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CHAPTER 6

Cost-Volume-Profit Analysis: Additional Issues


ASSIGNMENT CLASSIFICATION TABLE
Brief Exercises 1, 2, 3, 4, 5, 6 A Problems 1A, 2A B Problems 1B, 2B

Learning Objectives 1. Describe the essential features of a cost-volume-profit income statement. Apply basic CVP concepts.

Questions 1, 2, 3, 4

Do It! 1

Exercises

2.

2, 4, 5, 6

1, 2, 3, 4, 5, 6 7, 8, 9, 10

1, 2, 3, 4, 5 6, 7, 8, 9, 10 11, 12, 13

1A, 2A, 6A

1B, 2B, 6B

3.

Explain the term sales mix and its effects on break-even sales. Determine sales mix when a company has limited resources. Understand how operating leverage affects profitability. Explain the difference between absorption costing and variable costing. Discuss net income effects under absorption costing versus variable costing. Discuss the merits of absorption versus variable costing for management decision making.

7, 8, 9

4A

4B

4.

10, 11

11, 15

3A

3B

5.

12, 13, 14, 15, 16 17

12, 13, 14

14, 15, 16

5A, 6A

5B, 6B

*6.

16, 17, 18

17, 18, 19

7A, 8A

7B, 8B

*7.

19, 20, 21, 22

19

18

7A, 8A

7B, 8B

*8.

18

8A

8B

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6-1

ASSIGNMENT CHARACTERISTICS TABLE


Problem Number 1A 2A Description Compute break-even point under alternative courses of action. Compute break-even point and margin of safety ratio, and prepare a CVP income statement before and after changes in business environment. Determine sales mix with limited resources. Determine break-even sales under alternative sales strategies and evaluate results. Compute degree of operating leverage and evaluate impact of operating leverage on financial results. Determine contribution margin, break-even point, target sales, and degree of operating leverage. Prepare income statements under absorption costing and variable costing for a company with beginning inventory, and reconcile differences. 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. Compute break-even point under alternative courses of action. Compute break-even point and margin of safety ratio, and prepare a CVP income statement before and after changes in business environment. Determine sales mix with limited resources. Determine break-even sales under alternative sales strategies and evaluate results. Compute degree of operating leverage and evaluate impact of operating leverage on financial results. Determine contribution margin, break-even point, target sales, and degree of operating leverage. Prepare income statements under absorption costing and variable costing for a company with beginning inventory, and reconcile differences. 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. Difficulty Level Moderate Moderate Time Allotted (min.) 2030 2030

3A 4A 5A 6A *7A

Simple Moderate Moderate Moderate Moderate

1015 2030 2030 2030 2030

*8A

Moderate

2030

1B 2B

Moderate Moderate

2030 2030

3B 4B 5B 6B *7B

Simple Moderate Moderate Moderate Moderate

1015 2030 2030 2030 2030

*8B

Moderate

2030

6-2

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BLOOMS TAXONOMY TABLE

Correlation Chart between Blooms Taxonomy, Learning Objectives and End -of-Chapter Exercises and Problems
Learning Objective *1. Knowledge Comprehension Q6-2 Q6-4 Application BE6-2 BE6-3 BE6-4 BE6-5 BE6-6 BE6-2 BE6-3 BE6-4 BE6-5 BE6-6 DI6-2 E6-1 BE6-7 BE6-8 BE6-9 BE6-10 E6-2 E6-3 E6-4 E6-5 P6-1A P6-2A P6-4A DI6-3 E6-6 E6-7 E6-8 DI6-1 P6-1A P6-2A P6-1B P6-2B P6-6A P6-1B P6-2B P6-4B P6-6B Analysis BE6-1 P6-1A P6-2A P6-1B P6-2B BE6-1 P6-1A P6-2A P6-6A P6-1B P6-2B E6-6 E6-7 E6-8 P6-4A P6-6B Synthesis Evaluation

Describe the essential features Q6-1 of a cost-volume-profit income Q6-3 statement.

*2.

Apply basic CVP concepts.

Q6-2 Q6-4 Q6-5 Q6-6

*3.

Explain the term sales mix and Q6-7 its effects on break-even sales. Q6-8

Q6-8 Q6-9

E6-9 E6-10 P6-4A P6-4B

P6-4B

*4.

Determine sales mix when a Q6-11 company has limited resources. Understand how operating leverage affects profitability. Q6-12 Q6-13 Q6-15

Q6-10

BE6-11 E6-11 BE6-15 E6-12 DI6-4 E6-13 Q6-16 BE6-12 BE6-13 BE6-14 BE6-16 BE6-17 BE6-18 E6-17

P6-3A E6-11 P6-3B E6-12 E6-13

P6-3A P6-3B P6-6A P6-5B P6-6B P6-7B P6-8B

*5.

Q6-14

E6-14 P6-6A E6-14 E6-15 P6-5B E6-15 E6-16 E6-16 P6-5A P6-5A E6-18 P6-7B E6-18 E6-19 P6-8B E6-19 P6-7A P6-7A P6-8A P6-8A

**6.

Explain the difference between absorption costing and variable costing. Discuss net income effects under absorption costing versus variable costing. Discuss the merits of absorption versus variable costing for management decision making.

Q6-17

*7.

Q6-19 Q6-22 Q6-20 Q6-21 Q6-18

Q6-19 P6-7A P6-8B P6-7A BE6-19 P6-8A P6-8A E6-18 P6-7B P6-7B P6-8A P6-8B

P6-8B

**8.

Broadening Your Perspective

BYP6-7

BYP6-4 BYP6-5

BYP6-1 BYP6-2

BYP6-6 BYP6-9

BYP6-3 BYP6-8 BYP6-10

6-3

ANSWERS TO QUESTIONS
1. CVP or cost-volume-profit analysis is the study of the effects of changes in costs and volume on a companys profit. Managers use CVP analysis to make decisions involving break-even point, sales required to reach a target net income, margin of safety, the most profitable sales mix, allocation of limited resources, and operating leverage. Both types of income statements report the same amount of net income. But the format used to reach net income differs. A traditional income statements format consists of: Sales revenue cost of goods sold = gross profit; Gross profit selling and administrative expenses = net income. A CVP income statements format consists of: Sales revenue variable expenses = contribution margin; Contribution margin fixed expenses = net income. The CVP income statement isolates variable costs from fixed costs while the traditional income statement does not. The CVP format indicates contribution margin in total and frequently on a per unit basis as well. This format facilitates calculation of break-even point and target net income. It also highlights how changes in sales volume or cost structure affect net income. WHEAT COMPANY CVP Income Statement Sales ........................................................................................................ Variable costs ($500,000 X .75) + ($200,000 X .75) ................................. Contribution margin .................................................................................. 6. $900,000 525,000 $375,000

2.

3.

4.

5.

If the selling price is reduced but variable and fixed costs remain unchanged, the break-even point will increase. Sales mix is the relative percentage of each product sold when a company sells more than one product. Sales mix changes the calculation of the break-even point because the fixed costs must be divided by the weighted-average unit contribution margin. The 150,000-mile tire has a higher unit contribution margin, that is, each tire sold covers a larger amount of fixed costs. Therefore, if the sales mix shifts away from the 150,000-mile tire to the 50,000-mile tire, the company will have to sell more total tires in order to break-even. If a company has many products, the break-even point is calculated using sales information for divisions or product lines, rather than individual products. The weighted-average contribution margin ratio is computed by multiplying the sales mix percentage of each product line by the contribution margin ratio of each product line, and then summing the results. Total break-even sales in dollars is then calculated by dividing the companys total fixed costs by the weighted average contribution margin ratio. Finally, to determine the amount of sales generated by each product line at the break-even point, multiply the total break-even sales by the sales mix percentage of each product line.

7.

8.

9.

6-4

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Questions Chapter 6 (Continued) 10. Contribution margin per unit of limited resource is determined by dividing the contribution margin per unit of the product by the number of units of the limited resource required to produce the product. 11. The theory of constraints is a specific approach used to identify and manage constraints to achieve the companys goals. According to this theory, a company must continually identify its constraints and find ways to reduce or eliminate them, where appropriate. Examples of constraints would be production bottlenecks or poorly trained workers. 12. Cost structure refers to the relative proportion of fixed costs versus variable costs that a company incurs. Companies that rely heavily on fixed costs will have higher break-even points. 13. Operating leverage refers to the extent to which a companys net income reacts to a given change in sales. A company can increase its operating leverage by increasing its reliance on fixed costs. 14. Typically manual labor is considered a variable cost. Depreciation on factory equipment is a fixed cost. Therefore, if a company replaces manual labor with automated factory equipment it will increase its operating leverage, and increase its break-even point. 15. The degree of operating leverage is a measure of a companys relative operating leverage. It is calculated by dividing the contribution margin by net income at a particular level of sales. 16. Pines degree of operating leverage of 8 versus Firs measure of 4 tells us that Pine will experience twice (8 4) the increase (or decrease) in net income for a given increase (decrease) in sales as Fir. *17. Under absorption costing, both variable and fixed manufacturing costs are considered to be product costs. Under variable costing, only variable manufacturing costs are product costs and fixed manufacturing costs are expensed when incurred. *18. (a) The rationale for variable costing centers on the purpose of fixed manufacturing costs, which is to have productive facilities available for use. Since these costs are incurred whether a company operates at zero or 100% capacity, it is argued that they should be expensed when they are incurred. Variable costing is useful in product costing internally by management and it is useful in controlling manufacturing costs. Variable costing cannot be used for financial reporting purposes because it does not follow generally accepted accounting principles.

(b)

*19. One way to compute the difference is as follows: Ending inventory 8,500 X Fixed manufacturing overhead cost per unit X $5 = $42,500

Absorption costing will report a $42,500 higher net income than variable costing because a portion of the fixed manufacturing overhead costs are deferred in inventory.

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6-5

Questions Chapter 6 (Continued) *20. If production equals sales in any given period, the net incomes under both methods will be equal. In this case, there is no increase in the ending inventory. So fixed manufacturing overhead costs in the current period are not deferred to future periods through the ending inventory. *21. If production is greater than sales, absorption costing net income will be greater than variable costing net income. Absorption costing net income is higher because some of the fixed manufacturing overhead costs will be deferred in the inventory account until the products are sold. *22. In the long run, neither method will produce a higher net income amount. Over a long period of time, sales can never exceed production, nor production exceed sales by significant amounts. For this reason, over the lifetime of a corporation, variable costing and absorption costing will tend to yield the same net income amounts.

