ACCOUNTING

19

Cost‐Volume‐Profit Analysis: Additional Issues

 CHAPTER PREVIEW 

As the Feature Story about Whole Foods Market suggests, the relationship between a company's fixed and variable costs can have a huge impact on its profitability. In particular, the trend toward cost structures dominated by fixed costs has significantly increased the volatility of many companies' net income. The purpose of this chapter is to demonstrate additional uses of cost‐volume‐profit analysis in making sound business decisions.

Not Even a Flood Could Stop It

America has a reputation as a country populated with people who won't buy a restaurant meal unless it can be ordered from the driver's seat of a car. Customers want to receive said “meal” 30 seconds later from a drive‐up window and then consume the bagged product while driving one‐handed down an 8‐lane freeway. This is actually a fairly accurate depiction of the restaurant preferences (and eating habits) of one of the authors of this textbook. However, given the success of Whole Foods Market, this certainly cannot be true of all Americans.

Whole Foods Market began humbly in 1978 as a natural‐foods store called SaferWay. (Get it? A play on SafeWay grocery stores.) It was founded in Austin, Texas, by 25 year‐old John Mackey (a self‐described college dropout) and 21 year‐old Renee Lawson Hardy. They financed the first store by borrowing $45,000 from family and friends. The early days were “interesting.” First, John and Renee got kicked out of their apartment for storing grocery products there. No problem—they just moved into the store. They bathed in the store's dishwasher with an attached hose. They did whatever it took to keep their costs down and the store going.

Two years later, John and Renee merged SaferWay with another store to form the first Whole Foods Market. The store's first year was very successful. Well, that is until everything in the store was completely destroyed by Austin's biggest flood in more than 70 years. They lost $400,000 in goods—and they had no insurance. But within 28 days, with tons of volunteer work and understanding creditors and vendors, the store reopened.

Today, Whole Foods operates approximately 270 stores. The size of the average store has actually declined in recent years. While huge stores (up to 80,000 square feet) were successful in a few cities, in most locations the fixed costs of such a large facility made it hard to achieve profit targets. Then, when sales became sluggish during the recession, the company determined that it could reduce its fixed costs, such as rent and utility costs, by reducing its average store size by about 20%. However, with fewer square feet, managers must keep a close eye on the sales mix. They need to be aware of the relative contribution margins of each product line to maximize the profit per square foot while still providing the products its customers want.

Why is a company as successful as Whole Foods so concerned about controlling costs? The answer is that the grocery business runs on very thin margins. So while we doubt that anybody is bathing in the store's dishwashers anymore, Whole Foods is as vigilant about its costs today as it was during its first year of operations.

LEARNING OBJECTIVE 1

Apply basic CVP concepts.

As indicated in  Chapter 18 , cost‐volume‐profit (CVP) analysis is the study of the effects of changes in costs and volume on a company's profit. CVP analysis is important to profit planning. It is also a critical factor in determining product mix, maximizing use of production facilities, and setting selling prices.

BASIC CONCEPTS

Because CVP is so important for decision‐making, management often wants this information reported in a CVP income statement format for internal use. The CVP income statement classifies costs as variable or fixed, and computes a contribution margin.  Contribution margin 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.

Illustration 19-1  presents the CVP income statement for Vargo Video (which was shown in  Illustration 18-12  on page 893). Note that Vargo sold 1,600 camcorders at $500 per unit.

VARGO VIDEO COMPANY CVP Income Statement For the Month Ended June 30, 2017
			Total		Per Unit
	Sales (1,600 camcorders)		$ 800,000		$ 500
	Variable costs		480,000		300
	Contribution margin		320,000		$200
	Fixed costs		200,000
	Net income		$120,000

ILLUSTRATION 19-1 Basic CVP income statement

Companies often prepare detailed CVP income statements. The CVP income statement in  Illustration 19-2  uses the same base information as that presented in  Illustration 19-1  but provides more detailed information (using assumed data) about the composition of expenses.

VARGO VIDEO COMPANY CVP Income Statement For the Month Ended June 30, 2017
		Total		Per Unit
Sales				$ 800,000		$500
Variable expenses
Cost of goods sold		$400,000
Selling expenses		60,000
Administrative expenses		20,000
Total variable expenses				480,000		300
Contribution margin				320,000		$200
Fixed expenses
Cost of goods sold		120,000
Selling expenses		40,000
Administrative expenses		40,000
Total fixed expenses				200,000
Net income				$120,000

ILLUSTRATION 19-2 Detailed CVP income statement

▼ HELPFUL HINT

The appendix to this chapter provides additional discussion of income statements used for decision‐making.

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.

BASIC COMPUTATIONS

Before we introduce additional issues of CVP analysis, let's review some of the basic concepts that you learned in  Chapter 18 , specifically break‐even analysis, target net income, and margin of safety.

Break‐Even Analysis

Vargo Video's CVP income statement ( Illustration 19-2 ) shows that total contribution margin (sales minus variable expenses) is $320,000, and the company's unit contribution margin is $200. Recall that contribution margin can also be expressed in the form of the  contribution margin ratio(contribution margin divided by sales), which in the case of Vargo is 40% ($200÷$500)40% ($200÷$500).

Illustration 19-3  demonstrates how to compute Vargo's break‐even point in units (using unit contribution margin).

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 19-3 Break‐even point in units

Illustration 19-4  shows the computation for the break‐even point in dollars (using contribution margin ratio).

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 19-4 Break‐even point in dollars

When a company is in its early stages of operation, its primary goal is to break even. Failure to break even will lead eventually to financial failure.

Target Net Income

Once a company achieves break‐even, it then sets a sales goal that will generate a target net income. For example, assume that Vargo's management has a target net income of $250,000.  Illustration 19-5  shows the required sales in units to achieve its target net income.

(Fixed Costs+Target Net Income)÷Unit Contribution Margin=Required Sales in Units($200,000+$250,000)÷$200=2,250 units(Fixed Costs+Target Net Income)÷Unit Contribution Margin=Required Sales in Units($200,000+$250,000)÷$200=2,250 units ILLUSTRATION 19-5 Target net income in units

Illustration 19-6  uses the contribution margin ratio to compute the required sales in dollars.

(Fixed Costs+Target Net Income)÷Contribution Margin Ratio=Required Sales in Dollars($200,000+$250,000)÷.40=$1,125,000(Fixed Costs+Target Net Income)÷Contribution Margin Ratio=Required Sales in Dollars($200,000+$250,000)÷.40=$1,125,000 ILLUSTRATION 19-6 Target net income in dollars

In order to achieve net income of $250,000, Vargo has to sell 2,250 camcorders, for a total price of $1,125,000.

Margin of Safety

Another measure managers use to assess profitability is the margin of safety. The  margin of safety tells us  how far sales can drop before the company will be operating at a loss. Managers like to have a sense of how much cushion they have between their current situation and operating at a loss. This can be expressed in dollars or as a ratio. In  Illustration 19-2  (page 924), for example, Vargo reported sales of $800,000. At that sales level, its margin of safety in dollars and as a ratio are as follows.

Actual (Expected) Sales−Break-Even Sales=Margin of Safety in Dollars$800,000−$500,000=$300,000Actual (Expected) Sales−Break-Even Sales=Margin of Safety in Dollars$800,000−$500,000=$300,000 ILLUSTRATION 19-7 Margin of safety in dollars

As shown in  Illustration 19-8 , Vargo's sales could drop by $300,000, or 37.5%, before the company would operate at a loss.

Margin of Safety in Dollars÷Actual (Expected) Sales=Margin of Safety Ratio$300,000÷$800,000=37.5%Margin of Safety in Dollars÷Actual (Expected) Sales=Margin of Safety Ratio$300,000÷$800,000=37.5% ILLUSTRATION 19-8 Margin of safety ratio

CVP AND CHANGES IN THE BUSINESS ENVIRONMENT

To better understand how CVP analysis works, let's look at three independent situations that might occur at Vargo Video. Each case uses the original camcorder sales and cost data, which were as follows.

Unit selling price		$500
Unit variable cost		$300
Total fixed costs		$200,000
Break-even sales		$500,000 or 1,000 units

ILLUSTRATION 19-9 Original camcorder sales and cost data

Case I

A competitor is offering a 10% discount on the selling price of its camcorders. Management must decide whether to offer a similar discount.

Question: What effect will a 10% discount on selling price have on the break‐even point for camcorders?

Answer: A 10% discount on selling price reduces the selling price per unit to $450 [$500 − ($500 × 10%)]. Variable costs per unit remain unchanged at $300. Thus, the unit contribution margin is $150. Assuming no change in fi xed costs, break-even sales are 1,333 units, computed as follows.

Fixed Costs÷Unit Contribution Margin=Break-Even Sales$200,000÷$150=1,333 units (rounded)Fixed Costs÷Unit Contribution Margin=Break-Even Sales$200,000÷$150=1,333 units (rounded) ILLUSTRATION 19-10 Computation of break‐even sales in units

For Vargo, this change requires monthly sales to increase by 333 units, or 33⅓%, in order to break even. In reaching a conclusion about offering a 10% discount to customers, management must determine how likely it is to achieve the increased sales. Also, management should estimate the possible loss of sales if the competitor's discount price is not matched.

Case II

To meet the threat of foreign competition, management invests in new robotic equipment that will lower the amount of direct labor required to make camcorders. The company estimates that total fixed costs will increase 30% and that variable cost per unit will decrease 30%.

Question: What effect will the new equipment have on the sales volume required to break even?

Answer: Total fixed costs become $260,000 [$200,000 + (30% × $200,000)]. The variable cost per unit becomes $210 [$300 − (30% × $300)]. The new break-even point is approximately 897 units, computed as shown in  Illustration 19-11 .

Fixed Costs÷Unit Contribution Margin=Break-Even Sales$260,000÷($500−$210)=897 units (rounded)Fixed Costs÷Unit Contribution Margin=Break-Even Sales$260,000÷($500−$210)=897 units (rounded) ILLUSTRATION 19-11 Computation of break‐even sales in units

These changes appear to be advantageous for Vargo. The break‐even point is reduced by approximately 10%, or 100 units.

Case III

Vargo's principal supplier of raw materials has just announced a price increase. The higher cost is expected to increase the variable cost of camcorders by $25 per unit. Management decides to hold the line on the selling price of the camcorders. It plans a cost‐cutting program that will save $17,500 in fixed costs per month. Vargo is currently realizing monthly net income of $80,000 on sales of 1,400 camcorders.

Question: What increase in units sold will be needed to maintain the same level of net income?

Answer: The variable cost per unit increases to $325 ($300 + $25). Fixed costs are reduced to $182,500 ($200,000 − $17,500). Because of the change in variable cost, the unit contribution margin becomes $175 ($500 − $325). The required number of units sold to achieve the target net income is computed as follows.

(Fixed Costs+Target Net Income)÷Unit Contribution Margin=Required Sales in Units($182,500+$80,000)÷$175=1,500(Fixed Costs+Target Net Income)÷Unit Contribution Margin=Required Sales in Units($182,500+$80,000)÷$175=1,500 ILLUSTRATION 19-12 Computation of required sales

To achieve the required sales, Vargo Video will have to sell 1,500 camcorders, an increase of 100 units. If this does not seem to be a reasonable expectation, management will either have to make further cost reductions or accept less net income if the selling price remains unchanged.

We hope that the concepts reviewed in this section are now familiar to you. We are now ready to examine additional ways that companies use CVP analysis to assess profitability and to help in making effective business decisions.

MANAGEMENT INSIGHT

Amazon.com

Don't Just Look—Buy Something

When analyzing an Internet business such as Amazon.com, analysts closely watch the so‐called “conversion rate.” This rate is calculated by dividing the number of people who actually take action at an Internet site (buy something) by the total number of people who visit the site. Average conversion rates are from 3% to 5%. A rate below 2% is poor, while a rate above 10% is great.

Conversion rates have an obvious effect on the break‐even point. Suppose you spend $10,000 on your site, which then attracts 5,000 visitors. If you get a 2% conversion rate (100 purchases), your site costs $100 per purchase ($10,000÷100)($10,000÷100). A 4% conversion rate lowers your cost to $50 per transaction, and an 8% conversion rate gets you down to $25. Studies show that conversion rates increase if the site has an easy‐to‐use interface, fast‐performing screens, a convenient ordering process, and advertising that is both clever and clear.

Sources: J. William Gurley, “The One Internet Metric That Really Counts,”  Fortune (March 6, 2000), p. 392; and Milind Mody, “Chief Mentor: How Startups Can Win Customers Online,”  Wall Street Journal Online (May 11, 2011).

Besides increasing their conversion rates, what steps can online merchants use to lower their break‐even points? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 1

CVP Analysis

Krisanne Company reports the following operating results for the month of June.

KRISANNE COMPANY CVP Income Statement For the Month Ended June 30, 2017
			Total		Per Unit
	Sales (5,000 units)		$300,000		$60
	Variable costs		180,000		36
	Contribution margin		120,000		$24
	Fixed expenses		100,000
	Net income		$ 20,000

To increase net income, management is considering reducing the selling price by 10%, with no changes to unit variable costs or fixed costs. Management is confident that this change will increase unit sales by 25%.

Using the contribution margin technique, compute the break‐even point in units and dollars and margin of safety in dollars (a) assuming no changes to sales price or costs, and (b) assuming changes to sales price and volume as described above. (c) Comment on your findings.

Action Plan

✓ Apply the formula for the break‐even point in units.

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

✓ Apply the formula for the margin of safety in dollars.

SOLUTION

a. Assuming no changes to sales price or costs:

Break-even point in units = 4,167 units (rounded) ($100,000 ÷ $24)

Break-even point in sales dollars = $250,000 ($100,000 ÷ .40 a )

Margin of safety in dollars = $50,000 ($300,000 − $250,000)

a $24 ÷ $60

b. Assuming changes to sales price and volume:

Break-even point in units = 5,556 units (rounded) ($100,000 ÷ $18 b )

Break-even point in sales dollars = $300,000 ($100,000 ÷ ($18 ÷ $54 c ))

Margin of safety in dollars = $37,500 ($337,500 d  − $300,000)

b $60 − (.10 × $60) − 36 = $18

c $60 − (.10 × $60)

d 5,000 + (.25 × 5,000) = 6,250 units; 6,250 units × $54 = $337,500

c. The increase in the break‐even point and the decrease in the margin of safety indicate that management should not implement the proposed change. The increase in sales volume will result in a contribution margin of $112,500 (6,250×$18)$112,500 (6,250×$18), which is $7,500 less than the current amount.

Related exercise material:  BE19-3, BE19-4, BE19-5, BE19-6, E19-1, E19-2, E19-3, E19-4, E19-5, and  DO IT! 19-1.

LEARNING OBJECTIVE 2

Explain the term sales mix and its effects on break‐even sales.

To this point, our discussion of CVP analysis has assumed that a company sells only one product. However, most companies sell multiple products. When a company sells many products, it is important that management understand its sales mix.

Sales mix  is the relative percentage in which a company sells its multiple products. For example, if 80% of Hewlett Packard's unit sales are printers and the other 20% are PCs, its sales mix is 80% printers to 20% PCs.

Sales mix is important to managers because different products often have substantially different contribution margins. For example, Ford's SUVs and F150 pickup trucks have higher contribution margins compared to its economy cars. Similarly, first‐class tickets sold by United Airlines provide substantially higher contribution margins than coach‐class tickets. Intel's sales of computer chips for netbook computers have increased, but the contribution margin on these chips is lower than for notebook and desktop PCs.

BREAK‐EVEN SALES IN UNITS

Companies can compute break‐even sales for a mix of two or more products by determining the  weighted‐average unit contribution margin of all the products. To illustrate, assume that Vargo Video sells not only camcorders but high‐definition TVs as well. Vargo sells its two products in the following amounts: 1,500 camcorders and 500 TVs. The sales mix, expressed as a percentage of the 2,000 total units sold, is as follows.

Camcorders		TVs
1,500 units ÷ 2,000 units = 75%		500 units ÷ 2,000 units = 25%

ILLUSTRATION 19-13 Sales mix as a percentage of units sold

That is, 75% of the 2,000 units sold are camcorders, and 25% of the 2,000 units sold are TVs.

Illustration 19-14  shows additional information related to Vargo. The unit contribution margin for camcorders is $200, and for TVs it is $500. Vargo’s fixed costs total $275,000.

Unit Data		Camcorders		TVs
Selling price		$500		$1,000
Variable costs		300		500
Contribution margin		$200		$500
Sales mix—units		75%		25%
Fixed costs = $275,000

ILLUSTRATION 19-14 Per unit data—sales mix

To compute break‐even for Vargo, we must determine the weighted‐average unit contribution margin for the two products. We use the  weighted‐average contribution margin because Vargo sells three times as many camcorders as TVs. As a result, in determining an average unit contribution margin, three times as much weight should be placed on the contribution margin of the camcorders as on the TVs. Therefore, the camcorders must be counted three times for every TV sold. The weighted‐average contribution margin for a sales mix of 75% camcorders and 25% TVs is $275, which is computed as follows.

