Bill French, Accountant

(Cost Behavior and CVP analysis)

 The people present at the meeting
• Sales department:
– GM (sales): Arnie Winetki
– Asst. Managers (Sales): Ray Bradshaw and Unnamed
• Purchasing officer
• Representatives of manufacturing Departments
• Production engineering office (2)
– Production control: John Cooper
– Manufacturing: Fred Williams
• Accounting Department
– Controller: Wes Davidson
– Staff Accountant: Bill French <-- cost analysis and control
Questions to ponder at
1. What are the assumptions implicit in Bill French’s determination of
company’s break-even point?
2. On the basis of French’s revised information, what does next year
look like:
a. What is the break-even point?
b. What level of operations must be achieved to pay extra dividend, ignoring
union demands?
c. What level of operations must be achieved to meet the union demands,
ignoring bonus dividends?
d. What level of operations must be achieved to meet both dividends and
expected union requirements?
3. Can the break-even analysis help the company decide whether to alter
the existing product emphasis? What can the company afford to
invest for additional “C” capacity?
4. Is this type of analysis of any value? For what can it be used?
Unit selling price = $1.20
Unit variable cost = $0.75
Total fixed cost = $520,000
Last yr sales = 1500K Units
Plant capacity = 2000K
The chart pointed to a profitable year, dependent on meeting the sales volume that
had been maintained in the past. (status quo)
Q1. assumptions implicit in Duo’s break-even point estimate

• Variability of the variable costs is constant. A relatively

constant level of efficiency for machines and direct labor over
all portions of the range of operations.
• The fixed costs are truly fixed over the full range of
operations that has been pictured. In fact, some fixed costs are
likely to be step functions over this range.
• There will be a reasonably constant relationship between the
production and the sales pattern. Were this not the case, the
spread between the patterns would lead to an incurrence of
costs to be carried in inventory, and the full contribution
suggested by the chart may not be realized.
• The assumption (and a basic one in either aggregate or
product-line analyses) that the sales mix will remain constant
is a crucial one.
• sales prices will remain constant.
John Cooper, Production control: You know, Bill, I’m really concerned that
you haven’t allowed for our planned changes in volume next year. It seems to
me that you should have allowed for the sales department’s guess that we’ll
boost unit sales by 20 percent. We’ll be pushing 90 percent of capacity then. It
sure seems that this would make quite a difference in your figuring.
Bill French, Staff Accountant: That might be true, but as you can see, all you
have to do is read the cost and profit relationship right off the chart for the new
volume. Let’s see—at a million eight-hundred-thousand units we’d . . .

Net profit = 1,800,00 (1.20 – 0.75) – 520,000 = $290,000

Fred Williams, Manufacturing: Wait a minute, now! If you’re going to talk in
terms of 90 percent of capacity, and it looks like that’s what it will be, you had
better note that we’ll be shelling out some more for the plant. We’ve already
got approval on investments that will boost fixed costs by at least $10,000 a
month, easy. And that may not be all. We may call it 90 percent of plant
capacity, but there are a lot of places where we’re just full up and we can’t pull
things up any tighter. (i.e. 100% capacity utilization is not possible!)

John Cooper, Production control: Fred is right, but I’m not finished on this bit
about volume changes. According to the information that I’ve got here—and it
came from your office—I’m not sure that your break-even chart can really be
used even if there were to be no changes next year. It looks to me like you’ve
got average figures that don’t allow for the fact that we’re dealing with three
basic products. Your report on each product line’s costs last year (see Exhibit 2)
makes it pretty clear that the “average” is way out of line. How would the
break-even point look if we took this on an individual product basis?

Bill French, Staff Accountant: Well, I’m not sure. It seems to me that there is
only one break-even point for the firm. Whether we take it product by product
or in total, we’ve got to hit that point. I’ll be glad to check for you if you want,
but . . .
 Break-even analysis by product-line (Target profit is ZERO)
Overall line A line B line C