6-6

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SOLUTIONS TO BRIEF EXERCISES


BRIEF EXERCISE 6-1 1. 2. 3. (a) (b) (c) (d) (e) (f) $70 = ($250 $180) 28% ($70 $250) $200 = ($500 $300) 60% ($300 $500) $1,100 = ($330 30%) $770 ($1,100 $330)

BRIEF EXERCISE 6-2 HAMBY INC. Income Statement For the Quarter Ended March 31, 2014 Sales........................................................................ Variable expenses Cost of goods sold ......................................... Selling expenses............................................. Administrative expenses................................ Total variable expenses .......................... Contribution margin ............................................... Fixed expenses Cost of goods sold ......................................... Selling expenses............................................. Administrative expenses................................ Total fixed expenses ............................... Net income .............................................................. BRIEF EXERCISE 6-3 Contribution margin ratio = [($250,000 $175,000) $250,000] = 30% Required sales in dollars = $120,000 30% = $400,000 $2,000,000 $760,000 95,000 79,000 934,000 1,066,000 600,000 60,000 66,000 726,000 $ 340,000

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6-7

BRIEF EXERCISE 6-4 (a) $400Q = $250Q + $210,000 + $0 $150Q = $210,000 Q = 1,400 units (b) Contribution margin per unit $150, or ($400 $250) X = $210,000 $150 X = 1,400 units BRIEF EXERCISE 6-5 X = .60X + $210,000 + $60,000 .40X = $270,000 X = $675,000 BRIEF EXERCISE 6-6 Margin of safety = $1,200,000 $960,000 = $240,000 Margin of safety ratio = $240,000 $1,200,000 = 20% BRIEF EXERCISE 6-7 Model A12 B22 C124 Sales Mix Percentage 60% 15% 25% Unit Contribution Margin $10 ($50 $40) $30 ($100 $70) $100 ($400 $300) Weighted-Average Unit Contribution Margin $ 6.00 4.50 25.00 $35.50

6-8

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BRIEF EXERCISE 6-8 Total break-even = ($213,000 $35.50*) = 6,000 units *Computed in BE 6-7 Sales Units Units of A12 = .60 X 6,000 = 3,600 Units of B22 = .15 X 6,000 = 900 Units of C124 = .25 X 6,000 = 1,500 6,000 BRIEF EXERCISE 6-9 (a) Weighted-average contribution = margin ratio Total break-even point = in dollars (.30 X .20) + (.50 X .20) + ( .20 X .45) = .25

(b)

($440,000 .25) = $1,760,000

Birthday $1,760,000 X .30 = $ 528,000 Standard tapered $1,760,000 X .50 = 880,000 Large scented $1,760,000 X .20 = 352,000 $1,760,000 BRIEF EXERCISE 6-10 (a) Sales Mix Bedroom Division $500,000 $1,250,000 = .40 Dining Room Division $750,000 $1,250,000 = .60 Weight-average contribution = $575,000 = .46 margin ratio $1,250,000 OR Contribution Margin Ratio Bedroom Division($275,000 $500,000) = .55 Dining Room Division($300,000 $750,000) = .40 Weighted-average contribution margin ratio = (.55 X .40) + (.40 X .60) = .46

(b)

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6-9

BRIEF EXERCISE 6-11 Product A $12.0 2 $ 6 Product B $15 3 $ 5

Contribution margin per unit (a) Machine hours required (b) Contribution margin per unit of limited resource [(a) (b)] BRIEF EXERCISE 6-12 Degree of operating leverage (old) = Degree of operating leverage (new) = $200,000 $40,000 = 5 $240,000 $40,000 = 6

If Sams sales change, the resulting change in net income will be 1.2 times (6 5) higher with the new machine than under the old system. BRIEF EXERCISE 6-13 Break-even point in dollars: Logan Co. $60,000 ($120,000 $200,000) = $100,000 Morgan Co. $90,000 ($150,000 $200,000) = $120,000

Morgan Companys cost structure relies much more heavily on fixed costs than that of Logan Co. As result, Morgan has a higher contribution margin ratio of .75 ($150,000 $200,000) versus .60 ($120,000 $200,000), for Logan Co. Morgan also has much higher fixed costs to cover. Its break-even point is therefore higher than that of Logan Co. BRIEF EXERCISE 6-14 Degree of operating leverage = Contribution margin Net income Montana Corp. 1.6 = Contribution margin $50,000 Contribution margin = $50,000 X 1.6 = $80,000 APK Co. 5.4 = Contribution margin $50,000 Contribution margin = $50,000 X 5.4 = $270,000

6-10

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BRIEF EXERCISE 6-15 Product 1 $ 42 .15 $280 Product 2 $ 35 .10 $350

Contribution margin per unit (a) Machine hours required (b) Contribution margin per unit of limited resource [(a) (b)]

Product 2 has a higher contribution margin per limited resource, even though it has a lower contribution margin per unit. Given that machine hours are limited to 2,000 per month, Ger Corporation should produce Product 2. *BRIEF EXERCISE 6-16 Variable Costing Direct materials Direct labor Variable manufacturing overhead Total product costs *BRIEF EXERCISE 6-17 Absorption Costing Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Total product costs *BRIEF EXERCISE 6-18 (a) Absorption Costing ....... Direct materials................................................................ Direct labor ...................................................................... Variable manufacturing overhead .................................. Fixed manufacturing overhead ($128,000 8,000) ........ Total manufacturing cost per unit .................................. $20 14 15 16 $65 $14,400 25,600 32,400 12,000 $84,400 $14,400 25,600 32,400 $72,400

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6-11

*BRIEF EXERCISE 6-18 (Continued) (b) Variable Costing Direct materials ............................................... Direct labor...................................................... Variable manufacturing overhead ................. Total manufacturing cost per unit ................. $20 14 15 $49

*BRIEF EXERCISE 6-19 MEMO To: From: Re: Chief financial officer Student Absorption and variable costing

Under absorption costing, fixed manufacturing overhead is a product cost, while under variable costing, fixed manufacturing overhead is a period cost (expensed as incurred). Since units produced (50,000) exceeded units sold (48,000) last month, income under absorption costing will be higher than under variable costing. Some fixed overhead (2,000 units X $4 = $8,000) will be assigned to ending inventory and therefore not expensed under absorption costing, whereas all fixed overhead is expensed under variable costing. Therefore, absorption costing net income will be higher than variable costing net income by $8,000.

6-12

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SOLUTIONS TO DO IT! REVIEW EXERCISES DO IT! 6-1 AMANDA INC. Income Statement For the Month Ended January 31, 2014 Sales (10,000 units).......................................... Variable expenses Cost of goods sold..................................... Selling expenses ........................................ Administrative expenses ........................... Total variable expenses ...................... Contribution margin Fixed expenses Cost of goods sold..................................... Selling expenses ........................................ Administrative expenses ........................... Total fixed expenses ........................... Net income ....................................................... $400,000 $184,000 40,000 16,000 240,000 160,000 $ 70,000 30,000 50,000 150,000 $ 10,000

Contribution margin per unit: $160,000 10,000 units = $16 per unit. Contribution margin ratio: $160,000 $400,000 = 40% or $16 $40 = 40%. DO IT! 6-2 (a) Break-even point in units is 7,500 units ($150,000 $20). Break-even point in sales dollars is $375,000 ($150,000 .40*). The margin of safety in dollars is $75,000 ($450,000 $375,000). *$20 $50. (b) Break-even point in units is 8,333 units (rounded) ($150,000 $18*). Break-even point in sales dollars is $400,000 ($150,000 .375**). The margin of safety in dollars is $118,400 ($518,400*** $400,000). *$50 (.04 X $50) 30 = $18. **$18 $48 = .375 ***9,000 + (.20 X 9,000) = 10,800 units, 10,800 units X $48 = $518,400

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6-13

DO IT! 6-2 (Continued) The increase in the break-even point from $375,000 to $400,000 indicates that management should not implement the proposed change while the increase in the margin of safety from $75,000 to $118,400 indicates that management should implement the proposed change. Since the expected 20% increase in sales volume will result in a contribution margin of $194,400 (10,800 X $18) which is only $14,400 more than the current amount, management should be cautious before reducing unit prices. DO IT! 6-3 (a) The sales mix percentages as a function of units sold is: Basic 750 1,500 = 50% (b) Basic Plus 450 1,500 = 30% Premium 300 1,500 = 20%

The weighted-average unit contribution margin is:


[.50 X ($250 $195)] + [.3 X ($400 $288)] + [.20 X ($800 $416)] = $137.90.

(c) (d)

The break-even point in units is: $165,480 $137.90 = 1,200 units. The break-even units to produce for each product are: Basic: 1,200 units X 50% = 600 units Basic Plus 1,200 units X 30% = 360 units Premium: 1,200 units X 20% = 240 units 1,200 units

DO IT! 6-4 (a) The Best binoculars have the highest contribution margin per unit. Thus, ignoring any manufacturing constraints, it would appear that the company should shift toward production of more Best units.

6-14

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DO IT! 6-4 (Continued) (b) The contribution margin per unit of limited resource is calculated as:
Good $40 .5 = $80 Better Best $150 $420 1.5 = $100 6 = $70

Contribution margin per unit Limited resource consumed per unit

(c)

The Better binoculars have the highest contribution margin per unit of limited resource, even though they do not have the highest contribution margin per unit. Given the resource constraint, any additional capacity should be used to make Better binoculars.

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6-15

SOLUTIONS TO EXERCISES
EXERCISE 6-1 (a) 1. Contribution margin per room = Contribution margin per room = Contribution margin ratio = $60 ($8 + $37) $15 $15 $60 = 25%

Fixed costs = $8,800 + $2,400 + $1,500 + $800 = $13,500 Break-even point in rooms = $13,500 $15 = 900 2. Break-even point in dollars = = 900 rooms X $60 per room $54,000 per month

OR Fixed costs Contribution margin ratio = $13,500 .25 = $54,000 per month (b) 1. Margin of safety in dollars: Planned activity = 50 rooms per day X 30 days = 1,500 rooms per month Expected rental revenue = 1,500 rooms X $60 = $90,000 Margin of safety in dollars = $90,000 $54,000 = $36,000 $36,000 = 40% $90,000

2.

Margin of safety ratio:

EXERCISE 6-2 (a) Contribution margin in dollars: Sales = 4,000 X $30 =


$120,000 Variable costs = $120,000 X .75 = 90,000 Contribution margin $ 30,000

Contribution margin per unit: Contribution margin ratio:

$30 $22.50 ($30 X 75%) = $7.50. $7.50 $30 = 25%.

6-16

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EXERCISE 6-2 (Continued) (b) Break-even sales in dollars:


$16,800 = $67,200. 25%

Break-even sales in units:

$16,800 = 2,240. $7.50


$120,000 $67,200 = $52,800. $52,800 $120,000 = 44%.

(c) Margin of safety in dollars: Margin of safety ratio: EXERCISE 6-3

Current selling price = $310,000 5,000 units Current selling price = $62 1. Increase selling price to $68.20 ($62 X 110%). Net income = $341,000* $210,000 $75,000 = $56,000. *($68.20 X 5,000) 2. Reduce variable costs to 58% of sales. Net income = $310,000 $179,800** $75,000 = $55,200. **($310,000 X .58) 3. Reduce fixed costs to $55,000 ($75,000 $20,000). Net income = $310,000 $210,000 $55,000 = $45,000.

Alternative 1, increasing unit sales price, will produce the highest net income.

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6-17

EXERCISE 6-4 (a) 1. Contribution margin ratio is: $30,000 = 62.5% $48,000 $20,250 = $32,400 62.5%

Break-even point in dollars = 2. Round-trip fare =

$48,000 = $120 400 fares $32,400 = 270 fares $120

Break-even point in fares =

(b) At the break-even point fixed costs and contribution margin are equal. Therefore, the contribution margin at the break-even point would be $20,250. (c) Fare revenue ($108* X 500**) Variable costs ($18,000 X 1.20) Contribution margin Fixed costs Net income $54,000 21,600 32,400 20,250 $12,150

Yes, the fare decrease should be implemented because net income increases to $12,150. *$120 (.10 X $120) **400 + 100 EXERCISE 6-5 (a) HALL COMPANY CVP Income Statement For the Year Ended December 31, 2014 Total $1,560,000 720,000 840,000 500,000 $ 340,000 Per Unit $26 12 $14

Sales (60,000 X $26) ...................................... Variable costs (60,000 X $12) ........................ Contribution margin (60,000 X $14).............. Fixed costs..................................................... Net income .....................................................

