Select Solutions to Chapter 7

7-14 East Company, which is highly automated, will have a cost structure dominated
by fixed costs. West Company's cost structure will include a larger proportion
of variable costs than East Company's cost structure.
A firm's operating leverage factor, at a particular sales volume, is defined as
its total contribution margin divided by its net income. Since East Company has
proportionately higher fixed costs, it will have a proportionately higher total
contribution margin. Therefore, East Company's operating leverage factor will
be higher.
7-15 When sales volume increases, Company X will have a higher percentage
increase in profit than Company Y. Company X's higher proportion of fixed
costs gives the firm a higher operating leverage factor. The company's
percentage increase in profit can be found by multiplying the percentage
increase in sales volume by the firm's operating leverage factor.
7-16 The sales mix of a multiproduct organization is the relative proportion of sales
of its products.
The weighted-average unit contribution margin is the average of the unit
contribution margins for a firm's several products, with each product's
contribution margin weighted by the relative proportion of that product's sales.
7-17 The car rental agency's sales mix is the relative proportion of its rental
business associated with each of the three types of automobiles: subcompact,
compact, and full-size. In a multi-product CVP analysis, the sales mix is
assumed to be constant over the relevant range of activity.
7-18 Cost-volume-profit analysis shows the effect on profit of changes in expenses,
sales prices, and sales mix. A change in the hotel's room rate (price) will
change the hotel's unit contribution margin. This contribution-margin change
will alter the relationship between volume and profit.
7-21 The statement makes three assertions, but only two of them are true. Thus the
statement is false . A company with an advanced manufacturing environment
typically will have a larger proportion of fixed costs in its cost structure. This
will result in a higher break-even point and greater operating leverage.
However, the firm's higher break-even point will result in a reduced safety
margin.
7-22 Activity-based costing (ABC) results in a richer description of an organization's
cost behavior and CVP relationships. Costs that are fixed with respect to sales
volume may not be fixed with respect to other important cost drivers. An ABC
system recognizes these nonvolume cost drivers, whereas a traditional costing
system does not.
EXERCISE 7-24 (25 MINUTES)

Total Break-Even
Sales Variable Contribution Fixed Net Sales
Revenue Expenses Margin Expenses Income Revenue
1 $360,000 $120,000 $240,000 $90,000 $150,00 $135,000 a
0
2 55,000 11,000 44,000 25,000 19,000 31,250 b
3 320,000 c 80,000 240,000 60,000 80,000
180,000
d
4 160,000 130,000 30,000 30,000 -0- 160,000

Explanatory notes for selected items:

a
$135,000 = $90,000 (2/3), where 2/3 is the contribution-margin ratio.
b
$31,250 = $25,000/.80, where .80 is the contribution-margin ratio.
c
Break-even sales revenue.................................................................. $80,000
Fixed expenses................................................................................. 60,000
Variable expenses............................................................................. $20,000

Therefore, variable expenses are 25 percent of sales revenue.

When variable expenses amount to $80,000, sales revenue is $320,000.

d
$160,000 is the break-even sales revenue, so fixed expenses must be equal to the
contribution margin of $30,000 and profit must be zero.

EXERCISE 7-26 (25 MINUTES)

1. Profit-volume graph:
 Dollars per year

$300,000

$200,000

$100,000
Break-even point: Profit
20,000 tickets area
0 Tickets sold
5,000 10,000 15,000 20,000 25,000 per year

Loss
area
$(100,000)

$(200,000)

Annual fixed
expenses
$(300,000)

$(360,000)
EXERCISE 7-26 (CONTINUED)

2. Safety margin:

Budgeted sales revenue

(10 games 6,000 seats .45 full $20).................................... $540,000
Break-even sales revenue
(20,000 tickets $20)................................................................. 400,000
Safety margin................................................................................... $140,000

