Cost Management

Session 6 : MBA 2020

Cost-Volume-Profit Relationships
Prof. Arpita Ghosh
 Learning Goals
• Assumptions underlying CVP, Fixed Vs Variable Costs
• Basic CVP Relationships
– Contribution, Contribution Income Statement
– CVP Chart, Computing Contribution Margin Ratio or C/S Ratio
• Computing
– Break Even Point, Indifference Point
– Level of Sales needed to achieve Target Profit,
– Margin of safety,
– Multi-product Break even point
• Cost Structure – Operating Leverage & linkage with MOS
• Exercises
2
 Assumptions Underlying - CVP Analysis

1. Selling Price Per Unit is constant through out the entire relevant range
2. Total Costs are linear in nature over the relevant range
– Total cost can be accurately split into fixed and variable
components
– Total Fixed Cost, Variable cost per unit will not change during the
period
3. In multi product companies, sales mix is constant over relevant range
4. No change in inventory:
– Units Produced = Units sold during the period

3
 Income Statement – Traditional and Contribution Approach

Income Statement- Not Total Income Statement -

Traditional Approach disclosed (Rs) Contribution Approach Total(Rs)
Sales (1000 units) 1,00,000 Sales (1000 units) 100000
Less: Cost of Goods Sold
(COGS) Less: Variable Costs
Fixed 15,000 Variable Manufacturing 35000
Variable 35000 50,000 Variable Administrative 15000
Gross Margin 50,000 Variable Selling 10000 60000
Less: Operating Expenses
Contribution Margin 40000
Administrative Expenses
Fixed 10,000 Less: Fixed Costs
Variable 15,000 25,000 Fixed Manufacturing 15000
Selling Expenses Fixed Administrative 10000
Fixed 5,000
Variable 10,000 15,000 Fixed Selling 5000 30000
Operating Income 10,000 Operating Income 10000

4
 Income Statement – Traditional and Contribution Approach

Income Statement- Not Total Income Statement -

Traditional Approach disclosed (Rs) Contribution Approach Total(Rs)
Sales (1000 units) 1,00,000 Sales (1000 units) 100000
Less: Cost of Goods Sold
(COGS) Less: Variable Costs
Fixed 15,000 Variable Manufacturing 35000
Variable 35000 50,000 Variable Administrative 15000
Gross Margin 50,000 Variable Selling 10000 60000
Less: Operating Expenses
Contribution Margin 40000
Administrative Expenses
Fixed 10,000 Less: Fixed Costs
Variable 15,000 25,000 Fixed Manufacturing 15000
Selling Expenses Fixed Administrative 10000
Fixed 5,000
Variable 10,000 15,000 Fixed Selling 5000 30000
Operating Income 10,000 Operating Income 10000

5
 Contribution-Margin Approach

Income Statement - Contribution Approach Total (Rs) Per Unit (Rs)

Sales (1000 units) 100,000 100
Less: Variable Costs 60,000 60
Contribution 40,000 40
Less: Fixed Costs 30,000
Operating Income 10,000

So, Contribution = Sales - Variable Cost = 100000 – 60000 = 40000

= Fixed Cost + Profits = 30000 + 10000 = 40000
Break Even Sales =>
Where, Profits = 0, i.e. Sales (or Total revenue) = Total Costs
or, Contribution = Total fixed Costs. Here, 750 units

The break-even point is the point in the volume of activity

where the organization’s revenues and expenses are equal
6
 Contribution-Margin Approach

Income Statement - Contribution Approach Total (Rs) Per Unit (Rs)

Sales (1000 units) 100,000 100
Less: Variable Costs 60,000 60
Contribution 40,000 40
Less: Fixed Costs 30,000
Operating Income 10,000

So, Contribution = Sales - Variable Cost = 100000 – 60000 = 40000

= Fixed Cost + Profits = 30000 + 10000 = 40000
Break Even Sales =>
Where, Profits = 0, i.e. Sales (or Total revenue) = Total Costs
or, Contribution = Total fixed Costs. Here, 750 units

The break-even point is the point in the volume of activity

where the organization’s revenues and expenses are equal
7
 Cost-Volume-Profit Graph