6-18

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EXERCISE 6-5 (Continued) (b) HALL COMPANY CVP Income Statement For the Year Ended December 31, 2014 Total $1,543,500 567,000 976,500 650,000 $ 326,500 Per Unit $24.50 9.00 $15.50

Sales [(60,000 X 105%) X $24.50*] ................ Variable costs (63,000 X $9.00**) .................. Contribution margin (63,000 X $15.50)......... Fixed costs ($500,000 + $150,000) ............... Net income ..................................................... *$26.00 ($3 X 50%) = $24.50. **$12.00 ($12 X 25%) = $9.00. EXERCISE 6-6 Sales Mix Percentage 20% 50% 30%

Lawnmowers Weed-trimmers Chainsaws

Contribution Margin Per Unit $30 $20 $40

Weighted-Average Contribution Margin $ 6 10 12 $28

Total break-even sales in units = $4,200,000 $28 = 150,000 units Total Sales Mix Break-even Sales Percentage in Units 20% X 150,000 = 50% X 150,000 = 30% X 150,000 = Sales Units Needed Per Product 30,000 units 75,000 units 45,000 units 150,000 units

Lawnmowers Weed-trimmers Chainsaws Total units

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6-19

EXERCISE 6-7 (a) Sales Mix Percentage 70% 30% Contribution Margin Ratio 20% 60% Weighted-Average Contribution Margin Ratio .14 .18 .32

Oil changes Brake repair

Total break-even sales in dollars = $16,000,000 .32 = $50,000,000 Sales Mix Percentage 70% X 30% X Total Break-even Sales in Dollars $50,000,000 $50,000,000 Sales Dollars Needed Per Product $35,000,000 15,000,000 $50,000,000

Oil changes Brake repair Total sales (b)

= =

Sales to achieve target net income = ($80,000 + $60,000) .32 = $437,500 Sales Mix Total Percentage Sales Needed 70% X $437,500 = 30% X $437,500 = Sales Dollars Needed Per Product Per Store $306,250 131,250 $437,500

Oil changes Brake repair Total sales EXERCISE 6-8 (a)

Sales Mix Percentage Mail pouches and small boxes Non-standard boxes 80% 20%

Contribution Margin Ratio 20% 70%

Weighted-Average Contribution Margin Ratio .16 .14 .30

Total break-even sales in dollars = $12,000,000 .30 = $40,000,000


6-20

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EXERCISE 6-8 (Continued) Sales Mix Percentage Mail pouches and small boxes Non-standard boxes Total sales (b) Sales Mix Percentage Mail pouches and small boxes Non-standard boxes 40% 60% Contribution Margin Ratio 20% 70% Weighted-Average Contribution Margin Ratio .08 .42 .50 80% 20% X X Total Breakeven Sales in Dollars $40,000,000 $40,000,000 = = Sales Dollars Needed Per Product $32,000,000 8,000,000 $40,000,000

Total break-even sales in dollars = $12,000,000 .50 = $24,000,000 Sales Mix Percentage Mail pouches and small boxes Non-standardized boxes Total sales EXERCISE 6-9 (a) Weighted-average unit contribution margin = ($40 X .30) + ($20 X .60) + ($60 X .10) = $30 Break-even point in units = $630,000 $30 = 21,000 (b) Shoes (21,000 X .30) = 6,300 pairs of shoes Gloves (21,000 X .60) = 12,600 pairs of gloves Range-finders (21,000 X .10) = 2,100 range-finders 40% 60% X X Total Breakeven Sales in Dollars $24,000,000 $24,000,000 = = Sales Dollars Per Product $ 9,600,000 14,400,000 $24,000,000

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6-21

EXERCISE 6-9 (Continued) (c) Shoes: 6,300 X $40 = $252,000 Gloves: 12,600 X $20 = 252,000 Range-finders: 2,100 X $60 = 126,000 Total contribution margin 630,000 Fixed costs 630,000 Net income $ 0 EXERCISE 6-10 (a) Sales mix percentage iPad division: $600,000 ($600,000 + $400,000) = .60 iPod division: $400,000 ($600,000 + $400,000) = .40 Contribution margin ratio: iPad division: $180,000 $600,000 = .30 iPod division: $140,000 $400,000 = .35 (b) Weighted-average contribution = $320,000 = .32 OR margin ratio $1,000,000 Weighted-average contribution margin ratio = (.60 X .30) + (.40 X .35) = .32 (c) Break-even point in dollars = $120,000 .32 = $375,000 (d) Sales dollars needed at break-even point for each division iPad division: $375,000 X .60 = $225,000 iPod division: $375,000 X .40 = $150,000 EXERCISE 6-11 (a)
A Contribution margin per unit (a) Machine hours required (b) Contribution margin per unit of limited resource (a) (b) $ 5 2 $2.50 Product B $ $ 2 1 2 $

C 3 2 $1.50

(b) Product A should be manufactured because it results in the highest contribution margin per machine hour.
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EXERCISE 6-11 (Continued) (c) 1. Machine hours (a) (1,500 3) Contribution margin per unit of limited resource (b) Total contribution margin [(a) X (b)] Product A B 500 500 $ 2.50 $1,250 $ 2 $1,000

C 500 $1.50 $ 750

The total contribution margin = ($1,250 + $1,000 + $750) = $3,000. 2. Machine hours (a) Contribution margin per unit of limited resource (b) Total contribution margin [(a) X (b)] EXERCISE 6-12 (a) Product D: $30 $10 = 3.0 hours per unit Product E: $80 $10 = 8.0 hours per unit Product F: $35 $10 = 3.5 hours per unit (b) Selling price Variable costs Contribution margin Direct labor hours per unit Contribution margin per direct labor hour D $200 125 75 3.0 $ 25 Product E $ 300 160 140 8.0 $17.50 F $250 180 70 3.5 $ 20 Product A 1,500 $ 2.50 $3,750

(c) Product D should be produced because it generates the highest contribution margin per direct labor hour. Total direct labor hours available Contribution margin per direct labor hour Total contribution margin Product D 2,000 X $25 $50,000

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EXERCISE 6-13 (a) Selling price per unit Variable costs per unit Contribution margin per unit (a) Machine hours required (b) Contribution margin per machine hour (a) (b) Product Basic Deluxe $40 $ 52 20 22 $20 $ 30 .5 .8 $40 $37.50

(b) The Basic product should be manufactured because it results in the higher contribution margin per machine hour. (c) 1. Machine hours allocated X Contribution margin per machine hour Contribution margin 2. Machine hours allocated X Contribution margin per machine hour Contribution margin EXERCISE 6-14 (a) Armstrong Contador Contribution Margin $260,000 $450,000 Net Income $100,000 $100,000 Degree of Operating = Leverage = 2.60 = 4.50 Basic 500 $40 $20,000 Basic 1,000 $40 $40,000 Deluxe 500 $37.50 $18,750 Deluxe 0 $37.50 0 Total 1,000

$38,750 Total 1,000

$40,000

Interpretation: Contador has a higher degree of operating leverage. Its earnings would increase (decrease) by a greater amount than Armstrong if each experienced an equal increase (decrease) in sales.

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EXERCISE 6-14 (Continued) (b) Sales Variable costs Contribution margin Fixed costs Net income *$500,000 X 1.1 **$240,000 X 1.1 ***$ 50,000 X 1.1 (c) Each company experienced a $50,000 increase in sales. However, because of Contadors higher operating leverage, it experienced a $45,000 ($145,000 $100,000) increase in net income while Armstrong experienced only a $26,000 ($126,000 $100,000) increase. This is what we would have expected, since Contadors degree of operating leverage exceeds that of Armstrong. EXERCISE 6-15 (a)
Contribution Margin $300,000 $900,000 Net Income $250,000 $250,000 = = = Degree of Operating Leverage 1.20 3.60

Armstrong Company $550,000** 264,000** 286,000** 160,000** $126,000**

Contador Company $550,000*** 55,000*** 495,000*** 350,000*** $145,000***

Manual system Computerized system

(b) The computerized system would produce profits that are 3.0 times (3.60 1.20) as much as the manual system. With a $150,000 increase in sales, net income would increase $30,000 ($280,000 $250,000) under the manual system and $90,000 ($340,000 $250,000) under the computerized system.

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EXERCISE 6-15 (Continued) Manual System $1,650,000 1,320,000* 330,000 50,000 $ 280,000 Computerized System $1,650,000 660,000** 990,000 650,000 $ 340,000

Sales Variable costs Contribution margin Fixed costs Net income

*($1,200,000 $1,500,000) X $1,650,000 **($600,000 $1,500,000) X $1,650,000 (c)


(Actual Sales Manual system Computerized system ($1,500,000 $1,083,333**) $1,500,000 = .28 ($1,500,000 Break-even Sales) $250,000*) Actual Sales $1,500,000 = = Margin of Safety Ratio .83

*$ 50,000 ($300,000 $1,500,000) **$650,000 ($900,000 $1,500,000) The manual system could weather the greater decline in sales before reaching the break-even point. Under the manual system sales could drop 83% before suffering a loss, while sales under the computerized system could only decline by 28% before suffering a loss. EXERCISE 6-16 (a) Contribution Margin Traditional Yams $ 80,000 Auto-Yams $240,000 Net Income $50,000 $50,000 = = = Degree of Operating Leverage 1.60 4.80

Auto-Yams, which relies more heavily on fixed costs, has the higher degree of operating leverage, 4.8 versus 1.60. That means for every dollar of increase (decrease) in sales, Auto-Yams will generate 3 (4.80 1.60) times more (less) in contribution margin and net income.

