Cost Behavior

Cost behavior refers to the manner in which a cost changes as a related activity changes.
Variable Costs When the level of activity is measured in units produced, direct materials and direct labor
costs are generally classified as variable costs.
Variable costs are costs that vary in proportion to changes in the level of activity. For example, assume
that Jason Inc. produces stereo sound systems under the brand name of J-Sound. The parts for the stereo
systems are purchased from outside suppliers for $10 per unit and are assembled in Jason Inc.’s Waterloo
plant. The direct materials costs for Model JS-12 for the relevant range of 5,000 to 30,000 units of pro -
duction are shown below

Number of Units of Direct Materials Total Direct

Model JS-12 Produced Cost per Unit Materials Cost
5,000 units $10 $50,000
10,000 10 100,000
15,000 10 150,000
20,000 10 200,000
25,000 10 250,000
30,000 10 300,000

Variable costs are the same per unit, while the total variable cost changes in proportion to changes in the
activity base. For Model JS-12, for example, the direct materials cost for 10,000 units ($100,000) is twice
the direct materials cost for 5,000 units ($50,000). The total direct materials cost varies in proportion to
the number of units produced because the direct materials cost per unit ($10) is the same for all levels of
production. Thus, producing 20,000 additional units of JS-12 will increase the direct materials cost by
$200,000 (20,000 _ $10), producing 25,000 additional units will increase the materials cost by $250,000,
and so on.

Fixed Costs
Fixed costs are costs that remain the same in total dollar amount as the level of activity changes. To illus -
trate, assume that Minton Inc. manufactures, bottles, and distributes La Fleur Perfume at its Los Angeles
plant. The production supervisor at the Los Angeles plant is Jane Sovissi, who is paid a salary of $75,000
per year. The relevant range of activity for a year is 50,000 to 300,000 bottles of perfume. Sovissi’s salary
is a fixed cost that does not vary with the number of units produced. Regardless of the number of bottles
produced within the range of 50,000 to 300,000 bottles, Sovissi receives a salary of $75,000.

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Solutions Manual, Chapter 6 1
Although the total fixed cost remains the same as the number of bottles produced changes, the fixed cost
per bottle changes. As more bottles are produced, the total fixed costs are spread over a larger number of
bottles, and thus the fixed cost per bottle decreases. This relationship is shown below for Jane Sovissi’s
$75,000 salary.

Number of Bottles Total Salary for Salary per Bottle

of Perfume Produced Jane Sovissi of Perfume Produced
50,000 bottles $75,000 $1.500
100,000 75,000 0.750
150,000 75,000 0.500
200,000 75,000 0.375
250,000 75,000 0.300
300,000 75,000 0.250

Variable cost per unit = Difference in total cost

Difference in production

Variable cost per unit = $20,25 = $15

1,350 units

The fixed cost will be the same at both the highest and the lowest levels of production. Thus, the fixed
cost can be estimated at either of these levels. This is done by subtracting the estimated total variable cost
from the total cost, using the following total cost equation:
Total cost _ (Variable cost per unit _ Units of production) _ Fixed cost
Highest level:
$61,500 _ ($15 x2,100 units) = Fixed cost
$61,500 _ $31,500 = Fixed cost
$30,000 = Fixed cost
Lowest level:
$41,250 _ ($15 x 750 units) = Fixed cost
$41,250 _ $11,250 = Fixed cost
$30,000 = Fixed cost

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2 Managerial Accounting, 12th Edition
The total equipment maintenance cost for Kason Inc. can thus be analyzed as a
$30,000 fixed cost and a $15-per-unit variable cost. Using these amounts in the total cost equation, the to-
tal equipment maintenance cost at other levels of production can be estimated.

Cost-Volume-Profit Relationships
After costs have been classified as fixed and variable, their effect on revenues, volume, and profits can be
studied by using cost-volume-profit analysis. Cost-volumeprofit analysis is the systematic examination
of the relationships among selling prices, sales and production volume, costs, expenses, and profits. Cost-
volume-profit analysis provides management with useful information for decision making. For example,
cost-volume-profit analysis may be used in setting selling prices, selecting the mix of products to sell,
choosing among marketing strategies, and analyzing the effects of changes in costs on profits. In today’s
business environment, management must make such decisions quickly and accurately. As a result, the im-
portance of cost-volume-profit analysis has increased in recent years.

Contribution Margin Concept

One relationship among cost, volume, and profit is the contribution margin. The contribution margin is
the excess of sales revenues over variable costs. The contribution margin concept is especially useful in
business planning because it gives insight into the profit potential of a firm. To illustrate, the income
statement of Lambert Inc. in Exhibit 4 has been prepared in a contribution margin format.

