CH 6 Cost Volume Profit Revised Mar 18

Chapter
6-1
CHAPTER 6
COSTVOLUME
PROFIT ANALYSIS:
ADDITIONAL ISSUES
Chapter
6-2
Study Objectives
1. Describe the essential
features of a cost-volume-
profit income statement.
2. Apply basic CVP concepts.
3. Explain the term sales mix
and its effects on break-even
sales.
4. Determine sales mix when a
company has limited
resources.
5. Understand how operating
leverage affects profitability.
Chapter
6-3
Traditional Income
Statement
Revenue
Cost of goods sold
Gross margin
Administrative and
selling expense
Operating income
CVP income statement
Revenue
Variable Expense
Contribution margin
Fixed Expense
Operating income
Formulas and Formats to Be Used in the
Chapter
These sound alike but they are different
concepts
Chapter
6-4
Formula for contribution margin ratio (CMR)
CM per Unit/Unit Sales Price
Formula for breakeven in dollars
Fixed Cost/Contribution Margin Ratio
Formula for breakeven in units
Fixed Cost/Contribution Margin per Unit
Formula for margin of safety
Actual Sales Breakeven Sales

Chapter Review from Chapter 5
Chapter
6-5
Formula for margin of safety ratio
Margin of Safety in Dollars/ Actual or Expected
Sales Dollars
Breakeven with multiple products
Divide fixed costs by the weighted average unit
contribution margin of all products
Formula for weighted average unit
contribution margin
weighted contribution margin per-unit of each
product
Chapter
Chapter
6-6
Formula for margin of safety ratio
Margin of Safety in Dollars/ Actual or Expected
Sales Dollars
Breakeven with multiple products
Divide fixed costs by the weighted average unit
contribution margin of all products
Chapter
Chapter
6-7
Formula for breakeven in a company with
several divisions, each of which has many
products
Calculate the breakeven in terms of sales dollars
for division or product line (not individual
products)
Formula for weighted average contribution
margin ratio for company with multiple
divisions
(CMR x Sales Mix %) + (CMR x Sales Mix %)
Division One Division Two
Chapter
Chapter
6-8
Formula for breakeven in dollars using a
weighted average contribution margin ratio
Fixed Costs/Weighted-Average CMR = BE in $

Chapter
Chapter
6-9
Maximizing net income with a limited
resource
First produce the product with the largest
contribution margin per unit of scarce resource
Formula for degree of operating leverage
Total Contribution Margin in Dollars/Net Income

Chapter
Chapter
6-10
Cost-Volume-Profit Analysis:
Additional Issues

Cost-Volume-
Profit (CVP)
Review

Cost Structure
and Operating
Leverage
Basic concepts
Basic computations
CVP and changes in
the business
environment
Effect on contribution
margin ration
Effect on break-even
point
Effect on margin of
safety ratio
Operating leverage

Sales Mix

Break-even sales in
units
Break-even in
dollars
Sales mix with
limited resources
Chapter
6-11
Cost-Volume-Profit (CVP) Review
As noted in Chapter 5, CVP analysis is:
the study of the effects of changes in costs
and volume on a companys profit

CVP analysis is important to profit planning

CVP analysis is critical in management decisions such
as:
determining product mix,
maximizing use of production facilities,
setting selling prices
LO 1: Describe the essential features of
a cost-volume-profit income statement.
Chapter
6-12
Basic Concepts
Because CVP is so important, management often
wants the information reported in a special format
income statement.
The CVP income statement is for internal use only,
classifies costs and expenses as fixed or variable,
reports a contribution margin in the body of the
statement.
Contribution margin amount of revenue remaining
after deducting all variable costs
The contribution margin is often reported as a total
amount and on a per unit basis.