Camcorders¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯TVs¯¯¯¯¯¯¯¯⎛⎜⎝UnitContributionMargin×Sales MixPercentage⎞⎟⎠+⎛⎜⎝UnitContributionMargin×Sales MixPercentage⎞⎟⎠=Weighted-AverageUnit ContributionMargin($200×.75)+($500×.25)=$275Camcorders¯TVs¯(UnitContributionMargin×Sales MixPercentage)+(UnitContributionMargin×Sales MixPercentage)=Weighted-AverageUnit ContributionMargin($200×.75)+($500×.25)=$275

ILLUSTRATION 19-15 Weighted‐average unit contribution margin

Similar to our calculation in the single‐product setting, we can compute the break‐even point in units by dividing the fixed costs by the weighted‐average unit contribution margin of $275. The computation of break‐even sales in units for Vargo Video, assuming $275,000 of fixed costs, is as follows.

DECISION TOOLS 

The break‐even point in units helps managers determine how many units of each product need to be sold to avoid a loss.

Illustration 19-16  shows the break‐even point for Vargo is 1,000 units—camcorders and TVs combined. Management needs to know how many of the 1,000 units sold are camcorders and how many are TVs. Applying the sales mix percentages that we computed previously of 75% for camcorders and 25% for TVs, these 1,000 units would be comprised of 750 camcorders (.75×1,000 units)(.75×1,000 units) and 250 TVs (.25×1,000)(.25×1,000). This can be verified by the computations in  Illustration 19-17 , which shows that the total contribution margin is $275,000 when 1,000 units are sold, which equals the fixed costs of $275,000.

Fixed Costs÷Weighted-Average Unit Contribution Margin=Break-Even Point in Units$275,000÷$275=1,000 unitsFixed Costs÷Weighted-Average Unit Contribution Margin=Break-Even Point in Units$275,000÷$275=1,000 units ILLUSTRATION 19-16 Break‐even point in units

Product		Unit Sales		×		Unit Contribution Margin		=		Total Contribution Margin
Camcorders		750		×		$200		=		$ 150,000
TVs		250		×		500		=		125,000
		1,000								$275,000

ILLUSTRATION 19-17 Break‐even proof—sales units

Management should continually review the company's sales mix. At any level of units sold,  net income will be greater if higher contribution margin units are sold rather than lower contribution margin units. For Vargo, the TVs produce the higher contribution margin. Consequently, if Vargo sells 300 TVs and 700 camcorders, net income would be higher than in the current sales mix even though total units sold are the same.

An analysis of these relationships shows that a shift from low‐margin sales to high‐margin sales may increase net income even though there is a decline in total units sold. Likewise, a shift from high‐ to low‐margin sales may result in a decrease in net income even though there is an increase in total units sold.

BREAK‐EVEN SALES IN DOLLARS

The calculation of the break‐even point presented for Vargo Video in the previous section works well if a company has only a  small number of products. In contrast, consider 3M, the maker of Post‐it Notes, which has more than 30,000 products. In order to calculate the break‐even point for 3M using a weighted‐average unit contribution margin, we would need to calculate 30,000 different unit contribution margins. That is not realistic.

Therefore, for a company with many products, we calculate the break‐even point in terms of sales dollars (rather than units sold), using sales information for divisions or product lines (rather than individual products). This requires that we compute both sales mix as a percentage of total dollar sales (rather than units sold) and the contribution margin ratio (rather than unit contribution margin).

To illustrate, suppose that Kale Garden Supply Company has two divisions—Indoor Plants and Outdoor Plants. Each division has hundreds of different types of plants and plant‐care products.  Illustration 19-18  provides information necessary for determining the sales mix percentages for the two divisions of Kale Garden Supply.

		Indoor Plant Division			Outdoor Plant Division			Company Total
Sales		$  200,000			$  800,000			$1,000,000
Variable costs		120,000			560,000			680,000
Contribution margin		$   80,000			$  240,000			$  320,000
Sales mix percentage		$  200,000	=.20		$  800,000	=.80
(Division sales ÷ Total sales)		$1,000,000			$1,000,000

ILLUSTRATION 19-18 Cost‐volume‐profit data for Kale Garden Supply

As shown in  Illustration 19-19 , the contribution margin ratio for the combined company is 32%, which is computed by dividing the total contribution margin by total sales.

		Indoor Plant Division		Outdoor Plant Division		Company Total
Contribution margin ratio   (Contribution margin ÷ Sales)		$  80,000$200,000=.40$  80,000$200,000=.40		$240,000$800,000=.30$240,000$800,000=.30		$   320,000$1,000,000=.32$   320,000$1,000,000=.32

ILLUSTRATION 19-19 Contribution margin ratio for each division

It is useful to note that the contribution margin ratio of 32% for the total company is a weighted average of the individual contribution margin ratios of the two divisions (40% and 30%). To illustrate, in  Illustration 19-20  we multiply each division's contribution margin ratio by its sales mix percentage, based on dollar sales, and then total these amounts. The calculation in  Illustration 19-20  is useful because it enables us to determine how the break‐even point changes when the sales mix changes.

Indoor Plant Division		Outdoor Plant Division
(ContributionMargin Ratio(ContributionMargin Ratio	×	Sales MixPercentage)Sales MixPercentage)	+	(ContributionMargin Ratio(ContributionMargin Ratio	×	Sales MixPercentage)Sales MixPercentage)	=	Weighted-AverageContributionMargin RatioWeighted-AverageContributionMargin Ratio
(.40	×	.20)	+	(.30	×	.80)	=	.32

ILLUSTRATION 19-20 Calculation of weighted‐average contribution margin

Kale Garden Supply's break‐even point in dollars is then computed by dividing its fixed costs of $300,000 by the weighted‐average contribution margin ratio of 32%, as shown in  Illustration 19-21  (page 932).

Fixed Costs÷Weighted-Average Contribution Margin Ratio=Break-Even Point in Dollars$300,000÷.32=$937,500Fixed Costs÷Weighted-Average Contribution Margin Ratio=Break-Even Point in Dollars$300,000÷.32=$937,500 ILLUSTRATION 19-21 Calculation of break‐even point in dollars

The break‐even point is based on the sales mix of 20% to 80%. We can determine the amount of sales contributed by each division by multiplying the sales mix percentage of each division by the total sales figure. Of the company's total break‐even sales of $937,500, a total of $187,500 (.20×$937,500)$187,500 (.20×$937,500) will come from the Indoor Plant Division, and $750,000 (.80×$937,500)$750,000 (.80×$937,500) will come from the Outdoor Plant Division.

DECISION TOOLS 

The break‐even point in dollars helps managers determine the sales dollars required from each division to avoid a loss.

What would be the impact on the break‐even point if a higher percentage of Kale Garden Supply's sales were to come from the Indoor Plant Division? Because the Indoor Plant Division enjoys a higher contribution margin ratio, this change in the sales mix would result in a higher weighted‐average contribution margin ratio and consequently a lower break‐even point in dollars. For example, if the sales mix changes to 50% for the Indoor Plant Division and 50% for the Outdoor Plant Division, the weighted‐average contribution margin ratio would be 35% [(.40×.50)+(.30×.50)]35% [(.40×.50)+(.30×.50)]. The new, lower, break‐even point is $857,143 ($300,000÷.35)$857,143 ($300,000÷.35). The opposite would occur if a higher percentage of sales were expected from the Outdoor Plant Division. As you can see, the information provided using CVP analysis can help managers better understand the impact of sales mix on profitability.

SERVICE COMPANY INSIGHT

Zoom Kitchen

Healthy for You, and Great for the Bottom Line

Zoom Kitchen, a chain of restaurants in the Chicago area, was known for serving sizable portions of meat and potatoes. But the company's management was quite pleased when salad sales increased from 18% of its sales mix to 40%. Why were they pleased? Because the contribution margin on salads was much higher than on meat. The restaurant made a conscious effort to encourage people to buy more salads by offering an interesting assortment of salad ingredients including jicama, beets, marinated mushrooms, grilled tuna, and carved turkey. Management had to be very sensitive to contribution margin as opening up a new Zoom Kitchen restaurant was very costly.

Source: Amy Zuber, “Salad Sales ‘Zoom’ at Meat‐and‐Potatoes Specialist,”  Nation's Restaurant News (November 12, 2001), p. 26.

Why do you suppose restaurants are so eager to sell beverages and desserts? (Go to  WileyPLUS for this answer and additional questions.)

DO IT! 2

Sales Mix Break‐Even

Manzeck Bicycles International produces and sells three different types of mountain bikes. Information regarding the three models is shown below.

		Pro		Intermediate		Standard		Total
Units sold		5,000		10,000		25,000		40,000
Selling price		$800		$500		$350
Variable costs		$500		$300		$250

The company's total fixed costs to produce the bicycles are $7,500,000.

(a) Determine the sales mix as a function of units sold for the three products.

(b) Determine the weighted‐average unit contribution margin.

(c) Determine the total number of units that the company must sell to break even.

(d) Determine the number of units of each model that the company must sell to break even.

Action Plan

✓ The sales mix is the relative percentage of each product sold in units.

✓ The weighted‐average unit contribution margin is the sum of the unit contribution margins multiplied by the respective sales mix percentage.

✓ Determine the break‐even point in units by dividing the fixed costs by the weighted‐average unit contribution margin.

✓ Determine the number of units of each model to sell by multiplying the total break‐even units by the respective sales mix percentage for each product.

SOLUTION

(a) The sales mix percentages as a function of units sold are:

Pro		Intermediate		Standard
5,000/40,000 = 12.5%		10,000/40,000 = 25%		25,000/40,000 = 62.5%

(b) The weighted‐average unit contribution margin is:

[.125×($800−$500)]+[.25×($500−$300)]+[.625×($350−$250)]=$150[.125×($800−$500)]+[.25×($500−$300)]+[.625×($350−$250)]=$150

(c) The break‐even point in units is:

$7,500,000÷$150=50,000 units$7,500,000÷$150=50,000 units

(d) The break‐even units to sell for each product are:

Pro:	50,000 units × 12.5%	=	6,250 units
Intermediate:	50,000 units × 25%	=	12,500 units
Standard:	50,000 units × 62.5%	=	31,250 units
			50,000 units

Related exercise material:  BE19-7, BE19-8, BE19-9, BE19-10, E19-6, E19-7, E19-8, E19-9, E19-10, and  DO IT! 19-2.

LEARNING OBJECTIVE 3

Determine sales mix when a company has limited resources.

In the previous discussion, we assumed a certain sales mix and then determined the break‐even point given that sales mix. We now discuss how limited resources influence the sales‐mix decision.

All companies have resource limitations. The limited resource may be floor space in a retail department store, or raw materials, direct labor hours, or machine capacity in a manufacturing company. When a company has limited resources, management must decide which products to make and sell in order to maximize net income.

DECISION TOOLS 

Determining the contribution margin per unit of limited resource helps managers decide which product should receive any additional capacity of the limited resource.

To illustrate, recall that Vargo Video manufactures camcorders and TVs. The limiting resource is machine capacity, which is 3,600 hours per month. Relevant data consist of the following.

		Camcorders		TVs
Unit contribution margin		$200		$500
Machine hours required per unit		.2		.625

ILLUSTRATION 19-22 Contribution margin and machine hours

The TVs may appear to be more profitable since they have a higher unit contribution margin ($500) than the camcorders ($200). However, the camcorders take fewer machine hours to produce than the TVs. Therefore, it is necessary to find the  contribution margin per unit of limited resource—in this case, contribution margin per machine hour. This is obtained by dividing the unit contribution margin of each product by the number of units of the limited resource required for each product, as shown in  Illustration 19-23 .

▼ HELPFUL HINT

CM alone is not enough to make this decision. The key factor is CM per unit of limited resource.

		Camcorders		TVs
Unit contribution margin (a)		$200		$500
Machine hours required (b)		0.2		0.625
Contribution margin per unit of limited   resource [(a) ÷ (b)]		$1,000		$800

ILLUSTRATION 19-23 Contribution margin per unit of limited resource

The computation shows that the camcorders have a higher contribution margin per unit of limited resource. This would suggest that, given sufficient demand for camcorders, Vargo should shift the sales mix to produce more camcorders or increase machine capacity.

As indicated in  Illustration 19-23 , the constraint for the production of the TVs is the larger number of machine hours needed to produce them. In addressing this problem, we have taken the limited number of machine hours as a given and have attempted to maximize the contribution margin given the constraint. One question that Vargo should ask, however, is whether this constraint can be reduced or eliminated. If Vargo is able to increase machine capacity from 3,600 hours to 4,200 hours, the additional 600 hours could be used to produce either the camcorders or TVs. The total contribution margin under each alternative is found by multiplying the machine hours by the contribution margin per unit of limited resource, as shown below.

		Camcorders		TVs
Machine hours (a)		600		600
Contribution margin per unit of limited resource (b)		$    1,000		$      800
Contribution margin [(a) × (b)]		$600,000		$480,000

ILLUSTRATION 19-24 Incremental analysis—computation of total contribution margin

From this analysis, we can see that to maximize net income, all of the increased capacity should be used to make and sell the camcorders.

Vargo's manufacturing constraint might be due to a bottleneck in production or to poorly trained machine operators. In addition to finding ways to solve those problems, the company should consider other possible solutions, such as outsourcing part of the production, acquiring additional new equipment (discussed in  Chapter 24 ), or striving to eliminate any non–value‐added activities (see  Chapter 17 ). As discussed in  Chapter 14 , this approach to evaluating constraints is referred to as the theory of constraints. The  theory of constraints  is a specific approach used to identify and manage constraints in order to achieve the company's goals. According to this theory, a company must continually identify its constraints and find ways to reduce or eliminate them, where appropriate.

MANAGEMENT INSIGHT

Macy's

Something Smells

When fragrance sales went flat, retailers such as Macy's turned up the heat on fragrance manufacturers. They reduced the amount of floor space devoted to fragrances, leaving fragrance manufacturers fighting each other for the smaller space. The retailer doesn't just choose the fragrance with the highest contribution margin. Instead, it chooses the fragrance with the highest contribution margin per square foot for a given period of time. In this game, a product with a lower contribution margin, but a higher turnover, could well be the winner.

What is the limited resource for a retailer, and what implications does this have for sales mix? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 3

Sales Mix with Limited Resources

Carolina Corporation manufactures and sells three different types of high‐quality sealed ball bearings for mountain bike wheels. The bearings vary in terms of their quality specifications—primarily with respect to their smoothness and roundness. They are referred to as Fine, Extra‐Fine, and Super‐Fine bearings. Machine time is limited. More machine time is required to manufacture the Extra‐Fine and Super‐Fine bearings. Additional information is provided below.

		Product
		Fine		Extra-Fine		Super-Fine
Selling price		$6.00		$10.00		$16.00
Variable costs and expenses		4.00		6.50		11.00
Contribution margin		$2.00		$ 3.50		$ 5.00
Machine hours required		0.02		0.04		0.08

(a) Ignoring the machine time constraint, what strategy would appear optimal?

(b) What is the contribution margin per unit of limited resource for each type of bearing?

(c) If additional machine time could be obtained, how should the additional capacity be used?

Action Plan

✓ Calculate the contribution margin per unit of limited resource for each product.

✓ Apply the formula for the contribution margin per unit of limited resource.

✓ To maximize net income, shift sales mix to the product with the highest contribution margin per unit of limited resource.

SOLUTION

(a) The Super‐Fine bearings have the highest unit contribution margin. Thus, ignoring any manufacturing constraints, it would appear that the company should shift toward production of more Super‐Fine units.

(b) The contribution margin per unit of limited resource (machine hours) is calculated as:

		Fine		Extra-Fine		Super-Fine
Unit contribution marginLimited resource consumed per unitUnit contribution marginLimited resource consumed per unit		$2.02=$100$2.02=$100		$3.5.04=$87.50$3.5.04=$87.50		$5.08=$62.50$5.08=$62.50

(c) The Fine bearings have the highest contribution margin per unit of limited resource even though they have the lowest unit contribution margin. Given the resource constraint, any additional capacity should be used to make Fine bearings.

Related exercise material:  BE19-11, BE19-12, E19-11, E19-12, E19-13, and  DO IT! 19-3.

LEARNING OBJECTIVE 4

Indicate how operating leverage affects profitability.

Cost structure  refers to the relative proportion of fixed versus variable costs that a company incurs. Cost structure can have a significant effect on profitability. For example, computer equipment manufacturer Cisco Systems has substantially reduced its fixed costs by choosing to outsource much of its production. By minimizing its fixed costs, Cisco is now less susceptible to economic swings. However, as the following discussion shows, its reduced reliance on fixed costs has also reduced its ability to experience the incredible profitability that it used to have during economic booms.

