he lnternet boom o f t h e 1 9 9 0 s le d ma n y e n t re p re n e u rst o

believethat they couldearn profitswell abovethose of traditionalretail

storesby avoidingthe high fixed costsof brick-and-mortar
retailoutlets.
On line businessflourishedfor a wh ile , b u t wh e n t h e d o t . c o m b u b b le
burst, many of these Internetdreamsdied. Many,but not all. Consider
art.com,an e-tailbusinessthat offersover 100,000differentprints,pho-
tos, and postersto customersrangingfrom budget-mindedcollegestu-
dentsto professional
decoratorssearchingfor high-endart. Foundedin
1995,art.comhasenjoyedpositivecashflows and double-digitrevenue
growth since2000.In 2003,Deloitte& Touchenamedart.comone of the
fastest-growing
tech companiesin America.lt attractsmore than a mil-
lion peopleto its award-winning
Web site eachmonth.
Eventhough art.comdoesn'tface the fixed costsof traditional
retailoutlets,it still incursfixed coststied to its Web site and its custom-
framingfacilities.
lt alsoincursvariablecostsfor eachpieceof art.The bot-
tom line:e-tailor retail,everybusiness
facesfixed and variablecosts,and
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 Chapter7

art.com is no exception.Beforethey launchedthe company,how did

art.commanagersfigureout what salesvolumethey hadto reachto break
even?How did they forecastthe volume neededto achievetheir target
profit levels?And asthe companycontinuesto operate,how do managers
respondto fluctuatingbusinessconditions,changingvariableand fixed
costs, and pricing pressurefrom new competitors?Cost-volume-profit
(CVP)analysishelpsmanagersanswersuchquestions.W

LearningObjectives
ffi C"l.ulate the unit contributionmarginand the contributionmarginratio

ffi Ut" CVPanalysis pointsandtargetprofitvolumes

to find breakeven

ffi eerformsensitivity in response

analysis business
to changing conditions

ffi andtargetprofitvolumesfor multiproduct

rina breakeven companies

ffi O"t"rrine a firm'smarginof safetyandoperatingleverage

I
ffinthe last chapter, we discussedcost behavior patterns and methods managers use
to determine how their costs behave. We showed how managers use the contribu-
tion margin income statement to separately display the firm's variable and fixed
costs. In this chapter, we show how managers identify the volume of salesnecessary
to achieve breakeven and target profit levels. !7e also look at how changesin costs,
salesprice, and volume affect the firm's profit. Finally, we discussways to identify
the firm's risk level, including ways to gauge how easily a firm's profits could turn to
loss if salesvolume declines.

How Does Cost-Volume-ProfitAnalysis

Help Managers?
Cost-volume-profit, or CVP, analysis is a powerful tool that helps managers make
important business decisions. Cost-volume-profit analysis expressesthe relationships
among costs,volume, and profit or loss. For example, at art.com, managersneed to
determine how many pieces of art the company must sell each month just to cover
costs or to break even. CVP can provide the answer. CVP also helps art.com's man-
agers determine how many pieces of art the company must sell to earn a target profit,
such as $1,000,000 per month. And if costsor salespriceschange,CVP can help man-
agers decide how salesvolume would need to change to achieve the same profit level.
However, to use CVP, managers need certain data. They must also make sure
the data are consistent with the assumptions underlying CVP analysis. In addition,
managersneed a solid understanding of the contribution margin concept introduced
in the last chapter. In this section, we'll take a look at the data requirements,
assumptions, and contribution margin in more detail.
 Cost-Volume-Prof
it Analysis 361

Data Requinedfor Effective CVP Analysis

CVP analysis relies on the interdependency of five components, or pieces of infor-
mation. shown in Exhibit 7-1.

Componentsof CVPAnalysis

til
ill'

If you know or can estimate four of these five components, you can use CVP
analysis to compute the remaining unknown amount. Therefore, CVP helps man-
agers discover how changes in any of these components will affect their business.
Becausebusinessconditions are always changing, CVP helps managers prepare for
and respond to economic changes.Now, let's review the assumptions required for
CVP analysis.

CVPAssumptions
CVP analysis assumesthat:

1. A change in volume is the only factor that affects costs.

2, Managers can classify each cost (or the components of mixed costs) as
either variable or fixed. These costs are linear throughout the relevant range
of volume.
3. Revenuesare linear throughout the relevant range of volume.
4. Inventory levels will not change.

5. The sales mix of products will not change. Salesmix is the combination of
products that make up total sales.For example, art.com may sell 157o posters,
25Yo unframed photographs, and 60%" fuamed prints. If profits differ across
products, changesin salesmix will affect CVP analysis.

Let's start by looking at a simple firm that has only one product. Later, we'll
expand the firm to include a wider selection of products. Kay Pak, an entrepre-
neur, has just started an e-tail businessselling art posters on the Internet. Kay is a
"virtual retailer" and carries no inventory. Kay's software tabulates all customer
orders each day and then automatically places the order to buy posters from a
wholesaler. Kay buys only what she needs to fill the prior day's sales orders. The
posters cost $21 each, and Kay sells them for $35 each. Customers pay the ship-
ping costs, so there are no other variable selling costs. Monthly fixed costs for
server leasing and maintenance, software, and office rental total $7,000. Kay's rel-
evant range extends from 0 to 2,000 posters a month. Beyond this volume, Kay
will need to hire an employee and upgrade her \7eb site sofrware in order to han-
dle the increased volume.
362 Chaoter7
Calc ulat tehe uni t
contributionmargin
and t he c ont r ibu ti o n
m ar ginr at io
Let's seeif Kay's businessmeets the CVP assumptions:
1. Salesvolume is the only factor that affects her costs.
2. The $21 purchase cost for each poster is a variable cost. Thus, Kay's total
uariable cosl increasesin direct proportion to the number of posters she sells
(an extra $Zt in cost for each extra poster she sells). The $7,000 monthly
server leasing and maintenance, software, and office rental costs are fixed
and do not change no matter how many posters she sellswithin the relevant
range. \7e could graph each of these costs as a straight line, so they are linear
within the relevant range.
3. Kay's revenueis also lilear. She sellseach poster for $35, so a graph of her reve-
nues is a straight line beginning at the origin (if she doesn't sell any posters, she
won't have any revenue) that slopesupward at a rate of $35 per poster.
4. Kay has no inventory. If she did carry inventory, she wouldn't need to worry
about this assumption as long as she didn't allow her inventory levels to fluctu-
ate too much.
5. Kay sells just one size poster, so her salesmix is constant at 1.0004art posters.
Later, we'll expand her product line to include two different size posters-each
with a different salesprice and variable cost. The resulting CVP modification
works for any firm that offers two or more products as long as it assumesthat
salesmix will remain constant.
Kay's businessmeets all five assumptions,so her CVP analysiswill be accurate.
Becausemost business conditions do not meet these assumptions perfectly, man-
agers regard CVP analysis as approximate, not exact.
WhmMmf;* $Wmn"gfiut
ffi.mrnffimffihwtfimm
The last chapter introduced the contribution margin income statement, which sepa-
rates costs by behavior rather than function. Many managersprefer the contribution
margin income statement becauseit gives them the information for CVP analysis in
a "ready-to-use" format. On these income statements, the contribution margin is
the "dividing line"-all variable expensesgo above the line, and all fixed expenses
go below the line. The results of l(ay's first month of operations is shown in
ExhtbitT-2.
Contribution
Sa le sr e ve n ue(550 posters).... $ 19,250
L e ss:Va r ia b l e expenses (11,550 )
Co n tr ib u tio n margi n............ 7,700
L e ss:F ixe d expenses.......... (7,000 )
Op e r a tin g income............. $ 700
Notice that the contribution margin is the excessof salesrevenueover variable
expenses.The contribution margin tells managers how much revenue is left-after
paying variable expenses-f or contribwting toward covering fixed costs and then
generating a profit. Hence the name contribution margin.
 Cost-Volume-Prof
it Analvsis 363

The contribution margin is stated as a total amount on the contribution margin

income statement. However, managers often state the contribution margin on a per
unit basis and as a percentage,or ratio. A product's contribution margin per unit-
or unit contribution margin-is the excessof the selling price per unit over the vari-
able cost of obtaining and sellingeach unit. Some businessespay a salescommission
on each unit or have other variable costs, such as shipping costs, for each unit sold.
However, Kay's variable cost per unit is simply the price she pays for each poster.
Therefore, her unit contribution margin is:

Salesprice per poster... $35

Les s :V ar iab l e c o s t p e r p o s te r... .................;:; (21)
Contribution margin per poster... $;14

The unit contribution margin indicates how much profit each unit provides
before fixed costs are considered. Each unit first contributes this profit toward cov-
ering the firm's fixed costs. Once the company sells enough units to cover its fixed
costs,the unit contribution margin contributes directly to profit. For example, every
poster Kay sellsgenerates$14 of contribution margin that can be used to pay for the
monthly $7,000 of fixed costs. After l(ay sells enough posters to cover fixed costs,
each additional poster she sellswill generate$14 of operating income.
Managers can use the unit contribution margin to quickly forecast income at
any volume within their relevant range. First, they project the total contribution
margin by multiplying the unit contribution margin by the number of units sold.
Then, they simply subtract fixed costs. For example, let's assumethat Kay hopes to
sell 650 posters next month. She can project her operating income as follows:

Contributionmargin (650 postersX $14 per poster) $9,100

Less:Fixedexpenses (7,000)
Operatingincome.......... .. $2,100

If Kay sells650 postersnext month, her operating income should be $2,100.

The Ccnmtnthutf,mm gfir'nRmtim

tV1an
In addition to computing the unit contribution margin, managers often compute the
contribution margin ratio, which is the ratio of contribution margin to salesreve-
nue. Kay can compute her contribution margin ratio at the unit level as follows:

q14

bJJ

Kay could also compute the contribution margin ratio using any volume of
sales.Let's use her current salesvolume, pictured inExhlbit 7-2:

$7,700
$tq,zs0

The 40% contribution margin ratio means that each $1.00 of salesrevenuecon-
tributes $0.40 toward fixed expensesand profit, as shown in Exhibit 7-3.The remain-
ing $0.60 of each salesdollar is used to pay for variable costs.The contribution
margin ratio is the percentage of each sales dollar that is auailable for couering fixed
expensesand generatinga profit.
364 Chapter7

Breakdown of $1
of Sales Revenue

Managers can also use the contribution margin ratio to quickly forecast oper-
ating income within their relevant range. \7hen using the contribution margin ratio,
managersproject income basedon salesdollars rather than salesunits.For example,
what will I(ay's income be if salesrevenue reaches$70,000 one month? To find out,
simply rnultiply projected salesrevenue by the contribution margin ratio to get the
total contribution margin. Then, subtract fixed expenses:

Contribution margin ($70,000 salesX 40o/.) = $28,000

Less:Fixed expenses..... (7,000)
Operating income........
$Z1pg0

Let's verify. If I(ay has $70,000 of salesrevenue,she has sold 2,000 posters
($70,000 + $35 price per poster).Her completecontribution margin income state-
ment would be calculatedas follows:

Sa l e sre v e n u e(2,000 postersx $3S /poster)

................ $70,000
Less:Variable expenses(2,000 posters x $21lposter)........... (42,000)
C o n tri b u ti o n margi n (2,000 postersx $14l poster)............... $28,000
Less:Fixed expenses..... (7,000)
Op e ra ti n gi n c ome........ $21,000

The contribution margin per unit and contribution margin ratio help managers
quickly and easily project income at different salesvolumes. However, when project-
ing profits, managersmust keep in mind the relevant range. For instance,if I(ay
wants to project income at a volume of 5,000 posters, she shouldn't use the existing
contribution margin and fixed costs. Her current relevant range extends to only
2,000 postersper month. At a higher volume of sales,her variable cost per unit may
be lower than $21 (due to volume discountsfrom her suppliers)and her monthly
fixed costsmay be higher than $7,000 (due to upgrading her systemand hiring an
employeeto handle the extra salesvolume).
Rather than use individual unit contribution margins on each of their products,
Iarge companies that offer hundreds or thousands of products (like art.com) use
their contribution margin ratio to predict profits. As long as the salesmix remains
constant (one of our CVP assumptions), the contribution margin ratio will remain
constant.
'We'veseenhow managersuse the contribution margin to project income; but
managersuse the contribution margin for other purposestoo, such as motivating
the sales force. Salespeoplewho know the contribution margin of each product
can generatemore profit by emphasizinghigh-margin products. This is why many
 Cost-Volume-Profit Analvsis 365
\

companies base sales commissions on the contribution margins produced by sales

rather than on sales revenue alone.
In the next section,we'll seehow managersuse the contribution margin in CVP
analysis to determine their breakeven point and to determine how many units they
need to sell to reach target profits.

UsingCVPAnalysisto Find the

BreakevenPoint
A company'sbreakevenpoint is the saleslevel at which operatingincomeis zero. UseCVPanalysis to
Salesbelow the breakevenpoint result in a loss. Salesabovethe breakevenpoint find breakevenpoints
provide a profit. BeforeKay startedher business,she wanted to figure out how and target profit
many postersshewould haveto selljust to breakeven. vol umes
Therearethreewaysto calculatethe breakevenpoint. AII of the approaches are
basedon the incomestatement,so they all reachthe sameconclusion.The first two
methodsfind breakevenin termsof saleswnits.Thelast approachfinds breakevenin
terms of salesdollars.
1. The incomestatementapproach
2. The shortcut approachusing the wnit contribution margin
3. The shortcutapproachusingthe contribution marginratio
Let'sexaminethesethreeapproaches
in detail.

The Income StaternentApproach

The income statement approach simply breaks the income statement equation into
smaller components:

Let'susethis approachto find Kay's breakevenpoint. Recallthat Kay sellsher

postersfor $35 each and that her variablecost is $21 per poster.Kay's fixed
expenses total $7,000.At the breakevenpoint, operatingincomeis zero.Weusethis
informationto solvethe incomestatementequationfor the numberof postersKay
must sellto breakeven.

($:s
($3s
366 Chapter
7

Kay must sell500 postersto breakeven.Her breakevenpoint in salesdollarsis

$17,500(500postersx $35).
You cancheckyour answerby substitutingthe breakevennumberof units into the
incomestatementand checkinethat this levelof salesresultsin zero profit:

Salesrevenue(500postersx $35)........ $tZ,50O

(500postersx $21)
Less:Variableexpenses (10,500)
Contributionmargin
Less;Fixedexpenses..... (7,000)
Operatingincome........ . $ 0

a firm's fixed expenses

Notice that at breakeven, equalits contributionmargin.
In other words, the firm hasgeneratedjust enoughcontributionmargin to coverits
fixed expenses(but not enoughto generatea profit).

