Magis Academic Mentors

3-22 CVP computations. Garrett Manufacturing sold 410,000 units of its product for $68 per
unit in 2017. Variable cost per unit is $60, and total fixed costs are $1,640,000.

Required:
1. Calculate (a) contribution margin and (b) operating income.
2. Garrett’s current manufacturing process is labor intensive. Kate Schoenen, Garrett’s
production manager, has proposed investing in state-of-the-art manufacturing equipment,
which will increase the annual fixed costs to $5,330,000. The variable costs are expected to
decrease to $54 per unit. Garrett expects to maintain the same sales volume and selling price
next year. How would acceptance of Schoenen’s proposal affect your answers to (a) and (b)
in requirement 1?
3. Should Garrett accept Schoenen’s proposal? Explain.

SOLUTION

(10–15 min.) CVP computations.

1a. Sales ($68 per unit × 410,000 units) $27,880,000

Variable costs ($60 per unit × 410,000 units) 24,600,000
Contribution margin $ 3,280,000

1b. Contribution margin (from above) $3,280,000

Fixed costs 1,640,000
Operating income $1,640,000

2a. Sales (from above) $27,880,000

Variable costs ($54 per unit × 410,000 units) 22,140,000
Contribution margin $ 5,740,000

2b. Contribution margin $5,740,000

Fixed costs 5,330,000
Operating income $ 410,000

3. Operating income is expected to decrease by $1,230,000 ($1,640,000 − $410,000) if Ms.

Schoenen’s proposal is accepted.
The management would consider other factors before making the final decision. It is
likely that product quality would improve as a result of using state of the art equipment. Due to
increased automation, probably many workers will have to be laid off. Garrett’s management
will have to consider the impact of such an action on employee morale. In addition, the proposal
increases the company’s fixed costs dramatically. This will increase the company’s operating
leverage and risk.

3-1
3-23 CVP analysis, changing revenues and costs. Sunset Travel Agency specializes in flights
between Toronto and Jamaica. It books passengers on Hamilton Air. Sunset’s fixed costs are
$23,500 per month. Hamilton Air charges passengers $1,500 per round-trip ticket.

Calculate the number of tickets Sunset must sell each month to (a) break even and (b) make a
target operating income of $10,000 per month in each of the following independent cases.

Required:
1. Sunset’s variable costs are $43 per ticket. Hamilton Air pays Sunset 6% commission on
ticket price.
2. Sunset’s variable costs are $40 per ticket. Hamilton Air pays Sunset 6% commission on
ticket price.
3. Sunset’s variable costs are $40 per ticket. Hamilton Air pays $60 fixed commission per ticket
to Sunset. Comment on the results.
4. Sunset’s variable costs are $40 per ticket. It receives $60 commission per ticket from
Hamilton Air. It charges its customers a delivery fee of $5 per ticket. Comment on the
results.

SOLUTION

(35–40 min.) CVP analysis, changing revenues and costs.

1a. SP = 6% × $1,500 = $90 per ticket

VCU = $43 per ticket
CMU = $90 – $43 = $47 per ticket
FC = $23,500 a month

FC $23,500
Q = =
CMU $47 per ticket

= 500 tickets

FC + TOI $23,500 + $10,000

1b. Q = =
CMU $47 per ticket

$33,500
=
$47 per ticket
= 713 tickets

2a. SP = 6% × $1,500 = $90 per ticket

VCU = $40 per ticket
CMU = $90 – $40 = $50 per ticket
FC = $23,500 a month

3-2
 FC $23,500
Q = =
CMU $50 per ticket

= 470 tickets

FC + TOI $23,500 + $10,000

2b. Q = =
CMU $50 per ticket

$33,500
=
$50 per ticket
= 670 tickets

3a. SP = $60 per ticket

VCU = $40 per ticket
CMU = $60 – $40 = $20 per ticket
FC = $23,500 a month

FC $23,500
Q = =
CMU $20 per ticket
= 1,175 tickets

FC + TOI $23,500 + $10,000

3b. Q = =
CMU $20 per ticket

$33,500
=
$20 per ticket

= 1,675 tickets

The reduced commission sizably increases the breakeven point and the number of tickets
required to yield a target operating income of $10,000:

6%
Commission Fixed
(Requirement 2) Commission of $60
Breakeven point 470 1,175
Attain OI of $10,000 670 1,675

4a. The $5 delivery fee can be treated as either an extra source of revenue (as done below) or
as a cost offset. Either approach increases CMU $5:

SP = $65 ($60 + $5) per ticket

VCU = $40 per ticket
CMU = $65 – $40 = $25 per ticket
FC = $23,500 a month

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 FC $23,500
Q = =
CMU $25 per ticket

= 940 tickets

FC + TOI $23,500 + $10,000

4b. Q = =
CMU $25 per ticket

$33,500
=
$25 per ticket

= 1.340 tickets

The $5 delivery fee results in a higher contribution margin, which reduces both the breakeven
point and the tickets sold to attain operating income of $10,000.

3-27 CVP analysis, income taxes. The Home Style Eats has two restaurants that are open 24
hours a day. Fixed costs for the two restaurants together total $430,500 per year. Service varies
from a cup of coffee to full meals. The average sales check per customer is $8.75. The average
cost of food and other variable costs for each customer is $3.50. The income tax rate is 36%.
Target net income is $117,600.

Required:
1. Compute the revenues needed to earn the target net income.
2. How many customers are needed to break even? To earn net income of $117,600?
3. Compute net income if the number of customers is 170,000.

SOLUTION

(20–25 min.) CVP analysis, income taxes.

1. Variable cost percentage is $3.50 ÷ $8.75 = 40%

Let R = Revenues needed to obtain target net income
$117, 600
R – 0.40R – $430,500 =
1 - 0.36
0.60R = $430,500 + $183,750
R = $614,250 ÷ 0.60
R = $1,023,750

Fixed costs + Target operating income

or, Target revenues =
Contribution margin percentage

3-4
 Target net income $117, 600
Fixed costs + $430, 000 +
Target revenues = 1 - Tax rate = 1 - 0.36 = $1, 023, 750
Contribution margin percentage 0.60

Proof: Revenues $1,023,750

Variable costs (at 40%) 409,500
Contribution margin 614,250
Fixed costs 430,500
Operating income 183,750
Income taxes (at 36%) 66,150
Net income $ 117,600

2.a. Customers needed to break even:

Contribution margin per customer = $8.75 – $3.50 = $5.25
Breakeven number of customers = Fixed costs ÷ Contribution margin per customer
= $430,500 ÷ $5.25 per customer
= 82,000 customers

2.b. Customers needed to earn net income of $117,600:

Total revenues ÷ Sales check per customer
$1,023,750 ÷ $8.75 = 117,000 customers

3. Using the shortcut approach:

æ Change in ö æ Unit ö
Change in net income = ç number of ÷ ´ ç contribution ÷ ´ (1 - Tax rate )
ç customers ÷ ç margin ÷
è ø è ø
= (170,000 – 117,000) ´ $5.25 ´ (1 – 0.36)
= $278,250 ´ 0.64 = $178,080
New net income = $178,080 + $117,600 = $295,680

Alternatively, with 170,000 customers,

Operating income = Number of customers ´ Selling price per customer
– Number of customers ´ Variable cost per customer – Fixed costs
= 170,000 ´ $8.75 – 170,000 ´ $3.50 – $430,500 = $462,000
Net income = Operating income × (1 – Tax rate) = $462,000 × 0.64 = $295,680

The alternative approach is:

Revenues, 170,000 ´ $8.75 $1,487,500
Variable costs at 40% 595,000
Contribution margin 892,500
Fixed costs 430,500
Operating income 462,000
Income tax at 36% 166,320
Net income $ 295,680

3-5
3-28 CVP analysis, sensitivity analysis. Perfect Fit Jeans Co. sells blue jeans wholesale to
major retailers across the country. Each pair of jeans has a selling price of $50 with $35 in
variable costs of goods sold. The company has fixed manufacturing costs of $2,250,000 and fixed
marketing costs of $250,000. Sales commissions are paid to the wholesale sales reps at 10% of
revenues. The company has an income tax rate of 20%.