The choice of cost structure should be carefully considered. There are many ways that companies can influence their cost structure. For example, by acquiring sophisticated robotic equipment, many companies have reduced their use of manual labor. Similarly, some brokerage firms, such as E*Trade, have reduced their reliance on human brokers and have instead invested heavily in computers and online technology. In so doing, they have increased their reliance on fixed costs (through depreciation on the robotic equipment or computer equipment) and reduced their reliance on variable costs (the variable employee labor cost). Alternatively, some companies have reduced their fixed costs and increased their variable costs by outsourcing their production. Nike, for example, does very little manufacturing but instead outsources the manufacture of nearly all of its shoes. It has consequently converted many of its fixed costs into variable costs and therefore changed its cost structure.

Consider the following example of Vargo Video and one of its competitors, New Wave Company. Both make camcorders. Vargo uses a traditional, labor‐intensive manufacturing process. New Wave has invested in a completely automated system. The factory employees are involved only in setting up, adjusting, and maintaining the machinery.  Illustration 19-25  shows CVP income statements for each company.

		Vargo Video		New Wave Company
Sales		$800,000		$800,000
Variable costs		480,000		160,000
Contribution margin		320,000		640,000
Fixed costs		200,000		520,000
Net income		$120,000		$120,000

ILLUSTRATION 19-25 CVP income statements for two companies

Both companies have the same sales and the same net income. However, because of the differences in their cost structures, they differ greatly in the risks and rewards related to increasing or decreasing sales. Let's evaluate the impact of cost structure on the profitability of the two companies.

EFFECT ON CONTRIBUTION MARGIN RATIO

First let's look at the contribution margin ratio.  Illustration 19-26  shows the computation of the contribution margin ratio for each company.

Contribution Margin÷Sales=Contribution Margin RatioVargo Video$320,000÷$800,000=.40New Wave$640,000÷$800,000=.80Contribution Margin÷Sales=Contribution Margin RatioVargo Video$320,000÷$800,000=.40New Wave$640,000÷$800,000=.80 ILLUSTRATION 19-26 Contribution margin ratio for two companies

Because of its lower variable costs, New Wave has a contribution margin ratio of 80% versus only 40% for Vargo Video. That means that with every dollar of sales, New Wave generates 80 cents of contribution margin (and thus an 80‐cent increase in net income), versus only 40 cents for Vargo. However, it also means that for every dollar that sales decline, New Wave loses 80 cents in net income, whereas Vargo will lose only 40 cents. New Wave's cost structure, which relies more heavily on fixed costs, makes it more sensitive to changes in sales revenue.

EFFECT ON BREAK‐EVEN POINT

The difference in cost structure also affects the break‐even point. The break‐even point for each company is calculated in  Illustration 19-27 .

Fixed Costs÷Contribution Margin Ratio=Break-Even Point in DollarsVargo Video$200,000÷.40=$500,000New Wave$520,000÷.80=$650,000Fixed Costs÷Contribution Margin Ratio=Break-Even Point in DollarsVargo Video$200,000÷.40=$500,000New Wave$520,000÷.80=$650,000 ILLUSTRATION 19-27 Computation of break‐even point for two companies

New Wave needs to generate $150,000 ($650,000−$500,000)$150,000 ($650,000−$500,000) more in sales than Vargo Video before it breaks even. This makes New Wave riskier than Vargo because a company cannot survive for very long unless it at least breaks even.

EFFECT ON MARGIN OF SAFETY RATIO

We can also evaluate the relative impact that changes in sales would have on the two companies by computing the margin of safety ratio.  Illustration 19-28  shows the computation of the  margin of safety ratio for the two companies.

(Actual Sales−Break-Even Sales)÷Actual Sales=Margin of Safety RatioVargo Video($800,000−$500,000)÷$800,000=.38New Wave($800,000−$650,000)÷$800,000=.19(Actual Sales−Break-Even Sales)÷Actual Sales=Margin of Safety RatioVargo Video($800,000−$500,000)÷$800,000=.38New Wave($800,000−$650,000)÷$800,000=.19 ILLUSTRATION 19-28 Computation of margin of safety ratio for two companies

The difference in the margin of safety ratio also reflects the difference in risk between the two companies. Vargo Video could sustain a 38% decline in sales before it would be operating at a loss. New Wave could sustain only a 19% decline in sales before it would be “in the red.”

OPERATING LEVERAGE

Operating leverage  refers to the extent to which a company's net income reacts to a given change in sales. Companies that have higher fixed costs relative to variable costs have higher operating leverage. When a company's sales revenue is increasing, high operating leverage is a good thing because it means that profits will increase rapidly. But when sales are declining, too much operating leverage can have devastating consequences.

DECISION TOOLS 

Calculating the degree of operating leverage helps managers determine how sensitive the company's net income is to changes in sales.

Degree of Operating Leverage

How can we compare operating leverage between two companies? The  degree of operating leverage  provides a measure of a company's earnings volatility and can be used to compare companies. Degree of operating leverage is computed by dividing contribution margin by net income. This formula is presented in  Illustration 19-29  and applied to our two manufacturers of camcorders.

Contribution Margin÷Net Income=Degree of Operating LeverageVargo Video$320,000÷$120,000=2.67New Wave$640,000÷$120,000=5.33Contribution Margin÷Net Income=Degree of Operating LeverageVargo Video$320,000÷$120,000=2.67New Wave$640,000÷$120,000=5.33 ILLUSTRATION 19-29 Computation of degree of operating leverage

New Wave's earnings would go up (or down) by about two times (5.33÷2.67=2.00)(5.33÷2.67=2.00) as much as Vargo Video's with an equal increase (or decrease) in sales. For example, suppose both companies experience a 10% decrease in sales. Vargo's net income will decrease by 26.7% (2.67×10%)26.7% (2.67×10%), while New Wave's will decrease by 53.3% (5.33×10%)53.3% (5.33×10%). Thus, New Wave's higher operating leverage exposes it to greater earnings volatility risk.

You should be careful not to conclude from this analysis that a cost structure that relies on higher fixed costs, and consequently has higher operating leverage, is necessarily bad. Some have suggested that Internet radio company Pandora has limited potential for growth in its profitability because it has very little operating leverage. When its revenues grow, its variable costs (fees it pays for the right to use music) grow proportionally. When used carefully, operating leverage can add considerably to a company's profitability. For example, computer equipment manufacturer Komag enjoyed a 66% increase in net income when its sales increased by only 8%. As one commentator noted, “Komag's fourth quarter illustrates the company's significant operating leverage; a small increase in sales leads to a big profit rise.” However, as our illustration demonstrates, increased reliance on fixed costs increases a company's risk.

SERVICE COMPANY INSIGHT

Burlington Northern Railroad

There Is Something About a Train

A few years ago, Warren Buffett, arguably the most successful investor in history, bought a new train set—for $44 billion. The sage from Omaha bought Burlington Northern Railroad for a price that exceeded its fair value by 31%. At a time when the rest of the investing public was obsessed with technology companies like Facebook and Twitter, what could Buffett possibly see in a railroad? What he sees is a business whose costs are between 50–60% fixed. With such high fixed costs, railways have huge operating leverage. And because he bought the railroad at the bottom of a recession, when the economy turns around, Burlington could take off as well. Add to that the fact that railroad transport is very energy‐efficient, and it has high barriers to entry. So, as energy prices increase, more people will turn to the rails, but there are a limited number of railways. Makes sense to me.

Source: Liam Denning, “Buffett's Unusual Train of Thought,”  Wall Street Journal (November 4, 2009).

Why did Warren Buffett think that this was a good time to invest in railroad stocks? (Go to  WileyPLUS for this answer and additional questions.)

DO IT! 4

Operating Leverage

Rexfield Corp., a company specializing in crime scene investigations, is contemplating an investment in automated mass‐spectrometers. Its current process relies on a high number of lab technicians. The new equipment would employ a computerized expert system. The company's CEO has requested a comparison of the old technology versus the new technology. The accounting department has prepared the following CVP income statements for use in your analysis.

		CSI Equipment
		Old		New
Sales		$2,000,000		$2,000,000
Variable costs		1,400,000		600,000
Contribution margin		600,000		1,400,000
Fixed costs		400,000		1,200,000
Net income		$  200,000		$  200,000

Use the information provided above to do the following.

(a) Compute the degree of operating leverage for the company under each scenario.

(b) Discuss your results.

Action Plan

✓ Divide contribution margin by net income to determine degree of operating leverage.

✓ A higher degree of operating leverage will result in a higher change in net income with a given change in sales.

SOLUTION

(a)

		Contribution Margin		÷		Net Income		=		Degree of Operating Leverage
Old		$600,000		÷		$200,000		=		3
New		$1,400,000		÷		$200,000		=		7

(b) The degree of operating leverage measures the company's sensitivity to changes in sales. By switching to a cost structure dominated by fixed costs, the company would significantly increase its operating leverage. As a result, with a percentage change in sales, its percentage change in net income would be 2.33 (7÷3)2.33 (7÷3) times as much with the new technology as it would under the old.

Related exercise material:  BE19-13, BE19-14, BE19-15, E19-14, E19-15, E19-16, and  DO IT! 19-4.

USING  DECISION TOOLS—WHOLE FOODS MARKET

Whole Foods Market faces many decisions where it needs to apply the decision tools learned in this chapter, such as determining its cost structure. For example, suppose that Whole Foods Market has been approached by a robotics company with a proposal to significantly automate one of its stores. All stocking of shelves and bagging of groceries would be done by robots. Customers would check out through self‐service scanners and point‐of‐sale terminals. Any assistance would be provided by robots. Management has compiled the following comparative data for one average‐sized store.

		Old		New
Sales		$3,600,000		$3,600,000
Variable costs		2,800,000		2,000,000
Contribution margin		800,000		1,600,000
Fixed costs		480,000		1,280,000
Net income		$  320,000		$  320,000

INSTRUCTIONS

Use the information provided above to do the following.

a. Compute the degree of operating leverage for the company under each scenario, and discuss your results.

b. Compute the break‐even point in dollars and margin of safety ratio for the company under each scenario, and discuss your results.

SOLUTION

a.

b.		Contribution Margin		÷		Net Income		=		Degree of Operating Leverage
Old		$800,000		÷		$320,000		=		2.5
New		$1,600,000		÷		$320,000		=		5.0

c. The degree of operating leverage measures the company's sensitivity to changes in sales. By switching to a cost structure with higher fixed costs, Whole Foods would significantly increase its operating leverage. As a result, with a percentage change in sales, its percentage change in net income would be 2 times as much (5÷2.5)(5÷2.5) under the new structure as it would under the old.

d. To compute the break‐even point in sales dollars, we first need to compute the contribution margin ratio under each scenario. Under the old structure, the contribution margin ratio would be .22 ($800,000÷$3,600,000).22 ($800,000÷$3,600,000), and under the new it would be .44 ($1,600,000÷$3,600,000).44 ($1,600,000÷$3,600,000).

		Fixed Costs		÷		Contribution Margin Ratio		=		Break‐Even Point in Dollars
Old		$480,000		÷		.22		=		$2,181,818
New		$1,280,000		÷		.44		=		$2,909,090

e. Because Whole Foods' fixed costs would be substantially higher under the new cost structure, its break‐even point would increase significantly, from $2,181,818 to $2,909,090. A higher break‐even point is riskier because it means that the company must generate higher sales to be profitable.

f. The margin of safety ratio tells how far sales can fall before Whole Foods is operating at a loss.

(Actual Sales

−

Break-Even Sales)

÷

Actual Sales

=

Margin of Safety Ratio

Old

($3,600,000

−

$2,181,818)

÷

$3,600,000

=

.39

New

($3,600,000

−

$2,909,090)

÷

$3,600,000

=

.19

g. Under the old structure, sales could fall by 39% before the company would be operating at a loss. Under the new structure, sales could fall by only 19%.

h. On the one hand, grocery store sales are more stable than most products. Sales are less inclined to fluctuate with changes in the economy. However, Whole Foods sells many organic and unique products that have higher selling prices. It may be that during a recession, its customers might choose to switch to lower cost (e.g., non‐organic) substitutes at traditional, high‐volume grocery stores. If Whole Foods' sales are subject to significant swings, then changes in its cost structure could significantly affect its risk profile.

LEARNING OBJECTIVE *5

APPENDIX 19A: Explain the differences between absorption costing and variable costing.

In the earlier chapters, we classified both variable and fixed manufacturing costs as product costs. In job order costing, for example, a job is assigned the costs of direct materials, direct labor, and  both variable and fixed manufacturing overhead. This costing approach is referred to as  full or  absorption costing . It is so named because all manufacturing costs are charged to, or absorbed by, the product. Absorption costing is the approach used for external reporting under generally accepted accounting principles.

An alternative approach is to use  variable costing . Under variable costing, only direct materials, direct labor, and variable manufacturing overhead costs are considered product costs. Companies recognize fixed manufacturing overhead costs as period costs (expenses) when incurred. The difference between absorption costing and variable costing is shown graphically as follows.

ILLUSTRATION 19A-1 Difference between absorption costing and variable costing

Under both absorption and variable costing, selling and administrative expenses are period costs.

Companies may not use variable costing for external financial reports because generally accepted accounting principles require that fixed manufacturing overhead be accounted for as a product cost.

EXAMPLE COMPARING ABSORPTION COSTING WITH VARIABLE COSTING

To illustrate absorption and variable costing, assume that Premium Products Corporation manufactures a polyurethane sealant, called Fix‐It, for car windshields. Relevant data for Fix‐It in January 2017, the first month of production, are shown in  Illustration 19A-2 .

Selling price	$20 per unit.
Units	Produced 30,000; sold 20,000; beginning inventory zero.
Variable unit costs	Manufacturing $9 (direct materials $5, direct labor $3, and variable overhead $1).
	Selling and administrative expenses $2.
Fixed costs	Manufacturing overhead $120,000.
	Selling and administrative expenses $15,000.

ILLUSTRATION 19A-2 Sealant sales and cost data for Premium Products Corporation

The per unit manufacturing cost under each costing approach is computed in  Illustration 19A-3 .

Type of Cost		Absorption Costing		Variable Costing
Direct materials		$  5		$5
Direct labor		3		3
Variable manufacturing overhead		1		1
Fixed manufacturing overhead   ($120,000 ÷ 30,000 units produced)		4		0
Manufacturing cost per unit		$13		$9

ILLUSTRATION 19A-3 Computation of per unit manufacturing cost

The manufacturing cost per unit is $4 higher ($13−$9)($13−$9) for absorption costing. This occurs because fixed manufacturing overhead costs are a product cost under absorption costing. Under variable costing, they are, instead, a period cost, and so they are expensed. Based on these data, each unit sold and each unit remaining in inventory is costed under absorption costing at $13 and under variable costing at $9.

Absorption Costing Example

Illustration 19A-4  shows the income statement for Premium Products using absorption costing. It shows that cost of goods manufactured is $390,000, computed by multiplying the 30,000 units produced times the manufacturing cost per unit of $13 (see  Illustration 19A-3 ). Cost of goods sold is $260,000, after subtracting ending inventory of $130,000. Under absorption costing, $40,000 of the fixed overhead (10,000 units×$4)(10,000 units×$4) is deferred to a future period as part of the cost of ending inventory.

PREMIUM PRODUCTS CORPORATION Income Statement For the Month Ended January 31, 2017 Absorption Costing
Sales (20,000 units × $20)		$400,000
Cost of goods sold
Inventory, January 1	$  –0–
Cost of goods manufactured (30,000 units × $13)	390,000
Cost of goods available for sale	390,000
Less: Inventory, January 31 (10,000 units × $13)	130,000
Cost of goods sold (20,000 units × $13)		260,000
Gross profit		140,000
Variable selling and administrative expenses   (20,000 × $2)	40,000
Fixed selling and administrative expenses	15,000	55,000
Net income		$ 85,000

ILLUSTRATION 19A-4 Absorption costing income statement

▼ HELPFUL HINT

The income statement format in  Illustration 19A-4  is the same as that used under generally accepted accounting principles.

Variable Costing Example

As  Illustration 19A-5  (page 942) shows, companies use the cost‐volume‐profit format in preparing a variable costing income statement. The variable manufacturing cost of $270,000 is computed by multiplying the 30,000 units produced times variable manufacturing cost of $9 per unit (see  Illustration 19A-3 ). As in absorption costing, both variable and fixed selling and administrative expenses are treated as period costs.