The ShortcutApproachUsingthe Unit

ffiontributimmMfimngf;n
The shortcut method simply rearrangesthe income statement equation and isolates
"Units sold" on the left:

= Operatingincome
- Fixedexpenses
Salesrevenue- Variableexpenses
Contributionmargin = Operatingincome
- Fixedexpenses

(Contribution
marginperunit x Unitssold) = Fixed expenses+ Operating income

Dividing both sidesof the equationby contributionmargin per unit yieldsthe

shortcutmethod:

Fixgl expjnses+ operatingincome

salesin ,rnrr,-
uontnDutlonmargmper unlt

Kay can use this shortcut method to find her breakeven point in units. Kay's
fixed expensestotal $7,000, and her unit contribution margin is $14. At the
breakeven point, operating income is zero. Thus, Kay's breakevenpoint in units is:

., $7,000+ $0
satesl n unrts=
g14
= 50Spqrsters

Why does this shortcut method work? Recall that each poster provides $14 of
contribution margin. To break even, Kay must generateenough contribution margin
to cover $7,000 of fixed expenses.At the rate of $14 per poster, Kay must sell
500 posters($7,000/$14)to cover her $7,000 of fixed expenses.Becausethe short-
cut method simply rearrangesthe income statement equation, the breakevenpoint is
the sameunder both methods (500 posters).
 Cost-Volume-Profit
Analvsis 367

Silotr o<Think-.
Wh at would K ay l o p e ra ti n g i n c o me b e i f s h e s ol d 50' 1posters?W hat w oul d i t be
i f sh e s old 600 noste rs ?

;, , E v er y p o s te r s o l d p ro v i d e s $ 1 4 o f contri buti on margi n, w hi ch fi rst

co n t r ibut es t owa rd c o v e ri n g fi x e d c o s ts , th en profi t. Once K ay reaches her
b reak ev en point ( 5 0 0 p o s te rs ),s h e h a s c o v e red al l fi xed costs. Therefore, each
a d dit ional pos t er s o l d a fte r th e b re a k e v e n p oi nt contri butes $14 di rectl y to
p ro f it . lf K ay s ells5 0 1 p o s te rs ,s h e h a s s o l d o n e more poster than breakeven.H er
o p e r at ing inc om e i s $ 1 4 . l f s h e s e l l s 6 0 0 p o s ters, she has sol d' 100 more posters
th a n br eak ev en.H e r o p e ra ti n g i n c o me i s $ 1 ,400($14 per poster x 100 posters)
We c an v er if y as f o l l o w s .

margin(600posters
Contribution x $14perposter)........... $8,400
Less:Fixedexpenses........ (7,000)
Operatingincome $1,400

Once a company achieuesbreakeuen,each additional wnit sold contribwtes

its wniqweunit contribution margin directly to profit.

The $hortcutAppromchUsingthe Contribution

MarEin Ratio
It's easyto computethe breakevenpoint in unitsfor a simplebusiness like Kay'sthat
has only one product. But what about companiesthat havethousandsof products
such as art.com,Home Depot, and Amazon.com?It doesn'tmake sensefor these
companiesto determinethe number of eachvarious product they needto sell to
break even.Can you imaginea Home Depot managerdescribingbreakevenas
100,000wood screws,2 millionnails,3,000lawn mowers,10,000gallonsof paint,
and so forth? It simplydoesn'tmakesense.Therefore,multiproductcompaniesusu-
ally computebreakevenin termsof salesdollars,
This shortcutapproachdiffersfrom the other shortcutwe've just seenin only
oneway: Fixedexpenses plus operatingincomearedividedby the contributionmar-
gtnratio (not by contributionmarginper wnit)to yield salesin dollars(not units):

Fixedexpenses+ Operatingincome
Salesin Oorrur,_
Contributionmarsin ratio

Recall that Kay's contribution margin ratio is 40%. At the breakeven point,
operating income is $0, so Kay's breakevenpoint in salesdollars is:

$7,000+ $0
Sales ln unlls=-
0.40
368 Chapter7

This is the samebreakevensalesrevenuewe calculatedearlier(500 postersx

$35 salesprice: $17,500).
Why doesthe contribution margin ratio formula work? Each dollar of Kay's
salescontributes$0.40to fixed expensesand profit. To breakeven,shemust gener-
ate enoughcontribution margin at the rate of $0.40 per salesdollar to cover the
$7,000fixedexpenses ($7,000+ 0.40 : $17,500).

To recall which shortcut,formwlagiueswhicb resuh,remirmbelr'this:Diuiding

fixed costsby the ufiit'cantribwtian margin prouidesbreakeuenin salesunits.
Diuiding fixed costsby the contribwtion margin ratio prouidn b,reaheuen
in sales
dollars.

W
SupposeAmazon.com's total revenuesare $4.5billion,its variableexpensesare
$3.15billion,
and itsfixedexpenses are$1.1billion.What isthe breakeven pointin
salesdollars?

lk"mrrw$r*;We can usethe shortcutapproachthat usesthe contributionmargin

ratioto determinethe breakeven point.First,we computethe contribution
margin
ratio:The contributionmarginratiois 30%[($4.5- $3.15)+ $4.5].Then,we use
the ratioin the shortcutformula:

$1.1billion+ $0
0.30
= $3.667billion(rounded)

mustachievesalesrevenueof $3.667billionjustto breakeven.

Amazon.com

UsingCVPto PlanProfits
For establishedproducts and services,managersare more interestedin the saleslevel
needed to earn a target profit than in the breakeven point. Managers of new busi-
nessventures are also interested in the profits they can expect to earn. For example,
Kay doesn't want to just break even-she wants her businessto be her sole source of
income. She would like the businessto earn $4,900 of profit each month. How
many posters must Kay sell each month to reach her target profit?

We Sef,fi
f4mwMush fu'ffusmt to ffiarmmTmrgetFrmffit?
The only differencefrom our prior analysisis that insteadof determiningthe sales
levelneededfor zeroprofit (breakeven),
Kay now wantsto know how many posters
shemust sellto earn a $4,900profit. We can usethe incomestatementapproachor
 Cost-Volume-Profit Analvsis 369

the shortcut approach to find the answer.BecauseKay wants to know the number of
wnits, we'lI use the shortcut approach based on the unit contribution margin. This
time, instead of an operating income of zero (breakeven),we'll insert Kay's target
operating income of $4,900:

_ $11,900
$14
irli
:i rl
it.;t.l::11:t
-'

This analysis shows that Kay must sell 850 posters each month to earn profits
of $4,900 a month. Notice that this level of salesfalls within Kay's current relevant
range (0-2,000 posters per month), so the conclusion that she would earn $4,900 of
income at this salesvolume is valid. If the calculation resulted in a salesvolume out-
side the current relevant range (greater than 21000 units), we would need to reassess
our cost assumptrons.
Assume that Kay also wants to know how much salesrevenue she needsto earn
$4,900 of monthly profit. Becauseshe already knows the number of units needed
(850), she can easily translate this volume into salesrevenue:

If Kay only wanted to know the salesrevenue needed to achieve her target
profit rather than the number of units needed, she could have found the answer
directly by using the shortcut approach based on the contribution matgin ratio:

Finally, Kay could have used the income statement approach to find the same
answers:

SALESRT
($35x Ur old) - ($21 x Unitssold) $7,ooo $4,900
($35 - $Zt; x Unitssold $7,000 $4,900
$14 x Unitssold $11,900
Units sold $11,900/$14
Units sold r r :r f i ,l i l t,t';
37(J Chapter7

'We
can prove that our answers (from any of the three approaches) are correct by
preparing Kay's income statment for a salesvolume of 850 units:

S a l e sre v e n u e(850 postersx $35)........ $29,750

L e s s :Va ri a b l e expenses(850 postersX $21)........ (17,850)
C o n tri b u ti o n margi n 1.1.,900
L e s s :F i x e d e x p enses..... (7,000)
O p e ra ti n gi n c ome........ $ 4,900

,r1 ' r' r,1 i ri 'i ' i i ' i ; i i,;rl ,ri ;11
1 ,;i 1 1 ' i1,,r r- ii" -' " '
q1.X i' ,ri

By graphing the CVP relationships for her business,I(ay can see at a glance how
changesin the levels of saleswill affect profits. As in the last chapter, the volume of
units (posters)is placed on the horizontal r-axis; dollars, on the vertical y-axis.
Then, she follows five steps to graph the CVP relations for her business,as illus-
trated in ExhlbitT-4.

ume-Prof
Cost-Vol it Graph

S a l e sp o i n l

35,000
{step1}
S a l e sr e v e n ulei n e( R e d )
30,000
28,000

(Step4)
Breakeven
salespoint
20,000
point
Totalexpense
o 17,500 Variable
expenses

(Step3)
Totalexpenseline{blue)
10,000

7,000
(Step2)
Fixedexpenseline(green) Fixed
expenses

500
ofunits(posters)
Volume (x)

Srnp 1: Choosea salesvolume, such as 1,000 posters.Plot the point for total
salesrevenueat that volume: 1,000 postersX $35 per poster : sales
of $35,000. Draw the sdlesreuenueline from the origin (0) through
the $35,000 point. Why does the salesrevenue line start at the ori-
gin? If Kay does not sell any posters,there is no salesrevenue.
SrBp2: Draw the fixed expenseline, a horizontal line that intersectsthe y-axis
at $7,000. Recall that the fixed expenseline is flat becausefixed
 Cost-Volume-Profit Analvsis 371

expensesare the same($7,000) no matter how many postersKay sells

within her relevant range (up to 2,000 posters per month).
Srsp 3: Draw the total expense line. TotaI expense is the sum of variable
expenseplus fixed expense.Thus, total expenseis a mixed cost. So,
the total expenseline follows the form of the mixed cost line. Begin
by computing variable expense at the chosen sales volume: 1,000
posters x $21 per poster : variable expenseof $21,000. Add vari-
able expenseto fixed expense:$21,000 + $7,000 : $28,000. Plot
the total expensepoint ($28,000) for 1,000 units. Then, draw a
line through this point from the $7,000 fixed expenseintercept on
the dollars axis. This is the total expense line. Why does the total
expenseline start at the fixed expenseline? If Kay sells no posters,
she still incurs the $7,000 fixed cost for the server leasing, soft-
ware, and office rental, but she incurs no variable costs.
Srnp 4: Identify the breakeuen point. The breakeven point is the point
where the salesrevenue line intersectsthe total expenseline. This is
the point where salesrevenue equals total expenses.Our previous
analyses told us that Kay's breakeven point is 500 posters, or
$17,500 in sales.The graph shows this information visually.
SrBp 5: Mark the operating income and the operating /oss areas on the
graph. To the left of the breakevenpoint, the total expenseline lies
above the salesrevenue line. Expensesexceedsalesrevenue,leading
to an operating loss. If Kay sells only 300 posters, she incurs an
operating loss. The amount of the loss is the vertical distance
between the total exDenseline and the salesrevenue line:

earnsa profit. The verticaldis-

To the right of the breakevenpoint, the business
tance betweenthe salesrevenueline and the total expenseline equalsincome.
Exhibit 7-4 showsthat if Kay sells1,000 posters,sheearnsoperatingincomeof
$7,000($35,000salesrevenue- $28,000total expenses).
\X/hybotherwith a graph?Why not just usethe incomestatementapproachor
the shortcutcontributionmargin approach?Graphslike Exhibit 7-4 help managers
quickly estimatethe profit or loss earnedat different levelsof sales.The income
statementand contribution margin approachesindicateincomeor loss for only a
singlesalesamount.

DecisionGuidelines
CVPAruarysrs
Your friend wants to open her own ice cream parlor after college. She needshelp making the following decisions:

Decision Guidelines
How much will I earn on every ice cream cone I sell? The unit contribution margin shows managers how
much they earn on each unit sold after paying for variable
costsbwt before considering fixed expenses.The unit

continued . . .
372 Chapter7

Decision Guidelines
contribution margin is the amount each unit earns that
contributes toward covering fixed expensesand gener-
ating a profit. It is computed as:

Salespriceper unit
Less:Variablecostper unit
Contribution margin per unit

The contribution margin ratio shows managers how

much contribution margin is earned on every $1 of
sales.It is computed as:

Contribution margin
= Contribution margin ratio
Salesrevenue

Can I quickly forecast my income without creating a The contribution margin concept allows managers to
full income statement? forecast income quickly at different salesvolumes. First,
find the total contribution margin (by multiplying the
forecastednumber of units by the unit contribution
margin or by multiplying the forecastedsalesrevenue
by the contribution margin ratio) and then subtract all
fixed exoenses.
o How can I compute the number of ice cream cones lncome StatementApproach:
I'll have to sell to break even or earn a
target profit? Toalfixed Operating
Salesrevenue - rVarlable
,_...,.r. =
expenses
expense irrao_a"
r^, \ /.,.,, \
I Sale price per unit I _ [ Variable cost per .-it ] _ Total fixed _
-
Operating
Number of units x Number of ruris expenses income
[x J I /

ShortcwtUnit Contribution Margin Approach:

c5 a-t^^ Fixed expenses+ Operating income

l e st,-
t n l,..-it-
/ / l l t S =-
Contribution margin per wtit

r How can I computethe dollars of salesreuenueI'lI Shortcut Contribwtion Margin Ratio Approacb:
haveto generateto breakevenor earna targetprofit?
c -r ^^ :_ r_r, -..- Fixedexpenses+ Operating income
salesrnrlouart=ffi

What will my profits look like over a range of volumes? CVP graphs show managers, at a glance, how different
salesvolumes will affect orofits.
 Froblermt
Sumnnary
Fleet Foot buys hiking socks for $6 a pair and sellsthem for $10. Management bud-
getsmonthly fixed expensesof $10,000 for salesvolumes between0 and 12,000 pairs.

Requirements

L. Use the income statement approach and the shortcut unit contribution margin
approach to compute monthly breakeven salesin units.
2. Use the shortcut contribution margin ratio approach to compute the breakeven
point in salesdollars.

3. Compute the monthly saleslevel (in units) required to earn atarget operating
income of $14,000. Use either the income statement approach or the shortcut
contribution margin approach.

4. Preparea graph of Fleet Foot's CVP relationships,similar to Exhibit 7-4. Draw

the salesrevenue line, the fixed expenseline, and the total expenseline. Label the
axes, the breakeven point, the operating income area, and the operating loss area.