Units sold 1000 750 250

Sales (100 p.u.) 100000 75000 25000
Less: Variable Costs (60 p.u.) 60000 45000 15000
Contribution 40000 30000 10000
Less: Fixed Costs 30000 30000 30000
Operating Income 10000 0 -20000
Rupees (Revenues, Costs)

Break-even
point
125,000

100,000

75,000

50,000 Fixed expenses

25,000 MOS
(Units)

200 250 400 600 750 800 1,000 1,200

Units (Output or Sales) 8
 Profit-Volume Graph
Focuses on Profits and Volumes

50,000

40,000

30,000
Break-even
20,000 point
10,000
Profit

0 `

(10,000) 200 400 600 800 1000 1200

Units
(20,000)

(30,000)

9
 What is Contribution-Margin Ratio ?
Contributi on margin
Contributi on  Margin Ratio   100
Sales
Contributi on - Margin Per Unit
  100
Selling Price Per unit
Change in contributi on - margin
  100
Change in Sales
Income Statement -
Contribution Per Unit
Approach Total (Rs) (Rs)
Profit = (s – v) q – F
Sales (1000 units) 100,000 100 100% or
Less: Variable Costs 60,000 60 60% Profit = c × q – F

Contribution 40,000 40 40% s = selling price per unit

Less: Fixed Costs 30,000 v = variable cost per unit
F = total fixed costs
Operating Income 10,000 q = sales in units
c= contribution per unit
If Sales increase by 250 units, Increase in contribution ?
10
 Break-Even Point (in Units and in Rs)

EQUATION APPROACH
CONTRIBUTION MARGIN
APPROACH
q= Break-Even Point in units
Break Even Sales (units)
Profits = Sales – Variable Expenses - Fixed Expenses
= Total Fixed Expenses
Unit Sales Unit Sales Contribution-Margin per unit
sales × volume variable × volume − Fixed = Profits
price in units expense in units Expenses = Rs 30000
Rs 40
100 q - 60 q - 30,000 = Break Even Profit = 0 = 750 Units
40 q = Rs 30,000
q = Rs 30,000 ÷ 40 units Break Even Sales (Rs)
q = 750 units =Break-even Point ( in units) = Total Fixed Cost
Contribution-Margin Ratio
S = Break-even point in sales (Rs)
Sales – Variable Expenses - Fixed Expenses = Break Even Profit = 0 = Rs 30000
S – 0.60 S – Rs 30,000 = 0 0.40
0.40S = Rs 30000 = Rs 75,000
Or, 750 units * Rs100 S = Rs 30,000 ÷ 0.40
= Rs 75,000 S = Rs 75000 11
 Level of Sales needed to achieve a desired Target Profit
Assume the company wants to earn a target profit of Rs 20000.
How many units should it sell to earn the target profit
EQUATION APPROACH CONTRIBUTION MARGIN APPROACH
q= Number of units to be sold to earn the Target Profit
Sales to earn target profit (units) =
Profits = Sales – Variable Expenses - Fixed Expenses Total Fixed Expenses + Target Profit
Contribution-Margin per unit
Unit Sales Unit Sales
sales × volume variable × volume − Fixed = Profits
= Rs 50000
price in units expense in units Expenses Rs 40
= 1,250 Units
100 q - 60 q - 30,000 = Target Profit = Rs 20,000
40 q = Rs 30,000 + Rs 20,000
q = Rs 50,000 ÷ 40 units Sales to earn target profit (Rs) =
q = 1,250 units Total Fixed Cost + Target Profit
S = Sales in Rupees to attain Target Profit Contribution-Margin Ratio
Sales – Variable Expenses - Fixed Expenses = Target Profit
S – 0.60 S – Rs 30,000 = Rs 20,000
= Rs 50000
0.40
0.40S = Rs 50000
Or, 1250 units * Rs100 = Rs 125,000
S = Rs 50,000 ÷ 0.40
= Rs 125,000
S = Rs 125,000
12
 Level of Sales needed to achieve a desired Target Profit
Assume the company wants to earn a target profit of Rs 20000.
How many units should it sell to earn the target profit
EQUATION APPROACH CONTRIBUTION MARGIN APPROACH
q= Number of units to be sold to earn the Target Profit
Sales to earn target profit (units) =
Profits = Sales – Variable Expenses - Fixed Expenses Total Fixed Expenses + Target Profit
Contribution-Margin per unit
Unit Sales Unit Sales
sales × volume variable × volume − Fixed = Profits
= Rs 50000
price in units expense in units Expenses Rs 40
= 1,250 Units
100 q - 60 q - 30,000 = Target Profit = Rs 20,000
40 q = Rs 30,000 + Rs 20,000
q = Rs 50,000 ÷ 40 units Sales to earn target profit (Rs) =
q = 1,250 units Total Fixed Cost + Target Profit
S = Sales in Rupees to attain Target Profit Contribution-Margin Ratio
Sales – Variable Expenses - Fixed Expenses = Target Profit
S – 0.60 S – Rs 30,000 = Rs 20,000
= Rs 50000
0.40
0.40S = Rs 50000
Or, 1250 units * Rs100 = Rs 125,000
S = Rs 50,000 ÷ 0.40
= Rs 125,000
S = Rs 125,000
13
 Margin of Safety
Margin of Safety (in Rs) = Total Sales (budgeted) – Break Even Sales
Margin of Safety (in Rs) = Profit
CM Ratio
Margin of Safety (in Units) = Profit
Contribution per unit
Margin of Safety Percentage = Margin of Safety (in Rs) * 100
Total Sales