PREMIUM PRODUCTS CORPORATION Income Statement For the Month Ended January 31, 2017 Variable Costing
Sales (20,000 units × $20)		$400,000
Variable cost of goods sold
Inventory, January 1	$  –0–
Variable cost of goods manufactured (30,000 units × $9)	270,000
Variable cost of goods available for sale	270,000
Less: Inventory, January 31 (10,000 units × $9)	90,000
Variable cost of goods sold	180,000
Variable selling and administrative expenses (20,000 units × $2)	40,000	220,000
Contribution margin		180,000
Fixed manufacturing overhead	120,000
Fixed selling and administrative expenses	15,000	135,000
Net income		$ 45,000

ILLUSTRATION 19A-5 Variable costing income statement

▼ HELPFUL HINT

Note the difference in the computation of the ending inventory: $9 per unit here, $13 per unit in  Illustration 19A-4 .

There is one primary difference between variable and absorption costing: Under variable costing, companies charge the fixed manufacturing overhead as an expense in the current period. Fixed manufacturing overhead costs of the current period, therefore, are not deferred to future periods through the ending inventory. As a result, absorption costing will show a  higher net income number than variable costing  whenever units produced exceed units sold. This difference can be seen in the income statements in  Illustrations 19A-4  and  19A-5 . There is a $40,000 difference in the ending inventories ($130,000 under absorption costing versus $90,000 under variable costing). Under absorption costing, $40,000 of the fixed overhead costs (10,000 units×$4)(10,000 units×$4) has been deferred to a future period as part of inventory. In contrast, under variable costing, all fixed manufacturing costs are expensed in the current period.

As shown, when units produced exceed units sold, income under absorption costing is  higher. When units produced are less than units sold, income under absorption costing is  lower. When units produced and sold are the same, net income will be  equal under the two costing approaches. In this case, there is no increase in ending inventory. So fixed overhead costs of the current period are not deferred to future periods through the ending inventory.

NET INCOME EFFECTS

To further illustrate the concepts underlying absorption and variable costing, we will look at an extended example using Overbay Inc., a manufacturer of small airplane drones. We assume that production volume stays the same each year over the 3‐year period, but the number of units sold varies each year.

2016 Results

As indicated in  Illustration 19A-6 , the variable manufacturing cost per drone is $240,000, and the fixed manufacturing overhead cost per drone is $60,000 (assuming 10 drones). Total manufacturing cost per drone under absorption costing is therefore $300,000 ($240,000+$60,000)$300,000 ($240,000+$60,000). Overbay also has variable selling and administrative expenses of $5,000 per drone. The fixed selling and administrative expenses are $80,000.

		2016		2017		2018
Volume information
Drones in beginning inventory		0		0		2
Drones produced		10		10		10
Drones sold		10		8		12
Drones in ending inventory		0		2		0
Financial information
Selling price per drone		$400,000
Variable manufacturing cost per drone		$240,000
Fixed manufacturing overhead for the year		$600,000
Fixed manufacturing overhead per drone		$ 60,000 ($600,000 ÷ 10)
Variable selling and administrative expenses per drone		$   5,000
Fixed selling and administrative expenses		$  80,000

ILLUSTRATION 19A-6 Information for Overbay Inc.

An absorption costing income statement for 2016 for Overbay Inc. is shown in  Illustration 19A-7 .

OVERBAY INC. Income Statement For the Year Ended December 31, 2016 Absorption Costing
Sales (10 drones × $400,000)		$4,000,000
Cost of goods sold (10 drones × $300,000)		3,000,000
Gross profit		1,000,000
Variable selling and administrative expenses (10 drones × $5,000)	$50,000
Fixed selling and administrative expenses	80,000	130,000
Net income		$  870,000

ILLUSTRATION 19A-7 Absorption costing income statement—2016

Overbay reports net income of $870,000 under absorption costing.

Under a variable costing system, the income statement follows a cost‐volume‐profit (CVP) format. In this case, the manufacturing cost is comprised solely of the variable manufacturing costs of $240,000 per drone. The fixed manufacturing overhead costs of $600,000 for the year are expensed in 2016. As in absorption costing, the fixed and variable selling and administrative expenses are period costs expensed in 2016. A variable costing income statement for Overbay Inc. for 2016 is shown in  Illustration 19A-8 .

OVERBAY INC. Income Statement For the Year Ended December 31, 2016 Variable Costing
Sales (10 drones × $400,000)		$4,000,000
Variable cost of goods sold (10 drones × $240,000)	$2,400,000
Variable selling and administrative expenses (10 drones × $5,000)	50,000	2,450,000
Contribution margin		1,550,000
Fixed manufacturing overhead	600,000
Fixed selling and administrative expenses	80,000	680,000
Net income		$ 870,000

ILLUSTRATION 19A-8 Variable costing income statement—2016

As shown in  Illustration 19A-8  (page 943), the variable costing net income of $870,000 is the same as the absorption costing net income computed in  Illustration 19A-7  (page 943).  When the numbers of units produced and sold are the same, net income is equal under the two costing approaches. Because no increase in ending inventory occurs, no fixed manufacturing overhead costs incurred in 2016 are deferred to future periods using absorption costing.

2017 Results

In 2017, Overbay produced 10 drones but sold only eight drones. As a result, there are two drones in ending inventory. The absorption costing income statement for 2017 is shown in  Illustration 19A-9 .

OVERBAY INC. Income Statement For the Year Ended December 31, 2017 Absorption Costing
Sales (8 drones × $400,000)		$3,200,000
Cost of goods sold (8 drones × $300,000)		2,400,000
Gross profit		800,000
Variable selling and administrative expenses (8 drones × $5,000)	$40,000
Fixed selling and administrative expenses	80,000	120,000
Net income		$ 680,000

ILLUSTRATION 19A-9 Absorption costing income statement—2017

Under absorption costing, the ending inventory of two drones is $600,000 ($300,000×2)$600,000 ($300,000×2). Each unit of ending inventory includes $60,000 of fixed manufacturing overhead. Therefore, fixed manufacturing overhead costs of $120,000 ($60,000×2 drones)$120,000 ($60,000×2 drones) are deferred until a future period.

The variable costing income statement for 2017 is shown in  Illustration 19A-10 .

OVERBAY INC. Income Statement For the Year Ended December 31, 2017 Variable Costing
Sales (8 drones × $400,000)		$3,200,000
Variable cost of goods sold (8 drones × $240,000)	$1,920,000
Variable selling and administrative expenses (8 drones × $5,000)	40,000	1,960,000
Contribution margin		1,240,000
Fixed manufacturing overhead	600,000
Fixed selling and administrative expenses	80,000	680,000
Net income		$  560,000

ILLUSTRATION 19A-10 Variable costing income statement—2017

As shown, when units produced (10) exceeds units sold (8), net income under absorption costing ($680,000) is higher than net income under variable costing ($560,000). The reason: The cost of the ending inventory is higher under absorption costing than under variable costing. In 2017, under absorption costing, fixed manufacturing overhead of $120,000 is deferred and carried to future periods as part of inventory. Under variable costing, the $120,000 is expensed in the current period and, therefore the difference in the two net income numbers is $120,000 ($680,000−$560,000)$120,000 ($680,000−$560,000).

2018 Results

In 2018, Overbay produced 10 drones and sold 12 (10 drones from the current year's production and 2 drones from the beginning inventory). As a result, there are no drones in ending inventory. The absorption costing income statement for 2018 is shown in  Illustration 19A-11 .

OVERBAY INC. Income Statement For the Year Ended December 31, 2018 Absorption Costing
Sales (12 drones × $400,000)		$4,800,000
Cost of goods sold (12 drones × $300,000)		3,600,000
Gross profit		1,200,000
Variable selling and administrative expenses (12 drones × $5,000)	$60,000
Fixed selling and administrative expenses	80,000	140,000
Net income		$1,060,000

ILLUSTRATION 19A-11 Absorption costing income statement—2018

Fixed manufacturing costs of $720,000 ($60,000×12 drones)$720,000 ($60,000×12 drones) are expensed as part of cost of goods sold in 2018. This $720,000 includes $120,000 of fixed manufacturing costs incurred during 2017 and included in beginning inventory, plus $600,000 of fixed manufacturing costs incurred during 2018. Given this result for the absorption costing statement, what would you now expect the result to be under variable costing? Let's take a look.

The variable costing income statement for 2018 is shown in  Illustration 19A-12 .

OVERBAY INC. Income Statement For the Year Ended December 31, 2018 Variable Costing
Sales (12 drones × $400,000)		$4,800,000
Variable cost of goods sold (12 drones × $240,000)	$2,880,000
Variable selling and administrative expenses (12 drones × $5,000)	60,000	2,940,000
Contribution margin		1,860,000
Fixed manufacturing overhead	600,000
Fixed selling and administrative expenses	80,000	680,000
Net income		$1,180,000

ILLUSTRATION 19A-12 Variable costing income statement—2018

When drones produced (10) are less than drones sold (12), net income under absorption costing ($1,060,000) is less than net income under variable costing ($1,180,000). This difference of $120,000 ($1,180,000−$1,060,000)$120,000 ($1,180,000−$1,060,000) results because $120,000 of fixed manufacturing overhead costs in beginning inventory are charged to 2018 under absorption costing. Under variable costing, there is no fixed manufacturing overhead cost in beginning inventory.

Illustration 19A-13  (page 946) summarizes the results of the three years.

		Net Income under Two Costing Approaches
		2016		2017		2018
		Production = Sales		Production > Sales		Production < Sales
Absorption costing		$870,000		$ 680,000		$1,060,000
Variable costing		870,000		560,000		1,180,000
Difference		$  –0–		$120,000		$(120,000)

ILLUSTRATION 19A-13 Comparison of net income under two costing approaches

This relationship between production and sales and its effect on net income under the two costing approaches is shown graphically in  Illustration 19A-14 .

ILLUSTRATION 19A-14 Summary of income effects under absorption costing and variable costing

DECISION‐MAKING CONCERNS

Generally accepted accounting principles require that absorption costing be used for the costing of inventory for external reporting purposes. Net income measured under GAAP (absorption costing) is often used internally to evaluate performance, justify cost reductions, or evaluate new projects. Some companies, however, have recognized that net income calculated using GAAP does not highlight differences between variable and fixed costs and may lead to poor business decisions. Consequently, these companies use variable costing for internal reporting purposes. The following discussion and example highlight a significant problem related to the use of absorption costing for decision‐making purposes.

When production exceeds sales, absorption costing reports a higher net income than variable costing. The reason is that some fixed manufacturing costs are not expensed in the current period but are deferred to future periods as part of inventory. As a result, management may be tempted to overproduce in a given period in order to increase net income. Although net income will increase, this decision to overproduce may not be in the company's best interest.

Suppose, for example, a division manager's compensation is based upon the division's net income. In such a case, the manager may decide to meet the net income targets by increasing production. While this overproduction may increase the manager's compensation, the buildup of inventories in the long run will lead to additional costs to the company. Variable costing avoids this situation because net income under variable costing is unaffected by changes in production levels, as the following illustration shows.

Warren Lund, a division manager of Walker Enterprises, is under pressure to boost the performance of the Lighting Division in 2017. Unfortunately, recent profits have not met expectations. The expected sales for this year are 20,000 units. As he plans for the year, Warren has to decide whether to produce 20,000 or 30,000 units. The following facts are available for the division.

Beginning inventory	0
Expected sales in units	20,000
Selling price per unit	$15
Variable manufacturing cost per unit	$6
Fixed manufacturing overhead cost (total)	$60,000
Fixed manufacturing overhead costs per unit
Based on 20,000 units	$3 per unit ($60,000 ÷ 20,000 units)
Based on 30,000 units	$2 per unit ($60,000 ÷ 30,000 units)
Total manufacturing cost per unit
Based on 20,000 units	$9 per unit ($6 variable + $3 fixed)
Based on 30,000 units	$8 per unit ($6 variable + $2 fixed)
Variable selling and administrative expenses per unit	$1
Fixed selling and administrative expenses	$15,000

ILLUSTRATION 19A-15 Facts for Lighting Division—2017

Illustration 19A-16  presents the division's results based upon the two possible levels of output under absorption costing.

LIGHTING DIVISION Income Statement For the Year Ended December 31, 2017 Absorption Costing
		20,000		30,000
		Produced		Produced
Sales (20,000 units × $15)		$300,000		$ 300,000
Cost of goods sold		180,000 *		160,000 **
Gross profit		120,000		140,000
Variable selling and administrative expenses (20,000 units × $1)		20,000		20,000
Fixed selling and administrative expenses		15,000		15,000
Net income		$ 85,000		$105,000
*  20,000 units×$920,000 units×$9 **  20,000 units×$820,000 units×$8

ILLUSTRATION 19A-16 Absorption costing income statement—2017

If the Lighting Division produces 20,000 units, its net income under absorption costing is $85,000. If it produces 30,000 units, its net income is $105,000. By producing 30,000 units, the division has inventory of 10,000 units. This excess inventory causes net income to increase $20,000 because $20,000 of fixed costs (10,000 units×$2)(10,000 units×$2) are not charged to the current year, but are deferred to future periods.

What do you think Warren Lund might do in this situation? Given his concern about the profit numbers of the Lighting Division, he may be tempted to increase production. Although this increased production will increase 2017 net income, it may be costly to the company in the long run.

Now let's evaluate the same situation under variable costing.  Illustration 19A-17  (page 948) shows a variable costing income statement for production at both 20,000 and 30,000 units, using the information from  Illustration 19A-15 .

LIGHTING DIVISION Income Statement For the Year Ended December 31, 2017 Variable Costing
		20,000		30,000
		Produced		Produced
Sales (20,000 units × $15)		$300,000		$300,000
Variable cost of goods sold (20,000 units × $6)		120,000		120,000
Variable selling and administrative expenses (20,000 units × $1)		20,000		20,000
Contribution margin		160,000		160,000
Fixed manufacturing overhead		60,000		60,000
Fixed selling and administrative expenses		15,000		15,000
Net income		$ 85,000		$ 85,000

ILLUSTRATION 19A-17 Variable costing income statement—2017

From this example, we see that under variable costing, net income is not affected by the number of units produced. Net income is $85,000 whether the division produces 20,000 or 30,000 units. Why? Because fixed manufacturing overhead is treated as a period expense. Unlike absorption costing, no fixed manufacturing overhead is deferred through inventory buildup. Therefore, under variable costing, production does not increase income; sales do. As a result, if the company uses variable costing, managers like Warren Lund cannot affect profitability by increasing production.

POTENTIAL ADVANTAGES OF VARIABLE COSTING

Variable costing has a number of potential advantages relative to absorption costing:

1. Net income computed under variable costing is unaffected by changes in production levels. As a result, it is much easier to understand the impact of fixed and variable costs on the computation of net income when variable costing is used.

2. The use of variable costing is consistent with the cost‐volume‐profit material presented in  Chapters 18  and  19 .

3. Net income computed under variable costing is closely tied to changes in sales levels (not production levels) and therefore provides a more realistic assessment of the company's success or failure during a period.

4. The presentation of fixed and variable cost components on the face of the variable costing income statement makes it easier to identify these costs and understand their effect on the business. Under absorption costing, the allocation of fixed costs to inventory makes it difficult to evaluate the impact of fixed costs on the company's results.

Companies that use just‐in‐time processing techniques to minimize their inventories will not have significant differences between absorption and variable costing net income.

DO IT! 5

Variable Costing

Franklin Company produces and sells tennis balls. The following costs are available for the year ended December 31, 2017. The company has no beginning inventory. In 2017, 8,000,000 units were produced, but only 7,500,000 units were sold. The unit selling price was $0.50 per ball. Costs and expenses were as follows.

Variable costs per unit
Direct materials		$0.10
Direct labor		0.05
Variable manufacturing overhead		0.08
Variable selling and administrative expenses		0.02
Annual fixed costs and expenses
Manufacturing overhead		$500,000
Selling and administrative expenses		100,000

(a) Compute the manufacturing cost of one unit of product using variable costing.

(b) Prepare a 2017 income statement for Franklin Company using variable costing.

Action Plan

✓ Recall that under variable costing, only variable manufacturing costs are treated as manufacturing (product) costs.

✓ Subtract all fixed costs, both manufacturing overhead and selling and administrative expenses, as period costs.

SOLUTION

1. The cost of one unit of product under variable costing would be:

Direct materials		$0.10
Direct labor		0.05
Variable manufacturing overhead		0.08
		$0.23

2. The variable costing income statement would be as follows.

FRANKLIN COMPANY Income Statement For the Year Ended December 31, 2017 Variable Costing
Sales (7,500,000 × $0.50)		$3,750,000
Variable cost of goods sold (7,500,000 × $0.23)	$1,725,000
Variable selling and administrative expenses (7,500,000 × .02)	150,000	1,875,000
Contribution margin		1,875,000
Fixed manufacturing overhead	500,000
Fixed selling and administrative expenses	100,000	600,000
Net income		$1,275,000

Related exercise material:  BE19-16, BE19-17, BE19-18, BE19-19, E19-17, E19-18, and  E19-19.