$nilutf;mn
Requirement I
lncome stdtementapproach:

Fixed Operating
Sales
revenue Variableexpenses
expenses income
U"]:r) ( Variabte Units)
fSalerrice
Fixed Operating
- x
unrt " sotd,/ per unit sold expenses rncome
\ Per [.ot, .J
( $10x Unit ss ol d ) - ($6 x Unitssold) $i 0,000 $o
( $10 - $6) x Unitssold $1o,ooo
$4 x Unitssold $1o,ooo
Units sold $10,000+ $4
Breakeven salesin units 2,500units

Sbortcwt wnit contribution margin approach:

Salesin,roirc=ry
Lontflbutron margrn per unrt
$10'000+ $0
$10-$6
$1o,ooo
$4
= 2,500units

Cost-Volume-Prof
it Analvsis 373
 Requirement 2

Fixed expenses+ operating income

Salesin dollars -
Contribution margin rario

+ $0
$10,000
0.40*
= $25,000

,,contributionmarsin ratio = contnbutronmarginper unit = j4 = g.aO

Salepricepel unit $fO

Income statement equation approach :

Fixed operating
satesrevenue - variable
vanaDleexpenses expenses lncome

Is e l e p ri c e' _ U r ri rs)_ ( V ari abl e ,U ni r' ) _ Fi xed _ Operari ng

p e ru n i t s o l d peruni t" sol dJ expenses rncome
I ] l cost
- =
($10x Unitssold) - ($0x Unitssold) $10,000 $14,000
($ tO - $6)xU ni tssol d = $10,000+ $14, 000
$4 x Unitssold = $24,000
Unitssold = $24,000* $4
Unitssold = 6,000unirs

Shoficwt wnit contribwtion margin approach:

c^r^^ :- l tS=- _Fixed expenses* Operatingincome

) al eSr nU fl-_-.--
Contribution margin per unit

_ $24,000
$4
= 6000units

374 Chapter7
Requirement 4

60,000

50,000

40,000

S 3o,ooo

o
20,000

10,000

3,000 4,000 5,000 6,000

Units(x)

Analvsis
Cost-Volume-Profit
376 Chapter7

usingcvP when Business

ConditionsChange
Performsensitivity In today's fast-changing business world, managers need to quickly estimate how
analysisin responseto changes in salesprice, costs, or volume affect profits. In a recent drive to increase
ch angingbus ines s profitability, Starbucks analyzedthe profitability of each product at the store level.
conditions Then, it realigned prices. For example, coffee mugs and cDs had been money losers,
so it raised the prices of these items.
To predict how raising or lowering prices will affect profits, managers use
cvP to conduct sensitivity analysis. Sensitivity analysis is a "what-if" technique
that asks what results will be if actual prices or costs change or if an underlying
assumption such as salesmix changes.For example, increasedcompetition may
force Kay to lower her salesprice, while at the same time her suppliers increase
poster costs. How will these changes affect Kay's breakeven and target profit
volumes? what will happen if Kay changes her salesmix by offering posters in
two different sizes?How will she modify her cvP analysis?\fle'll tackle these
issuesnext.

ffihanglngthe SalesPnice
Let's assumethat Kay has now been in businessfor severalmonths. Becauseof com-
petition, Kay is considering cutting her salesprice to $31 per poster. If her variable
expensesremain $21 per poster and her fixed expensesstay at $7,000, how many
posters will she need to sell to break even?To answer this question, Kay calculatesa
new unit contribution margin using the new salesprice:

She then uses the new unit contribution margin to compute breakeven sales
in units:

_ $7,000+ $0
$10
= 700 posters

With the original $35 sale price, Kay's breakevenpoinr was 500 posters. If
Kay lowers the sales price to $31 per poster, her breakeven point increasesto
700 posters. The lower sales price means that each poster contributes /esstoward
fixed expenses($10 versus$14 before the price change),so Kay must sell 200 more
posters to break even. Each dollar of sales revenue would contribute $0.32
($10/$31) rather than $0.40 toward covering fixed expenses and generating
a profit.
 Cost-Volume-ProfitAnalvsis 377

If Kay reducesher salesprice to $31, how many postersmust she sell to achieve
her $4,900 monthly target profit? Kay again usesthe new unit contribution margin
to determine how many posters she will need to sell to reach her profit goals:

$7,000+ $4,900
Salesin units=
$ 10
1,190posters

\fith the original salesprice, Kay neededto sell only 850 posters per month to
achieve her target profit level. If Kay cuts her salesprice (and, therefore, her contri-
bution margin), she must sell more postersto achieveher financial goals.Kay could
have found these same results using the income statement approach. Exhibit 7-5
shows the effect of changesin salesprice on breakeven and target profit volumes.

The Effect of Changes in Sales Price

on Breakevenand Target Profit Volumes

thesame,
All elseremaining

then then

Stop & Think...

Kay believ es s he c o u l d d o mi n a te th e e -c o mmerce art poster busi nessi f she cut
th e s alespr ic e t o $ 2 0 . l s th i s a g o o d i d e a ?

No. T h e v a ri a b l ec o s t p e r p o s te r i s $ 21. l f K ay sel l spostersfor $20 each,

sh e los es$' l on e a c h p o s te r. Ka y w i l l i n c u r a l oss i f the sal espri ce i s l essthan the
va riablec os t .

ffiffi"mmm'mry
$wmp
Wmw"'ffi
mh-xff
m ffimm,trm
Let's assumethat Kay doesnot lower her salesprice. However, Kay's supplier raises
his price for each poster to $23.80 (insteadof the original $21).I(ay doesnot want
to pass this increaseon to her customers, so she holds her salesprice at the original
374 Chapter7

$35 per poster.Her fired costsremain $7,000. How many postersmust she sell to
break even after her supplier raises his prices? Kay's new contribution margin per
unit drops to $11.20 ($35 salesprice per poster - $23.80 variable cost per poster).
S o , h e r n e w b re a kevenpoi nr i s:

: :-, Fixed expenses + Operating income

Jdrtr) rrr u""t---6on[J-16u66n
margi n per uni t

$7,000+ $0
$ 11.20
= 625 posters

Higher uariable costsper unit haue the same effect as lower selling prices per
unit-they both reduce the product's unit contribwtion margin. As a result, I(ay will
have to sell more units to break even and achieve target profits. As shown in
Erhibit 7-6, a decreasein variable costswould have just the opposite effect.Lower
variable costsincreasethe contribution margin each poster provides and, therefore,
l o w e rsth e b re a k evenooi nt.

The Effect of Changes in VariableCosts

on Breakevenand Target Profit Volumes

All elseremaining
thesame,

then then

then then

SupposeKayis squeezedfrom both sides:Her supplycostshaveincreased to

$23.80per poster,yet shemustlowerher priceto $31in orderto compete.Under
theseconditions, how manyposterswill Kayneedto sellto achieveher monthly
target profit of $4,900?lf Kaydoesn'tthink she can sellthat manyposters,how
elsemightsheattemptto achieveher profitgoals?
 it Analvsis
Cost-Volume-Prof 379

,r;,i ' , l1; i1, K ayis no w i n a p o s i ti o nfa c e d b y ma n y compani es-her uni t contri buti on
, 111
ma rgin is s queez e db y b o th h i g h e r s u p p l y c o s tsa nd l ow er sal espri ces:

N ew s alespr ic e p e r p o s te r......... $31.00

Less:New variable cost per poster (23.80)

New contribution margin per poster $ 7.20

K ay ' snew c ont ri b u ti o n ma rg i n i s a b o u t h a l f o f w hat i t w as w hen she started her

b u s ines s( $14) .T o a c h i e v e h e r ta rg e t p ro fi t, h e r vol ume w i l l have to i ncreasedra-
ma tic ally( y et , it wo u l d s ti l l fa l l w i th i n h e r c u rre nt rel evantrange for fi xed costs-
which extends to 2,000 posters per month):

_ $7,000+ $4,900
$7.20
= t,653posters
(rounded)

Basedon hercurrentvolume,Kaymaynot believeshecansellso manyposters.

To maintaina reasonable profit level,Kaymay needto take othermeasures. For
example,she maytry to find a different with
supplier lower postercosts. She may
alsoattemptto lowerherfixedcosts.Forexample,perhapsshecouldnegotiatea
cheaperleaseon her officespaceor moveher business to a lessexpensive loca-
tion. Shecouldalsotry to increase her volumeby spending more on fixed costs,
Kaycouldalsoinvestigate
suchas advertising. sellingotherproducts,in addition
posters,
to herregular-size that would have higherunitcontributionmargins. We'll
discuss thesemeasures next.

ffihangimgFlxed Costs
Let'sreturnto Kay'soriginaldata($35sellingpriceand $21 variablecost).Kay has
decidedshereally doesn'tneeda storefrontofficeat the retail strip mall becauseshe
doesn'thavemany walk-in customers.Shecould decrease her monthly fixed costs
from $7,000to $4,200by moving her office to an industrialpark.
How will this decrease in fixed costs affect Kay's breakeven point? Changesin
fixed costsdo not affectthe contribution margin. Therefore,I(ay'sunit contribution
margin is still $14 per poster.However, her breakeven point changes becauseher
fixed costschange:

Becauseof the decreasein fixed costs, Kay will need to sell only 300 posters,
rather than 500 posters, to break even. The volume needed to achieve her monthly
$4,900 target profit will also decline. However, if Kay's fixed costs incredse,she will
have to sell more units to break even. Exhibit 7-7 shows the effect of changes in
fixed costs on breakeven and target profit volumes.
Chapter7

The Effectof Changesin FixedCosts

on Breakevenand TargetProfitVolumes

All elseremaining
thesame,

'We
have seen that changes in sales prices, variable costs, and fixed costs can
have dramatic effects on the volume of product that companies must sell to achieve
breakeven and target profits. Companies often turn to automation to decreasevari-
able costs (direct labor); but this, in turn, increasestheir fixed costs (equipment
depreciation). Companies often move production overseasto decreasevariable and
fixed production costs, feeling forced to take these measuresto keep their prices as
low as their competitors. For example, Charbroil, the maker of gas grills, said that if
it didn't move production overseas,profits would decline, or worse yet, the com-
pany would go out of business.

Kayhasbeen consideringadvertising as a meansto increaseher salesvolume.Kay

could spendan extra$3,500per month on Web site bannerads.How manyextra
posterswouldKayhaveto selljustto payfor theadvertising?
(UseKay'soriginaldata.)

Answer; Insteadof usinga//of Kay'sfixedcosts,we canisolatejustthe fixedcosts

relatingto advertising.
Thiswill allowus to figureout how manyextrapostersKay
wouldhaveto selleachmonthto breakevenon (or pay fod the advertising cost.
Advertisingis a fixedcost,so Kay'scontributionmarginremains$'14per unit.

Kaymustsell250extraposterseachmonthjustto payfor the costof advertising.

lf shesellsfewerthan250extraposters,she'llincrease
hervolumebut losemoneyon
the advertising.
lf shesellsmorethan250extraposters,her planwill haveworked-
she'llincreasehervolumeand herprofit.Eventhoughinvesting in the web banner
 Analvsis
Cost-Volume-Profit 381

ads increasesKay'sbreakevenpoint to 750 units (500 plus another 250 to cover the
adverlisingcosts),Kay may be willing to pay the extra $3,500if she expectsthe ads to
stimulateenough extra salesto rnore than cover the additional advertisingexpense.
Co m panies of t en fa c e th i s i s s u e .H o w m a n y e xtra 12-packsof soda do you thi nk
Coca-Colahasto sellto pay for one 3O-secondadvertisementduring the Super Bowl?

Another way that companies can offset cost and pricing pressuresis to expand
their product lines to include products with higher contribution margins. In the next
section, we'll see what happens when Kay decides to sell higher-margin, large-size
postersin addition to regular-sizeposters.

ffiffimqtw#Sm$ms mffiffiWPAmmfiywf;m
fuTfrxq
So far, we have assumedthat Kay sold only one size poster. \fhat would happen if Findbreakevenand
she offered more products? Companies that sell more than one product must con- targetprofitvolumes
sidersalesmix in figuring CVP relationships. A company earns more income by sell- for multiproduct
ing high-contribution margin products than by selling an equal number of companres
low-contribution margin products.
For example, Continental Airlines has focused on attracting more business-
people. Businesstravelers generally pay more for the same flight than leisure travel-
ers, yet the variable costs are the same. By increasing the proportion of
higher-paying businessfliers, Continental boosted its salesrevenue per available
seat-mile(availableseats x miles flown) from $0.074 to $0.090. Improving sales
mix by selling more high-margin tickets reduced Continental's breakeven point.
Before the change, Continental had to fill 63% of its seatsto break even. By attract-
ing more businesstravelers, Continental has to frll only 61.%.
The same CVP formulas that are used to perform CVP analysis for a company
with a single product can be used for any company that sellsmore than one product.
But first, we must compute the weighted-aueragecontribution margin of all prod-
ucts. Instead of using the simple average)we weight each product's unit contribution
margin by the relative number of units sold.
SupposeKay plans to sell two types of posters. In addition to her regular-size
posters, Kay plans to sell large posters. Let's assumethat none of I(ay's original costs
have changed. Recall that the regular posters have a unit contribution margin of $14
($35 salesprice - $21 variable cost). The larger posterswill sell for $70 each, yet
have variable costs of $40 each. Therefore, the unit contribution margin of each
large poster is $30 ($70 - $40). Kay is adding the large-posterline becauseit carries
a higher unit contribution margin. Assume that Kay's fixed expensesremain $7,000.
For every five regular posters sold, Kay expects to sell three large posters. In
other words, she expects 5/8 of the sales to be regular posters and 3/8 to be large
posters. This is a 5:3 salesmix. To compute breakeven salesin units, Kay first com-
putes the weighted-aueragecontribwtion margin as follows:

Regular Large
Posters Posters Total
Salespriceper unit..... $3s $70
Less:variablecostt.. (21) (4 0 )
";;;...........
Contributionmarginper unit........ $r + $30
Sales
mix.... X5 X3 8
Contributionmargin $zo $e0 s160
..
$20
342 Chapter7

Notice that the weighted-aueragecontrlbution margin per unit ($20) is lower, in

this case,than a simple auerageof the unit contribution margins l$ZZ : (1.4 + 30) + 21.
Theweighted averageislowerthanthesimple averagebecausemoreof thelower-margin
regular posters are sold than the higher-margin large posters. If more large posters were
sold than regular posters, the weighted-average contribution margin would be higber
than the simple average.
Once we've computed the weighted-averagecontribution margin, we use it in
the shortcut formula (alternativelg we could use the income statement approach):

The final stepsimply "breaks apart" the total numberof postersinto the regu-
lar and largesizesusingthe salesmix ratios:

As is often the casein real situations,thesecomputationsdon't yield round

numbers.Because Kay cannotsellpartial posters,shemust sell219 regularposters
and 1,32largepostersto avoid a loss.Usingtheseroundednumberswould leadto a
smallroundingerror in our checkfigures,however,so the rest of our computations
will usethe exactresults:218,75 regularpostersand 1.31..25
largeposters.
Kay'soverallbreakevenpoint in salesdollarsis $16,844(amountsroundedto
the nearestdollar):

'We can prove this breakevenpoint as follows:

\Wejust found Kay's breakeuen point, but Kay can also use the same steps to
calculate the volume she must sell to achieve a target profit. The only difference, as
before, is that she would vse tdrget profit, rather than zero, as the operating income
in the shortcut formula.
 Analvsis
Cost-Volume-Profit 383

Su ppos e K ay wou l d s ti l l l i k e to e a rn a m o n th ly profi t of $4,900.R ecal lthat she

n e e ded t o s ell 85 0 p o s te rs to a c h i e v eth i s p ro fi t l evel w hen she w as sel l i ng onl y
re g ular pos t er s .lf h e r s a l e sm i x i s 5 :3 , a s p l a n ned, w i l l she need to sel l more than
or fewer than 850 posters to achieve her target profit? Why?