Chapter
6-13
CVP Income Statement - Example
The CVP income statement for Vargo Video Company is
illustrated below: (This illustration was also presented
as Illustration 5-11 in Chapter 5)

Chapter
6-14
CVP Income Statement Example Contd
A detailed CVP income statement for Vargo Video Company is
illustrated below: (This uses the same base information as the
previous statement)

Chapter
6-15
Basic Computations A Review
Break-Even Analysis

As noted in Chapter 5, Vargo Companys
contribution margin per unit is $200 (sales price
$500 - $300 variable costs)

It was also shown that Vargo Companys
contribution margin ratio was:
LO 2: Apply basic CVP concepts.
Chapter
6-16
Break-Even Analysis
Vargo Companys break-even point in units or in
dollars (using contribution margin ratio) is:

In its early stages of operation, a companys
primary goal is to break-even.
Failure to break-even will eventually lead
to financial failure
Chapter
6-17
Target Net Income
Once a company achieves break-even sales, a sales
goal can be set that will result in a target net income
Assuming Vargos target net income is $250,000,
required sales in units and dollars to achieve this are:
Chapter
6-18
Margin of Safety
Remember from Chapter 5, the margin of safety tells
us how far sales can drop before the company will
operate at a loss
The margin of safety can be expressed in dollars or
as a ratio
Assuming Vargos sales are $800,000:
Chapter
6-19
CVP and Changes in the Business Environment
To better understand CVP analysis, three
independent cases involving Vargo company will be
examined.
Each case will use the original data for Vargo
Company:
LO 2: Apply CVP concepts.
Chapter
6-20
Basic Computations A Review: Case I
Should Vargo Company match a competitors 10%
discount and reduce selling price to $450 per unit?
With variable costs per unit unchanged, a 10%
discount in selling price will decrease the contribution
margin to $150 and increase break-even sales to 1,333
units

Management must decide how likely it is that Vargo
can achieve the increase in sales as well as the
likelihood of lost sales if the discount is not matched
Chapter
6-21
Basic Computations A Review: Case II
Use of new equipment is being considered that will
increase fixed costs by 30% and lower variable costs
by 30%. What effect will the new equipment have on
the sales required to break-even?
Fixed costs will increase $60,000 and variable costs
will decrease $90,000 (variable cost per unit =$210).

The change appears positive as break-even point is
reduced by approximately 10%
Chapter
6-22
Basic Computations A Review: Case III
Vargos supplier of raw materials has increased the
cost of raw materials which will increase the variable
cost per unit by $25.
Management will not change the selling price of the
DVDs.
Management intends to cut fixed costs by $17,500
Vargo currently has a net income of $80,000 on sales
of 1,400 DVDs
How many more units will need to be sold to maintain
the $80,000 net income?
Chapter
6-23
Basic Computations A Review: Case III
Variable cost per unit increases to $325 as a result of
the $25 increase in raw materials cost

Fixed costs decrease to $182,500

Contribution margin per unit is now $175

If Vargo cannot sell an additional 100 units,
management must further reduce costs, increase the
selling price of the DVDs, or accept a lower net income.
Chapter
6-24
Croc Catchers calculates its contribution margin to be
less than zero. Which statement is true?
a. Its fixed costs are less than the variable cost
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.
Lets Review
Chapter
6-25
Sales Mix
When a company sells more than one product
It is important to understand
its sales mix
The sales mix is the relative percentage in
which a company sells its products.
If a companys unit sales are 80%
printers and 20% computers, its
sales mix is 80% to 20%.
Sales mix is important because
different products often have very
different contribution margins.
LO 3: Explain the term sales mix and its effects on break-even sales.
Chapter
6-26
Break-Even Sales in Units
A company can compute break-even sales
for a mix of two or more products by
determining the
Weighted-average unit contribution
margin of all products

The weighted-average unit contribution
margin is the sum of the weighted
contribution margin of each product

LO 3: Explain the term sales mi and its effects on break-even sales.
Chapter
6-27
Break-Even Sales in Units - Example
Assume that Vargo Company sells two products and
has the following sales mix and related information:

Chapter
6-28
First, determine the weighted-average contribution
margin for Vargos two products:

Second, use the weighted-average unit contribution
margin to compute the break-even point in units

Chapter
6-29
With a break-even point of 1,000 units, Vargo must
sell:
750 DVD Players (1,000 units x 75%)
250 TVs (1,000 units x 25%)