REVIEW AND PRACTICE

LEARNING OBJECTIVES REVIEW

1. Apply basic CVP concepts. The CVP income statement classifies costs and expenses as variable or fixed and reports contribution margin in the body of the statement. Contribution margin is the amount of revenue remaining after deducting variable costs. It can be expressed as a per unit amount or as a ratio. The break‐even point in units is fixed costs divided by unit contribution margin. The break‐even point in dollars is fixed costs divided by the contribution margin ratio. These formulas can also be used to determine units or sales dollars needed to achieve target net income, simply by adding target net income to fixed costs before dividing by the contribution margin. Margin of safety indicates how much sales can decline before the company is operating at a loss. It can be expressed in dollar terms or as a percentage.

2. Explain the term sales mix and its effects on breakeven sales. Sales mix is the relative proportion in which each product is sold when a company sells more than one product. For a company with a small number of products, break‐even sales in units is determined by using the weighted‐average unit contribution margin of all the products. If the company sells many different products, then calculating the break‐even point using unit information is not practical. Instead, in a company with many products, break‐even sales in dollars is calculated using the weighted‐average contribution margin ratio.

3. Determine sales mix when a company has limited resources. When a company has limited resources, it is necessary to find the contribution margin per unit of limited resource. This amount is then multiplied by the units of limited resource to determine which product maximizes net income.

4. Indicate how operating leverage affects profitability. Operating leverage refers to the degree to which a company's net income reacts to a change in sales. Operating leverage is determined by a company's relative use of fixed versus variable costs. Companies with high fixed costs relative to variable costs have high operating leverage. A company with high operating leverage experiences a sharp increase (decrease) in net income with a given increase (decrease) in sales. The degree of operating leverage is measured by dividing contribution margin by net income.

5. Explain the differences between absorption costing and variable costing. Under absorption costing, fixed manufacturing costs are product costs. Under variable costing, fixed manufacturing costs are period costs.

If production volume exceeds sales volume, net income under absorption costing will exceed net income under variable costing by the amount of fixed manufacturing costs included in ending inventory that results from units produced but not sold during the period. If production volume is less than sales volume, net income under absorption costing will be less than under variable costing by the amount of fixed manufacturing costs included in the units sold during the period that were not produced during the period.

The use of variable costing is consistent with cost‐volume‐profit analysis. Net income under variable costing is unaffected by changes in production levels. Instead, it is closely tied to changes in sales. The presentation of fixed costs in the variable costing approach makes it easier to identify fixed costs and to evaluate their impact on the company's profitability.

 DECISION TOOLS REVIEW

DECISION CHECKPOINTS	INFO NEEDED FOR DECISION	TOOL TO USE FOR DECISION	HOW TO EVALUATE RESULTS
How many units of product A and product B do we need to sell to break even?	Fixed costs, weighted-average unit contribution margin, sales mix	Break-even point in units=Fixed costsWeighted-average contribution marginBreak-even point in units=Fixed costsWeighted-average contribution margin	To determine number of units of product A and B, allocate total break-even units based on sales mix.
How many dollars of sales are required from each division in order to break even?	Fixed costs, weightedaverage contribution margin ratio, sales mix	Break-even point in dollars=Fixed costsWeighted-average unit contribution margin ratioBreak-even point in dollars=Fixed costsWeighted-average unit contribution margin ratio	To determine the sales dollars required from each division, allocate the total break-even sales using the sales mix.
How many units of product A and B should we produce in light of a limited resource?	Unit contribution margin, limited resource required per unit	Contribution margin per unit of limited resource=Unit contribution marginLimited resource per unitContribution margin per unit of limited resource=Unit contribution marginLimited resource per unit	Any additional capacity of limited resource should be applied toward the product with higher contribution margin per unit of limited resource.
How sensitive is the company's net income to changes in sales?	Contribution margin and net income	Degree of operating leverage=Contribution marginNet incomeDegree of operating leverage=Contribution marginNet income	Reports the change in net income that occurs with a given change in sales. A high degree of operating leverage means that the company's net income is very sensitive to changes in sales.

GLOSSARY REVIEW

· *Absorption costing  A costing approach in which all manufacturing costs are charged to the product.

·  Cost structure  The relative proportion of fixed versus variable costs that a company incurs.

·  Degree of operating leverage  A measure of the extent to which a company's net income reacts to a change in sales. It is calculated by dividing contribution margin by net income.

·  Operating leverage  The extent to which a company's net income reacts to a change in sales. Operating leverage is determined by a company's relative use of fixed versus variable costs.

·  Sales mix  The relative percentage in which a company sells its multiple products.

·  Theory of constraints  A specific approach used to identify and manage constraints in order to achieve the company's goals.

· *Variable costing  A costing approach in which only variable manufacturing costs are product costs, and fixed manufacturing costs are period costs (expenses).

PRACTICE MULTIPLE-CHOICE QUESTIONS

(LO 1)

1. Which one of the following is the format of a CVP income statement?

(a) Sales−Variable costs=Fixed costs+Net incomeSales−Variable costs=Fixed costs+Net income.

(b) Sales−Fixed costs−Variable costs−Operating expenses=Net incomeSales−Fixed costs−Variable costs−Operating expenses=Net income.

(c) Sales−Cost of goods sold−Operating expenses=Net incomeSales−Cost of goods sold−Operating expenses=Net income.

(d) Sales−Variable costs−Fixed costs=Net incomeSales−Variable costs−Fixed costs=Net income.

(LO 1)

2. Croc Catchers calculates its contribution margin to be less than zero. Which statement is  true?

(a) Its fixed costs are less than the variable costs per unit.

(b) Its profits are greater than its total costs.

(c) The company should sell more units.

(d) Its selling price is less than its variable costs.

(LO 1)

3. Which one of the following describes the break‐even point?

(a) It is the point where total sales equal total variable plus total fixed costs.

(b) It is the point where the contribution margin equals zero.

(c) It is the point where total variable costs equal total fixed costs.

(d) It is the point where total sales equal total fixed costs.

(LO 1)

4. The following information is available for Chap Company.

Sales		$350,000
Cost of goods sold		$120,000
Total fixed expenses		$60,000
Total variable expenses		$100,000

Which amount would you find on Chap's CVP income statement?

(a) Contribution margin of $250,000.

(b) Contribution margin of $190,000.

(c) Gross profit of $230,000.

(d) Gross profit of $190,000.

(LO 1)

5. Gabriel Corporation has fixed costs of $180,000 and variable costs of $8.50 per unit. It has a target income of $268,000. How many units must it sell at $12 per unit to achieve its target net income?

(a) 51,429 units.

(b) 128,000 units.

(c) 76,571 units.

(d) 21,176 units.

(LO 1)

6. Mackey Corporation has fixed costs of $150,000 and variable costs of $9 per unit. If sales price per unit is $12, what is break‐even sales in dollars?

(a) $200,000.

(b) $450,000.

(c) $480,000.

(d) $600,000.

(LO 2)

7. Sales mix is:

(a) important to sales managers but not to accountants.

(b) easier to analyze on absorption costing income statements.

(c) a measure of the relative percentage of a company's variable costs to its fixed costs.

(d) a measure of the relative percentage in which a company's products are sold.

(LO 2)

8. Net income will be:

(a) greater if more higher‐contribution margin units are sold than lower‐contribution margin units.

(b) greater if more lower‐contribution margin units are sold than higher‐contribution margin units.

(c) equal as long as total sales remain equal, regardless of which products are sold.

(d) unaffected by changes in the mix of products sold.

(LO 3)

9. If the unit contribution margin is $15 and it takes 3.0 machine hours to produce the unit, the contribution margin per unit of limited resource is:

(a) $25.

(b) $5.

(c) $4.

(d) None of the answer choices are correct.

(LO 3)

10. MEM manufactures two products. Product X has a contribution margin of $26 and requires 4 hours of machine time. Product Y has a contribution margin of $14 and requires 2 hours of machine time. Assuming that machine time is limited to 3,000 hours, how should it allocate the machine time to maximize its income?

(a) Use 1,500 hours to produce X and 1,500 hours to produce Y.

(b) Use 2,250 hours to produce X and 750 hours to produce Y.

(c) Use 3,000 hours to produce only X.

(d) Use 3,000 hours to produce only Y.

(LO 3)

11. When a company has a limited resource, it should apply additional capacity of that resource to providing more units of the product or service that has:

(a) the highest contribution margin.

(b) the highest selling price.

(c) the highest gross profit.

(d) the highest unit contribution margin of that limited resource.

(LO 4)

12. The degree of operating leverage:

(a) can be computed by dividing total contribution margin by net income.

(b) provides a measure of the company's earnings volatility.

(c) affects a company's break‐even point.

(d) All of the answer choices are correct.

(LO 4)

13. A high degree of operating leverage:

(a) indicates that a company has a larger percentage of variable costs relative to its fixed costs.

(b) is computed by dividing fixed costs by contribution margin.

(c) exposes a company to greater earnings volatility risk.

(d) exposes a company to less earnings volatility risk.

(LO 4)

14. Stevens Company has a degree of operating leverage of 3.5 at a sales level of $1,200,000 and net income of $200,000. If Stevens' sales fall by 10%, Stevens can be expected to experience a:

(a) decrease in net income of $70,000.

(b) decrease in contribution margin of $7,000.

(c) decrease in operating leverage of 35%.

(d) decrease in net income of $175,000.

(LO 5)

*15. Fixed manufacturing overhead costs are recognized as:

(a) period costs under absorption costing.

(b) product costs under absorption costing.

(c) product costs under variable costing.

(d) part of ending inventory costs under both absorption and variable costing.

(LO 5)

*16. Net income computed under absorption costing will be:

(a) higher than net income computed under variable costing in all cases.

(b) equal to net income computed under variable costing in all cases.

(c) higher than net income computed under variable costing when units produced are greater than units sold.

(d) higher than net income computed under variable costing when units produced are less than units sold.

 

SOLUTIONS

1. (d) The format of a CVP income statement is Sales−Variable costs−Fixed costs=Net incomeSales−Variable costs−Fixed costs=Net income. Therefore, choices (a), (b), and (c) are incorrect.

2. (d) If contribution margin is less than zero, selling price is less than variable costs. The other choices are incorrect because if contribution margin is less than zero (a) selling price, not fixed costs, is less than variable costs; (b) neither profits or total costs can be determined from the contribution margin amount; and (c) selling more units will only increase the negativity of the contribution margin.

3. (a) The break‐even point is the point where total sales equal total variable costs plus total fixed costs. Choices (b), (c), and (d) are therefore incorrect.

4. (a) The CVP income statement would show Sales ($350,000)−Total variable expenses ($100,000)=Contribution margin ($250,000)Sales ($350,000)−Total variable expenses ($100,000)=Contribution margin ($250,000), not (b) contribution margin of $190,000. Choices (c) and (d) are incorrect because gross profit does not appear on a CVP income statement.

5. (b) Required sales in units to achieve net income=($180,000+$268,000)/($12−$8.50)=128,000 unitsRequired sales in units to achieve net income=($180,000+$268,000)/($12−$8.50)=128,000 units, not (a) 51,429 units, (c) 76,571 units, or (d) 21,176 units.

6. (d) Fixed costs ($150,000)÷Contribution margin ratio ($3÷$12)=$600,000Fixed costs ($150,000)÷Contribution margin ratio ($3÷$12)=$600,000, not (a) $200,000, (b) $450,000, or (c) $480,000.

7. (d) Sales mix is the relative percentage in which a company sells its multiple products. The other choices are incorrect because (a) sales mix is also important to accountants, and (b) absorption costing income statements are not needed. Choice (c) is an incorrect definition of sales mix.

8. (a) Net income will be greater if more higher‐contribution margin units are sold than lower‐contribution units. Choices (b), (c), and (d) are therefore incorrect statements.

9. (b) The contribution margin per unit of limited resource is Unit contribution margin ($15)÷Units of limited resource (3.0 machine hours)=$5Unit contribution margin ($15)÷Units of limited resource (3.0 machine hours)=$5, not (a) $25, (c) $4, or (d) none of the above.

10. (d) Unit contribution margin of Product X ($26÷4)<unit contribution margin of Product Y ($14÷2)Unit contribution margin of Product X ($26÷4)<unit contribution margin of Product Y ($14÷2), so the machine time should be applied toward the product with the higher unit contribution margin. Choices (a), (b), and (c) are incorrect because these options will not maximize MEM's income.

11. (d) The company should apply additional capacity of the limited resource to providing more units of the product or service that has the highest unit contribution margin of that limited resource, not (a) the highest contribution margin, (b) the highest selling price, or (c) the highest gross profit.

12. (d) All of the above statements about operating leverage are true. So while choices (a), (b), and (c) are true statements, choice (d) is the better answer.

13. (c) A high degree of operating leverage exposes a company to greater earnings volatility risk. The other choices are incorrect because a high degree of operating leverage (a) means a company has higher fixed costs relative to variable costs, not vice versa; (b) is computed by dividing contribution margin by net income, not fixed costs by contribution margin; and (d) exposes a company to greater, not less, earnings volatility risk.

14. (a) Net income ($200,000)×Operating leverage (3.5)×Decrease in sales (10%)=decrease in net income of $70,000Net income ($200,000)×Operating leverage (3.5)×Decrease in sales (10%)=decrease in net income of $70,000, not (b) decrease in contribution margin of $7,000, (c) decrease in operating leverage of 35%, or (d) decrease in net income of $175,000.

15. (b) Under absorption costing, fixed manufacturing overhead costs and variable manufacturing overhead costs are both product costs. The other choices are incorrect because (a) fixed manufacturing overhead costs are recognized as product costs under absorption costing, not period costs; (c) under variable costing, fixed manufacturing costs are recognized as period costs; and (d) fixed manufacturing costs are part of ending inventory under absorption costing only.

16. (c) Net income is higher under absorption costing than under variable costing when units produced exceed units sold, not (a) higher in all cases, (b) equal to net income under variable costing in all cases, or (d) higher when units produced are less than units sold.

PRACTICE EXERCISES

Compute break‐even point in units for a company with more than one product.

(LO 2)

1. Yard‐King manufactures lawnmowers, weed‐trimmers, and chainsaws. Its sales mix and unit contribution margins are as follows.

		Sales Mix		Unit Contribution Margin
Lawnmowers		30%		$35
Weed‐trimmers		50%		$25
Chainsaws		20%		$50

Yard‐King has fixed costs of $4,620,000.

INSTRUCTIONS

Compute the number of units of each product that Yard‐King must sell in order to break even under this product mix.

SOLUTIONS

1.

		Sales Mix Percentage		Unit Contribution Margin		Weighted-Average Contribution Margin
Lawnmowers		30%		$35		$10.50
Weed-trimmers		50		25		12.50
Chainsaws		20		50		10.00
						$33.00

Total break-even sales in units=$4,620,000÷$33.00=140,000 unitsTotal break-even sales in units=$4,620,000÷$33.00=140,000 units

		Sales Mix Percentage				Total Break-Even Sales				Sales Needed per Product
Lawnmowers		30%		×		140,000 units		=		42,000 units
Weed-trimmers		50		×		140,000		=		70,000
Chainsaws		20		×		140,000		=		28,000
Total units										140,000 units

Compute contribution margin and determine the product to be manufactured.

(LO 3)

2. Rene Company manufactures and sells three products. Relevant per unit data concerning each product are given below.

		Product
		A		B		C
Selling price		$12		$13		$15
Variable costs and expenses		$ 4		$ 8		$ 9
Machine hours to produce		2		1		2

INSTRUCTIONS

(a) Compute the contribution margin per unit of limited resource (machine hours) for each product.

(b) Assuming 4,500 additional machine hours are available, which product should be manufactured?

(c) Prepare an analysis showing the total contribution margin if the additional hours are (1) divided equally among the products, and (2) allocated entirely to the product identified in (b) above.

SOLUTION

2.

1.

2.		Product
		A		B		C
Unit contribution margin (a)		$8		$5		$6
Machine hours required (b)		2		1		2
Contribution margin per unit of limited resource (a) ÷ (b)		$4		$5		$3

3. Product B should be manufactured because it results in the highest contribution margin per machine hour.

4. (1)

		Product
		A		B		C
Machine hours (a) (4,500 ÷ 3)		1,500		1,500		1,500
Contribution margin per unit of limited resource (b)		$    4		$    5		$    3
Total contribution margin [(a)] × [(b)]		$6,000		$7,500		$4,500

5. The total contribution margin is $18,000 ($6,000 + $7,500 + $4,500)

6. (2)

		Product B
Machine hours (a)		4,500
Contribution margin per unit of limited resource (b)		$     5
Total contribution margin [(a) × (b)]		$22,500

Compute degree of operating leverage and evaluate impact of alternative cost structures on net income.