3. Let P denote the break-even ticket price, assuming a 10-game season and 40
percent attendance:

(10)(6,000)(.40) P (10)(6,000)(.40)($2) $360,000 = 0

24,000 P = $408,000
P = $17 per ticket
EXERCISE 7-28 (25 MINUTES)

1. (a) Traditional income statement:

PACIFIC RIM PUBLICATIONS, INC.
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 20XX
Sales ............................................................... $1,000,000
Less: Cost of goods sold.................................. 750,000
Gross margin...................................................... $ 250,000
Less: Operating expenses:
Selling expenses..................................... $75,000
Administrative expenses.......................... 75,000 150,000
Net income......................................................... $ 100,000

(b) Contribution income statement:

PACIFIC RIM PUBLICATIONS, INC.
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 20XX
Sales ............................................................... $1,000,000
Less: Variable expenses:
Variable manufacturing............................ $500,000
Variable selling........................................ 50,000
Variable administrative............................ 15,000 565,000
Contribution margin............................................. $ 435,000
Less: Fixed expenses:
Fixed manufacturing................................ $ 250,000
Fixed selling............................................ 25,000
Fixed administrative................................ 60,000
335,000
Net income.........................................................
100,000

contribution margin
2. Operatingleveragefactor (at $1,000,000sales level)
net income
$435,000
4.35
$100,000
EXERCISE 7-28 (CONTINUED)

percentageincrease operating
3.

Percentageincreasein et income
i nsalesrev nue lev ragefactor
= 12% 4.35
= 52.2%

4. Most operating managers prefer the contribution income statement for answering
this type of question. The contribution format highlights the contribution margin and
separates fixed and variable expenses.

PROBLEM 7-34 (30 MINUTES)

1. Break-even point in sales dollars, using the contribution-margin ratio:

fixed expenses
Break - even point
contributi on - margin ratio
$540,000 $216,000 $756,000

$30 $12 $6 .4
$30
$1,890,000

2. Target net income, using contribution-margin approach:

fixed expenses target net income
Sales units required to earn income of $540,000
unit contributi on margin
$756,000 $540,000 $1,296,000

$30 $12 $6 $12
108,000units

3. New unit variable manufacturing = $12 110%

cost
 = $13.20
Break-even point in sales dollars:
$756,000 $756,000
Break - even point
$30.00 $13.20 $6.00 .36
$30
$2,100,000
PROBLEM 7-34 (CONTINUED)

4. Let P denote the selling price that will yield the same contribution-margin ratio:
$30.00 $12.00 $6.00 P $13.20 $6.00

$30.00 P
P $19.20
.4
P
.4P P $19.20
$19.20 .6P
P $19.20/.6
P $32.00
Check: New contribution-margin ratio is:
$32.00 $13.20 $6.00
.4
$32.00
PROBLEM 7-36 (30 MINUTES)

1. Break-even point in units, using the equation approach:

$24 X ($15 + $3) X $1,800,000 = 0

$6 X = $1,800,000
$1,800,000
X = $6
= 300,000 units

2. New projected sales volume = 400,000 110%

= 440,000 units
Net income = (440,000)($24 $18) $1,800,000

= (440,000)($6) $1,800,000

= $2,640,000 $1,800,000 = $840,000

3. Target net income = $600,000 (from original problem data)

New disk purchase price = $15 130% = $19.50

Volume of sales dollars required:

fixed expenses target net profit

Volume of sales dollars required
contribution - margin ratio
$1,800,000 $600,000 $2,400,000

$24 $19.50 $3 .0625
$24
$38,400,00 0
PROBLEM 7-36 (CONTINUED)

4. Let P denote the selling price that will yield the same contribution-margin ratio:
$24 $15 $3 P $19.50 $3

$24 P
P $22.50
.25
P
.25P P $22.50
$22.50 .75P
P $22.50/.75
P $30

Check: New contribution-margin ratio is:

$30 $22.50
.25
$30

5. The electronic version of the Solutions Manual BUILD A SPREADSHEET

SOLUTIONS is available on your Instructors CD and on the Hilton, 8e website:
www.mhhe.com/hilton8e.