At this level, the total contribution margin will equal
the fixed costs of $275,000
Chapter
6-30
Break-Even Sales in Dollars
The calculation of break-even point in units works
well if the company has only a few products

Consider 3M which has over 30,000 different
products:
3M would need to calculate 30,000 different
unit contribution margins

When there are many products, calculate the break-
even point in terms of sales dollars for divisions or
product lines, NOT individual products
Chapter
6-31
Break-Even Sales in Dollars - Example
Assume that Kale Garden Supply Company has two
divisions: Indoor Plants and Outdoor Plants

Each division has hundreds of different plant
types

Compute sales mix as a percentage of total dollar
sales rather than units sold
and
Compute the contribution margin ratio rather than
the contribution margin per unit
Chapter
6-32
The information necessary to perform cost-
volume-profit analysis is:
Chapter
6-33
First, determine the weighted-average contribution
margin ratio for each division:

Second, use the weighted-average unit contribution
margin ratio to compute the break-even point in
dollars:

Chapter
6-34
With break-even sales of $937,500 and a sales mix
of 20% to 80%, Kale must sell:
$187,500 from the Indoor Plant division
$750,000 from the Outdoor Plant division
If the sales mix between the divisions changes, the
weighted-average contribution margin ratio also
changes, resulting in a new break-even point in
dollars.
Example - If the sales mix becomes 50% to 50%, the
weighted average contribution margin ratio changes
to 35%, resulting in a lower break-even point of
$857,143.

Chapter
6-35
Net income will be:
a. Greater if more higher-contribution margin units
are sold than lower-contribution margin units.
b. Greater is more lower-contribution margin units
are sold than higher-contribution margin units.
c. Equal as song as total sales remain equal,
regardless of which products are sold.
d. Unaffected by changes in the mix of products
sold.
Lets Review
Chapter
6-36
Sales Mix with Limited Resources
All companies have limited resources whether it be
floor space, raw materials, direct labor hours, etc.
Limited resources force management to decide which
products to sell to maximize net income.
Example: Vargo makes DVD players and TVs. The
limiting resource is machine capacity 3,600 hours per
month. Relevant date is as follows:
LO 4: Determine sales mix when a company has limited resources.
Chapter
6-37
Sales Mix with Limited Resources - Example
The TVs seem to be more profitable since they have the
higher contribution margin per unit, but they require
more machine hours to produce than the DVD Players
To determine the appropriate sales mix, compute the
contribution margin per unit of limited resource:

Since DVD players have higher contribution margin per
machine hour, management should produce more DVD
players if demand exists or else increase machine
capacity.
Chapter
6-38
Alternative: Increase machine capacity from
3,600 to 4,200 hours

To maximize net income, all 600 hours should be
used to produce and sell DVD players.
Sales Mix with Limited Resources - Example
Chapter
6-39
Theory of Constraints
Approach used to identify and
manage constraints so as to
achieve company goals
Requires identification of
constraints
Continual attempts to reduce or
eliminate constraints
Chapter
6-40
If the contribution margin per unit 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. No correct answer is given.
Lets Review
LO 4: Determine the sales mix when a company has limited resources.
Chapter
6-41
Cost Structure and Operating Leverage
Cost Structure is the
relative proportion of fixed
versus variable costs that a
company incurs
May have a significant
effect on profitability
Thus, a company must
carefully choose its cost
structure.
LO 5: Understand how operating leverage affects profitability.
Chapter
6-42
Comparison of Cost Structures
Vargo Video manufactures DVD players using a traditional,
labor-intensive manufacturing process
New Wave Company also manufactures DVD players, but uses a
completely automated system where factory employees only set
up, adjust, and maintain the machinery.