Break-even sales Actual sales

750 units 1000 units Percent
Sales (@ 100 p.u.) 75,000 100,000 100%
Less: variable expenses (@60 p.u.) 45,000 60,000 60%
Contribution margin 30,000 40,000 40%
Less: fixed expenses 30,000 30,000
Profit or Net income 0 10,000

1000 units – Rs (100,000 - Rs 25,000

750 units 75,000) = Rs100,000
MARGIN OF SAFETY =250 units Rs 25,000 = 25%
14
 Margin of Safety
Margin of Safety (in Rs) = Total Sales (budgeted) – Break Even Sales
Margin of Safety (in Rs) = Profit = 10,000/.40 = Rs25,000
CM Ratio
Margin of Safety (in Units) = Profit
= 10,000/40 = 250
Contribution per unit
Margin of Safety Percentage = Margin of Safety (in Rs) * 100
Total Sales

Break-even sales Actual sales

750 units 1000 units Percent
Sales (@ 100 p.u.) 75,000 100,000 100%
Less: variable expenses (@60 p.u.) 45,000 60,000 60%
Contribution margin 30,000 40,000 40%
Less: fixed expenses 30,000 30,000
Profit or Net income 0 10,000

1000 units – Rs (100,000 - Rs 25,000

750 units 75,000) = Rs100,000
MARGIN OF SAFETY =250 units Rs 25,000 = 25%
15
 Cost Structure: Operating Leverage
Measures how a given percentage change in sales affects profits
Can you establish a relationship
Operating leverage factor or
between DOL & MOS% ?
Degree of Operating Leverage (DOL) = Contribution Margin
MOS % = 1/ DOL *100
Operating Profit
So, if DOL = 4 , what is MOS % ?
% Change in Profit = DOL × % Change in Sales
DOL Calculations Company X Company Y
Sales 100,000 100% 100,000 100%
Variable expenses 60,000 60% 20,000 20%
Contribution margin 40,000 40% 80,000 80%
Fixed expenses 30,000 70,000
Net operating income 10,000 10,000
Degree of operating leverage 4 8
If Sales increase by 10% what will be the impact on Profits ? For X: 4* 10% =40% increase
Company X Company Y
Sales 110000 110,000
Variable expenses 66000 22,000
Contribution margin 44000 88,000
Fixed expenses 30,000 70,000
Net operating income 14,000 18,000
Increase in net operating income (14000-10000)/10000 = 40% (18000 – 10,000)/10,000 = 80 %
New DOL 3.14 4.88 16
 Cost Structure: Operating Leverage
Measures how a given percentage change in sales affects profits
Can you establish a relationship
Operating leverage factor or
between DOL & MOS% ?
Degree of Operating Leverage (DOL) = Contribution Margin
MOS % = 1/ DOL *100
Operating Profit
So, if DOL = 4 , what is MOS % ?
% Change in Profit = DOL × % Change in Sales
DOL Calculations Company X Company Y
Sales 100,000 100% 100,000 100%
Variable expenses 60,000 60% 20,000 20%
Contribution margin 40,000 40% 80,000 80%
Fixed expenses 30,000 70,000
Net operating income 10,000 10,000
Degree of operating leverage 4 8
If Sales increase by 10% what will be the impact on Profits ? For X: 4* 10% =40% increase
Company X Company Y
Sales 110000 110,000
Variable expenses 66000 22,000
Contribution margin 44000 88,000
Fixed expenses 30,000 70,000
Net operating income 14,000 18,000
Increase in net operating income (14000-10000)/10000 = 40% (18000 – 10,000)/10,000 = 80 %
New DOL 3.14 4.88
17
7-43 (p 306) on Operating Leverage (H-10)