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EXERCISE 6-16 (Continued) (b) % Change in Sales 15% decrease: Traditional Yams Auto-Yams 10% increase: Traditional Yams Auto-Yams (15%) (15%) 10% 10% X X X X X Degree of Operating Leverage 1.60 4.80 1.60 4.80 = = = = = % Change in Net Income (24.0%) (72.0%) 16.0% 48.0%

(c) There are several possible answers that could be given. For example, if the candied Yams business is fairly stable, Auto-Yams might be the choice, because they will generate the higher contribution margin and net income. If, however, sales swing widely from year to year, Traditional Yams might be chosen because they will provide the more stable contribution margin and net income. Finally, if the investment banker is a risk taker, she might choose Auto-Yams in spite of year to year sales swings. EXERCISE 6-17 (a) Unit Cost Direct materials Direct labor Variable manufacturing overhead Manufacturing cost per unit $ 7.50 2.45 5.80 $15.75

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EXERCISE 6-17 (Continued) (b) FELDE COMPANY Income Statement For the Year Ended December 31, 2014 Variable Costing Sales (80,000 lures X $25) Variable cost of goods sold (80,000 lures X $15.75) Variable selling and administrative expenses (80,000 lures X $3.90) Contribution margin Fixed manufacturing overhead Fixed selling and administrative expenses Net Income (loss) (c) Unit Cost Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead ($225,000 90,000) Manufacturing cost per unit (d) FELDE COMPANY Income Statement For the Year Ended December 31, 2014 Absorption Costing Sales (80,000 lures X $25) $2,000,000 Cost of goods sold (80,000 lures X $18.25) 1,460,000 Gross profit 540,000 Variable selling and administrative expenses (80,000 lures X $3.90) $312,000 Fixed selling and administrative expenses 240,100 552,100 Net Income $ (12,100) $ 7.50 2.45 5.80 2.50 $18.25 $2,000,000 $1,260,000 312,000 225,000 240,100 465,100 $ (37,100) 1,572,000 428,000

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*EXERCISE 6-18 (a) Direct materials used Direct labor incurred Variable manufacturing overhead Variable manufacturing costs $ 79,000 30,000 21,500 $130,500

Variable manufacturing cost per unit = $130,500 9,000 = $14.50 per unit Finished goods inventory cost = (9,000 8,200 units) X $14.50 = $11,600 (b) Absorption costing would show a higher net income because a portion of the fixed costs are deferred to future periods. The following computation indicates that finished goods inventory will be $4,000 higher under absorption costing which will cause its net income to be $4,000 higher. Direct materials used Direct labor incurred Variable manufacturing overhead Fixed manufacturing overhead Total manufacturing costs $ 79,000 30,000 21,500 45,000 $175,500

Total manufacturing costs per unit = $175,500 9,000 = $19.50 per unit Finished goods inventory cost = (9,000 8,200 units) X $19.50 = $15,600 Inventory (absorption costing) Inventory (variable costing) $15,600 11,600 $ 4,000

*EXERCISE 6-19 (a) Months in a year 12 Months in a year 12 X X X X Utility Expense Kilowatt Hourly Variable X = hours Charge Utilities 500 Monthly Fee $1,500 X = $0.40 Fixed Utilities = $2,400

= $18,000

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*EXERCISE 6-19 (Continued) Variable Costing Labor: Crate builders Material: Wood Variable Overhead: Utilities Nails Total manufacturing costs (b) Absorption Costing Labor: Crate builders Material: Wood Variable overhead: Utilities Nails Fixed overhead: Utilities Rent Total manufacturing costs $ 38,000 54,000 2,400 350 18,000 21,400 $134,150 $38,000 54,000 2,400 350 $94,750

(c) The entire difference in costs between the two methods is due to the fact that fixed overhead is included as part of manufacturing costs only under the absorption costing method. This difference amounts to $39,400 ($18,000 + $21,400).

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SOLUTIONS TO PROBLEMS
PROBLEM 6-1A (a) Sales were $2,000,000 and variable expenses were $1,100,000, which means contribution margin was $900,000 and CM ratio was .45. Fixed expenses were $1,035,000. Therefore, the break-even point in dollars is: $1,035,000 = $2,300,000 .45 (b) 1. The effect of this alternative is to increase the selling price per unit to $31.25 ($25 X 125%). Total sales become $2,500,000 (80,000 X $31.25). Thus, contribution margin ratio changes to 56% [($2,500,000 $1,100,000) $2,500,000]. The new break-even point is: $1,035,000 = $1,848,214 (rounded) .56 2. The effects of this alternative are: (1) fixed costs decrease by $160,000, (2) variable costs increase by $100,000 ($2,000,000 X 5%), (3) total fixed costs become $875,000 ($1,035,000 $160,000), and the contribution margin ratio becomes .40 [($2,000,000 $1,100,000 $100,000) $2,000,000]. The new break-even point is: $875,000 = $2,187,500 .40 3. The effects of this alternative are: (1) variable and fixed cost of goods sold become $734,000 each, (2) total variable costs become $884,000 ($734,000 + $92,000 + $58,000), (3) total fixed costs are $1,251,000 ($734,000 + $425,000 + $92,000) and the contribution margin ratio becomes .558 [($2,000,000 $884,000) $2,000,000]. The new break-even point is: $1,251,000 = $2,241,935 (rounded) .558 Alternative 1 is the recommended course of action using break-even analysis because it has the lowest break-even point.
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6-31

PROBLEM 6-2A

(a) (1) Sales Variable costs Direct materials Direct labor Manufacturing overhead ($350,000 X .70) Selling expenses ($250,000 X .40) Administrative expenses ($270,000 X .20) Total variable costs Contribution margin Sales Variable costs Direct materials Direct labor Manufacturing overhead Selling expenses Administrative expenses Total variable costs Contribution margin Current Year $1,500,000 511,000 290,000 245,000 100,000 54,000 1,200,000 $ 300,000 Projected Year $1,650,000 562,100 319,000 269,500 110,000 59,400 1,320,000 $ 330,000

Current Year $1,500,000 X 1.1 511,000 290,000 245,000 100,000 54,000 1,200,000 $ 300,000 X 1.1 X 1.1 X 1.1 X 1.1 X 1.1 X 1.1 X 1.1

(2) Fixed Costs Current Year Manufacturing overhead ($350,000 X .30) $105,000 Selling expenses ($250,000 X .60) 150,000 Administrative expenses ($270,000 X .80) 216,000 Total fixed costs $471,000

Projected year $105,000 150,000 216,000 $471,000

6-32

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PROBLEM 6-2A (Continued) (b) Unit selling price = $1,500,000 100,000 = $15 Unit variable cost = $1,200,000 100,000 = $12 Unit contribution margin = $15 $12 = $3 Contribution margin ratio = $3 $15 = .20
Break-even point in units 157,000 units Break-even point in dollars $2,355,000 = Fixed costs = $471,000 = Fixed costs = $471,000 Unit contribution margin $3.00 Contribution margin ratio .20

(c) Sales dollars


required for = (Fixed costs target net income $3,355,000 = ($471,000 + Target net income) Contribution margin ratio + $200,000) .20 Expected sales $3,355,000

(d) Margin of safety = (Expected sales


ratio 29.8% = ($3,355,000

Break-even sales) $2,355,000)

(e) (1) Sales Variable costs Direct materials Direct labor ($290,000 $104,000) Manufacturing overhead ($350,000 X .30) Selling expenses ($250,000 X .90) Administrative expenses ($270,000 X .20) Total variable costs Contribution margin Current Year $1,500,000 511,000 186,000 105,000 225,000 54,000 1,081,000 $ 419,000

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6-33

PROBLEM 6-2A (Continued) Fixed cost Manufacturing overhead ($350,000 X .70) Selling expenses ($250,000 X .10) Administrative expenses ($270,000 X .80) Total fixed costs $245,000 25,000 216,000 $486,000

(2) Contribution margin ratio = $419,000 $1,500,000 = .28 (rounded) (3) Break-even point in dollars = $486,000 .28 = $1,735,714 (rounded) The break-even point in dollars declined from $2,355,000 to $1,735,714. This means that overall the companys risk has declined because it doesnt have to generate as much in sales. The two changes actually had opposing effects on the break-even point. By changing to a more commission-based approach to compensate its sales staff the company reduced its fixed costs, and therefore reduced its break-even point. In contrast, the purchase of the new equipment increased the companys fixed costs (by increasing its equipment depreciation) which would increase the break-even point.

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PROBLEM 6-3A

(a) Selling price Less: Variable costs Contribution margin per unit Economy $30 14 $16

Product Standard $50 15 $35

Deluxe $100 46 $ 54

Ignoring the machine time constraint, the Deluxe product should be produced because it has the highest contribution margin per unit. (b) Contribution margin per unit (a) Machine hours required (b) Contribution margin per limited resource (a)/(b) Economy $16 .5 $32 Product Standard $ 35 .8 $43.75

Deluxe $ 54 1.6 $33.75

(c) If additional machine hours become available, the additional time should be used to produce the Standard product since it has the highest contribution margin per machine hour.

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6-35

PROBLEM 6-4A (a) Sales Mix Percentage 15% 50% 10% 25% X X X X X Contribution Margin Ratio 50% 25% 50% 80% = = = = = Weighted-Average Contribution Margin Ratio .075 .125 .050 .200 .450

Appetizers Main entrees Desserts Beverages

Total sales required to achieve target net income =

( $1,053,000 + $117,000 ) .45 = $2,600,000 Total Sales Needed $2,600,000 $2,600,000 $2,600,000 $2,600,000 Sales from Each Product $ 390,000 1,300,000 260,000 650,000 $2,600,000

Appetizers Main entrees Desserts Beverages

Sales Mix Percentage 15% 50% 10% 25%

X X X X X

= = = = =

(b) Sales Mix Percentage 25% 25% 10% 40% X X X X X Contribution Margin Ratio 50% 10% 50% 80% = = = = = Weighted-Average Contribution Margin Ratio .125 .025 .050 .320 .520

Appetizers Main entrees Desserts Beverages

Total sales required to achieve target net income = *$1,053,000 + $585,000

( $1,638,000* + $117,000) .52 = $ 3,375,000

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PROBLEM 6-4A (Continued) Thus, sales would have to increase by $775,000 ($3,375,000 $2,600,000) to achieve the target net income. This increase in sales is driven by the increase in fixed costs. The sales of each product line would be: Sales Mix Percentage 25% 25% 10% 40% X X X X X Total Sales Needed $3,375,000 $3,375,000 $3,375,000 $3,375,000 = = = = = Sales from Each Product $ 843,750 843,750 337,500 1,350,000 $3,375,000 Weighted-Average Contribution Margin Ratio .075 .050 .050 .200 .375

Appetizers Main entrees Desserts Beverages (c)

Appetizers Main entrees Desserts Beverages

Sales Mix Percentage 15% 50% 10% 25%

X X X X X

Contribution Margin Ratio 50% 10% 50% 80%

= = = = =

The weighted-average contribution margin ratio computed in part (a) was 45%. With the contribution margin ratio on entrees falling to 10%, that average will now be 37.5% as shown previously. Applying this to the new fixed costs of $1,638,000 and target net income of $117,000 we get: Total sales required to achieve target net income =

($1,638,000 + $117,000) .375 = $ 4,680,000 X X X X X Total Sales Needed $4,680,000 $4,680,000 $4,680,000 $4,680,000 = = = = = Sales from Each Product $ 702,000 2,340,000 468,000 1,170,000 $4,680,000

Appetizers Main entrees Desserts Beverages

Sales Mix Percentage 15% 50% 10% 25%

Relative to parts (a) and (b), the total required sales for (c) would increase. It appears that the least risky approach would be for Phil to switch to the new sales mix, but not to incur the additional fixed costs of expanding operations. If the switch in sales mix appears to be successful, then it may be appropriate for him to incur the additional fixed costs necessary for expansion of operations.
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6-37

PROBLEM 6-5A (a) To determine the break-even point in dollars we must first calculate the contribution margin ratio for each company. Contribution Margin $220,000 $320,000 Fixed Costs $180,000 $280,000
(Actual Sales ($500,000 ($500,000

Viejo Company Nuevo Company

Sales $500,000 $500,000

Contribution Margin = Ratio = .44 = .64 Break-even Point = in Dollars = $409,091 = $437,500
= = = Margin of Safety Ratio .182 .125

Viejo Company Nuevo Company

Contribution Margin Ratio .44 .64


Viejo Company Nuevo Company

Break-even Sales) $409,091) $437,500)

Actual Sales $500,000 $500,000

(b) Contribution Margin $220,000 $320,000 Net Income $40,000 $40,000 Degree of Operating = Leverage = 5.5 = 8.0