Both companies have the same sales and net income; however,
each has different risks and rewards due to changes in sales as
a result of their cost structures.
Chapter
6-43
Effect on Contribution Margin Ratio
The contribution margin ratio for each company is as follows:

Thus, New Wave contributes 80 cents to net income for each
dollar of increased sales while Vargo only contributes 40 cents.
However, New Wave loses 80 cents per dollar of sales
decrease while Vargo only loses 40 cents.
New Waves cost structure which relies on fixed costs is more
sensitive to changes in sales
Chapter
6-44
Effect on Break-even Point
The break-even point for each company is as follows:

New Wave needs to generate $150,000 more in sales than
Vargo to break-even.
Because of the greater break-even sales required, New Wave is
a riskier company than Vargo.
Chapter
6-45
Effect on Margin of Safety Ratio
The margin of safety ratio of each company is as follows:

The difference in the margin of safety ratio reflects the
difference in risk between New Wave and Vargo.
Vargo can sustain a 38% decline in sales before operating at a
loss versus only a 19% decline for New Wave before it would be
operating in the red.
Chapter
6-46
Operating Leverage
Operating leverage refers to the extent that net
income reacts to a given change in sales.

Higher fixed costs relative to variable costs cause
a company to have higher operating leverage.

When sales revenues are increasing, high operating
leverage means that profits will increase rapidly a
good thing.

When sales revenues are declining, too much
operating leverage can have devastating
consequences.
Chapter
6-47
Operating Leverage
The degree of operating leverage provides a measure
of a companys earnings volatility.
The degree of operating leverage is computed by
dividing total contribution margin by net income.
The computations for Vargo and New Wave are:

New Waves earnings would go up (or down) by about
two times (5.33 2.67 = 1.99) as much as Vargos
with an equal increase in sales.
Chapter
6-48
The degree of operating leverage:
a. Can be computed by dividing total contribution
margin by net income.
b. Provides a measure of the companys earnings
volatility.
c. Affects a companys break-even point.
d. All of the above.
Lets Review
Chapter
6-49
Chapter Review - Brief Exercise 6-9
Presto Candle Supply makes candles. The sales mix
(as a percent of total dollar sales) of its three
product lines is as follows: 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 10%
Standard tapered 20%
Large scented 45%

What is the weighted-average contribution margin
ratio?
Chapter
6-50
Chapter Review - Brief Exercise 6-9
Type of Candles CMR Sales Mix
Birthday 10% X 30% = 03%
Standard tapered 20% X 50% = 10%
Large scented 45% X 20% = 09%
Weighted Average Contribution Margin Ratio 22%

If the companys fixed costs are $440,000 per year, what is the
dollar amount of each type of candle that must be sold to break
even?

Step 1: Fixed Costs $440,000 WA CMR 22% = $ BEP $2,000,000

Step 2:
Birthday candles $2,000,000 X 30% = $ 600,000
Standard tapered $2,000,000 X 50% = 1,000,000
Large scented $2,000,000 X 20% = 400,000
Chapter
6-51
Appendix
Absorption Costing vs. Variable Costing
Under variable costing, product costs consist of:
Direct Materials
Direct Labor
Variable Mfg. Overhead

The difference between absorption and variable
costing is:

LO 6: Explain the difference between absorption costing
and variable costing.
Chapter
6-52
Appendix
Under both costing methods,
selling and administrative
expenses are treated as period
costs.

Companies may not use variable
costing for external financial
reports because GAAP requires
that fixed manufacturing
overhead be treated as a
product cost.

Fixed Mfg.
Overhead
Chapter
6-53
Appendix
Example Premium Products

Manufactures Fix-it, a sealant for car windows.

Relevant data for January 2008, the first month
of production are:
Chapter
6-54
Appendix
Example Continued
Per unit manufacturing cost under each approach.

The manufacturing cost per unit is $4 ($13 -$9)
higher for absorption costing because fixed
manufacturing costs are treated as product costs.