Sales $1,000,000
Variable costs 600,000
Contribution margin $ 400,000
Fixed costs 300,000
Income from operations $ 100,000

The contribution margin of $400,000 is available to cover the fixed costs of $300,000. Once the fixed
costs are covered, any remaining amount adds directly to the income from operations of the company.
Consider the graphic to the left. The fixed costs are a bucket and the contribution margin is water filling
the bucket. Once the bucket is filled, the overflow represents income from operations. Up until the point
of overflow, however, the contribution margin contributes to fixed costs (filling the bucket).
Contribution Margin Ratio
The contribution margin can also be expressed as a percentage. The contribution margin ratio, some-
times called the profit-volume ratio, indicates the percentage of each sales dollar available to cover the

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Solutions Manual, Chapter 6 3
fixed costs and to provide income from operations. For Lambert Inc., the contribution margin ratio is
40%, as computed below.

Contribution margin ratio = Sales -Variable costs

Sales
Contribution margin ratio $1,000,000 -_$600,000 = 40%
$1,000,000

The contribution margin ratio measures the effect of an increase or a decrease in sales volume on in-
come from operations. For example, assume that the management of Lambert Inc. is studying the effect of
adding $80,000 in sales orders. Multiplying the contribution margin ratio (40%) by the change in sales
volume ($80,000) indicates that income from operations will increase $32,000 if the additional orders are
obtained. The validity of this analysis is illustrated by the following contribution margin income state -
ment of Lambert Inc.:

Sales $1,080,000
Variable costs ($1,080,000 _ 60%) 648,000
Contribution margin ($1,080,000 _ 40%) $ 432,000
Fixed costs 300,000
Income from operations $ 132,000

Variable costs as a percentage of sales are equal to 100% minus the contribution margin ratio. Thus, in
the above income statement, the variable costs are 60% (100% _ 40%) of sales, or $648,000 ($1,080,000
_ 60%). The total contribution margin, $432,000, can also be computed directly by multiplying the sales
by the contribution margin ratio ($1,080,000 _ 40%). In using the contribution margin ratio in analysis,
factors other than sales volume, such as variable cost per unit and sales price, are assumed to remain con -
stant. If such factors change, their effect must be considered. The contribution margin ratio is also useful
in setting business policy. For example, if the contribution margin ratio of a firm is large and production
is at a level below 100% capacity, a large increase in income from operations can be expected from an in -
crease in sales volume. A firm in such a position might decide to devote more effort to sales promotion
because of the large change in income from operations that will result from changes in sales volume. In

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4 Managerial Accounting, 12th Edition
contrast, a firm with a small contribution margin ratio will probably want to give more attention to reduc-
ing costs before attempting to promote sales.

Break-Even Point
The break-even point is the level of operations at which a business’s revenues and expired costs are ex-
actly equal. At break-even, a business will have neither an income nor a loss from operations. The break-
even point is useful in business planning, especially when expanding or decreasing operations.
To illustrate the computation of the break-even point, assume that the fixed costs for Barker Corporation
are estimated to be $90,000. The unit selling price, unit variable cost, and unit contribution margin for
Barker Corporation are as follows:
Unit selling price $25
Unit variable cost 15
Unit contribution margin $10
The break-even point is 9,000 units, which can be computed by using the following equation:

Break-even sales (units) = Fixed cost

Unit contribution margin

Break-even sales (units) = $90,000 = 9,000 units

$10

The following income statement verifies the preceding computation:

Sales (9,000 units _$25) $225,000

Variable costs (9,000 units _$15) 135,000
Contribution margin $ 90,000
Fixed costs 90,000
Income from operations $ 0

The break-even point is affected by changes in the fixed costs, unit variable costs, and the unit selling
price. Next, we will briefly describe the effect of each of these factors on the break-even point.

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Solutions Manual, Chapter 6 5
Effect of Changes in Fixed Costs
Although fixed costs do not change in total with changes in the level of activity, they may change because
of other factors. For example, changes in property tax rates or factory supervisors’ salaries change fixed
costs. Increases in fixed costs will raise the break-even point. Likewise, decreases in fixed costs will
lower the break-even point. To illustrate, assume that Bishop Co. is evaluating a proposal to budget an ad-
ditional $100,000 for advertising. Fixed costs before the additional advertising are estimated at $600,000,
and the unit contribution margin is $20. The break-even point before the additional expense is 30,000
units, computed as follows:

Break-even sales (units) = Fixed costs

Unit contribution

Break-even sales (units) = $600,000 = 30,000 units

$20

If the additional amount is spent, the fixed costs will increase by $100,000 and the break-even point will
increase to 35,000 units, computed as follows:

Break-even sales (units) = Fixed costs

Unit contribution margin

Break-even sales (units) = $700,000 = 35,000 units

$20

The $100,000 increase in the fixed costs requires an additional 5,000 units ($100,000 x $20) of sales to
break even. In other words, an increase in sales of 5,000 units is required in order to generate an addi-
tional $100,000 of total contribution margin (5,000 units _ $20) to cover the increased fixed costs.
Effect of Changes in Unit Variable Costs
Although unit variable costs are not affected by changes in volume of activity, they may be affected by
other factors. For example, changes in the price of direct materials and the wages for factory workers pro-
viding direct labor will change unit variable costs. Increases in unit variable costs will raise the break-
even point. Likewise, decreases in unit variable costs will lower the break-even point. For example, when
fuel prices rise or decline, there is a direct impact on the break-even freight load for the Union Pacific