Break-even chart and the Profit Volume chart can be prepared for each product line
Ray Bradshaw, Asst. Manager (Sales): Guess I may as well get in on this one,
Bill. If you’re going to do anything with individual products, you ought to know
that we’re looking for a big shift in our product mix. The “A” line is really losing
out, and I imagine that we’ll be lucky to hold two-thirds of its volume next year.
Wouldn’t you buy that, Arnie? (Agreement from the general sales manager.)
That’s not too bad, though, because we expect that we should pick up the
200,000 that we lose, plus about a quarter million units more, in “C”
production. We don’t see anything that shows much of a change in “B.” That’s
been solid for years and shouldn’t change much now.
Arnie Winetki, GM(Sales): Bradshaw’s called it about as we figure it, but
there’s something else here. We’ve talked about our pricing on “C” enough,
and now I’m really going to push our side of it. Ray’s estimate of maybe half a
million units—450,000 I guess it was—increase on “C” for next year is on the
basis of doubling the price with no change in cost. We’ve been priced so low on
this item that it’s been a crime—we’ve got to raise it for two reasons. First, for
our reputation: the price is out of line with other products in its class and is
completely inconsistent with our quality reputation. Second, if we don’t raise
the price, we’ll be swamped, and we can’t handle it. You heard what Williams
said about capacity. The way the whole “C” field is exploding we’ll have to deal
with another half-million units in unsatisfied orders if we don’t jack the price
up. We can’t afford to expand that much for this product.
2(a) On the basis of revised information, what is the break-even point? 1279,872 units (64% of capacity)
 Hugh Fraser, AA to president: This certainly has been a helpful discussion. As long as
you’re going to try to get all the things together for next year, let’s see what I can add to
help you:
1. Let’s remember that everything that shows in the profit area here on Bill’s chart is
divided almost evenly between the government and us. Now, for last year we can read
a profit of about $150,000. That’s right; but we were left with half of that, and then
paid out dividends of $50,000 to stockholders. Since we’ve got an anniversary year
coming up, we’d like to put out a special dividend of about 50% extra. We ought to
retain $25,000 in the business, too. This means that we’d like to hit $100,000 PAT.
2. From where I sit, it looks as if we’re going to have negotiations with the union again,
and this time it’s likely to cost us. All the indications are—and this isn’t public—that we
may have to meet demands that will boost our production costs—what do you call
them here, Bill—variable costs—by 10 percent across the board. This may kill the
bonus-dividend plans, but we’ve got to hold the line on past profits. This means that
we can give that much to the union only if we can make it in added revenues. I guess
you’d say that that raises your break-even point, Bill—and for that one I’d consider the
company’s profit to be a fixed cost.
3. Maybe this is the time to think about switching or product emphasis. Arnie may know
better than I which of the products is more profitable. You check me out on this
Arnie—and it might be a good idea for you and Bill to get together on this one, too.
These figures that I have (Exhibit 2) make it look like the percentage contribution on
line “A” is the lowest of the bunch. If we’re losing volume there as rapidly as you sales
folks say, and if we’re as hard pressed for space as Fred has indicated, maybe we’d be
better off grabbing some of that big demand for “C” by shifting some of the assets from
Wes Davidson, Controller: I’ll see if I can summarize what everyone seems to
be looking for.
• First of all, I have the idea that your presentation is based on a rather important
series of assumptions. Most of the questions that were raised were really about
those assumptions. It might help us all if you try to set the assumptions down
in black and white so that we can see just how they influence the analysis.
• Then, I think that John would like to see the unit sales increase factored in, and
he’d also like to see whether there’s any difference if you base the calculations
on an analysis of individual product lines. Also, as Ray suggested, since the
product mix is bound to change, why not see how things look if the shift
materializes as he has forecast?
• Arnie would like to see the influence of a price increase in the “C” line; Fred
looks toward an increase in fixed manufacturing costs of $10,000 a month; and
Hugh has suggested that we should consider taxes, dividends, expected union
demands, and the question of product emphasis.

I think that ties it all together. Let’s hold off on our next meeting until Bill has
time to work some more on this.
 Q2a. With revised info, what is next year’s break-even point?

Assumptions (new):
10% increase in variable costs to meet union demands
$120,000 increase in fixed cost to support the product line C.
Solution:
Sale price per basket = 1.67(400K/1750K)+1.50(400K/1750K)+0.80(950K/1750K) = 1.16
VC per basket = 1.375(400K/1750K) + 0.69(400K/1750K) + 0.275(950K/1750K) = 0.62
Contribution per basket = 1.16 – 0.62 = $0.54
Fixed cost = 520,000 old + 120,000 for C = $640,000
Break-even level = 640,000 / 0.54 = 1190,961 vs. this year’s 1155,556
 Q2b. What level of operations must be achieved to pay the
extra dividend, ignoring union demands?