(LO 4)

3. The CVP income statements shown below are available for Vericelli Company and Boone Company.

		Vericelli Co.		Boone Co.
Sales revenue		$600,000		$600,000
Variable costs		320,000		120,000
Contribution margin		280,000		480,000
Fixed costs		180,000		380,000
Net income		$100,000		$100,000

INSTRUCTIONS

(a) Compute the degree of operating leverage for each company and interpret your results.

(b) Assuming that sales revenue increases by 10%, prepare a variable costing income statement for each company.

(c) Discuss how the cost structure of these two companies affects their operating leverage and profitability.

SOLUTIONS

3.

1.

2.		Contribution Margin		÷		Net Income		=		Degree of Operating Leverage
Vericelli		$280,000		÷		$100,000		=		2.8
Boone		480,000		÷		100,000		=		4.8

3. Boone has a higher degree of operating leverage. Its earnings would increase (decrease) by a greater amount than Vericelli if each experienced an equal increase (decrease) in sales.

4.

5.		Vericelli Co.		Boone Co.
Sales revenue		$660,000 *		$660,000
Variable costs		352,000 **		132,000 ***
Contribution margin		308,000		528,000
Fixed costs		180,000		380,000
Net income		$128,000		$148,000

6. *  $600,000×1.1$600,000×1.1

7. **  $320,000×1.1$320,000×1.1

8. ***  $120,000×1.1$120,000×1.1

9. Each company experienced a $60,000 increase in sales. However, because of Boone's higher operating leverage, it experienced a $48,000 ($148,000−$100,000)$48,000 ($148,000−$100,000) increase in net income while Vericelli experienced only a $28,000 ($128,000−$100,000)$28,000 ($128,000−$100,000) increase. This is what we would have expected since Boone's degree of operating leverage exceeds that of Vericelli.

PRACTICE PROBLEM

Determine sales mix with limited resources.

(LO 3)

Francis Corporation manufactures and sells three different types of water‐sport wakeboards. The boards vary in terms of their quality specifications—primarily with respect to their smoothness and finish. They are referred to as Smooth, Extra‐Smooth, and Super‐Smooth boards. Machine time is limited. More machine time is required to manufacture the Extra‐Smooth and Super‐Smooth boards. Additional information is provided below.

		Product
		Smooth		Extra-Smooth		Super-Smooth
Selling price		$60		$100		$160
Variable costs and expenses		50		75		130
Contribution margin		$10		$ 25		$ 30
Machine hours required		0.25		0.40		0.60
Total fixed costs: $234,000

INSTRUCTIONS

Answer each of the following questions.

(a) Ignoring the machine time constraint, what strategy would appear optimal?

(b) What is the contribution margin per unit of limited resource for each type of board?

(c) If additional machine time could be obtained, how should the additional capacity be used?

SOLUTION

(a) The Super‐Smooth boards have the highest unit contribution margin. Thus, ignoring any manufacturing constraints, it would appear that the company should shift toward production of more Super‐Smooth units.

(b) The contribution margin per unit of limited resource is calculated as follows.

		Smooth		Extra-Smooth		Super-Smooth
Unit contribution marginLimited resource consumed per unitUnit contribution marginLimited resource consumed per unit		$10.25=$40$10.25=$40		$25.40=$62.50$25.40=$62.50		$30.60=$50$30.60=$50

(c) The Extra‐Smooth boards have the highest contribution margin per unit of limited resource. Given the resource constraint, any additional capacity should be used to make Extra‐Smooth boards.

WileyPLUS

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

NOTE: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS

 1. What is meant by CVP analysis?

 2. Provide three examples of management decisions that benefit from CVP analysis.

 3. Distinguish between a traditional income statement and a CVP income statement.

 4. Describe the features of a CVP income statement that make it more useful for management decision‐making than the traditional income statement that is prepared for external users.

 5. The traditional income statement for Wheat Company shows sales $900,000, cost of goods sold $500,000, and operating expenses $200,000. Assuming all costs and expenses are 75% variable and 25% fixed, prepare a CVP income statement through contribution margin.

 6. If management chooses to reduce its selling price to match that of a competitor, how will the break‐even point be affected?

 7. What is meant by the term sales mix? How does sales mix affect the calculation of the break‐even point?

 8. Performance Company sells two types of performance tires. The lower‐priced model is guaranteed for only 50,000 miles; the higher‐priced model is guaranteed for 150,000 miles. The unit contribution margin on the higher‐priced tire is twice as high as that of the lower‐priced tire. If the sales mix shifts so that the company begins to sell more units of the lower‐priced tire, explain how the company's break‐even point in units will change.

 9. What approach should be used to calculate the break‐even point of a company that has many products?

10. How is the contribution margin per unit of limited resource computed?

11. What is the theory of constraints? Provide some examples of possible constraints for a manufacturer.

12. What is meant by “cost structure?” Explain how a company's cost structure affects its break‐even point.

13. What is operating leverage? How does a company increase its operating leverage?

14. How does the replacement of manual labor with automated equipment affect a company's cost structure? What implications does this have for its operating leverage and break‐even point?

15. What is a measure of operating leverage, and how is it calculated?

16. Pine Company has a degree of operating leverage of 8. Fir Company has a degree of operating leverage of 4. Interpret these measures.

17. Distinguish between absorption costing and variable costing.

18. (a) What is the major rationale for the use of variable costing?

   (b) Discuss why variable costing may not be used for financial reporting purposes.

19. Doc Rowan Corporation sells one product, its waterproof hiking boot. It began operations in the current year and had an ending inventory of 8,500 units. The company sold 20,000 units throughout the year. Fixed manufacturing overhead is $5 per unit, and total manufacturing cost per unit is $20 (including fixed manufacturing overhead costs). What is the difference in net income between absorption and variable costing?

20. If production equals sales, what, if any, is the difference between net income under absorption costing versus under variable costing?

21. If production is greater than sales, how does absorption costing net income differ from variable costing net income?

22. In the long run, will net income be higher or lower under variable costing compared to absorption costing?

BRIEF EXERCISES

Determine missing amounts for contribution margin.

(LO 1), AN

BE19-1 Determine the missing amounts.

	Unit Selling Price		Unit Variable Costs		Unit Contribution Margin		Contribution Margin Ratio
1.	$250		$180		(a)		(b)
2.	$500		(c)		$200		(d)
3.	(e)		(f)		$330		30%

Prepare CVP income statement.

(LO 1), AP

BE19-2 Hamby Inc. has sales of $2,000,000 for the first quarter of 2017. In making the sales, the company incurred the following costs and expenses.

		Variable		Fixed
Cost of goods sold		$760,000		$600,000
Selling expenses		95,000		60,000
Administrative expenses		79,000		66,000

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

Compute the break‐even point.

(LO 1), AP

BE19-3 Eastland Corp. had total variable costs of $150,000, total fixed costs of $120,000, and total revenues of $250,000. Compute the required sales in dollars to break even.

Compute the break‐even point.

(LO 1), AP

BE19-4 Dilts Company has a unit selling price of $400, variable costs per unit of $250, and fixed costs of $210,000. Compute the break‐even point in units using (a) the mathematical equation and (b) unit contribution margin.

Compute sales for target net income.

(LO 1), AP

BE19-5 For Rivera Company, variable costs are 70% of sales, and fixed costs are $210,000. Management's net income goal is $60,000. Compute the required sales needed to achieve management's target net income of $60,000. (Use the mathematical equation approach.)

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

(LO 1), AP

BE19-6 For Kosko Company, actual sales are $1,200,000 and break‐even sales are $960,000. Compute (a) the margin of safety in dollars and (b) the margin of safety ratio.

Compute weighted‐average unit contribution margin based on sales mix.

(LO 2), AP

BE19-7 NoFly Corporation sells three different models of a mosquito “zapper.” Model A12 sells for $50 and has variable costs of $35. Model B22 sells for $100 and has variable costs of $70. Model C124 sells for $400 and has variable costs of $300. The sales mix of the three models is A12, 60%; B22, 15%; and C124, 25%. What is the weighted‐average unit contribution margin?

Compute break‐even point in units for company with multiple products.

(LO 2), AP

BE19-8 Information for NoFly Corporation is given in BE19-7. If the company has fixed costs of $269,500, how many units of each model must the company sell in order to break even?

Compute break‐even point in dollars for company with multiple product lines.

(LO 2), AP

BE19-9 Dixie Candle Supply makes candles. The sales mix (as a percentage of total dollar sales) of its three product lines is birthday candles 30%, standard tapered candles 50%, and large scented candles 20%. The contribution margin ratio of each candle type is shown below.

Candle Type		Contribution Margin Ratio
Birthday		20%
Standard tapered		30%
Large scented		45%

(a) What is the weighted‐average contribution margin ratio?

(b) If the company's fixed costs are $450,000 per year, what is the dollar amount of each type of candle that must be sold to break even?

Determine weighted‐average contribution margin.

(LO 2), AP

BE19-10 Faune Furniture Co. consists of two divisions, Bedroom Division and Dining Room Division. The results of operations for the most recent quarter are:

		Bedroom Division		Dining Room Division		Total
Sales		$500,000		$750,000		$1,250,000
Variable costs		225,000		450,000		675,000
Contribution margin		$275,000		$300,000		$  575,000

(a) Determine the company's sales mix.

(b) Determine the company's weighted‐average contribution margin ratio.

Show allocation of limited resources.

(LO 3), AP

BE19-11 In Marshall Company, data concerning two products are unit contribution margin—Product A $10, Product B $12; machine hours required for one unit—Product A 2, Product B 3. Compute the contribution margin per unit of limited resource for each product.

Show allocation of limited resources.

(LO 3), AP

BE19-12 Sage Corporation manufactures two products with the following characteristics.

		Unit Contribution Margin		Machine Hours Required for Production
Product 1		$42		.15 hours
Product 2		$32		.10 hours

If Sage's machine hours are limited to 2,000 per month, determine which product it should produce.

Compute degree of operating leverage.

(LO 4), AP

BE19-13 Sam's Shingle Corporation is considering the purchase of a new automated shingle‐cutting machine. The new machine will reduce variable labor costs but will increase depreciation expense. Contribution margin is expected to increase from $200,000 to $240,000. Net income is expected to be the same at $40,000. Compute the degree of operating leverage before and after the purchase of the new equipment. Interpret your results.

Compute break‐even point with change in operating leverage.

(LO 4), AP

BE19-14 Presented below are variable costing income statements for Diggs Company and Doggs Company. They are in the same industry, with the same net incomes, but different cost structures.

		Diggs Co.		Doggs Co.
Sales		$200,000		$200,000
Variable costs		80,000		50,000
Contribution margin		120,000		150,000
Fixed costs		75,000		105,000
Net income		$ 45,000		$ 45,000

Compute the break‐even point in dollars for each company and comment on your findings.

Determine contribution margin from degree of operating leverage.

(LO 4), AP

BE19-15 The degree of operating leverage for Montana Corp. and APK Co. are 1.6 and 5.4, respectively. Both have net incomes of $50,000. Determine their respective contribution margins.

Compute product costs under variable costing.

(LO 5), AP

*BE19-16 The Rock Company produces basketballs. It incurred the following costs during the year.

Direct materials	$14,400
Direct labor	$25,600
Fixed manufacturing overhead	$12,000
Variable manufacturing overhead	$29,400
Selling costs	$21,000

What are the total product costs for the company under variable costing?

Compute product costs under absorption costing.

(LO 5), AP

*BE19-17 Information concerning The Rock Company is provided in BE19-16. What are the total product costs for the company under absorption costing?

Determine manufacturing cost per unit under absorption and variable costing.

(LO 5), AP

*BE19-18 Burns Company incurred the following costs during the year: direct materials $20 per unit; direct labor $14 per unit; variable manufacturing overhead $15 per unit; variable selling and administrative costs $8 per unit; fixed manufacturing overhead $128,000; and fixed selling and administrative costs $10,000. Burns produced 8,000 units and sold 6,000 units. Determine the manufacturing cost per unit under (a) absorption costing and (b) variable costing.

Compute net income under absorption and variable costing.

(LO 5), AP

*BE19-19  Harris Company's fixed overhead costs are $4 per unit, and its variable overhead costs are $8 per unit. In the first month of operations, 50,000 units are produced, and 46,000 units are sold. Write a short memo to the chief financial officer explaining which costing approach will produce the higher income and what the difference will be.

DO IT!

EXERCISES

Compute the break‐even point and margin of safety under different alternatives.

(LO 1), AP

DO IT! 19-1 Victoria Company reports the following operating results for the month of April.

VICTORIA COMPANY CVP Income Statement For the Month Ended April 30, 2017
		Total		Per Unit
Sales (9,000 units)		$450,000		$50
Variable costs		270,000		30
Contribution margin		180,000		$20
Fixed expenses		150,000
Net income		$ 30,000

Management is considering the following course of action to increase net income: Reduce the selling price by 4%, with no changes to unit variable costs or fixed costs. Management is confident that this change will increase unit sales by 20%.

Using the contribution margin technique, compute the break‐even point in units and dollars and margin of safety in dollars:

(a) Assuming no changes to selling price or costs, and

(b) Assuming changes to sales price and volume as described above.

Comment on your findings.

Compute sales mix, weighted‐average contribution margin, and break‐even point.

(LO 2), AP

DO IT! 19-2 Snow Cap Springs produces and sells water filtration systems for homeowners. Information regarding its three models is shown below.

		Basic		Basic Plus		Premium		Total
Units sold		750		450		300		1,500
Selling price		$250		$400		$800
Variable costs		$195		$285		$415

The company's total fixed costs to produce the filtration systems are $180,700.

(a) Determine the sales mix as a function of units sold for the three products.

(b) Determine the weighted‐average unit contribution margin.

(c) Determine the total number of units that the company must produce to break even.

(d) Determine the number of units of each model that the company must produce to break even.

Determine sales mix with limited resources.

(LO 3), AP

DO IT! 19-3 Zoom Corporation manufactures and sells three different types of binoculars. They are referred to as Good, Better, and Best binoculars. Grinding and polishing time is limited. More time is required to grind and polish the lenses used in the Better and Best binoculars. Additional information is provided below.

		Product
		Good		Better		Best
Selling price		$90.00		$330.00		$900.00
Variable costs and expenses		50.00		180.00		480.00
Contribution margin		$40.00		$150.00		$420.00
Grinding and polishing time required		0.5 hrs		1.5 hrs		6 hrs

(a) Ignoring the time constraint, what strategy would appear to be optimal?

(b) What is the contribution margin per unit of limited resource for each type of binocular?

(c) If additional grinding and polishing time could be obtained, how should the additional capacity be used?

Determine operating leverage.

(LO 4), AP

DO IT! 19-4 Bergen Hospital is contemplating an investment in an automated surgical system. Its current process relies on the a number of skilled physicians. The new equipment would employ a computer robotic system operated by a technician. The company requested an analysis of the old technology versus the new technology. The accounting department has prepared the following CVP income statements for use in your analysis.

		Old		New
Sales		$3,000,000		$3,000,000
Variable costs		1,600,000		700,000
Contribution margin		1,400,000		2,300,000
Fixed costs		1,000,000		1,900,000
Net income		$  400,000		$  400,000

(a) Compute the degree of operating leverage for the company under each scenario.

(b) Discuss your results.

EXERCISES

Compute break‐even point and margin of safety.

(LO 1), AP   

E19-1 The Soma Inn is trying to determine its break‐even point. The inn has 75 rooms that are rented at $60 a night. Operating costs are as follows.

Salaries		$10,600		per month
Utilities		2,400		per month
Depreciation		1,500		per month
Maintenance		800		per month
Maid service		8		per room
Other costs		34		per room

Instructions

(a) Determine the inn's break‐even point in (1) number of rented rooms per month and (2) dollars.

(b) If the inn plans on renting an average of 50 rooms per day (assuming a 30‐day month), what is (1) the monthly margin of safety in dollars and (2) the margin of safety ratio?

Compute contribution margin, break‐even point, and margin of safety.

(LO 1), AP

E19-2 In the month of June, Jose Hebert's Beauty Salon gave 4,000 haircuts, shampoos, and permanents at an average price of $30. During the month, fixed costs were $16,800 and variable costs were 75% 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.

(c) Compute the margin of safety in dollars and as a ratio.

Compute net income under different alternatives.

(LO 1), AP 

E19-3 Barnes Company reports the following operating results for the month of August: sales $325,000 (units 5,000); variable costs $210,000; and fixed costs $75,000. 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 sales volume.

2. Reduce variable costs to 58% of sales.

3. Reduce fixed costs by $15,000.

Instructions

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

Compute break‐even point and prepare CVP income statement.