PROBLEM 7-37 (30 MINUTES)

1. Unit contribution margin:

Sales $32.00
price
Less variable costs:
Sales commissions ($32 x 5%) $ 1.60
System variable costs 8.00 9.60
Unit contribution $22.40
margin..

Break-even point = fixed costs unit contribution margin

= $1,971,200 $22.40
= 88,000 units

2. Model A is more profitable when sales and production average 184,000 units.

Model A Model B

Sales revenue (184,000 units x $32.00)... $5,888,000 $5,888,000

Less variable costs:
Sales commissions ($5,888,000 x 5%) $ 294,400 $ 294,400
System variable costs:
184,000 units x $8.00. 1,472,000
184,000 units x $6.40. 1,177,600
Total variable costs.. $1,766,400 $1,472,000
Contribution margin... $4,121,600 $4,416,000
Less: Annual fixed costs.. 1,971,200 2,227,200
 Net $2,150,400 $2,188,800
income

3. Annual fixed costs will increase by $180,000 ($900,000 5 years) because of straight-
line depreciation associated with the new equipment, to $2,407,200 ($2,227,200 +
$180,000). The unit contribution margin is $24 ($4,416,000 184,000 units). Thus:

Required sales = (fixed costs + target net profit) unit contribution margin
= ($2,407,200 + $1,912,800) $24
= 180,000 units

4. Let X = volume level at which annual total costs are equal

$8.00X + $1,971,200 = $6.40X + $2,227,200
$1.60X = $256,000
X = 160,000 units
PROBLEM 7-38 (25 MINUTES)

1. Closing of mall store:

Loss of contribution margin at Mall Store............................................

$(108,000)
Savings of fixed cost at Mall Store (75%)............................................ 90,000
Loss of contribution margin at Downtown Store (10%).........................
(14,400)
Total decrease in operating income.................................................... $
(32,400)

2. Promotional campaign:

Increase in contribution margin (10%)................................................. $10,800

Increase in monthly promotional expenses ($180,000/12) .................... (15,000)
Decrease in operating income............................................................ $(4,200)

3. Elimination of items sold at their variable cost:

We can restate the November 20x4 data for the Mall Store as follows:

Mall Store
Items Sold at
Their
Variable Other Items
Cost
Sales....................................................................... $180,000*
$180,000*
Less: variable expenses........................................... 180,000 72,000
Contribution margin................................................. $ -0- $108,000

If the items sold at their variable cost are eliminated, we have:

Decrease in contribution margin on other items (20%)....................... $
(21,600)
Decrease in fixed expenses (15%).................................................... 18,000
Decrease in operating income........................................................... $
(3,600)

*$180,000 is one half of the Mall Store's dollar sales for November 20x4.

4. The electronic version of the Solutions Manual BUILD A SPREADSHEET

SOLUTIONS is available on your Instructors CD and on the Hilton, 8e website:
www.mhhe.com/hilton8e.

PROBLEM 7-39 (40 MINUTES)

1. Sales mix refers to the relative proportion of each product sold when a company sells
more than one product.

2. (a) Yes. Plan A sales are expected to total 65,000 units (19,500 + 45,500), which
compares favorably against current sales of 60,000 units.

(b) Yes. Sales personnel earn a commission based on gross dollar sales. As the
following figures show, Cold King sales will comprise a greater proportion of
total sales under Plan A. This is not surprising in light of the fact that Cold
King has a higher selling price than Mister Ice Cream ($43 vs. $37).

Current Plan A

Sales Sales
Units Mix Units Mix

Mister Ice Cream.......... 21,000 35% 19,500 30%

Cold King..................... 39,000 65% 45,500 70%
Total........................ 60,000 100% 65,000 100%

(c) Yes. Commissions will total $267,800 ($2,678,000 x 10%), which compares
favorably against the current flat salaries of $200,000.