Assumptions (new):
NO increase in variable costs as we ignore the union demands
$120,000 increase in fixed cost to support the product line C.
Solution:
Targeted dividend = 75,000 ====> Target PBT = 75,000 / 0.5 = 150,000
Sale price per basket = $1.16 (as per Q2a)
VC per basket = 0.62 / 1.10 = $0.56
Contribution per basket = 1.16 – 0.56 = $0.59
Fixed cost + target profit = $640,000 + 150,000 = $790,000
Break-even level = 790,000 / 0.59 = 1330,393 vs. this year’s 1155,556
Q2c. What level of operations must be achieved to meet the
union demand, ignoring bonus-dividends?
Assumptions (new):
10% increase in variable costs as we consider the union demands
$120,000 increase in fixed cost to support the product line C.
$50,000 target dividend viz. $100,000 pre-tax profit
Solution:
Targeted dividend = 50,000 => Target PBT = 50k/ 0.5 = 100,000
Sale price per basket = $1.16 (as per Q2a)
VC per basket = $0.62 (as per Q2a)
Contribution per basket = 1.16 – 0.62 = $0.54
Fixed cost + target profit = $640,000 + 100,000 = $740,000
Break-even level = 740,000 / 0.54 = 1377,049
Q2d. What level of operations must be achieved to meet both
dividend and the expected union requirements?
Assumptions (new):
10% increase in variable costs as we consider the union demands
$120,000 increase in fixed cost to support the product line C.
$75,000 target dividend viz. $150,000 pre-tax profit
Solution:
Targeted dividend = 75,000 => Target PBT = 75k/ 0.5 = 150,000
Sale price per basket = $1.16 (as per Q2a)
VC per basket = $0.62 (as per Q2a)
Contribution per basket = 1.16 – 0.62 = $0.54
Fixed cost + target profit = $640,000 + 150,000 = $790,000
Break-even level = 790,000 / 0.54 = 1470,093 baskets
Summary of question 2
Q3. Can the break-even analysis help the company decide whether
to alter the existing product emphasis? What can the company
afford to invest for additional “C” capacity?
Two points (in addition to factors already mentioned) should be recognized considering
a shift of capacity from product "A" to "C":
1. While the ratio of variable income to sales price is much higher for "C" than for "A"
(66% against 18%), this is in part compensated for by the lower sales price of "C."
2. While the per unit dollar contribution for "C" is higher than for "A" ($0.55 against
$0.42), the number of units that can be sold is a critical factor. Since the "A"
contribution is 56 percent of the "C" contribution, this would mean that the company
can afford to gain in "C" units only 56 percent of the number of "A" units that it
gives up. Similarly, in viewing the amount of capacity that can be added for "C," we
must consider (in addition to the compelling factors that do not come directly under
the cost-revenue measurement) the amount of variable income available to pay for
the added capacity and to return a reasonable profit at the same time. Here the
analysis wanders into the area of return on investment, but you may wish to sketch
out some figures. On the basis of a per unit contribution of $0.55 from "C," an
addition that would yield 100,000 additional units of "C" annually must not cost
more than about $50,000 by the time amortization and profit (at a proper rate of
return) are considered.
Q4. Is this type of analysis of any value? For what can it be used?
•There are really two aspects of the "usefulness" question.
– What kinds of decisions will be influenced by a break-even analysis;
– What insights into operations are gained in the analysis that precedes
constructing a break-even chart, even if the chart itself is not used
much after it is prepared?
• In my opinion, the break-even chart and the cost analysis
required in order to prepare it are more useful for clarifying
cost-volume relationships than for identifying the break-even
volume per se. Nevertheless, there are certain decisions for
which this type of analysis can be explicitly used; for example:
1. Given a certain complement of professional staff, how many hours of
professional time at standard billing rates must a CPA firm (or any
other professional services firm) bill in order to break even (i.e.,
recover professional salaries, support salaries, and other overhead
costs)?
Q4. Is this type of analysis of any value? For what can it be used?
2. How many additional units of sales (or sales dollars) must a
30-second ad on the Super Bowl telecast generate in order for the ad
“to pay for itself”?
3. Given projected costs of a new commercial aircraft and an estimate
of the price per plane that airlines will be willing to pay, what is the
break-even volume? Is it likely that the aircraft manufacturer can in
fact sell more than that number of planes?
4. If the price of a product is reduced 10 percent, how many more units
must be sold to earn the same profit as at the current price?
• The break-even analysis not be oversold. For example, I feel that
you may sometimes get the impression from your marketing course
that a new product introduction decision would be based on a
break-even analysis. Since many such introductions require
significant working capital (and perhaps fixed asset) investments,
capital budgeting techniques should be used, not break-even
analysis. However, as suggested by example 3 above, a break-even
analysis may provide a "quick-and-dirty" look at whether it is
worthwhile to go ahead and develop a full-blown discounted cash
flow analysis.
Key Issues?