(LO 1), AP 

E19-4 Comfi Airways, Inc., a small two‐plane passenger airline, has asked for your assistance in some basic analysis of its operations. Both planes seat 10 passengers each, and they fly commuters from Comfi's base airport to the major city in the state, Metropolis. Each month, 40 round‐trip flights are made. Shown below is a recent month's activity in the form of a cost‐volume‐profit income statement.

Fare revenues (400 passenger flights)				$48,000
Variable costs
Fuel		$14,000
Snacks and drinks		800
Landing fees		2,000
Supplies and forms		1,200		18,000
Contribution margin				30,000
Fixed costs
Depreciation		3,000
Salaries		15,000
Advertising		500
Airport hangar fees		1,750		20,250
Net income				$ 9,750

Instructions

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

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

(c) If ticket prices were decreased by 10%, passenger flights would increase by 25%. However, total variable costs would increase by the same percentage as passenger flights. Should the ticket price decrease be adopted?

Prepare a CVP income statement before and after changes in business environment.

(LO 1), AP

E19-5 Carey Company had sales in 2016 of $1,560,000 on 60,000 units. Variable costs totaled $900,000, and fixed costs totaled $500,000.

A new raw material is available that will decrease the variable costs per unit by 20% (or $3). However, to process the new raw material, fixed operating costs will increase by $100,000. Management feels that one‐half of the decline in the variable costs per unit should be passed on to customers in the form of a sales price reduction. The marketing department expects that this sales price reduction will result in a 5% increase in the number of units sold.

Instructions

Prepare a projected CVP income statement for 2017 (a) assuming the changes have not been made, and (b) assuming that changes are made as described.

Compute break‐even point in units for a company with more than one product.

(LO 2), AP

E19-6 Yard Tools manufactures lawnmowers, weed‐trimmers, and chainsaws. Its sales mix and unit contribution margin are as follows.

		Sales Mix		Unit Contribution Margin
Lawnmowers		20%		$30
Weed‐trimmers		50%		$20
Chainsaws		30%		$40

Yard Tools has fixed costs of $4,200,000.

Instructions

Compute the number of units of each product that Yard Tools must sell in order to break even under this product mix.

Compute service line break‐even point and target net income in dollars for a company with more than one service.

(LO 2), AN 

E19-7 PDQ Repairs has 200 auto‐maintenance service outlets nationwide. It performs primarily two lines of service: oil changes and brake repair. Oil change–related services represent 70% of its sales and provide a contribution margin ratio of 20%. Brake repair represents 30% of its sales and provides a 40% contribution margin ratio. The company's fixed costs are $15,600,000 (that is, $78,000 per service outlet).

Instructions

(a) Calculate the dollar amount of each type of service that the company must provide in order to break even.

(b) The company has a desired net income of $52,000 per service outlet. What is the dollar amount of each type of service that must be performed by each service outlet to meet its target net income per outlet?

Compute break‐even point in dollars for a company with more than one service.

(LO 2), AN 

E19-8 Express Delivery is a rapidly growing delivery service. Last year, 80% of its revenue came from the delivery of mailing “pouches” and small, standardized delivery boxes (which provides a 20% contribution margin). The other 20% of its revenue came from delivering non‐standardized boxes (which provides a 70% contribution margin). With the rapid growth of Internet retail sales, Express believes that there are great opportunities for growth in the delivery of non‐standardized boxes. The company has fixed costs of $12,000,000.

Instructions

(a) What is the company's break‐even point in total sales dollars? At the break‐even point, how much of the company's sales are provided by each type of service?

(b) The company's management would like to hold its fixed costs constant but shift its sales mix so that 60% of its revenue comes from the delivery of non‐standardized boxes and the remainder from pouches and small boxes. If this were to occur, what would be the company's break‐even sales, and what amount of sales would be provided by each service type?

Compute break‐even point in units for a company with multiple products.

(LO 2), AP

E19-9 Tiger Golf Accessories sells golf shoes, gloves, and a laser‐guided range‐finder that measures distance. Shown below are unit cost and sales data.

		Pairs of Shoes		Pairs of Gloves		Range‐ Finder
Unit sales price		$100		$30		$260
Unit variable costs		60		10		200
Unit contribution margin		$ 40		$20		$ 60
Sales mix		35%		55%		10%

Fixed costs are $620,000.

Instructions

(a) Compute the break‐even point in units for the company.

(b) Determine the number of units to be sold at the break‐even point for each product line.

(c) Verify that the mix of sales units determined in (b) will generate a zero net income.

Determine break‐even point in dollars for two divisions.

(LO 2), AP

E19-10 Personal Electronix sells iPads and iPods. The business is divided into two divisions along product lines. CVP income statements for a recent quarter's activity are presented below.

		iPad Division		iPod Division		Total
Sales		$600,000		$400,000		$1,000,000
Variable costs		420,000		260,000		680,000
Contribution margin		$180,000		$140,000		320,000
Fixed costs						120,000
Net income						$  200,000

Instructions

(a) Determine sales mix percentage and contribution margin ratio for each division.

(b) Calculate the company's weighted‐average contribution margin ratio.

(c) Calculate the company's break‐even point in dollars.

(d) Determine the sales level in dollars for each division at the break‐even point.

Compute contribution margin and determine the product to be manufactured.

(LO 3), AN

E19-11 Mars Company manufactures and sells three products. Relevant per unit data concerning each product are given below.

		Product
		A		B		C
Selling price		$9		$12		$15
Variable costs and expenses		$3		$10		$12
Machine hours to produce		2		1		2

Instructions

(a) Compute the contribution margin per unit of limited resource (machine hours) for each product.

(b) Assuming 3,000 additional machine hours are available, which product should be manufactured?

(c) Prepare an analysis showing the total contribution margin if the additional hours are (1) divided equally among the products, and (2) allocated entirely to the product identified in (b) above.

Compute contribution margin and determine the products to be manufactured.

(LO 3), AN

E19-12 Dalton Inc. produces and sells three products. Unit data concerning each product is shown below.

		Product
		D		E		F
Selling price		$200		$300		$250
Direct labor costs		30		80		35
Other variable costs		95		80		145

The company has 2,000 hours of labor available to build inventory in anticipation of the company's peak season. Management is trying to decide which product should be produced. The direct labor hourly rate is $10.

Instructions

(a) Determine the number of direct labor hours per unit.

(b) Determine the contribution margin per direct labor hour.

(c) Determine which product should be produced and the total contribution margin for that product.

Compute contribution margin and determine the products to be manufactured.

(LO 3), AN

E19-13 Helena Company manufactures and sells two products. Relevant per unit data concerning each product follow.

		Product
		Basic		Deluxe
Selling price		$40		$52
Variable costs		$22		$24
Machine hours		0.5		0.8

Instructions

(a) Compute the contribution margin per machine hour for each product.

(b) If 1,000 additional machine hours are available, which product should Helena manufacture?

(c) Prepare an analysis showing the total contribution margin if the additional hours are:

(1) Divided equally between the products.

(2) Allocated entirely to the product identified in part (b).

Compute degree of operating leverage and evaluate impact of alternative cost structures on net income.

(LO 4), AN

E19-14 The CVP income statements shown below are available for Armstrong Company and Contador Company.

		Armstrong Co.		Contador Co.
Sales		$500,000		$500,000
Variable costs		240,000		50,000
Contribution margin		260,000		450,000
Fixed costs		160,000		350,000
Net income		$100,000		$100,000

Instructions

(a) Compute the degree of operating leverage for each company and interpret your results.

(b) Assuming that sales revenue increases by 10%, prepare a variable costing income statement for each company.

(c) Discuss how the cost structure of these two companies affects their operating leverage and profitability.

Compute degree of operating leverage and evaluate impact of alternative cost structures on net income and margin of safety.

(LO 4), AN 

E19-15 Casas Modernas of Juarez, Mexico, is contemplating a major change in its cost structure. Currently, all of its drafting work is performed by skilled draftsmen. Rafael Jiminez, Casas' owner, is considering replacing the draftsmen with a computerized drafting system. However, before making the change, Rafael would like to know the consequences of the change, since the volume of business varies significantly from year to year. Shown below are CVP income statements for each alternative.

		Manual System		Computerized System
Sales		$1,500,000		$1,500,000
Variable costs		1,200,000		600,000
Contribution margin		300,000		900,000
Fixed costs		100,000		700,000
Net income		$  200,000		$  200,000

Instructions

(a) Determine the degree of operating leverage for each alternative.

(b) Which alternative would produce the higher net income if sales increased by $150,000?

(c) Using the margin of safety ratio, determine which alternative could sustain the greater decline in sales before operating at a loss.

Compute degree of operating leverage and impact on net income of alternative cost structures.

(LO 4), AN

E19-16 An investment banker is analyzing two companies that specialize in the production and sale of candied yams. Traditional Yams uses a labor‐intensive approach, and Auto‐Yams uses a mechanized system. CVP income statements for the two companies are shown below.

		Traditional Yams		Auto‐Yams
Sales		$400,000		$400,000
Variable costs		320,000		160,000
Contribution margin		80,000		240,000
Fixed costs		30,000		190,000
Net income		$ 50,000		$ 50,000

The investment banker is interested in acquiring one of these companies. However, she is concerned about the impact that each company's cost structure might have on its profitability.

Instructions

(a) Calculate each company's degree of operating leverage. Determine which company's cost structure makes it more sensitive to changes in sales volume.

(b) Determine the effect on each company's net income if sales decrease by 15% and if sales increase by 10%. Do not prepare income statements.

(c) Which company should the investment banker acquire? Discuss.

Compute product cost and prepare an income statement under variable and absorption costing.

(LO 5), AP 

*E19-17 Siren Company builds custom fishing lures for sporting goods stores. In its first year of operations, 2017, the company incurred the following costs.

Variable Costs per Unit
Direct materials		$7.50
Direct labor		$3.45
Variable manufacturing overhead		$5.80
Variable selling and administrative expenses		$3.90
Fixed Costs per Year
Fixed manufacturing overhead		$225,000
Fixed selling and administrative expenses		$210,100

Siren Company sells the fishing lures for $25. During 2017, the company sold 80,000 lures and produced 90,000 lures.

Instructions

(a) Assuming the company uses variable costing, calculate Siren's manufacturing cost per unit for 2017.

(b) Prepare a variable costing income statement for 2017.

(c) Assuming the company uses absorption costing, calculate Siren's manufacturing cost per unit for 2017.

(d) Prepare an absorption costing income statement for 2017.

Determine ending inventory under variable costing and determine whether absorption or variable costing would result in higher net income.

(LO 5), AN

*E19-18 Langdon Company produced 9,000 units during the past year, but only 8,200 of the units were sold. The following additional information is also available.

Direct materials used		$79,000
Direct labor incurred		$30,000
Variable manufacturing overhead		$21,500
Fixed manufacturing overhead		$45,000
Fixed selling and administrative expenses		$70,000
Variable selling and administrative expenses		$10,000

There was no work in process inventory at the beginning and end of the year, nor did Langdon have any beginning finished goods inventory.

Instructions

(a) What would be Langdon Company's finished goods inventory cost on December 31 under variable costing?

(b) Which costing method, absorption or variable costing, would show a higher net income for the year? By what amount?

Compute manufacturing cost under absorption and variable costing and explain difference.

(LO 5), AN

*E19-19 Crate Express Co. produces wooden crates used for shipping products by ocean liner. In 2017, Crate Express incurred the following costs.

Wood used in crate production		$54,000
Nails (considered insignificant and a variable expense)		$   350
Direct labor		$43,000
Utilities for the plant:
$1,500 each month,
plus $0.50 for each kilowatt‐hour used each month
Rent expense for the plant for the year		$21,400

Assume Crate Express used an average 500 kilowatt‐hours each month over the past year.

Instructions

(a) What is Crate Express's total manufacturing cost if it uses a variable costing approach?

(b) What is Crate Express's total manufacturing cost if it uses an absorption costing approach?

(c) What accounts for the difference in manufacturing costs between these two costing approaches?

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

Compute break‐even point under alternative courses of action.

(LO 1), AN

P19-1A Midlands Inc. had a bad year in 2016. For the first time in its history, it operated at a loss. The company's income statement showed the following results from selling 80,000 units of product: net sales $2,000,000; total costs and expenses $2,235,000; and net loss $235,000. Costs and expenses consisted of the following.

		Total		Variable		Fixed
Cost of goods sold		$1,568,000		$1,050,000		$   518,000
Selling expenses		517,000		92,000		425,000
Administrative expenses		150,000		58,000		92,000
		$2,235,000		$1,200,000		$ 1,035,000

Management is considering the following independent alternatives for 2017.

1. Increase unit selling price 25% with no change in costs and expenses.

2. Change the compensation of salespersons from fixed annual salaries totaling $200,000 to total salaries of $40,000 plus a 5% commission on net sales.

3. Purchase new high‐tech factory machinery that will change the proportion between variable and fixed cost of goods sold to 50:50.

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 to the nearest dollar.) Which course of action do you recommend?

(b) (2) $2,500,000

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

(LO 1), AN

P19-2A Lorge Corporation has collected the following information after its first year of sales. Sales were $1,500,000 on 100,000 units; selling expenses $250,000 (40% variable and 60% fixed); direct materials $511,000; direct labor $290,000; administrative expenses $270,000 (20% variable and 80% fixed); and manufacturing overhead $350,000 (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 first year.

(b) 157,000 units

(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?

(e) The company is considering a purchase of equipment that would reduce its direct labor costs by $104,000 and would change its manufacturing overhead costs to 30% variable and 70% fixed (assume total manufacturing overhead cost is $350,000, as above). It is also considering switching to a pure commission basis for its sales staff. This would change selling expenses to 90% variable and 10% fixed (assume total selling expense is $250,000, as above). Compute (1) the contribution margin and (2) the contribution margin ratio, and recompute (3) the break‐even point in sales dollars. Comment on the effect each of management's proposed changes has on the break‐even point.

(e) (3) $1,735,714

Determine break‐even sales under alternative sales strategies and evaluate results.

(LO 2), AN 

P19-3A The Grand Inn is a restaurant in Flagstaff, Arizona. It specializes in southwestern style meals in a moderate price range. Paul Weld, the manager of Grand, has determined that during the last 2 years the sales mix and contribution margin ratio of its offerings are as follows.

		Percent of Total Sales		Contribution Margin Ratio
Appetizers		15%		50%
Main entrees		50%		25%
Desserts		10%		50%
Beverages		25%		80%

Paul is considering a variety of options to try to improve the profitability of the restaurant. His goal is to generate a target net income of $117,000. The company has fixed costs of $1,053,000 per year.

Instructions

(a) Calculate the total restaurant sales and the sales of each product line that would be necessary to achieve the desired target net income.

(a) Total sales $2,600,000

(b) Paul believes the restaurant could greatly improve its profitability by reducing the complexity and selling price of its entrees to increase the number of clients that it serves. It would then more heavily market its appetizers and beverages. He is proposing to reduce the contribution margin ratio on the main entrees to 10% by dropping the average selling price. He envisions an expansion of the restaurant that would increase fixed costs by $585,000. At the same time, he is proposing to change the sales mix to the following.

		Percent of Total Sales			Contribution Margin Ratio
Appetizers		25%			50%
Main entrees		25%			10%
Desserts		10%			50%
Beverages		40%			80%

Compute the total restaurant sales, and the sales of each product line that would be necessary to achieve the desired target net income.

(b) Total sales $3,375,000

(c) Suppose that Paul reduces the selling price on entrees and increases fixed costs as proposed in part (b), but customers are not swayed by the marketing efforts and the sales mix remains what it was in part (a). Compute the total restaurant sales and the sales of each product line that would be necessary to achieve the desired target net income. Comment on the potential risks and benefits of this strategy.

Determine sales mix with limited resources.

(LO 3), AN

P19-4A Tanek Industries manufactures and sells three different models of wet‐dry shop vacuum cleaners. Although the shop vacs vary in terms of quality and features, all are good sellers. Tanek is currently operating at full capacity with limited machine time.

Sales and production information relevant to each model follows.

		Product
		Economy		Standard		Deluxe
Selling price		$30		$50		$100
Variable costs and expenses		$16		$20		$46
Machine hours required		0.5		0.8		1.6

Instructions

(a) Ignoring the machine time constraint, which single product should Tanek Industries produce?

(b) What is the contribution margin per unit of limited resource for each product?

(b) Economy $28

(c) If additional machine time could be obtained, how should the additional time be used?

Compute degree of operating leverage and evaluate impact of operating leverage on financial results.

(LO 4), AN

P19-5A The following CVP income statements are available for Blanc Company and Noir Company.

		Blanc Company		Noir Company
Sales		$500,000		$500,000
Variable costs		280,000		180,000
Contribution margin		220,000		320,000
Fixed costs		170,000		270,000
Net income		$ 50,000		$ 50,000

Instructions

(a) Compute the break‐even point in dollars and the margin of safety ratio (round to 3 places) for each company.

