Chapter 03 - Furdamcrtals of Cost-Vnleennc-Prerit nally sie 3 Fundamentals of Cost-Volume-Profit Analysis Solutions to Review Questions #1. Profit = TR-TC = PX-VK-F = (P-ViK-F where Proft = operating profit, TR = total revenue, TC = total costs, P = average unit selling price, Vo= average unit variable cost, X= quantity of units, F = total fiwed costs for the period. #2. Total costs = Total variable costs plus total fixed costs. 33. Total contribution margin: Total selling price — Variable manufacturing costs expensed — Variable nonmanufacturing costs expensed = Total contribution margin Gross margin: Total selling price — Variable manufacturing costs expensed — Fixed manufacturing costs expensed = Gross margin. HM. Profitvolume analysis plots only the contribution margin line against volume, while cost volume-profit analysis plots total revenue and total costs against volume. Profit-volume analysis is a simpler, but less complete, method of presentation.3-5. Costs that are fixed in the shart runll are usually not fixed in the Jong run. In fact few if any costs are fixed over a very long time horizon, because managers can make decisions that change a fim's cost structure 3-6. Operating leverage is the proportion of fixed costs in an organization's cost structure. It is important for managers because it determines how an increase in volume affects the change in profits. 3-7. The margin of safety is the excess of sales over the break-even volume. Managers can use the margin of safety to understand how far sales can fall before the firm is operating ata loss. 3-8. Fined costs + [Target profiti{i-fi] Tamget volume {units} = " : Unit contribution margin 3-3. Income taxes do not affect the bresk-sven equation because with zero income (breakeven) there are no income taxes to pay. 3-10. tis common to assume a fixed sales mix when solving for break-even volumes with muiple products because the contribution margin depends on the relative quantities of the individual products sold. Ifthe sales mix is not fixed, the break-even volume is indeterminate 3-11, Two common assumptions in CVP analysis are that unit prices and unit variable costs are constant It is also common to assume that fixed costs are constant over relatively large volume ranges. Akhough these assumptions are common, they are not a necessary part of (CVP analysis. C\VP analysis can accep? many forms of price and cost relations with volume. However, when more general relations are used, the common break-even formulas will no longer hold.Solutions to Critical Analysis and Discussion Questions B12. There may be a difference between costs used in cost-volume-profit analysis and costs expensed in financial statements. A common example is fixed manufacturing costs. Cost- volume-profit analysis assumes fied manufacturing costs are period costs, while they are treated as product costs for financial reporting, If part of current production is inventoried, some fixed manufacturing costs would not be expensed for financial reporting. On the other hand, if current sales include all of current production plus some from inventory, all fwed costs from this period plus some from previous periods would be expensed for financial reporting. #13. The accountant makes use ofa linearrepresentation to simplify the analysis of costs and revenues. These simplifying assumptions are generally reasonable within a relevant range of activity. Within this range, it is generally believed that the additional costs required to employ nonlinear analysis cannot be justified in terms of the benefits obtained. Thus, wathin this range. the linear model is considered the —bestl in a codtenefit sense. a4. As volume rises. it is likely that product markets will be saturated, leading to a need to cut prices to maintain of increase wolume. This price-custing would result in a nonlinear revenue function with a slope that becomes lass steep (though still positive} as volume increases Moreover, as activity increases and approaches capacity consbaints, costs tend to rise more than proportionately. Overtime premiums and shift pay differentials increase the uni labor costs. Similar costs may be incurred in terms of excess maintenance costs for running machines beyond their optimal performance levels, higher materials costs for any input commadity that is in short supply, and similar factors. These factors tend to cause costs to rise more than proportionately with an increase in activity. #15, Although the assumptions of CVF analysis appear relatively simplistic, C'VF analysis is a useful too! for understanding the relations among costs, volumes, and the resuking profit Clearly, the more important the decision, the more time that should be spent developing good assumptions. However, CVP analysis is useful for developing intuition about the cost structure of the finm. 216. Although there are no —profitsil in a nefer-proft organization, these organizations are still very concemed about the difference between inflows {irom fees, grants, sales, or other