' , 1will n e e d to s e l l fe w e rth a n 8 5 0 p osters becauseshe i s now sel l i ng

,ru ir " r , ' , ' , r rK, ,ay
so m e lar ge pos t e rs th a t h a v e a .h i g h e r u n i t c o n tri buti on margi n. W e can veri fy as
fo l lows :

Salesin total units =

w -averagecontribution margin per unit

_ $7,000+ $4,900
$20
= 595posters

Kaywould haveto sell a tota/of 595 posters:372 regularposters(595x 5/B)

and223largeposters(595x 3/B)toachievehertargetprofit.

Companies that offer hundreds of products (such as Home Depot and

Amazon.com) will not want to find the breakeven point in terms of units. Rather,
they'll want to know breakeven(or target profit volumes) in dollars of salesrevenue.
To find this volume, they'll first need to know their contribution margin ratio. If a
company prepares contribution margin income statements, it easily calculates the
contribution margin ratio by dividing the total contribution margin by total sales.
The contribution margin ratio is already weighted by the comp any'sactual salesmixt
If the company believesthat its salesmix will change next year, it can use forecasted
contribution margin income statementsto compute the contribution margin ratio.
Let's see how this would work for Kay. To use the contribution margin ratio
approach to estimate breakeven salesin dollars, I(ay must first estimate her contri-
bution margin ratio. Let's assumethat Kay expects to sell 500 regular posters and
300 large posters, although she could vse any total volume of salesas long as it's in
the expectedsalesmix ratio (5:3 in Kay's case).

Total expectedcontribution margin:

Regular pos te rs(5 0 0 x $ t+ 1 ............ $ 7,000
Large posters(300 x $30) $ 9,000
Total expectedcontributionmargin $16,000
Divided by total expectedsalesrevenue:
Regularposters(500X $3S1............ $17,500
Largeposters(300 x $70) 27,000
Total expected
sales + 38,500
Contribution margin ratio........... = 41.558"/o

Notice how Kay's contribution margin ratio is higher than it was when she sold
only regular posters (40%). That's becauseshe is now selling some large posters that
have a 42.9% contribution margin ratio ($30/$70).Becauseher salesmix changed,
she now has a different contribution margin ratio. The contribution margin ratio
usually changeswhen the salesmix changes.
384 Chapter7

Once Kay knows her contribution margin ratio, she can use the contribution
margin ratio approach to estimate breakeven salesin dollars:

+
- $7,000 $0
0.41588
= $16,844(rounded)

Notice that this is the same breakevenpoint in salesdollars we found earlier by

first finding breakevenin units.
If Kay's actual salesmix is not five regular posters to three large posters, her
actual operating income will differ from the planned amount euen if shesellsexactly
800 total posters. The salesmix greatly influences the breakevenpoint. \fhen com-
panies offer more than one product, they do not have a unique breakeven point.
Every salesmix assumption leads to a different breakevenpoint. In other words, the
breakevenpoint and operating income depend on the salesmix.

SupposeKay plansto sell 800 total postersin the 5:3 salesmix (fiveregular
posterssold for everythree largeposters).Sheactuallydoes sellB0Oposters-
375 regularand 425large.The salepricesper poster,variablecostsper poster,
and fixedexpenses areexactlyas predicted.Withoutdoing anycomputations, is
Kay'sactualoperatingincomegreaterthan,lessthan,or equalto her expected
income?

M,,wnffifl,t4*a^i,
Kay'sactualsalesmix did not turn out to be the 5:3 mix she expected.
Sheactually soldmoreof the higher-margin largepostersthan lower-margin regu-
lar posters.Thisfavorablechangein the salesmix causesher to earn a higher
operatingincomethansheexpected.

trnfornnation
Tecil"lnology
amdSemsitiwity
Analysis
'We
have just seen that Kay's breakevenpoint and target profit volumes are very
sensitive to changes in her business environment, including changes in sales
prices, variable costs, fixed costs, and salesmix assumptions.Information tech-
nology allows managers to perform a wide array of sensitivity analysesbefore
c o mmi tti n g to d eci si ons.Managers of smal l - to medi um-si zed compani es use
Excel spreadsheetsto perform sensitivity analyseslike those we just did for Kay.
Spreadsheetsallow managers to estimate how one change (or several simultane-
ous changes)affects businessoperations. Managers also use spreadsheetsoftware
to create CVP graphs like the one in Exhibit 7-4.
Many large companies use sophisticated enterprise resource planning software
such as SAP, Oracle, and PeopleSoftto provide detailed data ftor CVP analysis. For
example, after Searsstores lock their doors at9 p.m., records for each individual
transaction flow into a massive database.From a Diehard battery sold in Texas to a
Trader Bay polo shirt sold in New Hampshire, the system compiles an average of
1.5 million transactions a day. With the click of a mouse, managers accesssales
price, variable cost, and salesvolume for individual products to conduct breakeven
or profit planning analyses.
 Analvsis
Cost-Volume-Profit 385

Risklndicators
A firm's level of risk depends on many factors, including the general health of the Determinea firm's
economy and the specific industry in which the company operates. In addition, a marginof safetyand
firm's risk depends on its current volume of sales and the relative amount of fixed operatingleverage
and variable coststhat make up its total costs.Next, we discusshow a firm can gauge
its level of risk, to some extent, by its margin of safety and its operating leverage.

Margin of Safety
The margin of safety is the excessof expected salesover breakeven sales.This is the
"cushion," or drop in sales,the company can absorb without incurring a loss. The
higher the margin of safety, the greater the cushion against loss and the less risky
the businessplan. Managers use the margin of safety to evaluate the risk of current
operations as well as the risk of new plans.
Let's continue to assumethat Kay has been in businessfor several months and
that she generally sells 950 posters a month. Kay's breakeven point in our original
data is 500 posters. Kay can expressher margin of safety in units or in salesdollars:

Salescan drop by 450 posters,or $15,750a month,beforeKay incursa loss.

This is a comfortablemargin.
Managerscan also computethe margin of safetyas a percentageof sales.
Simplydividethe margin of safetyby sales.We obtain the samepercentage
whether
we useunits or dollars.
In units:

ln dollars:
386 Chapter7

The margin of safety percentage tells Kay that sales would have to drop by
more than 47.4% before she would incur a loss. If salesfall by less than 47.4%", she
would still earn a profit. If salesfall exactly 47.4"/", she would break even. This ratio
tells Kay that her businessplan is not unduly risky.

#permtfiffiffi Leqrffitrffi##
A company's operating leverage refers to the relative amount of fixed and variable
coststhat make up its total costs.Most companieshave both fixed and variable costs.
However, companies with high operating leverage have relatiuely more fixed costs
and relatively fewer variable costs. Companies with high operating leverageinclude
golf courses,airlines, and hotels. Becausethey have fewer variable costs,their contri-
bution margin ratio is relatively high. Recall from the last chapter that Embassy
Suites' variable cost of servicing each guest is low, which means that the hotel has a
high contribution margin and high operating leverage.
What does high operating leverage have to do with risk? If sales volume
decreases,the total contribution margin will drop significantly becauseeach sales
dollar contains a high percentageof contribution margin. Yet, the high fixed costs of
running the company remain. Therefore, the operating income of these companies
can easily turn from profit to loss if salesvolume declines.For example, airlines were
financially devastatedafter September11, 2001.,becausethe number of people flying
suddenly dropped, creating large reductions in contribution margin. Yet, the airlines
had to continue paying their high fixed costs.High operating leveragecompaniesare
at more risk becausetheir income declinesdrastically when salesvolume declines.
'$fhat
if the economy is growing and sales volume increases?High operating
leverage companies will reap high rewards, Remember that after breakeven, each
unit sold contributes its unit contribution margin directly to profit. Becausehigh
operating leveragecompanies have high contribution margin ratios, each additional
dollar of sale will contribute more to the firm's operating income. Exhibit 7-8 sum-
marizesthesecharacteristics.

Characteristics
of HighOperating
LeverageFirms

. High operaring Ieveragecompanies have:

-Higher leve.lsof fixed costs and lower leyels of variable costs
-H igh er contribution margin ratios
. For high operating leverage companies, changes in volume significantly
affect operating income, so they face:
-Higher lisk
-Higher potential for reward
Examples include golf courses,hotels, rental car agencies,theme parks,
airlines, cruise lines

However, companies with low operating leverage have relatively fewer fixed
costs and relatively more vaiable costs. For example, retailers incur significant
levels of fixed costs, but more of every salesdollar is used to pay for the merchan-
d i s e (a v a ri a b l e cost), so l ess ends up as contri buti on margi n. If sal esvolum e
declines, these companies have relatively fewer fixed costs to cover, so they are at
/essrisk of incurring a loss. If salesvolume increases,their relatively small contri-
bution margins ratios add to the bottom line, but in smaller increments.
Therefore, they reap less reward than high operating leveragecompanies experi-
encing the same volume increases. In other words, at low operating leuerage
 it Analvsis
Cost-Volume-Prof 387

conTpanies,cbanges in sales uolume do not haue as much impact on operating

income as they do at high operating leuerage companies. Exhibit 7-9 summarizes
these characteristics.

Characteristicsof Low Operating

LeverageCompanies

. Low operating leverage companies have:

:i''
-Higher levels of variable costs and lower levels of fixed costs ...

-Lower contribution margin ratios i,r,

. For low operating leveragecompanies, changesin volume do NOT have as
significant an effect on operating income, so they face:
-Lower risk :
-Lower potential for reward
Examples include merchandising companies.
.ir::l

A company's operating leverage factor tells us how responsive a company's

operating income is to changes in volume. The greater the operating leverage fac-
tors, the greater the impact a change in salesvolume has on operating income.
The operating leverage factor, at a given level ofsales, is calculated as:

contribution margin
operatingleveragefactor =
Operatingincome

'Sfhy
do we say, "at a given level of sales"? A company's operating leverage
factor will depend, to some extent, on the saleslevel used to calculate the contribu-
tion margin and operating income. Most companies compute the operating lever-
age factor at their current or expected volume of sales,which is what we'lI do in
our examples.
\flhat does the operating leveragefactor tell us?

The operating leueragefactor, at a giuen leuel of sales, indicates the

percentdge change in operating income that will occur from a 7oh cbange in
uolwme. In other words, it tells us how responsiue a company's operating
income is to changes in uolwme.

The lowest possible value for this factor is 1, which occurs only if the company
has no fixed costs (an extremely low operating leverage company). For a minute,
let's asswmethat Kay bas no fixed costs. Given this scenario, her unit contribution
margin ($14 per poster) contributes directly to profit becauseshe has no fixed costs
to cover. In addition, she has no risk. The worst she can do is break even, and that
will occur only if she doesn't sell any posters. Let's continue to assumethat she gen-
erally sells 950 posters a month, so this will be the level of salesat which we calcu-
Iate the operating leveragefactor:

S alesr ev enue( 9 5 0 p o s te rsx $ 3 5 /p o s te r)..... ........... .. $ 33,250

Less:Variable expenses(950 posters x $21lposter)..................... (19,950)
Contribution margin (950 posters X $14lposter)......................... $ 13,300
Less:Fixed expenses..... (0)
Operating income........ $ 13,300
388 Chapter
7

Her operating leveragefactor is:

Operatingleveragefactor=
*$"#
=l

What doesthis tell us? If Kay's volume changesby 1"/., her operating income will
change by 1% (her operating leverage factor of 1 multiplied by a 1"/" change in vol-
ume). What would happen to Kay's operating income if her volume changedby 15%
rather than 1%"?Her operating income would then change by 15% (her operating
leveragefactor of 1 multiplied by a 1,5% changein volume).
Let's now seewhat happensif we asswme,as usual, that Kay's fixed expensesare
87,000. \X/e'llonce again calculate the operating leueragefactor giuen Kay's cwrrent
leuel of sales(950 posters per month):

margin(950postersX $14lposter)
Contribution ...............,.........
$13,300
Less:Fixedexpenses..... (7,000)
Operating income. $ 6,300

Now that we have once again assumed that I(ay's fixed expensesare$7,000,
her operating leveragefactor is:

. $13.300
uperatlngleveragelactor =
T6J00

Notice that her operaringteverage,^,r",=*',n),r:;iT:.',us 1)when she has

more fixed costs ($7,000 versus $0). If Kay's salesvolume changesby 1.o/",her oper-
ating income will changeby 2.1,1,%(her operatingleveragefactor of 2.11 multiplied
by a 1,% change in volume). Again, what would happen to Kay's operating income
if her volume changed by 15% rather than 1o/o?Her operating income would then
change by 31,.65% (her operating leverage factor of 2.1.1.multiplied by a 1,5%
changein volume).
Managers use the firm's operating leveragefactor to determine how vulnerable
their operating income is to changes in sales volume-both positive and negative.
The larger the operating leverage factor is, the grearer the impact a change in sales
volume has on operating income. This is true for both increasesand decreasesin
volume. Therefore, companies with higher operating leverage factors are particu-
larly vulnerable to changesin volume. In other words, they have both higher risk of
incurring lossesif volume declinesand higher potential reward if volume increases.
Hoping to capitalize on the reward side, many companies have intentionally
increasedtheir operating leverageby lowering their variable costs while at the same
time increasing their fixed costs. This strategy works well during periods of eco-
nomic growth but can be detrimental when salesvolume slides.

AssumeKay'soriginaldata ($14unit contributionmargin,$7,000fixedcosts,and

950 postersper month salesvolume).Use Kay'soperatingleveragefactor to
determinethe percentageimpactof a 107"decreasein salesvolumeon Kay's
operatingincome.Proveyourresults.

continwed . . .
 Cost-Volume-Prof
it Analvsis 389

s4s'ts;++v*r': lf salesvolume decreasesby 10%,Kay'soperating income will decrease

b y 21. 1" / o( her ope ra ti n g l e v e ra g efa c to r o f 2 .1 ' 1mul ti pl i ed by a 10" /odecreasei n
vo l um e) .

Proof: Current volume of posters 950

Less:Decreasein volume (10% x 950) of posters ( e5)
New volume of posters.... 8s5
Multiplied by: Unit contribution margin x $t+
New total contribution margin $11,970
Less:Fixed expenses...... (7,000)
New operating rncome $ +,970
versusoperating income before changein volume $ 6,300"
Decreasein operating income $ (1 , 3 3 0 )
P er c en ta gceh a n g e($1 ,3 3 0 /$ 6 ,3 0 0...
) .......... 21.1%(rounded)
+(950 posters x
$14lunit contribution margin) - $7,000 fixed expenses

In this chapter, we have discussedhow managers use the contribution margin

and CVP analysis to predict profits, determine breakeven points and target profit
Ievels,and assesshow changesin the businessenvironment affect their profits. In the
next chapter, we look at severaltypes of short-term decisionsmanagers must make.
Cost behavior and the contribution margin will continue to play an important role
in thesedecisions.