18
 7-43 (p 306) on Operating Leverage (H-10)
2. Operating leverage refers to the use of fixed costs in an organization’s overall cost
structure. An organization that has a relatively high proportion of fixed costs and low
proportion of variable costs has a high degree of operating leverage.
1 and 3. Calculation of contribution margin and profit at 6,000 units of sales
Plan A Plan B
Sales revenue: 6,000 units x $120 $720,000 $720,000
Less: Variable costs:
• Cost of purchasing product: 6,000 units x $75 $450,000 $450,000
• Sales commissions: $720,00 x 10% 72,000 0
Total variable cost $522,000 $450,000
Contribution margin $198,000 $270,000
Fixed costs 33,000 99,000
Operating Profit $165,000 $171,000
Unit Contribution [120-{75+(10%*120)}] (120-75)
(A: 198,000/6,000; B: 270,000/6,000) = 33 =45
1. Break-Even Point (units) = Fixed Costs = 33,000 99,000
Unit Contribution 33 45
1,000 2,200
3. Operating Leverage Factor = Contribution margin = 198,000 270,000
Operating Profit 165,000 171,000
Plan B has the higher operating leverage factor  1.2 1.578
19
 7-43 continued
Operating Profit at 6,000 units of sales $165,000 $171,000
4 & 5 : Calculation of profit at 5,000 units Plan A Plan B
Sales revenue: 5,000 units x $120 $600,000 $600,000
Less: Variable costs:
• Cost of purchasing product: 5,000 units x $75 $375,000 $375,000
• Sales commissions: $600,000 x 10% 60,000 _0_
Total variable cost $435,000 $375,000
Contribution margin $165,000 $225,000
Fixed costs 33,000 99,000
Operating Profit $132,000 $126,000
Plan A profitability decrease:
$165,000 - $132,000 = $33,000
$33,000 ÷ $165,000 = 20%
Plan B profitability decrease:
$171,000 - $126,000 = $45,000
$45,000 ÷ $171,000 = 26.3%
The Company would experience a larger percentage decrease in income if it adopts Plan B.
• This situation arises because Plan B has a higher degree of operating leverage.
• Stated differently, Plan B’s cost structure produces a greater percentage decline in profitability from the
drop-off in sales revenue.
Note: The percentage decreases in profitability can be computed by multiplying the percentage decrease
in sales revenue by the operating leverage factor. Sales dropped from 6,000 units to 5,000 units, or
16.67%. Thus: Plan A: 16.67% x 1.2= 20%, Plan B: 16.67% x 1.578 = 26.3%
20
 7-43 continued

6. Heavily automated manufacturers have sizable investments in plant and equipment,

along with a high percentage of fixed costs in their cost structures. As a result, there is
a high degree of operating leverage.
– In a severe economic downturn, these firms typically suffer a significant decrease
in profitability. It will be less able to adapt to decline in consumer demand than a
company with labour intensive manufacturing process
– Such automated firms would be a more risky investment when compared with
firms that have a low degree of operating leverage.
– Of course, when times are good, increases in sales would tend to have a very
favorable effect on earnings in a company with high operating leverage.