Chapter
6-55
Appendix
Absorption Costing Income Statement
Chapter
6-56
Appendix
Variable Costing Income Statement
Chapter
6-57
Appendix
Summary of Income Effects
LO 7: Discuss net income effects under absorption costing
versus variable costing.
Chapter
6-58
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.
Lets Review
Chapter
6-59
The San Marcos is trying to determine its
breakeven point.
The inn has 75 rooms that are rented at $50 a
night. It incurred the following costs during the
year.
Salaries $8,500 per month
Utilities $2,000 per month
Depreciation $1,000 per month
Maintenance $500 per month
Maid service $5 per room
Other costs $33 per room

Exercise 6-1
Chapter
6-60
Determine the breakeven point in rooms per
month.
Breakeven point in rooms for months formula:
Fixed Costs/Contribution Margin = BEu
Contribution Margin = $50 - $5 - $35 = $12
Breakeven in rooms per month = ($8,500 +
$2,000 + $1,000 + $500)/12 = 1,000 rooms

Exercise 6-1
Chapter
6-61
Determine the breakeven point in dollars.
Breakeven in dollars formula+
Fixed Costs/Contribution Margin Ratio = BE$
Contribution Margin Ratio (CMR) =
Contribution Margin Per Room/Price
Contribution Margin = $50 - $5 - $35 = $12
Contribution Margin Ratio = $12/$50 = .24
Breakeven in rooms per month = ($8,500 +
$2,000 + $1,000 + $500)/.24 = $50,000

Exercise 6-1
Chapter
6-62
If the inn plans on renting an average of 50
rooms per day, what is the monthly margin of
safety in dollars?
Expected sales = 50 rooms $50 30 days =
$75,000
$75,000 - $50,000 = $25,000 margin of safety
What is the margin safety ratio?
$25,000/$75,000 = 33 1/3rd
Exercise 6-1
Chapter
6-63
In the month of June, Angelos Beauty Salon
gave 3500 haircuts, shampoos, and permanents
at an average price of $30.
During the month, fixed cost were $16,800 and
variable costs were 80% of sales.
Determine the contribution margin in dollars, per
unit, and as a ratio.
Exercise 6-2
Chapter
6-64
Contribution margin in dollars:
(3,500 $30) revenue .8(3,500 $30) = $21,000
Contribution margin per unit
$21,000/3,500 = $6
Contribution margin ratio
$6/$30 = 20%
Exercise 6-2
Chapter
6-65
Compute the margin of safety in dollars and as a
ratio
Breakeven in dollars = $16,800/.20 = $84,000
Breakeven in units = $16,800/$6 = 2,800
Margin of safety in dollars = (3,500 x $30) -
$84,000 = $21,000
Margin of safety ratio = $21,000/$105,000 =
.20%
Exercise 6-2
Chapter
6-66
Get Company reports the following operating
results for the month of August.
Sales $300,000 (5,000 units)
Variable cost $210,000
Fixed cost $70,000
Exercise 6-3
Chapter
6-67
Management is considering increasing sales
price with 10% with no change in variable costs.
Compute the net income to be earned.

Exercise 6-3
Sales $300,000 1.10 $330,000
Variable costs 210,000
Contribution margin $120,000
Fixed costs 70,000
Operating income $50,000
Chapter
6-68
Management is considering decreasing variable
expense to 58% of sales

Exercise 6-3
Sales $300,000
Variable costs 300,000 .58 174,000
Fixed costs 70,000
Chapter
6-69
Management is considering decreasing fixed
costs by $20,000

Exercise 6-3
Sales $300,000
Variable costs 210,000
Fixed costs 50,000
Chapter
6-70
Grass King manufactures lawnmowers, weed
trimmers, and chainsaws.
Its sales mix and contribution margin per unit
are as follows:
Exercise 6-6
Sales Mix Contribution
Margin per Unit
Lawnmowers 30% $30
Weed trimmers 50% $20
Chainsaws 20% $40
Grass King has fixed costs of $4,600,000
Chapter
6-71
Compute the number of units of each product
that Grass King must sell in order to break even
under this product mix.
Calculate weighted average contribution margin.
(.30 $30) + (.50 $20) + (.20 $40) =
$9 + $10+ $8 = $27
Divide fixed costs by a weighted average
contribution margin:
4,600,000/27 = 170,370.37 units
Exercise 6-6
Chapter
6-72
Tiger Golf Accessories sells golf shoes, gloves,
and a laser guided rangefinder that measures
distance. Shown below are unit cost and sales
data.