DecisionGuidelines
CVPArurlYsrs
Your friend did openthe ice creamparlor.But now she'sfacingchangingbusinessconditions.Sheneedshelp making
the following decisions:

Decision Guidelines
The cost of ice cream is rising, yet my competitors have Increasesin variable costs (such as ice cream) and
lowered their prices. How will these factors affect my decreasesin salesprices both decreasethe unit contribu-
breakeven and target profit levels? tion margin and contribution margin ratio. You will
have to sell more units in order to achieve breakeven
and target profit levels.You can use sensitivity analysis
to better pinpoint the actual volume you'Il need to sell.
Simply compute your new unit contribution margin and
use it in the shortcut unit contribution margin formula.
'Would
it help if I could renegotiate my leasewith the Decreasesin fixed costs do not affect the firm's contri-
Iandlord? bution margin. However, a decreasein fixed costs
means that the company will have to sell fewer units to
achieve breakeven and target profit levels. Increasesin
fixed costs have the oooosite effect.

continued .
 Chapter7
Decision
I've been thinking about selling other products in addition
to ice!cream. \7ill this affect my target profit levels?
If the economytakesa downturn, how much risk do I
f.aceof incurringa loss?
Guidelines
Your contribution margin ratio will changedepending
on your salesmix. A companyearnsmore incomeby
sellinghigher-marginproducts than by sellingan equal
numberof lower-marginproducts.If you can shift sales
toward higher contribution margin products,you will
have to sell fewer units to reachbreakevenand target
profit levels.
The margin of safety indicates how far sales volume can,
decline before you would incur a loss:
The operatingleveragefactor indicatesthe percentage
changein operatingincomethat will occur from a'l,o/o
changein volume.It tellsyou how sensitiveyour com-
pany'soperatingincomeis to changesin volume.At a
givenlevelof sales,the operatingleveragefactor is:
ffiruxffiffiw&ffiffi&fl ffi
ffimmfuffiwmre
Recall from Summary Problem 1 that Fleet Foot buys hiking socks for $6 a pair and
sellsthem for $10. Monthly fixed costs are $10,000 (for salesvolumes between 0
and 12,000 pairs), resulting in a breakevenpoint of 2,500 units. Assumethat Fleet
Foot has been selling 8,000 pairs of socksper month.

Requirements

1. What is Fleet Foot's current margin of safety in units, in salesdollars, and as a

percentage?Explain the results.

2. At this level of sales,what is Fleet Foot's operating leveragefactor? If volume

declines by 25% due to increasing competition, by what percentage will the
company's operating income decline?

3. Competition has forced Fleet Foot to lower its salesprice to $9 a pair. How will
this affect Fleet'sbreakevenpoint?
4, To compensatefor the lower salesprice, Fleet Foot wants to expand its product
line to include men's dresssocks.Each pair will sell for $7.00 and cost $2.75
from the supplier. Fixed costs will not change. Fleet expectsto sell four pairs of
dress socks for every one pair of hiking socks (at its new $9 salesprice). What
is Fleet'sweighted-averagecontribution margin? Given the 4:1 salesmix, how
many of eachtype of sock will it need to sell to break even?

W fl mw
ffiW}Afl'u"MWM{ffiW,fi

Requirennent I

Margin of safety in units = Expected salesin units - Breakevensalesin units

= 8,000- 2,500
= 5,500units

Margin of safety in salesdollars = Margin of safety in units x salesprice per unit

= 5,500 units X $10/unit
= $55,000

o{ safety in units
Margin of safety as a percentag. * Yargin
Ixpected salesrn unrts

_ 5,500 pairs
8,000 pairs
= 68.75%

Fleet Foot's margin of safety is quite high. Saleshave to fall by more than 5,500
units (or $55,000) before Fleet incurs a loss. Fleet will continue to earn a profit
unlesssalesdroo bv more than 68.75%.

it Analvsis
Cost-Volume-Prof 391
 At its currentlevelof volume,Fleet'soperatingincomeis:

Contributionmargin(8,000pairsX $4/pair) $ 32,000

Less:Fixedexpenses..... (1 0 , 0 0 0 )
income........
Operating $ 22,000

Fleet'soperating leverage factor at this level of salesis computed as:

leverage
operating =
factor
ffitrffi
$32,000
$22,000
= 1.45(rounded)

If salesvolume declinesby 25"/., operatingincomewill declineby 36.25%

(Fleet's
operatingleverage
factorof 1.45multipliedby 25%).

Requirement 3
If Fleetdrops its salesprice to $9 per pair, its contributionmargin per pair declines
priceof $9 - variablecostof $6).Eachsalecontributes
to $3 (sales lesstowardcov-
ering fixed costs.Fleet'snew breakevenpoint increases to 3,334 pairs of socks
($10,000fixedcosts+ $3 unit contributionmargin).

Requirement 4

Hiking Dress
Socks Socks Total
Salesprice per unit $ e.00 $ 7.00
Deduct:Variableexpenseper unit (6 . 0 0 ) (2 . 7s )
Contributionmarginper unit $ :.oo 5 4.2s
Salesmix xLx45
Contributionmargin s 3.00 $17.00 $20.00
Weighted-averagecontribution
marginper unit ($2015) $ 4 .0 0

F'ixed expenses+ Operating income

Salesin total units = rX/eighted-average
contribution margin per unit
+0
$10,000
$+
= 2,500pairsof socks

Breakevensalesof dresssocks (2,500 x 415)......... 2,000 pairs dresssocks

Breakevensalesof hiking socks (2,500 x 1/5)....... 500 pairs hiking socks

By expanding its product line to include higher-margin dresssocks, Fleet is able

to decreaseits breakevenpoint back to its original level (2,500 pairs). However, to
achievethis breakeven point, Fleet must sell the planned ratio of four pairs of dress
socks to every one pair of hiking socks.
Chapter7
RgVi€W Analysis
Cost-volume-Profit
mAccounting Vocabulary
Breakeven Point (p. 365) Operating Leverage (p. 386)
The saleslevelat which operatingincomeis The relativeamountof fixed and variablecosts
zero:Totalrevenuesequaltotal expenses. that make up a firm'stotal costs.

Gontribution Margin Per Unit (p. 363)
The excessof the unit sales orice over the vari-
able cost per unit. Also calledunit contribution
margrn.
Gontribution Margin Income Statement
(p.362)
An incomestatementthat groups costs by
behaviorratherthan function:can be used onlv
by internalmanagement.
Operating Leverage Factor (p. 387)
At a given levelof sales,the contributionmar-
gin dividedby operatingincome.The operating
leveragefactor indicates the percentage
changein operatingincomethat will occur from
a 1%ochangein salesvolume.
Sales Mix (p. 361)
The combinationof productsthat make up
total sales.

Gontribution Margin Ratio (p. 363) Sensitivity Analysis (p. 376)

Ratioof contributionmarginto sales revenue.
Cost-Volume-Profit (GVP) Analysis (p. 360)
Expressesthe relationshipsamong costs, vol-
ume, and profitor loss.
A "what-if"techniquethat asks what resultswill
be if actual pricesor costs changeor if an
underlyingassumptionchanges.

Margin of Safety (p. 385)

Excess of expected sales over breakevensales.
The drop in salesa companycan absorb with-
out incurringan operatingloss.

wOuick Check
Use the following informationfor QuestionsL through 10. Grand Canyon
Railway operatesa turn-of-the-centurytrain that transportspassengers from
\X/illiams, Arizona,to the Grand Canyon and back everyday. Assumethat the
train ticketssell for $60 per passenger)
the railway'svariablecostsare $10 per
passenger, and its fixed expenses
are $50,000eachmonth.
t . 'Whatis the contributionmargin ratio (rounded)?
a. 1,6.67%
b. 1.00%
c. 83.33%
d. needsalesvolumeto calculate
2 . Computethe breakevenpoint in salesdollars.
a. $300,000
b. $60,000
c. $50,000
d. $100,000

Cost-Vol
ume-Prof
it Analvsis 393
 3. What will the Railway's operating income be if thev sell 1.001 ticketsin one
month?
a. $SO
b. $10
c. $60
d. $60,060
4. If the Grand Canyon Railway wants to earn $100,000 in profit per month,
how many ticketsmust it sell?
a. 1,000
b. 31,000
c. 30,000
d. 3,000
5. On the Grand CanyonRailway'sCVP graph,the total cost line intersectsthe
total revenueline at which of the following points?
a. the levelof the fixed costs
b. the levelof the variablecosts
c. the breakevenpoint
d. the origin
6. If the Grand CanyonRailway expectsto serve1,200 passengers
next month,
what is the margin of safety?
a. 200 passengers
b. L,000passengers
c. 1,200passengers
d. 2,200passengers
7, lf the Grand Canyon Railway serves1,200 passengers,
what is its operating
Ieveragefactor?
a. 1,
b.6
c. 3.27
d. 0.1.6
8. If the Grand CanyonRailway'svolume decreases
by 8To,by what percentage
will its operatingincomedecrease?
a. 48%
b. 1%
c. 26.1,6%
d. 8%
9. If the Grand CanyonRailwaycutsits ticket priceto $50 per passenger,
what is
the new breakevenpoint?
a. 100 more passengers than with the original $60 ticket price
b. 250 more passengers
than with the original $60 ticket price
c. 100 fewerpassengers
than with the original $60 ticket price
d. 250 fewerpassengers
than with the original $60 ticket price

394 Chapter7
10. The Grand Canyon Railway is thinking about selling souvenirs on the train. The
souvenirswill sell for $10 each and have a variable cost of $4 each. The Grand
Canyon Railway managers think that they will sell an average of one souvenir to
each passenger.Assuming that fixed expensesremain at $50,000, how will the
sale of souvenirs affect the number of passengersneededto break even?
a. It will have no effect.
b. It will increasethe number needed.
c. It will decreasethe number needed.
d. Not enough information is provided.

Ouick CheckAnswers
)'0I q ' 6 o ' 8 q ' L o ' 9 ? ' 9 p' v e' t, q' 7 2' l

For Internet Exercises,Excel in Practice,and additional online activities, go to this

book's Web site at www.prenhall.com/bamber.

Cost-Volume-Profit Analvsis 39s

AssessYour Progress
w LearningObjectives

ffi Calculatethe unit contributionmarginand the contributionmarginratio

ffi UseCVPanalysisto find breakevenpointsand target profit volumes
ffit Performsensitivityanalysisin responseto changingbusinessconditions
ffit Find breakevenand target profit volumesfor multiproductcompanies
ffit Determinea firm's marginof safetyand operatingleverage

mShort Exercises

BayCruiselineDataSet usedfor S7-1through57-12

s7-1 Compute unit contribution margin and contribution margin ratio (Leaming
Objectiue 1)
Use the information from the Bay Cruiseline Data Set to compute the following:
a. \What is the contribution margin per passenger?
b. \What is the contribution margin ratio (round to five digits)?

c. Use the unit contribution margin to project operating income if monthly sales
total 10,000 passengers.
d. Use the contribution margin ratio to project operating income if monthly sales
revenuetotals $500,000.

s7-2 Project change in income (Learning Objectiue 7)

Use the information from the Bay Cruiseline Data Set. If Bay Cruiseline sells an addi-
tional 500 tickets, by what amount will its operating income increase (or operating
loss decrease)?

s7-3 Find breakeven (Learning Objectiue 2)

Use the information from the Bay Cruiseline Data Set to compute the number of din-
ner cruise tickets it must sell to break even.
a. Use the income statement equation approach.
b. Using the shortcut unit contrtbotion margin approach, perform a numerical
proof to ensure that your answer is correct.
c. Use your answers from a and b to determine the salesrevenue neededto break even.
d. Use the shortcut contribution margin ratio approach to verify the salesrevenue
neededto break even.

396 Chapter7
S7-4 Find target profit volume (Leaming Objectiue 2)
Use the information from the Bay Cruiseline Data Set. If Bay Cruiseline has a target
operating income of $40,000 per month, how many dinner cruise tickets must the
company sell?

S7-5 Prepare a CVP graph (Learning Objectiue 2)

Use the information from the Bay Cruiseline Data Set. Draw a graph of Bay
Cruiseline's CVP relationships. Include the salesrevenue line, the fixed expense line,
and the total expenseline. Label the axes, the breakeven point, the income area, and
the loss area.

s7-6 lnterpret a CVP graph (Leaming Objectiue2)

Describewhat eachletter standsfor in the CVP graph.

150 E
pointis at
Thebreakeven o units
andat
@ dollur r of s ales .

S7-7 Ghanges in sales price and variable costs (Learning Objectiue 3)

Use the information from the Bay Cruiseline Data Set.
t. SupposeBay Cruiseline cuts its dinner cruise ticket price from $60 to $S0 to
rncreasethe number of passengers.Compute the new breakeven point in units
and in salesdollars. Explain how changesin salesprice generally affect the
breakevenpoint.
2. Assume that Bay Cruiseline doesnot cut the price. Bay Cruiseline could reduce
its variable costs by no longer serving an appetizer before dinner. Supposethis
operating change reducesthe variable expensefrom $20 to $15 per passenger.
Compute the new breakevenpoint in units and in dollars. Explain how changes
in variable costs generally affect the breakeven point.

S7-8 Changes in fixed costs (Learning Objectiue 3)

Use the information from the Bay Cruiseline Data Set. Suppose Bay Cruiseline
embarks on a cost-reduction drive and slashesfixed expensesfrom $275,000 per
month to $200,000 per month.
l. Compute the new breakeven point in units and in salesdollars.
2. Is the breakevenpoint higher or lower than in S7-3?Explain how changesin fixed
costs generally affect the breakevenpomt.

Cost-Volume-Prof
it Analvsis 397
 S7-9 Compute weighted-average contribution margin (Learning Obiectiue 4)
Use the information from the Bay Cruiseline Data Set. SupposeBay Cruiseline decides
to offer two types of dinner cruises:regular cruises and executive cruises.The execu-
tive cruise includes complimentary cocktails and a five-course dinner on the upper
deck. Assume that fixed expensesremain at $27 5,000 per month and that the follow-
ing ticket prices and variable expensesapply:

Assumingthat Bay Cruiselinee-xpects to sell sevenregularcruisesfor everyone

executivecruise,computethe weighted-average contribution margin per unit. Is it
higheror lower than a simpleaveragecontributionmargin?\fhy? Is it higheror lower
than the regularcruisecontributionmargin calculatedin S7-1?Why? Will this new
salesmix causeBay Cruiseline'sbreakevenpoint to increaseor decrease from what it
was when it sold only regularcruises?

57-10 Continuation of S7-9: breakeven (LearningObjectiue4)

Referto your answerto 37-9.
a. Computethe total numberof dinnercruisesthat Bay Cruiselinemust sellto
breakeven.
b. Computethe numberof regularcruisesand executivecruisesthe companymust
sellto breakeven.