21
 Break Even Point: Multiple -Products
Product A Product B
1000 units Per Unit 2000 units Per Unit
Sales 100,000 100 300,000 150 400,000 100%
Variable expenses 70,000 70 120,000 60 190,000 47.5%
Contribution 30,000 30 180,000 90 210,000 52.5%
Fixed expenses 141,750
Net operating income 68,250
Sales Mix in units =1000:2000 = 1: 2 1000 units 2000 units
% of Total 0.33 0.67
Contribution Margin per unit 30.00 90
Weighted Contribution Margin (% Total* CM) 10.0 60.0
Weighted average Contribution Margin per unit = 10+60 = Rs 70
Break Even Point (units) = Fixed expenses = 141,750 2,025
Weighted average Contribution Margin per unit 70.00 Combined units
Break Even Point (units) 675 1,350

Overall C/S ratio = 210,000 = 52.50%

400,000
Break Even Point Sales (Rs) = 141,750 = Rs 270,000 Combined
0.525
Sales Mix in Rs 100,000:300,000 =1:3 0.25 0.75
Break Even Point Sales (Rs) = 67,500 202,500
=675*100 =1350*150
How would the BEP change when Sales-Mix changes say, 2000 units of A & 1000 units of B are sold ?
22
 Application of CVP: Impact of changes on BEP and Profits
Impact on Profits of three independent changes:
1. Increase in Selling Price (S.P.) by 10%  Profit Increases
2. Variable Cost (V.C.) increases by 10%  Profit Decreases
3. Fixed Cost (F.C) increases by 10%  Profit Decreases

old 1000 units Increase in Increase in Increase in

(In Rupees) p.u. S.P. V.C. F.C
Sales 100 100000 110000 100000 100000
Less: Variable Costs 60 60000 60000 66000 60000
Contribution 40 40000 50000 34000 40000
Less: Fixed Costs 30000 30000 30000 33000
Operating Income 10000 20000 4000 7000
BEP in units (old) = Rs30,000/40= 750 units
Impact on BEP of three independent changes:
1. Increase in Selling Price (S.P.) by 10%  CM per unit increases to Rs50
• BEP = 30,000/50= 600 units (Decreases)
2. Variable Cost (V.C.) increases by 10% CM per unit decreases to Rs34
• BEP = 30,000/34= 882.35 units (Increases)
3. Fixed Cost (F.C) increases by 10%--> BEP =33,000/40= 825 units (Increases by 10%)
23
 Application of CVP: Impact of changes on BEP and Profits
Impact on Profits of three independent changes:
1. Increase in Selling Price (S.P.) by 10%  Profit Increases
2. Variable Cost (V.C.) increases by 10%  Profit Decreases
3. Fixed Cost (F.C) increases by 10%  Profit Decreases

old 1000 units Increase in Increase in Increase in

(In Rupees) p.u. S.P. V.C. F.C
Sales 100 100000 110000 100000 100000
Less: Variable Costs 60 60000 60000 66000 60000
Contribution 40 40000 50000 34000 40000
Less: Fixed Costs 30000 30000 30000 33000
Operating Income 10000 20000 4000 7000
BEP in units (old) = Rs30,000/40= 750 units
Impact on BEP of three independent changes:
1. Increase in Selling Price (S.P.) by 10%  CM per unit increases to Rs50
• BEP = 30,000/50= 600 units (Decreases)
2. Variable Cost (V.C.) increases by 10% CM per unit decreases to Rs34
• BEP = 30,000/34= 882.35 units (Increases)
3. Fixed Cost (F.C) increases by 10%--> BEP =33,000/40= 825 units (Increases by 10%)
24
 Predicting Profit : Interdependent Changes in Key Variables 
Decrease in selling price, Increase in sales volume,
Increase in fixed costs and decrease in Variable costs

If Selling Price is cut by Rs10 per unit, Sales volume would increase to 2500 units.
Fixed costs are planned to be increased by Rs15000 and Variable Cost pu can be reduced by Rs20
Old (A) New( B)
Sales Volume 1000 units 2500 units
Sales (A:Rs100, B:Rs90) Rs 100000 Rs 225000
Less: Variable Costs (A:Rs60, B:Rs40) 60000 100000
Contribution 40000 125000
Less: Fixed Costs 30000 45000
Operating Income 10000 80000