Mister Ice Cream sales: 19,500 units x $37............... $ 721,500

Cold King sales: 45,500 units x $43.......................... 1,956,500
Total sales............................................................. $2,678,000
 PROBLEM 7-39 (CONTINUED)

(d) No. The company would be less profitable under the new plan.

Current Plan A
Sales revenue:
Mister Ice Cream: 21,000 units x $37; 19,500 units x $37................ $ 777,000 $ 721,500
Cold King: 39,000 units x $43; 45,500 units x $43........................... 1,677,000 1,956,500
Total revenue................................................................................ $2,454,000 $2,678,000
Less variable cost:
Mister Ice Cream: 21,000 units x $20.50; 19,500 units x $20.50...... $ 430,500 $ 399,750
Cold King: 39,000 units x $32.50; 45,500 units x $32.50................. 1,267,500 1,478,750
Sales commissions (10% of sales revenue)....................................... 267,800
Total variable cost........................................................................ $1,698,000 $2,146,300
Contribution margin................................................................................. $ 756,000 $ 531,700
Less fixed cost (salaries).......................................................................... 200,000 ----___
Net income............................................................................................... $ 556,000 $ 531,700

3. (a) The total units sold under both plans are the same; however, the sales mix has
shifted under Plan B in favor of the more profitable product as judged by the
contribution margin. Cold King has a contribution margin of $10.50 ($43.00 -
$32.50), and Mister Ice Cream has a contribution margin of $16.50 ($37.00 -
$20.50).

Plan A Plan B

Sales Sales
Units Mix Units Mix

Mister Ice Cream............... 19,500 30% 39,000 60%

Cold King.......................... 45,500 70% 26,000 40%
Total............................. 65,000 100% 65,000 100%
 PROBLEM 7-39 (CONTINUED)

(b) Plan B is more attractive both to the sales force and to the company.
Salespeople earn more money under this arrangement ($274,950 vs. $200,000),
and the company is more profitable ($641,550 vs. $556,000).

Current Plan B
Sales revenue:
Mister Ice Cream: 21,000 units x $37; 39,000 units x $37 $ 777,000 $1,443,000
.................................................................................................................
Cold King: 39,000 units x $43; 26,000 units x $43 1,677,000 1,118,000
.................................................................................................................
Total revenue $2,454,000 $2,561,000
.................................................................................................................
Less variable cost:
Mister Ice Cream: 21,000 units x $20.50; 39,000 units x $20.50 $ 430,500 $ 799,500
.................................................................................................................
Cold King: 39,000 units x $32.50; 26,000 units x $32.50 1,267,500 845,000
.................................................................................................................
Total variable cost $1,698,000 $1,644,500
.................................................................................................................
Contribution margin................................................................................ $ 756,000 $ 916,500
Less: Sales force compensation:
Flat salaries 200,000
.................................................................................................................
Commissions ($916,500 x 30%) 274,950
.................................................................................................................
Net income.............................................................................................. $ 556,000 $ 641,550
PROBLEM 7-41 (45 MINUTES)

1. Break-even sales volume for each model:

annual rental cost
Break-even volume
unit contributi on margin

(a) Standard model:

$16,000
Break - even volume 25,000tubs
$3.50 $2.86

(b) Super model:

$22,000
Break - even volume 27,500tubs
$3.50 $2.70

(c) Giant model:

$40,000
Break - even volume 40,816tubs (rounded)
$3.50 $2.52
PROBLEM 7-41 (CONTINUED)

2. Profit-volume graph:

Dollars per year (in

thousands)

$40
Profit

$20
Break-even point:
40,816 tubs
Profit
area Tubs sold
0 per year
10 20 30 40 50 (in thousands)
Loss
area
Loss

($20)

Fixed rental cost: $40,000 per year

($40)
PROBLEM 7-41 (CONTINUED)