S7-11 Compute margin of safety (LearningObjectiue5)

Usethe information from the Bay CruiselineData Set.If Bay Cruiselinesells7,000 din-
ner cruises,computethe margin of safety:
a. In units (dinnercruisetickets).
b. In salesdollars.
c. As a percentage of sales.

S7-12 Compute and use operating leverage factor (Leaming Obiectiue5)

Usethe informationfrom the Bay CruiselineData Set.
a. Computethe operatingleveragefactor when Bay Cruiselinesells10,000dinner
crulses.
b. If volumeincreasesby 1,0"/o,
by what percentagewill operatingincomeincrease?
c. If volumedecreases
by SYo,by what percentage
will operatingincomedecrease?

57-13 Gompute margin of safety (LearningObjectiue5)

ConsiderKay'se-tailposterbusiness. SupposeKay expectsto sell800 posters.Usethe
original data ($35 salesprice, $21 variablecost, $7,000 fixed expenses)
to compute
her margin of safety:
a, In units(posters).
b. In salesdollars.
c. As a percentage of expectedsales.

57-14 Compute and use operating leverage factor (LearningObjectiue5)

Suppose Kay sells800 posters.Usethe originaldata ($35 salesprice,$21 variablecost,
$7,000 fixed expenses)to computeher operatingleveragefactor.If salesvolumeincreases
[}Tr,by what percentage will her operatingincomechange? Proveyour answer.
398 Chapter7
nsExercises
E7-15 Prepare contribution margin income statements (Leaming Objectiue1)
AussieTravelusesthe contributionmarginincomestatementinternally.Aussie'sfirst-
quarterresultsare as follows:

S a l e sr e v en u e ... $ 312,s00
Less: Variable expenses (12s,000)
C o n t r i b u tio n m a r g in ,........... 187,500
L e s s :F i x ed e xp e n se s.......... (170,000)
O p e r a t i n g in co m e ............. q__%Igq

Aussie's
relevantrangeis betweensalesof $250,000and $360,000.

Requirements
1. Preparecontributionmarginincomestatementsat saleslevelsof $250,000and
$360,000.(Hint: IJsethe contributionmarginratio.)
2. Computebreakeven salesin dollars.

E7-16 Work backward to find missing information (Leaming Objectiues7,2)

Berg Drycleanershas determinedthe following about their costs:total variable
expenses are $401000,total fixed expenses
are $30,000,and the salesrevenueneeded
to break evenis $40,000.Use the contributionmargin incomestatementand the
shortcutcontributionmargin approachesto determineBergDrycleaners'current
(1)salesrevenueand(2) operatingincome.(Hint:First,find the contributionmargin
ratio; then,preparethe contributionmargin incomestarement.)

E7-17 Find breakeven and target profit volume (LearningObjectiues1, 2)

Big Footproducessportssocks.Thecompanyhasfixedexpenses of $85,000andvari-
ableexpensesof $0.85per package. Eachpackagesellsfor $1.70.
Requirements
1,. Computethe contributionmarginper packageand the contributionmarginratio.
2. Find the breakevenpoint in units and in dollarsusingthe contributionmargin
shortcutapproaches.
3. Find the numberof packagesBig Foot needsto sellto earn a $25,000operating
rncome.

E7-18 Continuation of E7-17: changing costs (LearningObjectiue3)

Referto Big Foot inET-17.If Big Foot can decrease its variablecoststo $0.75per
packageby increasingits fixed coststo $100,000,how manypackages will it haveto
sellto generate
$25,000of operatingincome?Is this moreor lessthan before?Why?

Cost-Volume-Profit
Analvsis 399
 EZ-19 Find breakeven and target profit volume (LearningObiectiues1,2)
Owner ShanLo is consideringfranchisingher Happy'Wok restaurantconcept.She
believespeoplewill pay $5 for alarge bowl of noodles.Variablecostsare $t.SO a
bowl. Lo estimatesmonthly fixed costsfor franchisees
at $8,400.

Requirements
1. Usethe contributionmarginratio shortcutapproachto find a franchisee's
breakevensalesin dollars.
want a minimum monthly oper-
2, Is franchisinga good ideafor Lo if franchisees
ating incomeof $8,750 and Lo believes that most locationscould generate
$25,000in monthly sales?

E7-2O Gontinuation of E7-19: changing business conditions (Leaming Obiectiue3)

Refer to Happy Wok in E7-1,9.Lo did franchiseher restaurantconcept.Becauseof
Happy Wok's success, Noodles-n-Morehas come on the sceneas a competitor.To
mainrainits market share,Happy ITok will haveto lower its salesprice to $4.50 per
bowl. At the sametime, Happy'Wok hopesto increaseeachrestaurant'svolume to
6,000 bowls per month by embarkingon a marketingcampaign.Eachfranchisewill
have to contribute$500 per month to cover the advertisingcosts.Prior to these
changes,most locationswere selling5,500 bowls per month.

Requirements
']-..'!7hatwas the averagerestaurant'soperatingincomebeforethesechanges?
2. Assumingthat the pricecut and advertisingcampaignare successful at increas-
still earntheir targetprofit
ing volumeto the projectedlevel,will the franchisees
of $8,250per month?Showyour calculations.

E7-21 Compute breakeven and proiect income (Leaming Obiectiues7,2)

Dave'sSteelPartsproducesparts for the automobileindustry.The companyhas
of $640,000and a contributionmargin of.80'h of revenues.
monthly fixed expenses

Requirements
L. ComputeDave'sSteelParts'monthlybreakevensalesin dollars.Usethe contri-
bution marginratio shortcutapproach'
2. Usethe contributionmarginratio to projectoperatingincome(or loss)if rev-
enuesare $500,000and if they are $1,000,000'
3. Do the resultsin Requirement2 makesensegiventhe breakevensalesyou com-
puted in Requirement1? ExPIain.

E7-22 Continuation of E7-21=changing business conditions (Leaming Objectiue3)

play: The
Referto Dave'sSteelPartsinET-21..Dave feelslike he'sin a giant squeeze
automotivemanufacturersare demandinglower prices,and the steelproducershave
increasedraw materialcosts.Dave'scontributionmargin has shrunk to 60o/oof rev-
enues.Dave'smonthly operatingincome,prior to thesepressures,was $160,000.

Requirements
1. To maintainthis samelevelof profit, what salesvolume(in salesrevenue)must
Davenow achieve?
2. Davebelievesthat his monthly salesrevenuewill go only as high as $1,000,000.
He is thinking about moving operationsoverseas to cut fixed costs.If monthly
salesare $1,000,000,by how much will he needto cut fixed coststo maintain
his prior profit levelof $160,000per month?

400 Chapter7
E7-23 ldentify information on a GVP graph (Learning Objectiue 2)
Chad Brown is considering starting a'Web-based educational business,e-Prep MBA.
He plans to offer a short-course review of accounting for students entering MBA pro-
grams. The materials would be available on a password-protected Web site, and stu-
dents would complete the course through self-study.Brown would have to grade the
course assignments,but most of the work is in developing the course materials, setting
up the site, and marketing. Unfortunately, Brown's hard drive crashed before he fin-
ished his financial analysis. However, he did recover the following partial CVP chart:

70,000

60,000

50,000

40,000

30,000

20,000

10,000

200 300 400 500 600 700

Requirements
1. Label each axis, salesrevenue line, total expenseline, fixed expenseline, operat-
ing income area, and operating loss area.
2. If Brown attracts 400 students to take the course, will the venture be profitable?
3. What are the breakeven salesin students and dollars?

E7-24 Prepare a CVP graph (Learning Objectiue 2)

Supposethat Turner Field, the home of the Atlanta Braves, earns total revenue that
averages$24 for every ticket sold. Assume that annual fixed expensesare $24 million
and that variable expensesare $4 per ticket.

Requirements
1. Prepare the ballpark's CVP graph under these assumptions.Label the axes, sales
revenue line, fixed expenseline, total expenseline, operating loss area, and
operating income area on the graph.
2. Show the breakevenpoint in dollars and in tickets.

E7-25 Work backward to find new breakeven point (Learning Objectiues 2,3)
Bevil Industries is planning on purchasing a new piece of equipment that will increase
the quality of its production. It hopes the increased quality will generatemore sales.
The company's contribution margin ratio is 40"h, and its current breakeven point is
$500,000 in salesrevenue.If Bevil Industries'fixed expensesincreaseby $40,000 due
to the equipment, what will its new breakevenpoint be (in salesrevenue)?

Cost-Volume-Prof
it Analvsis 4(J1
 E7-26 Find consequence of rising fixed costs (Learning Obiectiues 1, 3)
DeAnna Braun sells homemade knit scarvesfor $16 each at local crafts shows. Her
contribution margin ratio is 62.5%. Currently, the crafts show entrance fees cost
DeAnna $t,000 per year. The crafts shows are raising their entrance feesby 15"/" next
year. How many extra scarveswill DeAnna have to sell next year just to pay for rising
entrancefee costs?

E7-27 Extension ot E7-26= multiproduclfirm (Learning Obiectiue 4)

Arlan Braun admired his wife's success at selling scarves at local crafts shows
(87-26), so he decided to make two types of plant stands to sell at the shows. Arlan
makes twig stands out of downed wood from his backyard and the yards of his
neighbors, so his variable cost is minimal (wood screws, glue, and so forth).
However, Arlan has to purchase wood to make his oak plant stands. His unit prices
and costs are as follows:

The twig standsare more popular,so Arlan sellsfour twig standsfor everyone
oak stand.DeAnnachargesher husband$300 to shareher booth at the craftsshows
(after all, shehas paid the entrancefees).How many of eachplant standdoesArlan
needto sellto breakeven?Will this affectthe numberof scarvesDeAnnaneedsto sell
to breakeven?Explain.

E7-28 Find breakeven for a multiproduct firm (LearningObiectiue4)

RacerScootersplans to sell a motorizedstandardscooterfor $54 and a motorized
chromescooterfor $78. RacerScooterspurchasesthe standardscooterfor $36 and
the chromescooterfor $50. RacerScootersexpectsto sell two chromescootersfor
everythreestandardscooters.RacerScooters'monthly fixed expenses are $9,680.
How many of eachtype of scootermust RacerScooterssell monthly to break even?
To earn$6,600?

E7-29 Work backward to find missing data (Learning Obiectiue4)

Kenishamanufactures two stylesof watches-the Digital and the Classic.The follow-
ing datapertainto the Digital:

Kenisha'smonthly fixed expenses total $190,000.\X/henDigitalsand Classicsare

the saleof 2,000 total watchesresultsin an oper-
sold in the mix of 7:3, respectively,
ating incomeof $60,000.Computethe contributionmarginper watch for the Classic.

E7-30 Breakeven and an advertising decision at a multiproduct company (Learning

Objectiues3,4, 5)
Dick's SportingGoodsis a national retailerof sportingequipment.Last year,Dick's
salesrevenues were$2.47billion. Of this amount,
totaled$Z.eZbillion. Total expenses
approximately$1.88 billion were variable,while the remainderwere fixed. Since

402 Chapter7
 Dick's offers thousands of different products, its managers prefer to calculate the
breakevenpoint in terms of salesdollars rather than units.
1. \7hat is Dick's current operating income?
2. What is Dick's contribution margin ratio (round to the nearestpercent)?
3. What is Dick's breakevenpoint in salesdollars (round to the nearesttwo decimals)?
(Hint:The contribution margin ratio calculated in requirement two is already
weighted by Dick's actual salesmix.)
4. \flhat is Dick's current margin of safety percentage (round to the nearest percent)?
Ifhat does it mean?
5. Dick's top management is deciding whether to embark on a $0.05 billion dollar
nationwide advertisementcampaign. The marketing firm has projected annual
salesvolume to increaseby 1,5% as a result of this campaign. Assuming that the
projections are correct, what effect would this advertising campaign have on
Dick's annual operating income?

E7-31 Compute margin of safety and operating leverage (Learning Obiectiue S)

Use the Aussie Travel data in E7-15 to answer the following questions:
L. What is Aussie Travel's current margin of safety (in dollars)?
2. \X/hat is Aussie Travel's current operating leveragefactor?
3. If salesvolume increases5o/" next quarter, by what percentagewill Aussie's
operating income increase?\X/hat will the new operating income be?

E7-32 Work backward through margin of safety (Learning ObjectiueS)

Bill'sBait Shophad budgetedbait salesfor the seasonat $10,000,with a 92,000mar-
gin of safety.However,due to unseasonable weather,bait salesreachedonly $9,200.
Actual salesexceeded breakevensalesby what amount?

E7-33 Compute margin of safety and operating leverage (LearningObjectiueS)

Ronnie'sRepair Shop has a monthly target operatingincomeof $12,000. Variable
expensesare 70Toof sales,and monthly fixed expenses
are $9,000.

Requirements
L. Computethe monthly marginof safetyin dollarsif the shopachieves its
incomegoal.
2. ExpressRonnie'smarginof safetyas a percentage of targetsales.
3. \X/hatis Ronnie'soperatingleveragefactorat the targetlevelof operating
income?
4. Assumethat Ronniereacheshis target.By what percentage will Ronnie'soperat-
ing incomefall if salesvolumedeclinesby 1,0%?

E7'34 Use operating leverage factor to find fixed costs (Learning Obiectiue5)
Murray Manufacturing had a 1..25 operating leverage factor when sales were
$50,000.Murray Manufacturing'scontribution margin ratio was 20o/o.Nfhat were
Murray Manufacturing'sfixed expenses?

Cost-Volume-Prof
it Analvsis 403
 E7-35 Gomprehensive GVP analysis (LearningObiectiues1,2, 3, 4, 5)
FlashCo.manufactures1 GB flashdrives(jumpdrives).Priceand costdatafor a rel-
evantrangeextendingto 200,000unitsper month are as follows:

Salesprice per unit (current monthly sales :'r ' r i . ,. l :i . 'l

volumeis 120,000units).......... $1.'.2:$;69;

. ., i i :
i : r ',,:1

',',a;AA:
..I.. .t....: '
, 5,;00
:':.,2,2i0'
,.tr ;40

$191,400
276,600

Requirements
1. What is the company'scontribution margin per unit? Contribution margin per-
centage?Total contribution margin?
'Sfhat
2, would the company's monthly operating income be if the company sold
150,000 units?
3. \7hat would the company's monthly operating income be if the company had
salesof $4,000,000?
'S7hat
4. is the breakeven point in units? In salesdollars?
5. How many units would the company have to sell to earn a target monthly profit
of $260,000?
6, Management is currently in contract negotiations with the labor union. If the
negotiations fail, direct labor costs will increaseby 1,0% and fixed costs will
increaseby $22,500 per month. If thesecostsincrease,how many units will the
company have each month to break even?
7. Return to the originaI data for this question and the rest of the questions. !7hat
is the company's current operating leveragefactor (round to two decimals)?
8. If salesvolume increasesby 87", by what percentagewill operating income
increase?
9. \What is the firm's current margin of safety in salesdollars? \il/hat is its margin
of safety as a percentageof sales?
10. Say FlashCo.adds a secondline of flash drives (2 GB rather than 1 GB). A
package of the 2 GB flash drives will sell for $45 and have variable cost per unit
of $20 per unit. The expected salesmix is three of the small flash drives (1 GB)
for every one large flash drive (2 GB). Given this salesmix, how many of each
type of flash drive will FlashCo. need to sell to reach its target monthly profit of
$260,000? Is this volume higher or lower than previously needed (in
Question 5) to achievethe same target profit? \flhy?