Incremental Approach
Total Contribution Margin- New(B) (90-40) *2500 125000
Total Contribution Margin - Old (A) (100-60) *1000 40000
Increase in total contribution Margin 85000
Less: Increase in Fixed costs 15,000
Increase in Operating Profit 70,000

Difference in profit caused by 1) different Contribution per unit (cut in Selling Price and
Variable Cost) 2) different sales volume and 3) Increase in Fixed Costs
25
7-38 (p 303) on CVP Relationships (H-10)

26
 7-38 (p 303) on CVP Relationships (H-10)
1. Closing of Mall store:
Loss of contribution margin at Mall Store $(108,000)
Savings of fixed cost at Mall Store (75% of $120,000) 90,000
Loss of contribution margin at Downtown Store (10% of $144,000) (14,400)
Total decrease in operating income $(32,400)
Increase in Sales and Increase in Fixed costs
2. Promotional campaign:
Increase in contribution margin (10% of $108,000) $ 10,800
Increase in monthly promotional expenses ($180,000/12) (15,000)
Decrease in operating income $(4,200)

3. Elimination of items sold at their variable cost

We can restate the November 20x4 data for the Mall Store as follows:
If Variable cost items are Eliminated Mall Store
*$180,000 is one half of the Mall Store's dollar sales for Items Sold at their
November 20x4 Variable Cost Other items
Sales $ 180,000 $ 180,000
Less: Variable expenses (Mall store :180 +72 = $252,000) 180,000 72,000
Contribution margin $ - 0- $ 108,000
Decrease in Sales, Decrease in Fixed costs
If the items sold at their variable cost are eliminated:
Decrease in contribution margin on other items 20% of $108,000 $ (21,600)
Decrease in fixed expenses 15% of $120,000 18,000
Decrease in operating income $ (3,600)
27
 7-38 (p 303) on CVP Relationships (H-10)
1. Closing of Mall store:
Loss of contribution margin at Mall Store $(108,000)
Savings of fixed cost at Mall Store (75% of $120,000) 90,000
Loss of contribution margin at Downtown Store (10% of $144,000) (14,400)
Total decrease in operating income $(32,400)
Increase in Sales and Increase in Fixed costs
2. Promotional campaign:
Increase in contribution margin (10% of $108,000) $ 10,800
Increase in monthly promotional expenses ($180,000/12) (15,000)
Decrease in operating income $(4,200)

3. Elimination of items sold at their variable cost

We can restate the November 20x4 data for the Mall Store as follows:
If Variable cost items are Eliminated Mall Store
*$180,000 is one half of the Mall Store's dollar sales for Items Sold at their
November 20x4 Variable Cost Other items
Sales $ 180,000 $ 180,000
Less: Variable expenses (Mall store :180 +72 = $252,000) 180,000 72,000
Contribution margin $ - 0- $ 108,000
Decrease in Sales, Decrease in Fixed costs
If the items sold at their variable cost are eliminated:
Decrease in contribution margin on other items 20% of $108,000 $ (21,600)
Decrease in fixed expenses 15% of $120,000 18,000
Decrease in operating income $ (3,600)
28
H-10 : 2- 59 – (2) (p 76): Understanding Cost Concepts
 H-10 : 2- 59 – (2) (p 76): Understanding Cost Concepts
2 a. CopyFast Company would be indifferent to acquiring either the small-volume copier, 1500S, or
the medium-volume copier, 1500M, at the point where the costs for 1500S and 1500M are equal.
This point may be calculated using the following formula, where X equals the number of copies:
(Variable costS  X) + fixed costS = (variable costM  X) + fixed costM
1500S 1500M
$.07X + $4,000 = $.045X + $5,500
$.025X = $1,500
X = 60,000 copies
The conclusion is that the company would be indifferent to acquiring either the 1500S or 1500M
machine at an annual volume of 60,000 copies.
2 b. A decision rule for selecting the most profitable copier, when the volume can be estimated, would
establish the points where management is indifferent to each machine. The volume where the costs are
equal between alternatives can be calculated using the following formula, where X equals the number of
copies:
(Variable costS  X) + fixed costS = (variable costM  X) + fixed costM

