Cost Volume Profit Relationship

Solving a problem
 Consider the following problem :

Due to erratic sales of its sole product a high-capacity battery for laptop computers -
PEM, Inc., has been experiencing difficulty for some time. The company's contribution
format income statement for the most recent month is given below:

Sales (13,400 units * $40 per unit) $536,000

Variable expenses $268,000
Contribution margin $268,000
Fixed expenses $298,000
Net operating loss $(30,000)
 Required:
1. Compute the company's CM ratio and its break-even point in both unit sales and dollar
sales.
2. The president believes that a $6,500 increase in the monthly advertising budget,
combined with an intensified effort by the sales staff, will result in an $80,000 increase in
monthly sales. If the president is right, what will be the effect on the company's monthly
net operating income or loss? (Use the incremental approach in preparing your answer.)
3. Refer to the original data. The sales manager is convinced that a 10% reduction in the
selling price, combined with an increase of $39,000 in the monthly advertising budget, will
double unit sales. What will the new contribution format income statement look like if
these changes are adopted?
4. Refer to the original data. The Marketing Department thinks that a fancy new package
for the laptop computer battery would help sales. The new package would increase
packaging costs by 40 cents per unit. Assuming no other changes, how many units would
have to be sold each month to earn a profit of $4,600?
5. Refer to the original data. By automating, the company could reduce variable
expenses in half. However, fixed expenses would increase by $51,000 each month.
a. Compute the new CM ratio and the new break-even point in both unit sales and dollar
sales.
b. Assume that the company expects to sell 20,500 units next month. Prepare two
contribution format income statements, one assuming that operations are not automated
and one assuming that they are.
c. Would you recommend that the company automate its operations? Explain.
 Requirement no: 1
Compute the company's CM ratio and its break-even point in both unit sales
and dollar sales.

CM ratio:
=Contribution margin/Sales
= 268 000/536 000
= 50%
Break-even point (Units):
=Fixed Costs/Contribution margin per unit
= 298 000/20
= 14 900 units
(Contribution margin per unit = $268 000/ 13 400 units = $20)
Break-even point ($):
= Break-even units x selling price
= 14 900 units x $40 per unit
= $596 000
 Requirement no: 2
The president believes that a $6,500 increase in the monthly advertising budget, combined with an
intensified effort by the sales staff, will result in an $80,000 increase in monthly sales. If the president is
right, what will be the effect on the company's monthly net operating income or loss? (Use the
incremental approach in preparing your answer.)

Increase in contribution margin:

= Increased sales revenue x CMR
= 80,000 x 50%
= 40,000
Effect on the company’s income/loss:
= Increased CM – Increased FC
= 40,000 – 6,500
= 33,500 (increase in profit/decrease in loss)
 Requirement no: 3
Refer to the original data. The sales manager is convinced that a 10% reduction in the selling price,
combined with an increase of $39,000 in the monthly advertising budget, will double unit sales. What
will the new contribution format income statement look like if these changes are adopted?

New contribution format income statement:

Sales Revenue((13400 x 2) x ($40 x 90%)) 964 800

(Less) Variable Costs ((13400 x 2) x 20) 536 000
Contribution Margin 428 800
(Less) Fixed Expenses($298 000 + $39 000) 337 000
Net Profit 91 800
 Requirement no: 4
Refer to the original data. The Marketing Department thinks that a fancy new package for the laptop
computer battery would help sales. The new package would increase packaging costs by 40 cents per
unit. Assuming no other changes, how many units would have to be sold each month to earn a profit of
$4,600?

Target profit quantity:

= (Fixed costs + Profit)/Contribution per unit
(Since the variable costs per unit have increased, the
contribution margin per unit must be recalculated)
New contribution margin/unit:
= $40 - ($20 + $0.4) = $40 - 20.4 = $19.6
The required sales units:
= ($298 000 + $4 600)/$19.6 = 15 438.8
= 15 439 units
 Requirement no: 5
Refer to the original data. By automating, the company could reduce variable
expenses in half. However, fixed expenses would increase by $51,000 each
month.

a. Compute the new CM ratio and the new break-even point in both unit sales and dollar sales.
b. Assume that the company expects to sell 20,500 units next month. Prepare two contribution
format income statements, one assuming that operations are not automated and one assuming
that they are.
c. Would you recommend that the company automate its operations? Explain.
 Requirement no: 5 (a)
Compute the new CM ratio and the new break-even point in both unit sales and dollar
sales.

New CM ratio:
(New variable expense = (268,000/13,400) x 50%) = 10
(Contribution margin per unit = 40 – 10 = 30)
=Contribution margin per unit/Selling price
= 30/40
= 75%
New Break-even point (Units):
=Fixed Costs/Contribution margin per unit
= (298 000 + 51000)/30
= 11,633.3 ≈ 11,634 units

New Break-even point ($):

= Fixed Costs/Contribution margin ratio
= (298 000 + 51000)/0.75
= $465333
 Requirement no: 5 (b)
Assume that the company expects to sell 20,500 units next month. Prepare two contribution
format income statements, one assuming that operations are not automated and one assuming
that they are.

Income Statement for Income Statement for No

Automation: Automation:
Sales Revenue(20 500 units x $40) 820 000 Sales Revenue(20 500 units x $40) 820 000
(-)Variable Costs (20 500 units x (20/2) 205 000 (-)Variable Costs (20 500 units x (20) 410 000
Contribution Margin 615 000 Contribution Margin 410 000
(-)Fixed Expenses($298 000 + $51 000) 349 000 (-) Fixed Expenses 298 000
Net Profit 266 000 Net Profit 112 000

Requirement no: 5 (c)

Would you recommend that the company automate its operations?

Yes, I would recommend automation

Thank you