Exercise 6-9
Pair of
shoes
Pair of
gloves
Rangefinder
Unit sales price $100 $30 $250
Unit variable cost 60 10 200
Unit contribution margin $40 $20 $50
Sales mix 40% 50% 10%
Chapter
6-73
Compute the breakeven point in units for the
company.
Weighted average contribution margin =
(.40 $40) + (.50 $20) + (.10 $50) =
$16+ $10+ $5 = $31
Divide fixed costs by weighted average
contribution margin
$620,000/$31 = 20,000 units
Exercise 6-9
Chapter
6-74
Determine the number of units to be sold at the
breakeven point for each product line.
Shoes (20,000 X .40) = 8,000 pairs of shoes
Gloves (20,000 X .50) = 10,000 pairs of gloves
Range finders (20,000 X .10) = 2,000 range
finders

Exercise 6-9
Chapter
6-75
Verify that the mix of sales determined will
generate a zero net income.

Shoes: 8,000 X $40 = $320,000
Gloves: 10,000 X $20 = 200,000
Range finders: 2,000 X $50 = 100,000
Total contribution margin 620,000
Fixed costs 620,000
Net income $ 0

Exercise 6-9
Chapter
6-76
Dalton Company manufactures and sells two
products.
Relevant per-unit data concerning each product
follow.

Exercise 6-13
Basic product Deluxe
product
Selling price $40 $52
Variable costs $18 $24
Machine hours .5 .7
Chapter
6-77
Compute the contribution margin per machine
hour for each product.

Exercise 6-13
Basic Product Deluxe Product
Selling price $40 $52
Variable cost $18 $24
Contribution margin per
unit
$22 $28
Divide by machine hours .5 .7
Contribution margin per
machine hour
$44 $40
If 1000 additional machine hours are available, which product should
Dalton manufacture?
The product with the highest contribution margin perseveres
resource the basic product.
Chapter
6-78
Total contribution margin if the hours are divided
equally among the products.

Exercise 6-13
Basic Deluxe Total
Machine hours allocated 500 500 1,000
X Contribution margin
per machine hour

$44

$40

Contribution margin $22,000 $20,000 $42,000
Chapter
6-79
Total contribution margin if the hours dedicated
to the product with the largest contribution
margin per scarce resource.

Exercise 6-13
Basic Deluxe Total
Machine hours allocated 1,000 -0- 1,000
X Contribution margin
per machine hour

$44

$40

Contribution margin $44,000 -0- $44,000
Chapter
6-80
An investment banker is analyzing two
companies that specialize in the production and
sale of candied apples.
Old Fashion Apples uses a labor-intensive
approach, and Mech-Apple uses a mechanized
system.
CVP income statements for the two companies
are shown below.
E 6-16
Chapter
6-81
Old-Fashioned Apples Mech Apples
Sales $400,000 $400,000
Variable costs 320,000 160,000
Contribution margin 80,000 240,000
Fixed costs 20,000 180,000
Net income 60,000 60,000
E 6-16
The investment banker is interested in
acquiring one of these companies. However, she
is concerned about the impact each companys
cost structure might have on its profitability.
Chapter
6-82
Calculate each companys degree of operating
leverage.
Formula: Contribution margin/Net income
Old-Fashion Apples:
80,000/60,000 = 1.333
Mech-Apples
240,000/60,000 = 4.0000
Mech-Apples is more sensitive to changes in
sales volume.

E 6-16
Chapter
6-83
Determine the effect on each companys net
income if sales decreased by 10% and if sales
increased by 5%.

E 6-16

% Change
in Sales

X
Degree of
Operating
Leverage

=

% Change in
Net Income
10% decrease:
Old Fashion
Mech-Apple

(10%)
(10%)

X
X

1.33
4.00

=
=

(13.3%)
(40.0%)

5% increase:
Old Fashion
Mech-Apple

5%
5%

X
X

1.33
4.00

=
=

6.65%
20.0%
Which investment do you think the
investment banker choose?
Chapter
6-84
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