Viejo Company Nuevo Company

Because Nuevo Company relies more heavily on fixed costs, it has a higher degree of operating leverage. This means that its net income will be more sensitive to changes in sales. For a given change in sales, the change in net income will be 1.45 (8.0 5.5) times higher for Nuevo Company than for Viejo Company. (c) Sales Variable costs Contribution margin Fixed costs Net income *$500,000 X 1.2 **$280,000 X 1.2 ***$180,000 X 1.2 Viejo Company $600,000* 336,000** 264,000 180,000 $ 84,000 Nuevo Company $600,000 216,000*** 384,000 280,000 $104,000

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PROBLEM 6-5A (Continued) (d) Sales Variable costs Contribution margin Fixed costs Net income (Loss) *$500,000 X .80 **$280,000 X .80 ***$180,000 X .80 (e) In part (b) the degree of operating leverage of Nuevo Company was higher than that of Viejo Company, telling us that the net income of Nuevo Company was more sensitive to changes in sales than that of Viejo Company. In part (c) we see that a 20% increase in sales increased the net income of Nuevo Company by $64,000 ($104,000 $40,000), while the net income of Viejo Company increased by only $44,000 ($84,000 $40,000). However, in part (d) we see that a 20% decrease in sales resulted in a $64,000 ($40,000 + $24,000) decline in net income for Nuevo Company, while Viejo Companys net income only declined by $44,000 ($40,000 + $4,000). The increased risk caused by higher operating leverage is also seen in part (a). Nuevo Company has a higher break-even point, and a lower margin of safety ratio than Viejo Company. Thus, while operating leverage can be very beneficial for a company that expects its sales to increase, it can also significantly increase a companys risk. Viejo Company $400,000* 224,000** 176,000 180,000 ($ 4,000) Nuevo Company $400,000 144,000*** 256,000 280,000 ($ 24,000)

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6-39

PROBLEM 6-6A

(a) Reformat the income statement to CVP format. All amount are in $000s. Sales ........................................................ Variable costs ($31,500 + $13,500) ......... Contribution margin ................................ Less: Fixed costs ($8,610 + $10,260) .... Operating income.................................... $75,000 45,000 30,000 18,870 $11,130

Contribution margin ratio = $30,000 $75,000 = 40% Break-even point = $18,870 40% = $47,175 (b) If a hired workforce replaces sales agents, commissions will be reduced to 8% of sales, or $6,000; but fixed costs will increase by $7,500. Sales ........................................................ Variable costs ($31,500 + $6,000) ........... Contribution margin ................................ Less: Fixed costs ($18,870* + $7,500) ... Operating income.................................... *($8,610 + $10,260) Contribution margin ratio = $37,500 $75,000 = 50% Break-even point = $26,370 50% = $52,740 (c) Operating leverage = contribution margin operating income (1) Current situation: from part (a) $30,000 $11,130 = 2.70 (2) Proposed situation: from part (b) $37,500 $11,130 = 3.37 $75,000 37,500 37,500 26,370 $11,130

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PROBLEM 6-6A (Continued) The calculations indicate that at a sales level of $75 million, a percentage change in sales and contribution margin will result in 2.70 times that percentage change in operating income if Bonita continues to use sales agents. If they choose to employ their own, the change in operating income will be 3.37 times the percentage change in sales. The higher contribution margin per dollar of sales and higher fixed costs from Bonita employing their own agents gives them more operating leverage. This will result in greater benefits (increases in operating income) if revenues increase, but greater risks (decreases in operating income) if revenues decline. (d) The sales level at which operating incomes will be identical is called the point of indifference. This would be when the cost of the network of agents (18% of sales) is exactly equal to the cost of paying employees 8% commission along with additional fixed costs of $7.5 million. None of the other costs is relevant, because they will not change between alternatives. Let the sales volume = S 18% X S = (8% X S) + $7,500,000 .18S = .08S + $7,500,000 .10S = $7,500,000 S = $75,000,000

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6-41

*PROBLEM 6-7A

(a)

GARDNER COMPANY Income Statement For the Year Ended December 31, 2013 Variable Costing Sales (2,500 tons X $2,000) ......................... Variable cost of goods sold Inventory, January 1 ............................ Variable cost of goods manufactured [4,000 tons X ($2,000 X .15)] ............ Variable cost of goods available for sale .............................................. Inventory, December 31 [1,500 tons X ($2,000 X .15)] ............ Variable cost of goods sold ................. Variable selling expenses [2,500 tons X ($2,000 X .10)] ............ Contribution margin .................................... Fixed manufacturing overhead ................... Fixed administrative expenses ................... Net income ................................................... $5,000,000 $ 0

1,200,000 1,200,000 450,000 750,000 500,000 2,000,000 500,000 1,250,000 3,750,000 2,500,000 $1,250,000

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*PROBLEM 6-7A (Continued) GARDNER COMPANY Income Statement For the Year Ended December 31, 2014 Variable Costing Sales (4,000 tons X $2,000) ........................... Variable cost of goods sold Inventory, January 1 .............................. Variable cost of goods manufactured [2,500 tons X ($2,000 X .15)] .............. Variable cost of goods available for sale ................................................ Inventory, December 31 ......................... Variable cost of goods sold .................. Variable selling expenses [4,000 tons X ($2,000 X .10)] .............. Contribution margin ...................................... Fixed manufacturing overhead ..................... Fixed administrative expenses ..................... Net income ..................................................... (b) $8,000,000 $ 450,000 750,000 1,200,000 0 1,200,000 800,000 2,000,000 500,000 2,000,000 6,000,000 2,500,000 $3,500,000

GARDNER COMPANY Income Statement For the Year Ended December 31, 2013 Absorption Costing Sales (2,500 tons X $2,000) ...................... Cost of goods sold Inventory, January 1 ......................... Cost of goods manufactured............ Cost of goods available for sale ...... Inventory, December 31 .................... Cost of goods sold ............................ Gross profit ............................................... Variable selling expenses [2,500 tons X ($2,000 X .10)] ................. Fixed administrative expenses ................ Net income ................................................ $5,000,000 $ 0 3,200,000 (1) 3,200,000 1,200,000 (2) 2,000,000 3,000,000 500,000 500,000 1,000,000 $2,000,000

(1) 4,000 X [($2,000 X .15) + ($2,000,000 4,000)] (2) 1,500 X [($2,000 X .15) + ($2,000,000 4,000)]

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6-43

*PROBLEM 6-7A (Continued) GARDNER COMPANY Income Statement For the Year Ended December 31, 2014 Absorption Costing Sales (4,000 tons X $2,000) .................. Cost of goods sold Inventory, January 1 ..................... Cost of goods manufactured ........ Cost of goods available for sale ... Inventory, December 31 ................ Cost of goods sold ........................ Gross profit ........................................... Variable selling expenses [4,000 tons X ($2,000 X .10)] ............. Fixed administrative expenses ............ Net income ............................................ $8,000,000 $1,200,000 2,750,000 (1) 3,950,000 0 3,950,000 4,050,000 800,000 500,000 1,300,000 $2,750,000

(1) 2,500 X [($2,000 X .15) + ($2,000,000 2,500)] (c) The variable costing and the absorption costing net income can be reconciled as follows:
2013 2014 Variable costing net income $1,250,000 $3,500,000 Fixed manufacturing overhead expensed with variable costing $2,000,000 $2,000,000 Less: Fixed manufacturing overhead expensed with absorption costing (1,250,000)(1) (2,750,000)(2) Difference 750,000 (750,000) Absorption costing net income $2,000,000 $2,750,000

(1)

In 2013, with absorption costing $1,250,000 $2,000,000 X

2,500 units sold 4,000

units produced

of the

fixed manufacturing overhead is expensed as part of cost of goods sold, and $750,000

1,500 units in inventory $2,000,000 X 4,000 units produced


(2)

is included in the ending inventory.

In 2014, with absorption costing $2,750,000 of fixed manufacturing overhead is expensed as part of cost of goods sold. This includes the fixed manufacturing overhead for 2014 of $2,000,000 plus $750,000 of fixed manufacturing overhead from 2013 that was included in the beginning inventory for 2014.

6-44

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*PROBLEM 6-7A (Continued) (d) Income parallels sales under variable costing as seen in the increase in net income in 2014 when 1,500 additional units were sold. In contrast, under absorption costing, income parallels production as seen in the higher net income in 2013 when production exceeded sales by 1,500 tons.

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6-45

*PROBLEM 6-8A (a) DILITHIUM BATTERIES DIVISION Income Statement For the Year Ended December 31, 2014 Absorption Costing _______________________________________________________________ 60,000 90,000 Produced Produced Sales (60,000 units X $30) $1,800,000 $1,800,000 Cost of goods sold (60,000 units X $21) 1,260,000 (60,000 X $18) 1,080,000 Gross profit 540,000 720,000 Variable selling and administrative expenses (60,000 units x $2) 120,000 120,000 Fixed selling and administrative expenses 50,000 50,000 Net income $ 370,000 $ 550,000 (b) DILITHIUM BATTERIES DIVISION Income Statement For the Year Ended December 31, 2014 Variable Costing _______________________________________________________________ 60,000 90,000 Produced Produced Sales (60,000 units X $30) $1,800,000 $1,800,000 Variable cost of goods sold (60,000 units X $12) 720,000 720,000 Variable selling and administrative expenses (60,000 units X $2) 120,000 120,000 Contribution margin 960,000 960,000 Fixed manufacturing overhead 540,000 540,000 Fixed selling and administrative expenses 50,000 50,000 Net income $ 370,000 $ 370,000

6-46

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*PROBLEM 6-8A (Continued) (c) If the company produces 90,000 units, but only sells 60,000 units, then 30,000 units will remain in ending inventory. Under absorption costing these 30,000 units will each include $6 of fixed manufacturing overheada total of $180,000. However, under variable costing, fixed manufacturing overhead is expensed when incurred. This accounts for the $180,000 difference ($550,000 $370,000) in net income. This is summarized as: Net income under absorption costing Less: Fixed manufacturing overhead included in ending inventory (30,000 units X $6) Net income under variable costing $550,000 180,000 $370,000

(d) Variable costing has a number of advantages over absorption costing for decision making and evaluation purposes. (1) The use of variable costing is consistent with cost-volume-profit and incremental analysis. (2) Net income computed under variable costing is unaffected by changes in production levels. Note that, under variable costing the companys net income is $370,000 no matter what the level of production is. (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 companys 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 companys results.

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6-47

PROBLEM 6-1B

(a) Sales were $2,400,000 and variable expenses were $1,536,000, which means contribution margin was $864,000 and CM ratio was .36. Fixed expenses were $936,000. Therefore, the break-even point in dollars is: $936,000 = $2,600,000 .36 (b) 1. The effect of this alternative is to increase the selling price per unit to $15 ($12 X 125%). Total sales become $3,000,000 (200,000 X $15). Thus, contribution margin changes to 48.8% [($3,000,000 $1,536,000) $3,000,000]. The new break-even point is: $936,000 = $1,918,033 (rounded) .488 2. The effects of this alternative are: (1) fixed costs decrease by $120,000, (2) variable costs increase by $144,000 ($2,400,000 X 6%), (3) total fixed costs become $816,000 ($936,000 $120,000), and the contribution margin becomes .30 [($2,400,000 $1,536,000 $144,000) $2,400,000]. The new break-even point is: $816,000 = $2,720,000 .30 3. The effects of this alternative are: (1) variable and fixed cost of goods sold become $594,400 and $891,600, (2) total variable costs become $1,060,400 ($594,400 + $356,000 + $110,000), (3) total fixed costs are $1,411,600 ($891,600 + $325,000 + $195,000) and the contribution margin becomes .5582 [($2,400,000 $1,060,400) $2,400,000]. The new break-even point is: $1,411,600 = $2,529,749 (rounded) .558 Alternative 1 is the recommended course of action using break-even analysis because it has the lowest break-even point.