404 Chapter7
m Problefit5 (probtem
set A)

P7-36A Find missing data in CVP relationships (LearningObjectiues7,2)

The budgetsof four companiesyield the following information:

Company
a R s ,,7
Targetsales........... $720,000 $300,000 $190,000
Variableexpenses.........1.,..........
216,Q00
Fixedexpenses
.............. 156,000
Operatingincome(loss)............ $ 3o,ooo$ S r.,,' ' 80,000
+---+-
Units sold.,. 11.2,000 -4F 12tA0A" , tr5,750
Contributionmarginper unit.... $ e.50 $ 40
Contributionmarginratio......... 0.60

Requirements
1. Fill in the blanksfor eachcompany.
2. Computebreakeven,in salesdollars,for eachcompany.Which companyhasthe
lowestbreakevenpoint in salesdollars?'$7hatcausesthe low breakevenpoint?

P7-37A Find breakeven and target profit and prepare income statements (Learning
Obiectiues7,2)
A travelingproductionof ThePhantomof the opera performseachyear.The average
show sells800 ticketsat $50 a ticket.Thereare 100 showseachyear.The show hasa
castof 40, eachearningan averageof $260 per show.The castis paid only after each
show.The other variableexpenseis program printing costsof $6 per guest.Annual
fixed expensestotal $942,400.

Requirements
L Computerevenueand variableexpenses for eachshow.
2. Usethe incomestatementequationapproachto computethe numberof shows
neededannuallyto breakeven.
3, use the shortcutunit contributionmargin approachto computethe numberof
showsneededannuallyto earna profit of $1,438,400. Is this goalrealistic?
Give your reason.
4. PrepareThe Phantomof the Opera'scontributionmarginincomestatementfor
100 showseachyear.Reportonly two categories of expenses: variableand fixed.

P7-38A Comprehensive CVP problem (Leaming Objectiues7,2, 5)

TeamSpirit imprints calendarswith collegenames.The companyhas fixed expenses
of $1,035,000eachmonthplusvariableexpenses of $3.60per cartonof calendars.Of
the variableexpense,70'/" is Cost of GoodsSold,while the remaining 30% relatesto
variableoperatingexpenses. Teamspirit sellseachcarton of calendarsfor $10.50.

Requirements
l. Usethe incomestatementequationapproachto computethe numberof cartons
of calendarsthat TeamSpirit must selleachmonth to breakeven.

continued . . .

Cost-Volume-Prof
it Analysis 405
 2. Use the contribution margin ratio shortcut formula to compute the dollar
amount of monthly salesTeam Spirit needsin order to earn $285,000 in operat-
ing income (round the contribution margin ratio to two decimal places).
3. Prepare Team Spirit's contribution margin income statement for June for sales
of 450,000 cartons of calendars.
4. \fhat is June'smargin of safety (in dollars)? What is the operating leveragefactor
at this level of sales?
By what percentagewill operating income change if July's salesvolume is 13"/"
higher? Prove your answer.

P7-39A Compute breakeven, prepare CVP graph, and respond to change (Learning
Obiectiues1,2,3)
Personal Investors is opening an office in Lexington, Kentucky. Fixed monthly
expensesare office rent ($2,500), depreciation on office furniture ($260), utilities
($2AO;,specialtelephonelines ($600), a connectionwith an online brokerageservice
($6+O;,and the salary of a financial planner ($3,+OO;.Variable expensesinclude pay-
mentsto the financial planner (1,0%of revenue),advertising(5% of revenue),supplies
and postage (2% of revenue),and usagefeesfor the telephone lines and computerized
brokerageservice(3% of revenue).

Requirements
L. Use the contribution margin ratio CVP formula to compute the investment firm's
breakevenrevenuein dollars. If the averagetrade leads to $400 in revenuefor
PersonalInvestors, how many trades must it make to break even?
2. Use the income statement equation approach to compute dollar revenuesneeded
to earn monthly operatingincome of $3,840.
3. Graph PersonalInvestors'CVP relationships.Assumethat an averagetrade leads
to $400 in revenuefor PersonalInvestors.Show the breakevenpoint, salesrevenue
line, fixed expenseline, total expenseline, operating loss area, operating income
area, and salesin units (trades)and dollars when monthly operating income of
$3,840 is earned.The graph should range from 0 to 40 units (trades).
4, Assume that the averagerevenue that Personal Investors earns decreasesto
$300 per trade. How does this affect the breakevenpoint in number of trades?

P7-40A GVP analysis at a multiproducttlrm (Leaming Objectiues 4, S)

The contribution margin income statement of Extreme Coffee for February 2008 follows:

Sa le sr e ve n u e ...
Variable expenses:
Co st o f g o o d s so ld ................ $32,000
M a r ke tin g e xp e n se........,.. 10,000
General and adminrstrative expense.... 3,000 45,000
Co n tr ib u tio n m a r g in ............ 45,000
Fixed expenses:
M a r ke tin g e xp e n se........... 16,5
00
General and admjnistrative expense 3,500 20,000
Op e r a tin g in co m e ............. $25,000

406 Chapter7
 Extreme Coffee sellsthree small coffeesfor every large coffee. A small coffee sellsfor
$2, with a variable expenseof $1. A large coffee sellsfor $4, with a variable expenseof $2.

Requirements
1. Determine Extreme Coffee's monthly breakevenpoint in the numbers of small
coffees and large coffees.Prove your answer by preparing a summary contribu-
tion margin income statement at the breakeven level of sales.Show only rwo
categoriesof expenses:variable and fixed.
2. Compute Extreme Coffee's margin of safety in dollars.
3. Use Extreme Coffee's operating leveragefactor to determine its new operaring
income if salesvolume increases15%. Prove your results using the contribution
margin income statement format. Assume that salesmix remains unchanged.

m Problems (probtem
set B)

P7-418 Find missing data in CVP relationships (Leaming Obiectiues7,2)

The budgetsof four companiesyield the following information:

Requirements
l. Fill in the blanksfor eachcompany.
2. Computebreakeven,in salesdollars,for eachcompany.\fhich companyhasthe
lowestbreakevenpoint in salesdollars?'!7hatcausesthe low breakevenpoint?

P7'428 Find breakeven and target profit and prepare income statement (Learning
Obiectiues7,2)
InternationalProductionsperformsCats,theplay.The average showsellsL,000tickets
at $60 a ticket. Thereare 120 showsa yeat.Catshasa castof 60, eachearningan aver-
ageof $320 a show.The castis paid only after eachshow.The othervariableexpense
is programprinting costsof $8 per guest.Annual fixed expensestotal $295,200.

Requirements
l. Computerevenueand variableexpenses for eachshow.
2. Usethe incomestatementequationapproachto computethe numberof shows
Calsmust perform eachyearto breakeven.

continued.

Cost-Volume-Profit Analvsis 4|J7

 3. Use the shortcut contribution margin approach to compute the number of shows
neededeach year to earn a profit of $4,264,000. Is this profit goal realistic?Give
your reason.
4. Prepare the Cats contribution margin income statement for 1,20 shows for the
year. Report only two categoriesof expenses:variable and fixed.

P7-438 Gomprehensive CVP problem (Learning Obiectiues 1,2, 5)

Fanfare sells flags with team logos. Fanfare has fixed expensesof $678,600 per year
plus variable expensesof $4.20 per flag. Of this variable expense,607o relates to the
cost of goods sold, whtle 40%orelates to operating expenses.Each flag sells for $12.

Requirements
l. Use the income statement equation approach to compute the number of flags
that Fanfare must sell eachyear to break even.
2. Use the contribution margin ratio shortcut formula to compute the dollar sales
Fanfare needsin order to earn $32,500 in operating income'
3. Prepare Fanfare'scontribution margin income statement for the year ended
December31,,2008, for salesof 100,000 flags.
'ufhat
4. is December'smargin of safety (in dollars)? What is the operating leverage
f.actor at this level of sales?
5. By what percentagewill operating income change if January's salesvolume is
5% higher? Prove your answer.

P7-448 Compute breakeven, prepare CVP graph, and respond to change (Learning
Objectiues7,2,3)
Money Maker InvestmentGroup is openingan office in Atlanta. Fixed monthly
expenses are office rent ($9,100),depreciationon office furniture ($700),utilities
($1,400),specialtelephone lines($L,600),a connection with an onlinebrokerage ser-
vice ($2,000),and the salary of a financial planner ($4,800). Variableexpenses
includepaymentsto the financialplanner(8% of revenue),advertising(72ohof rev-
enue),suppliesand postage(4% of revenue),and usagefeesfor the telephonelines
and computerizedbrokerageservice(6% of.revenue).

Requirements
"1,.Usethe contributionmarginratio CVP formula to computeMoney Maker
InvestmentGroup'sbreakevenrevenuein dollars.If the averagetradeleadsto
$700 in revenuefor Money Maker InvestmentGroup, how many tradesmust it
maketo breakeven?
2. Usethe incomestatementequationapproachto computethe dollar revenues
neededto earna targetmonthly operatingincomeof $9'800.
3. Graph Money Maker InvestmentGroup'sCVP relationships.Assumethat an
averagetradeleadsto $700 in revenuefor Money Maker InvestmentGroup.
Showthe breakevenpoint, salesrevenueline, fixed expenseline, total expense
line, operatinglossarea,operatingincome area,andsalesin units (trades)and
dollarswhen monthly operatingincomeof $9,800is earned.The graph should
rangefrom 0 to 80 units (trades).
4. Assumethat the averagerevenuethat Money Maker InvestmentGroup earns
decreasesto $560 per trade.Computethe new breakevenpoint in trades.How
doesthis affectthe breakevenpoint?

408 Chapter7
P7-458 CVP analysis at a multiproductfirm (Learning Objectiues4, 5)
The contribution margin income statementof Isabelle'sIce Cream Shoppefor July
2008 follows:

Isabellesellsfour sugarconesfor everyone large waffle cone.A regular sugar

conesellsfor $2, with a variableexpenseof $1. A largewaffle conesellsfor $4, with
a variableexpenseof $2.

Requirements
t, DetermineIsabelle'smonthly breakevenpoint in the numbersof regularsugar
conesand largewaffle cones.Proveyour answerby preparinga summarycon-
tribution marginincomestatementat the breakevenlevelof sales.Showonly
two categoriesof expenses:variableand fixed.
2. ComputeIsabelle'smarginof safetyin dollars.
3, UseIsabelle'soperatingleveragefactorto determineher new operatingincomeif
salesvolumeincreases by 15%. Proveyour resultsusingthe contributionmargin
incomestatementformat. Assumethat salesmix remainsunchanged.

Cost-Volume-Profit
Analvsis 409
 KrrewFed#€
AppHyVsn,#ff
rr*pssision Cases

Case 7-46. Determine feasibility of business plan (Learning Objectiue 2)

Brian and Nui Soon live in Macon, Georgia.Two yearsago, they visited Thailand. Nui,
a professionalchef, was impressedwith the cooking methods and the spicesusedin the
Thai food. Macon does not have a Thai restaurant, and the Soonsare contemplating
opening one. Nui would supervisethe cooking, and Brian would leave his current job
to be the maitre d'. The restaurant would serve dinner Tuesday through Saturday.
Brian has noticed a restaurant for lease.The restaurant has seventables, each
of which can seat four. Tables can be moved together for a large party. Nui is plan-
ning two seatingsper evening, and the restaurant will be open 50 weeks per year.
The Soons have drawn up the following estimates:

Averagerevenue,including beveragesand dessert....... $ 40 per meal

Averagecost of the food...... $ fZ per meal
C h e f:s a n d d i s hw asher,ssal ari eS ..' .....i ,..' ..... $50,400peryeer
R e n t (p re mi s es, !:.i i , i .,r..!,.,..,.,..$ 4,000per rnonth
equi prnent)...:..............
C l e a n i n g(l i n e l and premi ses),...:....
;..,.:;q.;.i .i ,...,...
r.i r!.. $ per month
SOO
f r. I
Replacementof dishes,cutlery. glasses $ :OOper month
Utilities, advertising,telephone.... $ 1,900per month

Requirements
Compute annwal breakeven number of meals and sales revenue for the restaurant.
Also, compute the number of meals and the amount of salesrevenueneededto earn
operating income of $75,600 for the year.How many mealsmust the Soonsserveeach
night to earn their target income of $75,600? Should the couple open the restaurant?
Support your answer.

lililEthical lssue

lssue 7-47. Ethical dilemma with GVP analysis error (Learning Objectiue 2)
You have just begun your summer internship at Tmedic. The company supplies ster-
ilized surgical instruments for physicians.To expand sales,Tmedic is considering
paying a commission to its salesforce. The controller, Jane Hewitt, asks you to com-
pute (1) the new breakeven salesfigure and (2) the operating profit if salesincrease
157o under the new salescommission plan. She thinks you can handle this task
becauseyou learned CVP analysis in your accounting class.
You spend the next day collecting information from the accounting records,
performing the analysis, and writing a memo to explain the results. The company
president is pleasedwith your memo. You report that the new salescommission plan
will lead to a significant increase in operating income and only a small increase in
breakevensales.
The following week, yourealize that you made an error in the CVP analysis.You
overlooked the salespersonnel's$2,500 monthly salaries,and you did not include this
fixed marketing expensein your computations. You are not surewhat to do. If you tell
Hewitt of your mistake, she will have to tell the president.In this case,you are afuaid
Tmedic might not offer you permanent employment after your internship.
41O Chaoter7
Requirements
1. How would your error affect breakeven salesand operating income under the
proposed sales commission plan? Could this cause the president to reject the
salescommissionproposal?
2. Consider your ethical responsibilities.Is there a difference between (a) initially
making an error and (b) subsequentlyfailing to inform the controller?
3. Supposeyou tell Hewitt of the error in your analysis.Why might the consequences
not be as bad as you fear? Should Hewitt take any responsibility for your error?
\fhat could Hewitt have done differently?
4. After considering all of the factors, should you inform Hewitt or simply
keep quiet?

wTeam Project
Project 7-48. Advertisingcampaign and production level decisions
(Leaming Objectiues7, 3)
EZPAK Manufacturing producesfilament packagingtape. In 2008, EZPAK
Manufacturingproducedand sold 15 million rolls of tape. The companyhas
recentlyexpandedits capacity,so it can now produceup to 30 million rolls per year.
EZPAK Manufacturing'saccountingrecordsshow the following resultsfrom 2008:

There were no beginning or ending inventories in 2008.