For the 1500M machine compared to the 1500L machine:

1500M 1500L
$.045X + $5,500 = $.025X + $10,000
$.02X = $4,500
X = 225,000 copies

The decision rule is to select the alternative as shown in the following chart.
Anticipated Annual Volume Optimal Model Choice
060,000 1500S
60,000225,000 1500M
225,000 and higher 1500L 30
 7-54 (p 313) Break Even Analysis (H-10)

31
 7-54 (p 313) Break Even Analysis (H-10)
The break-even point is 16,900 patient-days calculated as follows:
COMPUTATION OF BREAK-EVEN POINT
IN PATIENT-DAYS: PEDIATRICS
FOR THE YEAR ENDED JUNE 30, 20X6
Total fixed costs:
Medical center charges $3,480,000
Supervising nurses ($30,000  4) 120,000
Nurses ($24,000  10) 240,000
Aids ($10,800  20) 216,000
Total fixed costs $4,056,000
Contribution margin per patient-day:
Revenue per patient-day $360
Variable cost per patient-day:
($7,200,000 ÷ $360 = 20,000 patient-days)
($2,400,000 ÷ 20,000 patient-days) 120
Contribution margin per patient-day $240
Break-even point in patient-days total fixed costs $4,056,000
 
contributi on margin per patient - day $240
 16,900 patient days
32
 7-54 continued
2. Net earnings would decrease by $728,000, calculated as follows:
COMPUTATION OF PROFIT OR LOSS FROM RENTAL
OF ADDITIONAL 20 BEDS: PEDIATRICS
FOR THE YEAR ENDED JUNE 30, 20X6
A) Increase in revenue
(20 additional beds  90 days  $360 charge per day) $648,000
Increase in expenses:
Variable charges by medical center
(20 additional beds  90 days  $120 per day) $216,000
Fixed charges by medical center
($3,480,000  60 beds = $58,000 per bed)
($58,000  20 beds) 1160,000
Salaries
(20,000 patient-days before additional 20 beds + 20 additional
beds  90 days = 21,800, which does not exceed 22,000 patient-days;
therefore, no additional personnel are required) - 0 -
B) Total increase in expenses ($1,376,000)

Net change in earnings from rental of additional 20 beds (A)- (B) $(728,000)

33
 7-54 continued
2. Net earnings would decrease by $728,000, calculated as follows:
COMPUTATION OF PROFIT OR LOSS FROM RENTAL
OF ADDITIONAL 20 BEDS: PEDIATRICS
FOR THE YEAR ENDED JUNE 30, 20X6
A) Increase in revenue
(20 additional beds  90 days  $360 charge per day) $648,000
Increase in expenses:
Variable charges by medical center
(20 additional beds  90 days  $120 per day) $216,000
Fixed charges by medical center
($3,480,000  60 beds = $58,000 per bed)
($58,000  20 beds) 1160,000
Salaries
(20,000 patient-days before additional 20 beds + 20 additional
beds  90 days = 21,800, which does not exceed 22,000 patient-days;
therefore, no additional personnel are required) - 0 -
B) Total increase in expenses ($1,376,000)

Net change in earnings from rental of additional 20 beds (A)- (B) $(728,000)

34
Self-Study Problems
7-46 (p350)

36
 7-46 (p350)
$1,250,000  $750,000 4. Number of sales units required to earn target net profit,
1. Unit contribution margin  given the manufacturing changes
25,000 units
Sales=25*50,000 =1250,000  $20 per unit new fixed costs  target net profit