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PROBLEM 6-2B

(a) (1) Sales Variable costs Direct materials Direct labor Manufacturing overhead ($240,000 X .20) Selling expenses ($200,000 X .30) Administrative expenses ($250,000 X .30) Total variable costs Contribution margin Sales Variable costs Direct materials Direct labor Manufacturing overhead Selling expenses Administrative expenses Total variable costs Contribution margin Current Year $1,000,000 327,000 190,000 48,000 60,000 75,000 700,000 $ 300,000 Projected Year $1,200,000 392,400 228,000 57,600 72,000 90,000 840,000 $ 360,000

Current Year $1,000,000 X 1.2 327,000 190,000 48,000 60,000 75,000 700,000 $ 300,000 X 1.2 X 1.2 X 1.2 X 1.2 X 1.2 X 1.2 X 1.2

(2) Fixed Costs Current Year Manufacturing overhead ($240,000 X .80) $192,000 Selling expenses ($200,000 X .70) 140,000 Administrative expenses ($250,000 X .70) 175,000 Total fixed costs $507,000

Projected year $192,000 140,000 175,000 $507,000

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6-49

PROBLEM 6-2B (Continued) (b) Unit selling price = $1,000,000 40,000 = $25.00 Unit variable cost = $700,000 40,000 = $17.50 Unit contribution margin = $25.00 $17.50 = $7.50 Contribution margin ratio = $7.50 $25 = .30
Break-even point in units 67,600 units Break-even point in dollars $1,690,000 = Fixed costs = $507,000 = Fixed costs = $507,000 Unit contribution margin $7.50 Contribution margin ratio .30

(c) Sales dollars


required for = (Fixed costs target net income $2,090,000 = ($507,000 + Target net income) Contribution margin ratio + $120,000) .30 Expected sales $2,090,000

(d) Margin of safety = (Expected sales


ratio 19.1% = ($2,090,000

Break-even sales) $1,690,000)

(e) (1) Sales Variable costs Direct materials Direct labor ($190,000 $90,000) Manufacturing overhead ($240,000 X .10) Selling expenses ($200,000 X .80) Administrative expenses ($250,000 X .30) Total variable costs Contribution margin Fixed cost Manufacturing overhead ($240,000 X .90) Selling expenses ($200,000 X .20) Administrative expenses ($250,000 X .70) Total fixed costs Current Year $1,000,000 327,000 100,000 24,000 160,000 75,000 686,000 $ 314,000 $ 216,000 40,000 175,000 $ 431,000

6-50

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PROBLEM 6-2B (Continued) (2) Contribution margin ratio = $314,000 $1,000,000 = .314 (3) Break-even point in dollars = $431,000 .314 = $1,372,611 (rounded) The break-even point in dollars declined from $1,690,000 to $1,372,611. This means that overall the companys risk has declined because it doesnt have to generate so much in sales. The two changes actually had opposing effects on the break-even point. By changing to a more commission-based approach to compensate its sales staff the company reduced its fixed costs, and therefore reduced its break-even point. In contrast, the purchase of the new equipment increased the companys fixed costs (by increasing its equipment depreciation) and reduced its variable direct labor cost, both of which would increase the break-even point.

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6-51

PROBLEM 6-3B

(a) Selling price Less: Variable costs Contribution margin per unit Economy $270 144 $126

Product Standard $450 260 $190

Deluxe $650 430 $220

Ignoring the machine time constraint, the Deluxe product should be produced because it has the highest contribution margin per unit. (b) Contribution margin per unit (a) Machine hours required (b) Contribution margin per limited resource (a)/(b) Economy $126 .6 $210 Product Standard $ 190 .8 $237.50

Deluxe $ 220 1.1 $ 200

(c) If additional machine hours become available, the additional time should be used to produce the Standard product since it has the highest contribution margin per machine hour.

6-52

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PROBLEM 6-4B (a) Sales Mix Percentage 15% 60% 10% 15% X X X X X Contribution Margin Ratio 60% 25% 40% 80% = = = = = Weighted-Average Contribution Margin Ratio .09 .15 .04 .12 .40

Appetizers Main entrees Desserts Beverages

Total sales required to achieve target net income = Sales Mix Percentage 15% 60% 10% 15%

( $352,000 + $176,000 ) .40 = $1,320,000 X X X X X Total Sales $1,320,000 $1,320,000 $1,320,000 $1,320,000 = = = = = Sales from Each Product $ 198,000 792,000 132,000 198,000 $1,320,000 Weighted-Average Contribution Margin Ratio .15 .04 .05 .20 .44

Appetizers Main entrees Desserts Beverages (b)

Appetizers Main entrees Desserts Beverages

Sales Mix Percentage 25% 40% 10% 25%

X X X X X

Contribution Margin Ratio 60% 10% 50% 80%

= = = = =

Total sales required to achieve target net income = *$352,000 X 1.5

( $528,000* + $176,000) .44 = $1,600,000

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PROBLEM 6-4B (Continued) Thus, sales would have to increase by $280,000 ($1,600,000 $1,320,000) to achieve the target net income. This increase in sales is driven by the increase in fixed costs. The sales of each product line would be: Sales Mix Percentage 25% 40% 10% 25% X X X X X Total Sales Needed $1,600,000 $1,600,000 $1,600,000 $1,600,000 = = = = = Sales Dollars Per Product $ 400,000 640,000 160,000 400,000 $1,600,000 Weighted-Average Contribution Margin Ratio .09 .06 .05 .12 .32

Appetizers Main entrees Desserts Beverages (c)

Appetizers Main entrees Desserts Beverages

Sales Mix Percentage 15% 60% 10% 15%

Contribution X Margin Ratio X 60% X 10% X 50% X 80%

= = = = =

The weighted-average contribution margin ratio computed in part (a) was 40%. With the contribution margin ratio on entrees falling to 10%, that average will now be 32% as shown above. Applying this to the new fixed costs of $528,000 and target net income of $176,000 we get: Total sales required to achieve target net income =

($528,000 + $176,000) .32 = $2,200,000 X X X X X Total Sales Needed $2,200,000 $2,200,000 $2,200,000 $2,200,000 = = = = = Sales from Each Product $ 330,000 1,320,000 220,000 330,000 $2,200,000

Appetizers Main entrees Desserts Beverages

Sales Mix Percentage 15% 60% 10% 15%

6-54

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PROBLEM 6-4B (Continued) Relative to parts (a) and (b), the total required sales for (c) would increase. It appears that the least risky approach would be for Michael to switch to the new sales mix, but not to incur the additional fixed costs of expanding operations. If the switch in sales mix appears to be successful, then it may be appropriate for him to incur the additional fixed costs necessary for expansion of operations.

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6-55

PROBLEM 6-5B

(a) To determine the break-even point in dollars we must first calculate the contribution margin ratio for each company. Contribution Margin $400,000 $800,000 Fixed Costs $200,000 $600,000 Sales = $1,000,000 = $1,000,000 = Contribution Margin Ratio .40 .80 Break-even Point in Dollars $500,000 $750,000
Margin of Safety (Actual Sales Lyte Company Darke Company ($1,000,000 ($1,000,000 Break-even Sales) $500,000) $750,000) Actual Sales $1,000,000 $1,000,000 = = = Ratio .50 .25

Lyte Company Darke Company

Lyte Company Darke Company

Contribution Margin Ratio = .40 = .80 =

(b)
Contribution Net Margin Income = $400,000 $200,000 = $800,000 $200,000 = Degree of Operating Leverage 2.00 4.00

Lyte Company Darke Company

Because Darke Company relies more heavily on fixed costs, it has a higher degree of operating leverage. This means that its net income will be more sensitive to changes in sales. For a given change in sales, the change in net income will be 2.0 (4.00 2.00) times higher for Darke Company than for Lyte Company.

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PROBLEM 6-5B (Continued) (c) Sales Variable costs Contribution margin Fixed costs Net income *$1,000,000 X 1.3 **$600,000 X 1.3 ***$200,000 X 1.3 (d) Sales Variable costs Contribution margin Fixed costs Net income *$1,000,000 X .70 **$600,000 X .70 ***$200,000 X .70 (e) In part (b) the degree of operating leverage of Darke Company was higher than that of Lyte Company, telling us that the net income of Darke Company was more sensitive to changes in sales than that of Lyte Company. In part (c) we see that a 30% increase in sales increased the net income of Darke Company by $240,000 ($440,000 $200,000), while the net income of Lyte Company increased by only $120,000 ($320,000 $200,000). However, in part (d) we see that a 30% decrease in sales resulted in a $240,000 ($40,000 + $200,000) decline in net income for Darke Company, while Lyte Companys net income only declined by $120,000 ($200,000 $80,000). The increased risk caused by higher operating leverage is also seen in part (a). Darke Company has a higher break-even point, and a lower margin of safety ratio than Lyte Company. Thus, while operating leverage can be very beneficial for a company that expects its sales to increase, it can also significantly increase a companys risk. Lyte Company $700,000* 420,000** 280,000 200,000 $ 80,000 Darke Company $700,000 140,000*** 560,000 600,000 ($ 40,000) Lyte Company $1,300,000* 780,000** 520,000 200,000 $ 320,000 Darke Company $1,300,000 260,000*** 1,040,000 600,000 $ 440,000

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6-57

PROBLEM 6-6B

(a) Reformat the income statement to CVP format. All amount are in $000s. Sales .................................................................. Variable costs ($58,500 + $19,500) ................... Contribution margin .......................................... Less: Fixed costs ($11,000 + $10,000) ............ Operating income..............................................