In January 2009, EZPAK Manufacturing hired a new president, I(evin
McDaniel. McDaniel has a one-year contract specifying that he will be paid 10%"of
EZPAK Manufacturing's 2009 operating income (based on traditional absorption
costing) instead of a salary. Ln2009, McDaniel must make two major decisions:
1. Should EZPAK Manufacturing undertake a major advertising campaign? This
campaign would raise sales to 25 million rolls. This is the maximum level of
salesthat EZPAK Manufacturing can expect to make in the near future. The ad
campaign would add an additional $3.S million in marketing and administra-
'Without
tive costs. the campaign, saleswill be 15 million rolls.
2. How many rolls of tape will EZPAK Manufacturing produce?
At the end of the year, EZPAK Manufacturing's board of directors will eval-
uate McDaniel's performance and decide whether to offer him a contract for the
following year.

continwed . .

Cost-Volume-Profit
Analysis 41 I
 Requirements
'within
your group, form two subgroups. The first subgroup assumesthe role of
Kevin McDaniel,EZPAK Manufacturing's new president. The second subgroup
assumesthe role of EZPAK Manufacturing's board of directors. McDaniel will meet
with the board of directors shortly after the end of 2009 to decide whether he will
remain atEzP{KManufacturing. Most of your effort should be devoted to advance
preparation for this meeting. Each subgroup should meet separatelyto prepare for
the meeting between the board and McDaniel. fHint: Keep computations (other
than per-unit amounts) in millions.]
Keuin McDaniel sbould:
L. Compute EZPAK Manufacturing's 2008 operating income.
2. Decide whether to adopt the advertising campaign by calculating the projected
increasein operating income from the advertising campaign. Do not include the
executive bonus in this calculation. Prepare a memo to the board of directors
explaining this decision. Use the memo format outlined in Case 6-43. Give this
memo to the board of directors as soon as possible (before the joint meeting).
3. Assume that EZPAK Manufacruring adopts the advertising campaign. Decide
how many rolls of tape to produce in 2009. Assume that no safety stock is con-
sidered necessaryto EZPAK's business.
4. Given your responseto Question 3, prepare an absorption costing income
statement for the year ended December 31, 2009, ending with operating
income before bonus. Then, compute your bonus separately.The variable cost
per unit and the total fixed expenses(with the exception of the advertising cam-
paign) remain the same as in 2008. Give this income statement and your bonus
computation to the board of directors as soon as possible (before your meeting
with the board).
5. Decide whether you want to remain atEZPAK Manufacturing for another
year. You currently have an offer from another company. The contract with the
other company is identical to rhe one you currently have with EZPAK
Manufacturing-you will be paid 1.0'/. of absorption costing operating income
instead of a salary.

Tbe board of directors should:

L. Compute EZPAK Manufacturing's 2008 operating income.
2. Determine whether EZPAK Manufacruring should adopt the advertising
campaign by calculating the projected increase in operating income from the
advertising campaign. Do not include the executive bonus in this calculation.
3. Determine how many rolls of tape EZPAK Manufacuring should produce in
2009. Assume that no safety stock is considerednecessaryto EZPAK's business.
4. Evaluate McDaniel's performance based on his decisions and the information
he provided to the board . (Hint: You may wanr ro prepare a variable costing
income statement.)
5. Evaluate the contract's bonus provision. Are you satisfied with this provision?
If so, explain why. If not, recommend how it should be changed.

After McDaniel has given the board his memo and income statement and after
the board has had a chance to evaluate McDaniel's performance, McDaniel and the
board should meet. The purpose of the meeting is to decide whether it is in their
mutual interest for McDaniel to remain with EZPAK Manufacturing and, if so, the
terms of the contract EZPAK Manufacturing will offer McDaniel.

412 Chapter7
frhapten7zDennoDoc t
'u+
Using CVP for Sensitivity Analysis

LearningObjectiues2, 3, 4

Hacker Golf has developeda unique swing trainer golf club. The company
currentlypaysa productioncompanyto producethe golf club at a costof $22 each.
Other variablecoststotal $6 per golf club, and monthly fixed expenses
are $16,000.
HackerGolf currentlysellsthe trainergolf club for $48.
NOTE: Solveeachrequirement asa separate situation.

Requirements

t, ffim$er*ilmtm
$'{;**kma, g*anfir'r*
Bpre;,*kewmm
ffimBf'ru finrumiltm.

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rmflmfimg't;fr"nc* prilceto $4"S,Wffi"
smfi[finng
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tFrwnmw hrmmkq]wmm 6mmmfi*m"

#" Maskmrffiqe$$
hms$mn*md ffiffidsw tm pnmdNcm
fld*flmpffirh.y thm golf cluxhet'fi*'r
lmvpepn
amstn$ S'flS. ffimfinunfim$tm
tfuqnffimqro
&xrmmflqmv#u'r
i*-rul'rits"

4" #$mcmunmm m'nmrnyen*m{mmq*n'm h;nurmr'mc'4mmmte*d *a6mflfEtmwmtm gm ailarmgwrftff,r

{&'rm
tr;,lfimm{'m[q*h,
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mmffymmmg[mvm#wr mwmrlr#mmrtr"sfiu"nmr mfrNfinsthey smill"h{am&swr ffimfidsmn
pNncft'nm*im.
thm gfimwmm fmr Sffimp,mfinnmd smilfithmu"m fmr $$ a p;nf;r-"tr'cpEmUffimmmt
cmmtssflar{"ililcil
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ffimr'ffimff$tf}. nhm
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firunt*ril$;m
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fiilffihs; gmfifgf;mwmm.

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n mmn'r*rfrknmtfimnn
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4"

DemoDoc 1 Page1 of 6 | Chapter7

ffiwffiwxffi
ffims S ffimffirutrFffiffis
Requirement I

tl,-+ierul;l'**r
+'.f*:th.il,r'*[i]r'1.:l;il;,i,1-,'rit
]]{iiiiitil ir'} clirtt*$.
To determine how changesin salesprices, costs, or volume affect profits, let's first start
by calculatingthe current breakevenpoint.
To determine the breakeven point, we first must calculate the contribution margin
per unit. The contribution margin is calculatedby subtracting variable costs from the
salesrevenue.Therefore:

Contribution margin per unit = Salesprice per unit - Variable cost per unit

Hacker Golf's variable cost per club (unit) is the price it pays for each club ($22)
plus its additional variable costs per golf club ($6). Therefore, its unit contribution
margrn ls:

S e l l i n gp ri c e p e r c1ub............ $4 8
V a ri a b l e c o s t p er cl ub ($22 + $6) .......... (2 8)
Contribution margin per club...... $ZO

The contribution margin representsthe amount from each unit sold that is avail-
able to cover fixed expenses.That meansHacker Golf earns $20 per club, which con-
tributes toward fixed expensesuntil fixed expensesare covered. After fixed expensesare
covered,eachclub sold contributes$20 directly to the company'soperatingincome.
Breakevenis the level of salesat which income is zero. The breakevenooint can be
calculatedas follows:

Fixld exp-enses
+ operatingincome
in units-
Breakeven
Lontnbutlonmarglnpef unrt
$ie 'o-99+$0
in units-
Breakeven

= 800 trainerclubs

Requirement 2

liilltri;k'iii:f,iitt tiiii,r littlii,,n

"::t
rli,l,;,v1frr1f6\.t1t ,t,t,t,!t,,itr
'f:.1'v,tt, tiir|'i.li,:.,\i,
Lt't',i,,tiir\,;,itr,,!titti'r.'titti!

Evenif HackerGolf raisesits salespriceper club to $49.95,its variablecosts($28per

unit) andfixedexpenses($16,000)will staythe same.As a resultof increasing the sales
price,thecompanywill now havea highercontributionmarginper unit:

priceperclub............
Selling $49.95
Variablecostper club ($22+ $6).......... (28.00)
Contributionmarginper club...... $21.95

Chapter7 I DemoDoc 1 SolutionsPaoe2 of 6

 Once again, you can use the breakevenformula to find the new breakevenpoint:

Fixedexpenses + operatingincome
Breakevenin units-
C o n tri b u ti o m
n argi nper uni t
$ 1 6 ,0 0 0+ $ 0
br eaK e v el n u n trs=
$x %
= 728.93roundedto 729 trainerclubs

rWith the increasedselling price, breakevenhas been reduced from 800 clubs to
729 cltbs. The higher price meansthat each club contributesmore to fixed expenses.
You can prove the answer by preparing an income statementfor a salesvolume of
729 units:

Sales
revenue (729 X $49.95)... S 36,412(rounded)
Less:Variableexpenses(729x $28)............ (20,41.2)
Total contributionmargin........ 16,000
Less:Fixedexpenses..... (1 6 , 0 0 0 )
Operatingincome........ 0

If the selling price increases,the volume required to break even or achievetarget

profit goals decreases(provided costs do not change).Conversely,if the selling price
decreases, the volume required to break even or achievetarget profit goals increases.

Requinennent 3

(,i:t,
l.n,ii,'.1,t:.,1+tr'
tt',rliiln,l,,r;
'it'!i
t.:Lt: t: li'\ tr,l,,(;',t,,tri,t:
rtit
r'tii,'iii, r,,1
1i,
Let's return to Hacker Golf's original salesprice ($48). Assuming that Hacker Golf has
found a new company to produce the golf club for $19 each, the company'svariable
costsper club will decrease.However, fixed expensesremain the same ($16,000). Once
again, Hacker Golf's contribution margin per unit will increaseas a result of this
changein businessconditions:

S ellingpr ic e per c l u b ............ $48

Var iable c os t pe r c l u b ($ 1 9 + $ 6 ) .......... (25)
Contribution margin per club....... $Z:

The new breakeyenDoint is found as follows:

n , Fixed expenses+ Operating income

DreaKe\en:--
ll) --.-:--
unlts =
coltrnh.,l,Jn marb'tnper uilr
s t 6' 000 s0
Brea ke v enin unir s- -
h/.t

= 695.65roundedto 696 clubs

\X/ith the reduced variable cost, Hacker Golf's breakevenin units decreasesfrom
800 clubs to 696 clubs. Using this information, Hacker Golf's managelnentmust
decideif it is worth the risk to switch to a new oroducer.

DemoDoc 1 SolutionsPage3 of 6 | Chapter7

 You can also prove this result by prepanng an Income statement:

S a l e sre v e n u e(696 x $48)........ $ 33,400(rounded)

L e s s :Va ri a b l e expenses(696 x $25)............ (17,400)
Total contribution margin........ 16,000
Less:Fixed expenses..... (1 6 , 0 0 0 )
Op e ra ti n gi n c o me........ $o

As variable or fixed expensesincrease,so doesthe volume neededto break evenor

achievetarget profits. Conversely,as these expensesdecrease,the volume needed to
break even or achievetarget profits also decreases.

1, r,l'li1L.li li" Ii r

', lrt,:l i'i;,,,r,rl",;,,l, il l,,

'

I ,, , I rr
I ,, I

Calculating the breakevenpoint is fairly straightforward when a company is selling

oniy one product. But Hacker:Golf is now consideringselling two products. Now,
breakevenbecomesmore complicated.Different products will have different effectson
the contribution margins becauseof dif,ferentcostsand sellingprices.So, the company
needsto considerthe salesmix (a combination of products that make up total sales)in
deterrniningCVP relationships.
Finding the breakevenpoint for multiproduct firms involves a simple three-step
process.The fir:ststepis to calculatea combined weighted-averagecontribution margin
for all of the productsthat the cornpanysells.
contribution margin.
Step 1: Calculatethe weighted-average
Hacker Golf believesthat it can sell one glove for every four clubs that it sells.This
would give the companya 4:1 salesmix. So,Hacker expectsthat 1/5 (or 20%) of sales
will be glovesand 415(or 80%) of saleswill be trainer clubs.
Let's return to Hacker's original selling price and variabie costs for the trainer
club. Recall that Hacker Golf earnsa $20 contribution rnargin on eachgolf club that it
on eachgolf glove that it sells:
sells.Hacker will also earn a $4 contribr-rtionr-r-rargin

Clubs Gloves
Salesprice per unit $48 $e
Less:Variable cost per unit (2 8 ) ( s)
Contribution margin per unit....... $20 $+

The weighted-averagecontribution margin is calculatedby multiplying the contri-

bution margin per unit by the salesmix expectedfor each product, Once we have a

Chapter7 | DemoDoc 1 SolutionsPaqe4 of 6

total contribution margin for the bundle of products ($80 + $4 : $84, in this case),we
divide it by the total number of units (5) in the salesmix, as follows:

Clubs Gloves Total

Salesprice per unit $48 $e
LessrVariable cost per unit (2 8 ) ( s)
q4
C ont r ibut ior rm a rg i n p e r u n i t $20
Salesmix in units x4 X1 5
Contribution margin $80 $4 84
ITeighted-averagecontribution
margin per unit ($84/5) $16.80

The $16.80 representsa weighted-averagecontribution margin for all of the prod-

ucts that Hacker Golf sells.The golf clubs are weighted more heavily becauseHacker
Golf expectsto sell four times as many clubs as golf gloves.
The next step is to calculatethe breakevenin units for the bundle of products.
Step 2: Calculate the breakeven point in units for the total of both products
combined.
This is calculatedusing the breakevenformula modified for the weighted-average
contribution margin in the denominator:

Fir-g-d + operating income

erper-rses
Salesin total units-
Weighted-averageconrribution
marglnper unlt

\7e know from the question that fixed expenseswill not be affected, so they
should remain at $16,000. The weighted-averagecontribution margin, as we just
calculated,is $16.80 per unit. So, we compute total salesas follows:

tt??::r; tt
in totarunits=
sales
= 9 52.38roundedto 953

'We
Hacker Golf must sell 953 clubs and glovescombined to break even. round up
becauseHacker Golf cannot sell a partial unit. Management needsto know how many
units of eacb product must be sold to break even.Therefore, the next step is to deter-
mine how many of the total salesunits (953) need to be clubs and how many need to
be glovesin order to break even.
Step 3: Calculate the breakeven in units for each product line.
BecauseHacker Golf believesthat it will sell four trainer clubs for every one pair
of gloves, the total number of units, 953, is multiplied by each product's salesmix
percentage:

salesof clubs:[953 x (415)l=762.4roundedto 763

Breakeven

salesof gloves:[953 x (1/5)]= 190.6roundedto191

Breakeven

From this analysis,we know that Hacker Golf needsto sell763 trainer clubs and
191 pairs of glovesto break even.

DemoDoc 1 SolutionsPage5 of 6 | Chapter7

 Requirement 5

L,$see e*ntributton nrargimimeornestmtscmemt to pn*ve the breakeveunpmiatt

ca*cufatedimRequirernemt 4"
To test the calculationof the breakevenpoint, you would add the revenuegenerated
from all sales,subtractthevariablecostsassociatedwith all sales,andsubtractthe total
fixed expenses. The resultshouldbalanceto zero(or closeto zeroin casesin which
roundingoccurs).

Thereis a slight $24 profit becauseof a roundingerror.

Chapter7 | DemoDoc 1 SolutionsPaoe6 of 6