VC= $(1050,000-300,000) new unit contributi on margin
fixed costs $306,000  $200,000 *
Break - even point (in units)  
unit contribution margin $16
 31,625 units *Last year's profit:
$300,000 ($25)(50,000) – $1050,000
  15,000 units
$20 = $200,000
2. Number of sales units required to earn target net profit
fixed costs  target net profit unit contributi on margin
 Contributi on - margin ratio 
unit contributi on margin sales price
$20
Old contributi on - margin ratio   .40
$300,000  $280,000 $50 *
  29,000 units
$20 5. Let P denote the price required to cover increased
DM cost & maintain the same CM ratio:
new fixed costs
3. New break - even point (in units)  P  $30 *  $4 †
new unit contributi on margin  .40
P
$300,000  ($36,000/6 ) * P  $34  .40 P
  19,125 units .60 P  $34
$20  $4 †
P  $56.67 (rounded)
*Annual straight-line depreciation on new machine
†$4.00 = $9 – $5 increase in the unit cost of the new part *Old VC pu = $30 = $750,000  25,000
Increase in direct-material cost = $4
$56.67  $30  $4
New contribution - margin ratio 
Changes in Fixed expenses and VC pu on BEP (units) $56.67
 .40 (rounded)
37
7-35 (p302)
1 fixed costs
Break - even point (in units) 
unit contributi on margin
$702,000
  135,000 units
$25.00  $19.80

fixed cost
2 Break - even point (in sales dollars) 
contributi on - margin ratio
$702,000
  $3,375,000
$25.00  $19.80
$25.00

3. Number of sales units required fixed costs  target net profit


to earn target net profit unit contributi on margin
$702,000  $390,000
  210,000 units
$25.00  $19.80

4 Margin of safety = budgeted sales revenue – break-even sales revenue

= (140,000)($25) – $3,375,000 = $125,000

5 Break-even point if direct-labor costs increase by 10 percent:

New unit = $25.00 – $8.20 – ($4.00)(1.10) – $6.00 – $1.60
contribution margin
= $4.80

fixed costs
Break-even point 
new unit contributi on margin
$702,000
  146,250 units
$4.80

38
7-47 (p 309)

39
1. Memorandum
Date: Today
To: Vice President for Manufacturing, Saturn Game Company
From: I.M. Student, Controller
Subject: Activity-Based Costing

The $300,000 cost that has been characterized as fixed is fixed with respect to sales volume. This cost will not
increase with increases in sales volume. However, as the activity-based costing analysis demonstrates, these
costs are not fixed with respect to other important cost drivers. This is the difference between a traditional
costing system and an ABC system. The latter recognizes that costs vary with respect to a variety of cost
drivers, not just sales volume.

2. New break-even point if automated manufacturing equipment is installed:

Sales price $52
Costs that are variable (with respect to sales volume):
Unit variable cost (.8 × $750,000 ÷25,000) 24
Unit contribution margin $28

Costs that are fixed (with respect to sales volume):

Setup (300 setups at $100 per setup) 30,000
Engineering (800 hours at $56 per hour) 44,800
Inspection (100 inspections at $90 per inspection) 9,000
General factory overhead 3,32,200
Total 4,16,000
Fixed selling and administrative costs 60,000
Total costs that are fixed (with respect to sales volume) $476,000
40
3. Sales (in units) required to show a profit of $280,000:
Number of sales units required to earn target net profit  fixed cost  target net profit
unit contributi on margin
$476,000  $280,000

$28
 27,000 units
4. If management adopts the new manufacturing technology:

(a) Its break-even point will be higher (17,000 units instead of 15,000 units).

(b) The number of sales units required to show a profit of $280,000 will be lower (27,000 units instead of 29,000
units).

(c) These results are typical of situations where firms adopt advanced manufacturing equipment and practices. The
break-even point increases because of the increased fixed costs due to the large investment in equipment.
However, at higher levels of sales after fixed costs have been covered, the larger unit contribution margin ($28
instead of $20) earns a profit at a faster rate. This results in the firm needing to sell fewer units to reach a given
target profit level.

5. The controller should include the break-even analysis in the report. The Board of Directors needs a complete
picture of the financial implications of the proposed equipment acquisition. The break-even point is a relevant
piece of information. The controller should accompany the break-even analysis with an explanation as to why
the break-even point will increase. It would also be appropriate for the controller to point out in the report that
the advanced manufacturing equipment would require fewer sales units at higher volumes in order to achieve a
given target profit, as in requirement (3) of this problem.

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Thanks

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