(a) BE, Blanc $386,364 BE, Noir $421,875

(b) Compute the degree of operating leverage for each company and interpret your results.

(b) DOL, Blanc 4.4 DOL, Noir 6.4

(c) Assuming that sales revenue increases by 20%, prepare a CVP income statement for each company.

(d) Assuming that sales revenue decreases by 20%, prepare a CVP income statement for each company.

(e)  Discuss how the cost structure of these two companies affects their operating leverage and profitability.

Determine contribution margin, break‐even point, target sales, and degree of operating leverage.

(LO 1, 4), AN

P19-6A Bonita Beauty Corporation manufactures cosmetic products that are sold through a network of sales agents. The agents are paid a commission of 18% of sales. The income statement for the year ending December 31, 2017, is as follows.

BONITA BEAUTY CORPORATION Income Statement For the Year Ended December 31, 2017
Sales				$75,000,000
Cost of goods sold
Variable		$31,500,000
Fixed		8,610,000		40,110,000
Gross margin				34,890,000
Selling and marketing expenses
Commissions		13,500,000
Fixed costs		10,260,000		23,760,000
Operating income				$11,130,000

The company is considering hiring its own sales staff to replace the network of agents. It will pay its salespeople a commission of 8% and incur additional fixed costs of $7.5 million.

Instructions

(a) Under the current policy of using a network of sales agents, calculate the Bonita Beauty Corporation's break‐even point in sales dollars for the year 2017.

(a) $47,175

(b) Calculate the company's break‐even point in sales dollars for the year 2017 if it hires its own sales force to replace the network of agents.

(c) Calculate the degree of operating leverage at sales of $75 million if (1) Bonita Beauty uses sales agents, and (2) Bonita Beauty employs its own sales staff. Describe the advantages and disadvantages of each alternative.

(c) (2) 3.37

(d) Calculate the estimated sales volume in sales dollars that would generate an identical net income for the year ending December 31, 2017, regardless of whether Bonita Beauty Corporation employs its own sales staff and pays them an 8% commission or continues to use the independent network of agents.

(CMA‐Canada adapted)

Prepare income statements under absorption costing and variable costing for a company with beginning inventory, and reconcile differences.

(LO 5), AN

*P19-7A Jackson Company produces plastic that is used for injection‐molding applications such as gears for small motors. In 2016, the first year of operations, Jackson produced 4,000 tons of plastic and sold 3,500 tons. In 2017, the production and sales results were exactly reversed. In each year, the selling price per ton was $2,000, variable manufacturing costs were 15% of the sales price of units produced, variable selling expenses were 10% of the selling price of units sold, fixed manufacturing costs were $2,800,000, and fixed administrative expenses were $500,000.

Instructions

(a) Prepare income statements for each year using variable costing. (Use the format from  Illustration 19A-5 .)

(a) 2017 $2,700,000

(b) Prepare income statements for each year using absorption costing. (Use the format from  Illustration 19A-4 .)

(b) 2017 $2,350,000

(c) Reconcile the differences each year in net income under the two costing approaches.

(d)  Comment on the effects of production and sales on net income under the two costing approaches.

Prepare absorption and variable costing income statements and reconcile differences between absorption and variable costing income statements when sales level and production level change. Discuss relative usefulness of absorption costing versus variable costing.

(LO 5), AN

*P19-8A Dilithium Batteries is a division of Enterprise Corporation. The division manufactures and sells a long‐life battery used in a wide variety of applications. During the coming year, it expects to sell 60,000 units for $30 per unit. Nyota Uthura is the division manager. She is considering producing either 60,000 or 90,000 units during the period. Other information is presented in the schedule.

Division Information for 2017
Beginning inventory	0
Expected sales in units	60,000
Selling price per unit	$30
Variable manufacturing costs per unit	$12
Fixed manufacturing overhead costs (total)	$540,000
Fixed manufacturing overhead costs per unit:
Based on 60,000 units	$9 per unit ($540,000 ÷ 60,000)
Based on 90,000 units	$6 per unit ($540,000 ÷ 90,000)
Manufacturing costs per unit:
Based on 60,000 units	$21 per unit ($12 variable + $9 fixed)
Based on 90,000 units	$18 per unit ($12 variable + $6 fixed)
Variable selling and administrative expenses	$2
Fixed selling and administrative expenses (total)	$50,000

Instructions

(a) Prepare an absorption costing income statement, with one column showing the results if 60,000 units are produced and one column showing the results if 90,000 units are produced.

(a) 90,000 units: NI $550,000

(b) Prepare a variable costing income statement, with one column showing the results if 60,000 units are produced and one column showing the results if 90,000 units are produced.

(b) 90,000 units: NI $370,000

(c) Reconcile the difference in net incomes under the two approaches and explain what accounts for this difference.

(d)  Discuss the relative usefulness of the variable costing income statements versus the absorption costing income statements for decision making and for evaluating the manager's performance.

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

CD19 Current Designs manufactures two different types of kayaks, rotomolded kayaks and composite kayaks. The following information is available for each product line.

		Rotomolded		Composite
Sales price/unit		$950		$2,000
Variable costs/unit		$570		$1,340

The company's fixed costs are $820,000. An analysis of the sales mix identifies that rotomolded kayaks make up 80% of the total units sold.

Instructions

(a) Determine the weighted‐average unit contribution margin for Current Designs.

(b) Determine the break‐even point in units for Current Designs and identify how many units of each type of kayak will be sold at the break‐even point. (Round to the nearest whole number.)

(c) Assume that the sales mix changes, and rotomolded kayaks now make up 70% of total units sold. Calculate the total number of units that would need to be sold to earn a net income of $2,000,000 and identify how many units of each type of kayak will be sold at this level of income. (Round to the nearest whole number.)

(d) Assume that Current Designs will have sales of $3,000,000 with two‐thirds of the sales dollars in rotomolded kayaks and one‐third of the sales dollars in composite kayaks. Assuming $660,000 of fixed costs are allocated to the rotomolded kayaks and $160,000 to the composite kayaks, prepare a CVP income statement for each product line.

(e) Using the information in part (d), calculate the degree of operating leverage for each product line and interpret your findings. (Round to two decimal places.)

WATERWAYS

( Note: This is a continuation of the Waterways problem from  Chapters 14 – 18 .)

WP19 This problem asks you to perform break‐even analysis based on Waterways' sales mix and to make sales mix decisions related to Waterways' use of its productive facilities. An optional extension of the problem (related to the chapter appendix) also asks you to prepare a variable costing income statement and an absorption costing income statement.

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

  EXPAND YOUR | CRITICAL THINKING

DECISION‐MAKING ACROSS THE ORGANIZATION

CT19-1 E‐Z Seats manufactures swivel seats for customized vans. It currently manufactures 10,000 seats per year, which it sells for $500 per seat. It incurs variable costs of $200 per seat and fixed costs of $2,000,000. It is considering automating the upholstery process, which is now largely manual. It estimates that if it does so, its fixed costs will be $3,000,000, and its variable costs will decline to $100 per seat.

Instructions

With the class divided into groups, answer the following questions.

(a) Prepare a CVP income statement based on current activity.

(b) Compute contribution margin ratio, break‐even point in dollars, margin of safety ratio, and degree of operating leverage based on current activity.

(c) Prepare a CVP income statement assuming that the company invests in the automated upholstery system.

(d) Compute contribution margin ratio, break‐even point in dollars, margin of safety ratio, and degree of operating leverage assuming the new upholstery system is implemented.

(e) Discuss the implications of adopting the new system.

E

MANAGERIAL ANALYSIS

CT19-2 For nearly 20 years, Specialized Coatings has provided painting and galvanizing services for manufacturers in its region. Manufacturers of various metal products have relied on the quality and quick turnaround time provided by Specialized Coatings and its 20 skilled employees. During the last year, as a result of a sharp upturn in the economy, the company's sales have increased by 30% relative to the previous year. The company has not been able to increase its capacity fast enough, so Specialized Coatings has had to turn work away because it cannot keep up with customer requests.

Top management is considering the purchase of a sophisticated robotic painting booth. The booth would represent a considerable move in the direction of automation versus manual labor. If Specialized Coatings purchases the booth, it would most likely lay off 15 of its skilled painters. To analyze the decision, the company compiled production information from the most recent year and then prepared a parallel compilation assuming that the company would purchase the new equipment and lay off the workers. Those data are shown below. As you can see, the company projects that during the last year it would have been far more profitable if it had used the automated approach.

		Current Approach		Automated Approach
Sales		$2,000,000		$2,000,000
Variable costs		1,500,000		1,000,000
Contribution margin		500,000		1,000,000
Fixed costs		380,000		800,000
Net income		$  120,000		$  200,000

Instructions

(a) Compute and interpret the contribution margin ratio under each approach.

(b) Compute the break‐even point in sales dollars under each approach. Discuss the implications of your findings.

(c) Using the current level of sales, compute the margin of safety ratio under each approach and interpret your findings.

(d) Determine the degree of operating leverage for each approach at current sales levels. How much would the company's net income decline under each approach with a 10% decline in sales?

(e) At what level of sales would the company's net income be the same under either approach?

(f) Discuss the issues that the company must consider in making this decision.

AN

REAL‐WORLD FOCUS

CT19-3 In a recent report, the Del Monte Foods Company reported three separate operating segments: consumer products (which includes a variety of canned foods including tuna, fruit, and vegetables); pet products (which includes pet food and snacks and veterinary products); and soup and infant‐feeding products (which includes soup, broth, and infant feeding and pureed products).

In its annual report, Del Monte uses absorption costing. As a result, information regarding the relative composition of its fixed and variable costs is not available. We have assumed that $860.3 million of its total operating expenses of $1,920.3 million are fixed and have allocated the remaining variable costs across the three divisions. Sales data, along with assumed expense data, are provided below.

	(in millions)
		Sales		Variable Costs
Consumer products		$1,031.8		$  610
Pet products		837.3		350
Soup and infant-feeding products		302.0		100
		$2,171.1		$1,060

Instructions

(a) Compute each segment's contribution margin ratio and the sales mix.

(b) Using the information computed in part (a), compute the company's break‐even point in dollars, and then determine the amount of sales that would be generated by each division at the break‐even point.

AN

CT19-4 The external financial statements published by publicly traded companies are based on absorption cost accounting. As a consequence, it is very difficult to gain an understanding of the relative composition of the companies' fixed and variable costs. It is possible, however, to learn about a company's sales mix and the relative profitability of its various divisions. This exercise looks at the financial statements of FedEx Corporation.

Address: www.fedex.com/us/investorrelations , or go to www.wiley.com/college/kimmel

Steps

1. Go to the site above.

2. Under “Financial Information,” choose “Annual Reports.”

3. Choose “2013 Annual Report.”

Instructions

(a) Read page 9 of the report under the heading “Description of Business.” What are the three primary product lines of the company? What does the company identify as the key factors affecting operating results?

(b) Page 21 of the report lists the operating expenses of FedEx Ground. Assuming that rentals, depreciation, and “other” are all fixed costs, prepare a variable costing income statement for 2013, and compute the division's contribution margin ratio and the break‐even point in dollars.

(c) Page 61, Note 14 (“Business segment information”) provides additional information regarding the relative profitability of the business segments.

(i) Calculate the sales mix for 2011 and 2013. ( Note: Exclude “other” when you calculate total revenue.)

(ii) The company does not provide the contribution margin for each division, but it does provide “operating margin” (operating income divided by revenues) on pages 21, 22, and 23 for three divisions. List these for each division for 2011 and 2013.

(iii) Assuming that the “operating margin” (operating income divided by revenues) moves in parallel with each division's contribution margin, how has the shift in sales mix affected the company's profitability from 2011 to 2013?

E   CT19-5 The June 8, 2009, edition of the  Wall Street Journal has an article by JoAnn Lublin entitled “Smart Balance Keeps Tight Focus on Creativity.”

Instructions

Read the article and answer the following questions.

(a) Describe Smart Balance's approach to employment and cost structure.

(b) What function does it keep “in‐house”?

(c) Based on the discussion in this chapter, what are the advantages to Smart Balance's approach?

(d) Based on the discussion in this chapter, what are the disadvantages to Smart Balance's approach?

COMMUNICATION ACTIVITY

CT19-6 Easton Corporation makes two different boat anchors—a traditional fishing anchor and a high‐end yacht anchor—using the same production machinery. The contribution margin of the yacht anchor is three times as high as that of the other product. The company is currently operating at full capacity and has been doing so for nearly two years. Bjorn Borg, the company's CEO, wants to cut back on production of the fishing anchor so that the company can make more yacht anchors. He says that this is a “no‐brainer” because the contribution margin of the yacht anchor is so much higher.

Instructions

Write a short memo to Bjorn Borg describing the analysis that the company should do before it makes this decision and any other considerations that would affect the decision.

E

ETHICS CASE

*CT19-7 Brett Stern was hired during January 2017 to manage the home products division of Hi‐Tech Products. As part of his employment contract, he was told that he would get $5,000 of additional bonus for every 1% increase that the division's profits exceeded those of the previous year.

Soon after coming on board, Brett met with his plant managers and explained that he wanted the plants to be run at full capacity. Previously, the plant had employed just‐in‐time inventory practices and had consequently produced units only as they were needed. Brett stated that under previous management the company had missed out on too many sales opportunities because it didn't have enough inventory on hand. Because previous management had employed just‐in‐time inventory practices, when Brett came on board there was virtually no beginning inventory. The selling price and variable costs per unit remained the same from 2016 to 2017. Additional information is provided below.

		2016		2017
Net income		$  300,000		$  525,000
Units produced		25,000		30,000
Units sold		25,000		25,000
Fixed manufacturing overhead costs		$1,350,000		$1,350,000
Fixed manufacturing overhead costs per unit		$       54		$       45

Instructions

(a) Calculate Brett's bonus based upon the net income shown above.

(b) Recompute the 2016 and 2017 results using variable costing.

(c) Recompute Brett's 2017 bonus under variable costing.

(d) Were Brett's actions unethical? Do you think any actions need to be taken by the company?

E

ALL ABOUT YOU

CT19-8 Many of you will some day own your own business. One rapidly growing opportunity is no‐frills workout centers. Such centers attract customers who want to take advantage of state‐of‐the‐art fitness equipment but do not need the other amenities of full‐service health clubs. One way to own your own fitness business is to buy a franchise. Snap Fitness is a Minnesota‐based business that offers franchise opportunities. For a very low monthly fee ($26, without an annual contract), customers can access a Snap Fitness center 24 hours a day.

The Snap Fitness website ( www.snapfitness.com) indicates that start‐up costs range from $60,000 to $184,000. This initial investment covers the following pre‐opening costs: franchise fee, grand opening marketing, leasehold improvements, utility/rent deposits, and training.

Instructions

(a) Suppose that Snap Fitness estimates that each location incurs $4,000 per month in fixed operating expenses plus $1,460 to lease equipment. A recent newspaper article describing no‐frills fitness centers indicated that a Snap Fitness site might require only 300 members to break even. Using the information provided above and your knowledge of CVP analysis, estimate the amount of variable costs. (When performing your analysis, assume that the only fixed costs are the estimated monthly operating expenses and the equipment lease.)

(b) Using the information from part (a), what would monthly sales in members and dollars have to be to achieve a target net income of $3,640 for the month?

(c) Provide five examples of variable costs for a fitness center.

(d) Go to a fitness‐business website, such as Curves, Snap Fitness, or Anytime Fitness, and find information about purchasing a franchise. Summarize the franchise information needed to decide whether entering into a franchise agreement would be a good idea.

E

CONSIDERING PEOPLE, PLANET, AND PROFIT

CT19-9 Many politicians, scientists, economists, and businesspeople have become concerned about the potential implications of global warming. The largest source of the emissions thought to contribute to global warming is from coal‐fired power plants. The cost of alternative energy has declined, but it is still higher than coal. In 1980, wind‐power electricity cost 80 cents per kilowatt hour. Using today's highly efficient turbines with rotor diameters of up to 125 meters, the cost can be as low as 4 cents (about the same as coal), or as much as 20 cents in places with less wind.

Some people have recently suggested that conventional cost comparisons are not adequate because they do not take environmental costs into account. For example, while coal is a very cheap energy source, it is also a significant contributor of greenhouse gases. Should environmental costs be incorporated into decision formulas when planners evaluate new power plants? The basic arguments for and against are as follows.

1. YES: As long as environmental costs are ignored, renewable energy will appear to be too expensive relative to coal.

2. NO: If one country decides to incorporate environmental costs into its decision‐making process but other countries do not, the country that does so will be at a competitive disadvantage because its products will cost more to produce.

Instructions

Write a response indicating your position regarding this situation. Provide support for your view.