3. The sales price per tub is the same regardless of the type of machine selected.
Therefore, the same profit (or loss) will be achieved with the Standard and
Super models at the sales volume, X , where the total costs are the same.
Variable Cost Total
Model per Tub Fixed Cost
Standard............................................. $2.86 $16,000
Super................................................. 2.70 22,000

This reasoning leads to the following equation: 16,000 + 2.86 X = 22,000 +

2.70 X

Rearranging terms yields the following: (2.86 2.70) X = 22,000

16,000
.16 X = 6,000
X = 6,000/.16
X = 37,500
Or, stated slightly differently:

Volume at which both

fixed cost differential
machines produce the same variable cost differential
profit
$6,000
$.16
37,500tubs

Check: the total cost is the same with either model if 37,500 tubs are sold.

Standard Super
Variable cost:
Standard, 37,500 $2.86.................... $107,250
Super, 37,500 $2.70......................... $101,250
Fixed cost:
Standard, $16,000............................... 16,000
Super, $22,000.................................... 22,000
Total cost................................................. $123,250 $123,250

Since the sales price for popcorn does not depend on the popper model, the
sales revenue will be the same under either alternative.
PROBLEM 7-43 (35 MINUTES)

1. Plan A break-even point = fixed costs unit contribution margin

= $33,000 $33*
= 1,000 units

Plan B break-even point = fixed costs unit contribution margin

= $99,000 $45**
= 2,200 units

* $120 - [($120 x 10%) + $75]

** $120 - $75

2. Operating leverage refers to the use of fixed costs in an organizations overall cost
structure. An organization that has a relatively high proportion of fixed costs and
low proportion of variable costs has a high degree of operating leverage.
PROBLEM 7-43 (CONTINUED)

3. Calculation of contribution margin and profit at 6,000 units of sales:

Plan A Plan B

Sales revenue: 6,000 units x $120. $720,000 $720,000

Less variable costs:
Cost of purchasing product:
6,000 units x $75. $450,000 $450,000

Sales commissions: $720,000 x 10%... 72,000 ----__
Total variable cost.. $522,000 $450,000
Contribution $198,000 $270,000
margin
Fixed 33,000 99,000
costs.
Net $165,000 $171,000
income.

Plan A has a higher percentage of variable costs to sales (72.5%) compared to Plan
B (62.5%). Plan Bs fixed costs are 13.75% of sales, compared to Plan As 4.58%.

Operating leverage factor = contribution margin net income

Plan A: $198,000 $165,000 = 1.2
Plan B: $270,000 $171,000 = 1.58 (rounded)

Plan B has the higher degree of operating leverage.

4 & 5. Calculation of profit at 5,000 units:

Plan A Plan B

Sales revenue: 5,000 units x $600,000 $600,000

$120.
Less variable costs:
Cost of purchasing product:
5,000 units x $375,000 $375,000
$75..
Sales commissions: $600,000 x 10%... 60,000 ----
__
Total variable $435,000 $375,000
cost..
Contribution $165,000 $225,000
margin
Fixed 33,000 99,000
costs
Net $132,000 $126,000
income.
PROBLEM 7-43 (CONTINUED)

Plan A profitability decrease:

$165,000 - $132,000 = $33,000; $33,000 $165,000 = 20%

Plan B profitability decrease:

$171,000 - $126,000 = $45,000; $45,000 $171,000 = 26.3% (rounded)

PneumoTech would experience a larger percentage decrease in income if it adopts

Plan B. This situation arises because Plan B has a higher degree of operating leverage.
Stated differently, Plan Bs cost structure produces a greater percentage decline in
profitability from the drop-off in sales revenue.

Note: The percentage decreases in profitability can be computed by multiplying the

percentage decrease in sales revenue by the operating leverage factor. Sales dropped
from 6,000 units to 5,000 units, or 16.67%. Thus:

Plan A: 16.67% x 1.2 = 20.0%

Plan B: 16.67% x 1.58 = 26.3% (rounded)

6. Heavily automated manufacturers have sizable investments in plant and equipment,

along with a high percentage of fixed costs in their cost structures. As a result, there is
a high degree of operating leverage.

