adjustments to labor levels.
ISSUE 8-59 "RELIANCE GROUP MAY SEE SHIELD FROM CREDITORS," THE WALL STREET JOURNAL, AUGUST 15, 2000, DEVON SPURGON, GREGORY ZUCKERMAN, AND FRANCINE L. POPE.
Managers apply operating leverage to convert small changes in sales into large changes in a firm’s profitability. Fixed costs are the lever that managers use to take a small increase in sales and obtain a much larger increase in net income. Having a cost structure with relatively high fixed costs provides rewards and risks to a firm. With a high degree of operating leverage, each additional sale decreases the average cost per unit. Each dollar of revenue becomes pure profit once the fixed costs are covered. This is beneficial if sales are increasing; however, the reverse is true if sales are decreasing. With decreasing sales, the fixed costs do not decrease, and profit declines significantly more than revenue.
In the article, high operating leverage was not working to benefit Reliance Group Holdings, Inc. Consequently, its stock rating was downgraded.
ISSUE 8-60 “LEVI WILL CUT 20% OF WORK FORCE, SHUT SIX PLANTS IN RESTRUCTURING,” THE WALL STREET JOURNAL, APRIL 9, 2002, TERI AGINS.
The cost structure is the relative proportion of fixed to variable costs. Outsourcing can lead to lower fixed costs, if it enables a company to divest of fixed assets (such as plant and equipment) or eliminate salaried personnel (such as department supervisors). As fixed costs are reduced, the company moves toward a cost structure with a larger proportion of variable costs.