$120,000 78,000 42,000 21,000 $ 21,000

Contribution margin ratio = $42,000 $120,000 = 35% Break-even point = $21,000 35% = $60,000 (b) If a hired workforce replaces sales agents, commissions will be reduced to 10% of sales, or $12,000; but fixed costs will increase by $12,000. Sales .................................................................. $120,000 Variable costs ($58,500 + $12,000) ................... 70,500 Contribution margin .......................................... 49,500 Less: Fixed costs ($21,000* + $12,000) ........... 33,000 Operating income.............................................. $ 16,500 *($11,000 + $10,000) Contribution margin ratio = $49,500 $120,000 = 41.25% Break-even point = $33,000 41.25% = $80,000 (c) Operating leverage = contribution margin operating income (1) Current situation: from part (a) $42,000 $21,000 = 2.00 (2) Proposed situation: from part (b) $49,500 $16,500 = 3.00

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PROBLEM 6-6B (Continued) The calculations indicate that at a sales level of $120 million, a percentage change in sales and contribution margin will result in 2.00 times that percentage change in operating income if Peaches continues to use sales agents. If they choose to employ their own, the change in operating income will be 3.00 times the percentage change in sales. The higher contribution margin per dollar of sales and higher fixed costs from Peaches employing their own agents gives them more operating leverage. This will result in greater benefits (increases in operating income) if revenues increase, but greater risks (decreases in operating income) if revenues decline. (d) The sales level at which operating incomes will be identical is called the point of indifference. This would be when the cost of the network of agents (16.25% of sales) is exactly equal to the cost of paying employees 10% commission along with additional fixed costs of $12.0 million. None of the other costs is relevant, because they will not change between alternatives. Let the sales volume = S 16.25% X S = (10% X S) + $12,000 .1625S = .10S + $12,000 .0625S = $12,000 S = $192,000

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6-59

*PROBLEM 6-7B

(a)

FAB COMPANY Income Statement For the Year Ended December 31, 2013 Variable Costing Sales (400,000 yards X $2.50) ...................... Variable cost of goods sold Inventory, January 1 ............................. Variable cost of goods manufactured [500,000 yards X $2.50 X 30%] .......... Variable cost of goods available for sale ............................................... Inventory, December 31 [100,000 yards X $2.50 X 30%] .......... Variable cost of goods sold .................. Variable selling expenses [400,000 yards X $2.50 X 10%] .......... Contribution margin ..................................... Fixed manufacturing overhead .................... Fixed administrative expenses .................... Net income .................................................... $1,000,000 $ 0 375,000 375,000 75,000 300,000 100,000 400,000 100,000 400,000 600,000 500,000 $ 100,000

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*PROBLEM 6-7B (Continued) FAB COMPANY Income Statement For the Year Ended December 31, 2014 Variable Costing Sales (500,000 yards X $2.50) .................... Variable cost of goods sold Inventory, January 1 ........................... Variable cost of goods manufactured [400,000 yards X $2.50 X 30%] ........ Variable cost of goods available for sale ............................................. Inventory, December 31 ...................... Variable cost of goods sold ............... Variable selling expenses [500,000 yards X ($2.50 X 10%)] ..... Contribution margin ................................... Fixed manufacturing overhead .................. Fixed administrative expenses .................. Net income .................................................. (b) $1,250,000 $ 75,000 300,000 375,000 0 375,000 125,000 400,000 100,000 500,000 750,000 500,000 $ 250,000

FAB COMPANY Income Statement For the Year Ended December 31, 2013 Absorption Costing Sales (400,000 yards X $2.50) .................. Cost of goods sold Inventory, January 1 ......................... Cost of goods manufactured............ Cost of goods available for sale Inventory, December 31 .................... Cost of goods sold ............................ Gross profit ............................................... Variable selling expenses [400,000 yards X ($2.50 X .10)] ............. Fixed administrative expenses ................ Net income ................................................ $1,000,000 $ 0 775,000 (1) 775,000 155,000 (2) 620,000 380,000 100,000 100,000 200,000 $ 180,000

(1) 500,000 X [($2.50 X 30%) + ($400,000 500,000)] (2) 100,000 X [($2.50 X 30%) + ($400,000 500,000)]

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6-61

*PROBLEM 6-7B (Continued) FAB COMPANY Income Statement For the Year Ended December 31, 2014 Absorption Costing Sales (500,000 yards X $2.50) .............. Cost of goods sold Inventory, January 1 ..................... Cost of goods manufactured ........ Cost of goods available for sale... Inventory, December 31 ................ Cost of goods sold ........................ Gross profit ........................................... Variable selling expenses [500,000 yards X ($2.50 X .10)] ......... Fixed administrative expenses ............ Net income ............................................ $1,250,000 $ 155,000 700,000 (1) 855,000 0 855,000 395,000 125,000 100,000 225,000 $ 170,000

(1) 400,000 X [($2.50 X 30%) + ($400,000 400,000)] (c) The variable costing and the absorption costing income from operations can be reconciled as follows:
2013 Variable costing net income Fixed manufacturing overhead expensed with variable costing Less: Fixed manufacturing overhead expensed with absorption costing Difference Absorption costing income $100,000 $400,000 (320,000)(1) 80,000 $180,000 $400,000 (480,000)(2) (80,000) $170,000
400,000 units sold 500,000

2014 $250,000

(1)

In 2013, with absorption costing $320,000

$400,000 X

units manufactured

of

the fixed manufacturing overhead is expensed as part of cost of goods sold, and $80,000

100,000 units in inventory $400,000 X 500,000 units produced


(2)

is included in the ending inventory.

In 2014, with absorption costing $480,000 of fixed manufacturing overhead is expensed as part of cost of goods sold. This includes the fixed manufacturing overhead for 2014 of $400,000 plus $80,000 of fixed manufacturing overhead from 2013 that was included in the beginning inventory for 2014.

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*PROBLEM 6-7B (Continued) (d) Income parallels sales under variable costing as seen in the increase in net income in 2014 when 100,000 additional units were sold. In contrast, under absorption costing, income parallels production as seen in the higher net income in 2013 when production exceeded sales by 100,000.

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6-63

*PROBLEM 6-8B (a) ELECTRICOIL DIVISION Income Statement For the Year Ended December 31, 2014 Absorption Costing 200,000 Produced $1,800,000 250,000 Produced $1,800,000

Sales (200,000 units X $9) Cost of goods sold (200,000 units X $5.50) Gross profit Variable selling and administrative expenses (200,000 units X $0.40) Fixed selling and administrative expenses Net income (b)

1,100,000 (200,000 X $5.00) 1,000,000 700,000 800,000 80,000 15,000 $ 605,000 80,000 15,000 $ 705,000

ELECTRICOIL DIVISION Income Statement For the Year Ended December 31, 2014 Variable Costing _______________________________________________________________ 200,000 250,000 Produced Produced Sales (200,000 units X $9) $1,800,000 $1,800,000 Variable cost of goods sold (200,000 units X $3) 600,000 600,000 Variable selling and administrative expenses (200,000 units X $0.40) 80,000 80,000 Contribution margin 1,120,000 1,120,000 Fixed manufacturing overhead 500,000 500,000 Fixed selling and administrative expenses 15,000 15,000 Net income $ 605,000 $ 605,000
6-64
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*PROBLEM 6-8B (Continued) (c) If the company produces 250,000 units, but only sells 200,000 units, then 50,000 units will remain in ending inventory. Under absorption costing these 50,000 units will each include $2.00 of fixed manufacturing costa total of $100,000. However, under variable costing, fixed manufacturing cost is expensed when incurred. This accounts for the $100,000 difference ($705,000 $605,000) in net income. This is summarized as: Net income under absorption costing Less: Fixed manufacturing cost included in ending inventory Net income under variable costing $705,000 100,000 $605,000

(d) Variable costing has a number of advantages over absorption costing for decision making and evaluation purposes. (1) The use of variable costing is consistent with cost-volume-profit and incremental analysis: (2) Net income computed under variable costing is unaffected by changes in production levels. Note that, under variable costing the companys net income is $605,000 no matter what the level of production is. (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 companys 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 makes it difficult to evaluate the impact of fixed costs on the companys results.

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6-65

BYP 6-1

DECISION-MAKING AT CURRENT DESIGNS

(a) Rotomolded Kayaks (($950 $570) X .80) Composite Kayaks = (($2,000 $1,340) X .20)

Weighted Average Unit Contribution Margin $436

(b) Break-even Sales = $820,000 $436 = 1,881 units Break-even Sales Distribution: Rotomolded Kayaks = 1,881 X 80% = 1,505 units Composite Kayaks = 1,881 X 20% = 376 units

(c) Target Net Income in Units: Rotomolded Kayaks + ($380 X .70) Composite Kayaks ($660 X .30) Weighted-Average CM/Unit $464

Required Sales in Units = ($820,000 + $2,000,000) $464 = 6,078 units Break-even Sales Distribution: Rotomolded Kayaks = 6,078 X 70% = 4,255 units Composite Kayaks = 6,078 X 30% = 1,823 units

(d) CVP Income Statement Rotomolded $2,000,000 1,200,000* 800,000 660,000 $ 140,000 Composite $1,000,000 670,000** 330,000 160,000 $ 170,000

Sales Variable Costs Contribution Margin Fixed Costs Net Income *($570 $950) X $2,000,000 BYP 6-1 (Continued)
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**($1,340 $2,000) X $1,000,000

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(e) Degree of Operating Leverage Rotomolded Kayaks = $800,000 $140,000 = 5.71 Composite Kayaks = $330,000 $170,000 = 1.94 At a sales mix of 2/3 to 1/3, the degree of operating leverage is nearly three times as high for the rotomolded kayaks as it is for the composite kayaks. This means that the companys net income will respond more quickly to a change in the sales of rotomolded kayaks than to composite kayaks. For example, an increase in sales of the rotomolded kayaks will increase the companys net income at a faster rate than an increase in the sales of the composite kayaks. This result will differ depending on what sales mix assumption is made.

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BYP 6-2 (a)

DECISION-MAKING ACROSS THE ORGANIZATION

Sales (10,000 seats X $500) Variable costs (10,000 seats X $200) Contribution margin Fixed costs Net income

$5,000,000 2,000,000 3,000,000 2,000,000 $1,000,000

(b) Contribution margin ratio = $3,000,000 $5,000,000 = .60 Break-even point in dollars = $2,000,000 .60 = $3,333,333 Margin of safety ratio = ($5,000,000 $3,333,333) $5,000,000 = .333 Degree of operating leverage = $3,000,000 $1,000,000 = 3.0 (c) Sales (10,000 seats X $500) Variable costs (10,000 seats X $ 100) Contribution margin Fixed costs Net income $5,000,000 1,000,000 4,000,000 3,000,000 $1,000,000

(d) Contribution margin ratio = $4,000,000 $5,000,000 = .80 Break-even point in dollars = $3,000,000 .80 = $3,750,000 Margin of safety ratio = ($5,000,000 $3,750,000) $5,000,000 = .25 Degree of operating leverage = $4,000,000 $1,000,000 = 4.00 (e) By automating its manufacturing process the company will replace some of its variable costs with fixed costs. This shift toward more fixed costs will increase its break-even point from $3,333,333 to $3,750,000 and reduce its margin of safety from 33.3% to 25%. This means that under the old system sales could fall by 33.3% percent before the company would operate at a loss, whereas under the automated system they could only fall by 25%. Both of these findings suggest that the company would be riskier with the automated system. However, the companys degree of operating leverage would increase from 3.0 to 4.00. This means that with a change in sales, the change in net income would be 1.33 (4 3) times higher under the automated system. This would be good if the company expects sales to increase, but would be bad if the companys sales fall.

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BYP 6-3

MANAGERIAL ANALYSIS

(a)

The contribution margin ratios under each approach are: Current approach Automated approach $500,000/$2,000,000 = .25 $1,000,000/$2,000,000 = .50

This means that for every dollar of sales, net income goes up by 25 cents under the current approach, but by $.50 under the automated approach. (b) The break-even points in sales dollars under each approach are: Current approach Automated approach $380,000/.25 $800,000/.50 = = $1,520,000 $1,600,000

This shows that, under the automated approach, the companys sales would have to be 5.26% higher just to break-even. (c) At the current level of sales, the margin of safety ratio under each approach is: Current approach Automated approach ($2,000,000 $1,520,000)/$2,000,000 ($2,000,000 $1,600,000)/$2,000,000 = .24 = .20

The company has a low margin of safety under either approach. Under the current approach sales could drop 24% before the company would be operating at a loss. Under the automated approach the companys sales could drop by 20% before it would be operating at a loss. (d) The degree of operating leverage under each approach at the current level of sales is: Current approach Automated approach $500,000/$120,000 $1,000,000/$200,000 = = 4.17 5.00

This means that for a 10% drop in sales net income would drop by 41.7 percent for the current approach, but 50% for the automated approach. Recall, however, that at the current level of sales the company makes considerably more money using the automated approach.