In a severe economic downturn, these firms typically suffer a significant

decrease in profitability. Such firms would be a more risky investment when
compared with firms that have a low degree of operating leverage. Of course, when
times are good, increases in sales would tend to have a very favorable effect on
earnings in a company with high operating leverage.
CASE 7-55 (50 MINUTES)

1. Break-even point for 20x4, based on current budget:

$15,000,00 0 $9,000,000 $3,000,000
Contribution - margin ratio .20
$15,000,00 0
fixed expenses
Break - evenpoint
contribution - margin ratio
$150,000
$750,000
.20

2. Break-even point given employment of sales personnel:

New fixed expenses:

Previous fixed expenses............................................................. $ 150,000

Sales personnel salaries (3 x $45,000)....................................... 135,000
Sales managers salaries (2 $120,000).................................... 240,000
Total.......................................................................................... $ 525,000

New contribution-margin ratio:

Sales.........................................................................................
......................................................................... $15,000,000
Cost of goods sold..................................................................... 9,000,000
Gross margin............................................................................. $
6,000,000
Commissions (at 5%)................................................................. 750,000
Contribution margin.................................................................... $
............................................................................. 5,250,000
$5,250,000
Contribution - margin ratio .35
$15,000,000

fixed expenses
Estimatedbreak - even point
contributi on - margin ratio
$525,000
$1,500,000
.35
CASE 7-55 (CONTINUED)

1. Assuming a 25% sales commission:

New contribution-margin ratio:

Sales.........................................................................................
......................................................................... $15,000,000
Cost of goods sold..................................................................... 9,000,000
Gross margin............................................................................. $
............................................................................. 6,000,000
Commissions (at 25%)............................................................... 3,750,000
Contribution margin.................................................................... $
............................................................................. 2,250,000

$2,250,000
Contributi on - margin ratio .15
$15,000,000
target after - tax net income
fixed expenses
Sales volume in dollars (1 t )

required to earn after- contributi on - margin ratio
tax net income $1,995,000
$150,000
(1 .3) $3,000,000

.15 .15
$20,000,000

Check:

Sales.......................................................... $
20,000,000
Cost of goods sold (60% of sales)................
12,000,000
Gross margin.............................................. $
8,000,000
Selling and administrative expenses:
Commissions......................................... $ 5,000,000
All other expenses (fixed)....................... 150,000 5,150,000
Income before taxes.................................... $
2,850,000
Income tax expense (30%).......................... 855,000
Net income................................................. $
1,995,000
CASE 7-55 (CONTINUED)

2. Sales dollar volume at which Lake Champlain Sporting Goods Company is

indifferent:

Let X denote the desired volume of sales.

Since the tax rate is the same regardless of which approach management
chooses, we can find X so that the companys before-tax income is the same
under the two alternatives. (In the following equations, the contribution-margin
ratios of .35 and .15, respectively, were computed in the preceding two
requirements.)

.35 X $525,000 = .15 X $150,000

.20 X = $375,000
X = $375,000/.20
X = $1,875,000

Thus, the company will have the same before-tax income under the two
alternatives if the sales volume is $1,875,000.

Check:

Alternatives
Employ
Sales Pay 25%
Personnel Commission
Sales................................................................. $1,875,000 $1,875,000
Cost of goods sold (60% of sales)....................... 1,125,000 1,125,000
Gross margin...................................................... $ 750,000 $ 750,000
Selling and administrative expenses:
Commissions.................................................. 93,750* 468,750
All other expenses (fixed)................................ 525,000 150,000
Income before taxes........................................... $ 131,250 $ 131,250
Income tax expense (30%).................................. 39,375 39,375
Net income......................................................... $ 91,875 $ 91,875

*$1,875,000 5% = $93,750

$1,875,000 25% = $468,750