Required:
1. How many jeans must Perfect Fit sell in order to break even?
2. How many jeans must the company sell in order to reach:
a. a target operating income of $420,000?
b. a net income of $420,000?
3. How many jeans would Perfect Fit have to sell to earn the net income in requirement 2b if:
(Consider each requirement independently.)
a. the contribution margin per unit increases by 10%.
b. the selling price is increased to $51.50.
c. the company outsources manufacturing to an overseas company increasing variable costs
per unit by $2.00 and saving 70% of fixed manufacturing costs.

SOLUTION

CVP analysis, sensitivity analysis.

1. CMU = $50−$35−(0.10 × $50) = $10

FC $2,500,000
Q = =
CMU $10 per pair
= 250,000 pairs
Note: No income taxes are paid at the breakeven point because operating income is $0.

FC + TOI $2,500,000 + $420,000

2a. Q = =
CMU $10 per pair

$2,920,000
=
$10 per pair
= 292,000 pairs

Target net income $420, 000 $420, 000

2b. Target operating income = = = = $525,000
1 - tax rate (1 - 0.20) 0.80
Quantity of output units Fixed costs + Target operating income $2,500, 000 + $525, 000
required to be sold = =
Contribution margin per unit $10

= 302,500 pairs

3a. Contribution margin per unit increases by 10%

Contribution margin per unit = $10 × 1.10 = $11

3-6
 Quantity of output units Fixed costs + Target operating income $2,500, 000 + $525, 000
required to be sold = =
Contribution margin per unit $11

= 275,000 pairs

The net income target in units decreases from 302,500 pairs in requirement 2b to 275,000 pairs.

3b. Increasing the selling price to $51.50

Contribution margin per unit = $51.50 − $35 − (0.10 × $51.50) = $11.35

Quantity of output units Fixed costs + Target operating income $2,500, 000 + $525, 000
required to be sold = =
Contribution margin per unit $11.35

= 266,520 pairs (rounded)

The net income target in units decreases from 302,500 pairs in requirement 2b to 266,520 pairs.

3c. Increase variable costs by $2 per unit and decrease fixed manufacturing costs by 70%.
Contribution margin per unit = $50 – $37 ($35 + $2) – (0.10 × $50) = $8
Fixed manufacturing costs = (1 – 0.7) × $2,250,000 = $675,000
Fixed marketing costs = $250,000
Total fixed costs = $675,000 + $250,000 = $925,000

Quantity of output units Fixed costs + Target operating income $925, 000 + $525, 000
required to be sold = =
Contribution margin per unit $8

= 181,250 pairs
The net income target in units decreases from 302,500 pairs in requirement 2b to 181,250 pairs.

3-29 CVP analysis, margin of safety. Suppose Morrison Corp.’s breakeven point is revenues of
$1,100,000. Fixed costs are $660,000.

Required:
1. Compute the contribution margin percentage.
2. Compute the selling price if variable costs are $16 per unit.
3. Suppose 75,000 units are sold. Compute the margin of safety in units and dollars.
4. What does this tell you about the risk of Morrison making a loss? What are the most likely
reasons for this risk to increase?

SOLUTION

(10 min.) CVP analysis, margin of safety.

Fixed costs
1. Breakeven point revenues =
Contribution margin percentage

3-7
 $660,000
Contribution margin percentage = = 0.60 or 60%
$1,100,000
Selling price - Variable cost per unit
2. Contribution margin percentage =
Selling price
SP - $16
0.60 =
SP
0.60 SP = SP – $16
0.40 SP = $16
SP = $40
3. Breakeven sales in units = Revenues ÷ Selling price = $1,100,000 ÷ $40 = 27,500 units
Margin of safety in units = Sales in units – Breakeven sales in units
= 75,000 – 27,500 = 47,500 units

Revenues, 75,000 units ´ $40 $3,000,000

Breakeven revenues 1,100,000
Margin of safety $1,900,000

4. The risk of making a loss is low. Sales would need to decrease by 47,500 units ÷ 75,000 units
= 63.33% before Morrison Corp. will make a loss. The most likely reasons for this risk to
increase is greater competition, weakness in the economy, or bad management.

3-8