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BYP 6-3 (Continued) (e) In order to solve for the sales level where net income would be equal under either approach, set the two CVP equations equal to each other and solve for sales:
Sales ((1 .75) X Sales) $380,000 = Sales ((1 .5) X Sales) $800,000 (.25 X Sales) $380,000 = (.5 X Sales) $800,000 (.25 X Sales) = $420,000 Sales = $1,680,000

When sales are equal to $1,680,000 the company would make the same amount of income under either approach.
Current approach Automated approach $1,680,000 [(1 .25) X $1,680,000] $380,000 = $40,000 $1,680,000 [(1 .5) X $1,680,000] $800,000 = $40,000

(f)

Based upon this numeric analysis it would appear that the decision to purchase the automated system would be a good decision. The current level of sales far exceeds the break-even point, and, unless sales were to fall all the way to $1,680,000, the company would be better off under the automated system. However, there are many difficult issues that should also be considered. Not-the-least of these is the decision to lay-off 15 employees, many of whom have likely been with the company for a long time. Also, the company should carefully evaluate whether the automated system will be able to attain the same level of quality as the skilled employees. Perhaps the automated system would be more appropriate for some of the painting work, while skilled labor would be more appropriate for other painting work.

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BYP 6-4 (a) ($ in millions)

REAL-WORLD FOCUS

Sales Variable costs Contribution margin Contribution margin Sales Contribution margin ratio Division sales Total sales Sales mix percentage (b)

Consumer Products $1,031.8 610.0 $ 421.8 $ 421.8 1,031.8 40.9% $1,031.8 2,171.1 47.5%

Pet Products $ 837.3 350.0 $ 487.3 $ 487.3 837.3 58.2% $ 837.3 2,171.1 38.6%

Soup and Infant-Feeding Products $ 302.0 100.0 $ 202.0 $ 202.0 302.0 66.9% $ 302.0 2,171.1 13.9%

Consumer products Pet products Soup and infant-feeding products Break-even point in dollars

Weighted-Average Sales Mix Contribution Contribution Percentage X Margin Ratio = Margin Ratio 47.5% 40.9% .194 38.6% 58.2% .225 13.9% 66.9% .093 .512

$860,300,000 .512 = $1,680,273,438 Sales Mix Sales from Percentage X Total Sales = Each Product* 47.5% X $1,680,273,438 = $ 798,129,883 38.6% X $1,680,273,438 = 648,585,547 13.9% X $1,680,273,438 = 233,558,008 $1,680,273,438

Consumer products Pet products Soup and infantfeeding products Total sales *Sales are rounded

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BYP 6-5

REAL-WORLD FOCUS

(a) The four primary product lines are FedEx Express (provides express transportation); FedEx Ground (small package ground delivery); FedEx Freight (regional, less-than-truckload freight service); and FedEx Services (Kinkos). The key factors affecting operating results are the volumes of shipments transported through networks; the mix of services purchased by customers; the prices obtained for services; ability to manage cost structure for capital expenditures and operating expenses; and ability to match operating costs to shifting volumes. (b) FEDEX GROUND Income Statement For the Year Ended May 31, 2008 Variable Costing (In Millions) ____________________________________________________________ Revenues ...................................................... $ 6,751 Variable costs: Salaries and employee benefits ............. $1,073 Purchased transportation ...................... 2,691 Fuel .......................................................... 201 Maintenance and repairs ........................ 145 Intercompany charges ............................ 658 4,768 Contribution margin................................ 1,983 Fixed costs: Rentals ..................................................... 189 Depreciation and amortization ............... 305 Other ........................................................ 753 1,247 Net income ................................................... $ 736 Contribution Margin $1,983 Fixed Costs $1,247 Contribution Margin Ratio 29.4% Break-even Point in Dollars $4,241.5 million

Revenues $6,751 Contribution Margin Ratio .294

= = = =

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BYP 6-5 (Continued) (c) (i)


2008 FedEx Express FedEx Ground FedEx Freight FedEx Services Total $24,421 $38,244 = 63.9% 6,751 $38,244 = 17.6% 4,934 $38,244 = 12.9% 2,138 $38,244 = 5.6% $38,244 2006 $21,446 $32,485 = 66.0% 5,306 $32,485 = 16.3% 3,645 $32,485 = 11.2% 2,088 $32,485 = 6.4% $32,485

(ii) FedEx Express FedEx Ground FedEx Freight FedEx Services *$(891) $2,138

2008 7.8% 10.9% 6.7% (41.7%)*

2006 8.2% 13.3% 13.3% ____

(iii) In part (ii) we see that in all divisions the companys operating margins declined. We also see in part (ii) that in 2006 FedEx Express had the lowest operating margin (8.2%), and FedEx Services had the lowest in 2008 (41.7%) while FedEx Ground had the highest (13.3% and 10.9%). In part (i) we see that the company shifted its sales mix percentage down in FedEx Express (66.0% to 63.9%) and FedEx Services (6.4% and 5.6%) but increased its sales mix percentage for FedEx Ground (16.3% to 17.6%) and FedEx Freight (11.2% to 12.9%). Thus, during this period two of the companys divisions became more profitable, and the company successfully shifted its sales mix so that more of its revenue came from its more profitable divisions.

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BYP 6-6

REAL-WORLD FOCUS

(a) Smart Balance relies very heavily on outsourcing. It keeps it employees and investments in fixed assets to a minimum. As a consequence it has very low fixed costs. (b) The company keeps new-product development and marketing in house. (c) The potential advantage of having very low fixed costs is that the company has a lower break-even point. It can be profitable at relatively low volumes of sales and therefore it has less potential for financial failure. (d) The potential disadvantage of this approach is that its low fixed costs means that the company has low operating leverage. If the companys sales increase significantly, it would not enjoy the same increase in profitability as a company that was producing its own goods.

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BYP 6-7

COMMUNICATION ACTIVITY

MEMO To: From: Re: Bjorn BorgCEO Student Best use of limited resources

I share your concern, that, since we are operating at full capacity, we need to ensure that our product mix maximizes our profitability. The decision of how to best utilize our limited productive resources is one of the most important decisions we face. We currently make two different anchors, a traditional fishing anchor, and a high-end yacht anchor. The contribution margin per unit produced of the yacht anchor is three times that of the fishing anchor, thus one might logically assume that we should shift our production toward producing the yacht anchor. However, this assumption ignores an element that is critical to the decision. In order to make a proper decision, we would need to know the contribution margin per unit of limited resource that each product produces. While the yacht anchor has a very high contribution margin, it also consumes considerably more productive resources. I propose that a study be done to determine exactly how much of the limited productive resource is consumed by one unit of each of the two anchor types. In addition, at the same time that this study is being undertaken, I propose that the marketing department undertake a study of the demand for each anchor type. This is important so that we dont produce anchors that we cant sell. Finally, a shift in our product mix would maximize our profitability at our current level of productive capacity. However, we should also consider a more long-term solution to our production constraints. Since we have been operating at, or near full capacity for two years, it would seem appropriate to undertake a study of whether an acquisition of additional plant equipment would be appropriate.

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*BYP 6-8

ETHICS CASE

(a) The divisions net income increased by $225,000 ($525,000 $300,000). This represents a 75% increase over the previous year ($225,000 $300,000). Thus Bretts bonus would be 75 X $5,000 = $375,000. (b) In 2013 the number of units produced and sold were equal. When this occurs variable costing and absorption costing provide the same results. Thus, in 2013, net income under variable costing would have been $300,000. In 2014, units produced exceeded units sold by 5,000 units. However, net income under variable costing is not impacted by the number of units produced. Since the number of units sold did not change from 2013 to 2014, and the selling price, variable cost per unit, and total fixed costs didnt change, the divisions net income in 2014 would equal its 2013 income of $300,000. (c) In part (b) it was determined that the divisions net income would have been $300,000 in 2014 under variable costing. Since this is the same as 2013 net income, Brett would not receive a bonus. (d) If Brett intentionally overproduced inventory in order to increase his bonus, then his actions were unethical. Overproduction of inventory increases the companys costs related to inventor y, such as storage, handling, waste and theft. Based on the information provided we cant actually determine Bretts motives. He may have believed that just-in-time inventory was causing the company to lose sales due to stock-outs. If that was the case, there would be options available to the company other than totally giving up on just-in-time practices. In order to eliminate any potential conflicts of interest between Brett and the company, and to ensure that his actions are in the best interest of the company, the company could begin preparing variable costing income statements to supplement its absorption costing statements for the purpose of calculating bonuses. This would eliminate any incentive Brett might have to over-produce, as well as providing useful information for other internal management decision making.

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BYP 6-9

ALL ABOUT YOU

(a)

Using a common equation for CVP analysis, Sales = Variable Costs + Fixed Costs + Net Income, and substituting the information provided, and knowing that at break-even, net income = $0, ($26 X 300) = Variable Costs + ($4,000 + $1,460) + $0 $7,800 = Variable Costs + $5,460 + $0 $2,340 = Variable Costs (in total) or $7.80 (variable costs/member/month) = $2,340 300

(b)

To find the sales required to margin must be calculated. Contribution Margin Contribution Margin Contribution Margin Contribution Margin per Unit Contribution Margin Ratio

reach a target net income, contribution = = = = = Sales Variable Costs $7,800 $2,340 $5,460 $5,460/300 memberships = $18.20 $5,460/$7,800 = 70%

To compute the sales required to reach a target net income of $3,640. Required Sales in Units = (Fixed Costs + /Contribution Margin Target Net Income) per Unit Required Sales in Units = ($5,460 + $3,640)/$18.20 Required Sales in Units = 500 memberships Required Sales in Dollars = 500 memberships X $26 = $13,000 Using the contribution margin ratio, Required Sales in Dollars = (Fixed Costs + Target Net Income) Required Sales in Dollars = ($5,460 + $3,640)/70% Required Sales in Dollars = $13,000 (c) (d) Answers will vary. Suggested examples include franchise fees, employee wages, utilities, supplies, and maintenance. Answers will vary. /Contribution Margin Ratio

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BYP 6-10 CONSIDERING CORPORATE SOCIAL RESPONSIBILITY

Discussion Guide: If reduction of greenhouse gas emissions is a goal, then one step toward attainment of that goal is to assign a cost to greenhousegas emissions. One approach that is currently being used is the buying and selling of carbon-emission rights. As companies buy and sell emission rights, the price of polluting becomes a tangible factor in the formulations that will be used to make future energy-source decisions. This approach has been effective in addressing similar issues, such as the reduction of sulfur emissions. However, as suggested in the No response, many believe that, to be effective and fair, an enforceable international agreement on such an approach would be necessary. In the United States, companies currently participate on a voluntary basis; in some other countries, participation is required. Another factor to consider in these decisions is the timing of conversion to new technology. A gradual conversion to new technologies as existing power plants reach the end of their productive lives would be far less costly than a rapid conversion to new technologies that required scrapping existing plants before they are fully depreciated. Decisions about which plants to replace and when to replace them will require careful cost-benefit analyses.

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