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6 Managerial Accounting, 12th Edition
railroad. To illustrate, assume that Park Co. is evaluating a proposal to pay an additional 2% commission
on sales to its salespeople as an incentive to increase sales. Fixed costs are estimated at
$840,000, and the unit selling price, unit variable cost, and unit contribution margin before the additional
2% commission are as follows:

Unit selling price $250

Unit variable cost 145
Unit contribution margin $105

The break-even point is 8,000 units, computed as follows:

Break-even sales (units) = Fixed costs
Unit contribution margin

Break-even sales (units) = $840,000 = 8,000 units

$105
If the sales commission proposal is adopted, variable costs will increase by $5 per unit ($250 _ 2%). This
increase in the variable costs will decrease the unit contribution margin by $5 (from $105 to $100). Thus,
the break-even point is raised to 8,400 units, computed as follows:

Break-even sales (units) = Fixed costs

Unit contribution margin

Break-even sales (units) = $840,000 = 8,400 units

$100
At the original break-even point of 8,000 units, the new unit contribution margin of $100 would provide
only $800,000 to cover fixed costs of $840,000. Thus, an additional 400 units of sales will be required in
order to provide the additional $40,000 (400 units _ $100) contribution margin necessary to break even.

Effect of Changes in the Unit Selling Price

Increases in the unit selling price will lower the break-even point, while decreases in the unit selling price
will raise the break-even point. To illustrate, assume that Graham Co. is evaluating a proposal to increase
the unit selling price of its product from $50 to $60. The following data have been gathered:
Current Proposed
Unit selling price $50 $60

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Solutions Manual, Chapter 6 7
Unit variable cost 30 30
Unit contribution margin $20 $30
Total fixed costs $600,000 $600,000
The break-even point based on the current selling price is 30,000 units, computed as follows

Break-even sales (units) = Fixed costs

Unit contribution margin

Break-even sales (units) = $600,000 = 30,000 units

$20
If the selling price is increased by $10 per unit, the break-even point is decreased to 20,000 units, com-
puted as follows:

Break-even sales (units) = Fixed costs

Unit contribution margin

Break-even sales (units) $600,000 = 20,000 units

$30
The increase of $10 per unit in the selling price increases the unit contribution margin by $10. Thus, the
break-even point decreases by 10,000 units (from 30,000 units to 20,000 units).

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8 Managerial Accounting, 12th Edition
1. The new income statement would be:
Total Per Unit
Sales (8,050 units)................. $209,300 $26.00
Variable expenses.................. 144,900 18.00
Contribution margin.............. 64,400 $ 8.00
Fixed expenses....................... 56,000
Net operating income............ $ 8,400
You can get the same net operating income using the following approach.
Original net operating income................. $8,000
Change in contribution margin
(50 units × $8.00 per unit).................... 400
New net operating income....................... $8,400

2. The new income statement would be:

Total Per Unit
Sales (7,950 units).......................... $206,700 $26.00
Variable expenses........................... 143,100 18.00
Contribution margin....................... 63,600 $ 8.00
Fixed expenses................................ 56,000
Net operating income..................... $ 7,600
You can get the same net operating income using the following approach.
Original net operating income................................ $8,000
Change in contribution margin
(-50 units × $8.00 per unit)................................. (400)
New net operating income...................................... $7,600
Exercise 6-1 (continued)

3. The new income statement would be:

Total Per Unit
Sales (7,000 units).................... $182,000 $26.00
Variable expenses..................... 126,000 18.00
Contribution margin................. 56,000 $ 8.00
Fixed expenses.......................... 56,000
Net operating income............... $ 0
Note: This is the company's break-even point.

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10 Managerial Accounting, 12th Edition
Exercise 6-2 (20 minutes)

1. The CVP graph can be plotted using the three steps outlined in the text. The graph appears on
the next page.
Step 1. Draw a line parallel to the volume axis to represent the total fixed expense. For
this company, the total fixed expense is $12,000.
Step 2. Choose some volume of sales and plot the point representing total expenses (fixed
and variable) at the activity level you have selected. We’ll use the sales level of 2,000 units.
Fixed expense................................................................................. $12,000
Variable expense (2,000 units × $24 per unit)............................... 48,000
Total expense.................................................................................. $60,000

Step 3. Choose some volume of sales and plot the point representing total sales dollars at
the activity level you have selected. We’ll use the sales level of 2,000 units again.
Total sales revenue (2,000 units × $36 per unit)............................ $72,000

2. The break-even point is the point where the total sales revenue and the total expense lines
intersect. This occurs at sales of 1,000 units. This can be verified by solving for the break-
even point in unit sales, Q, using the equation method as follows:
Sales = Variable expenses + Fixed expenses + Profits
$36Q = $24Q + $12,000 + $0
$12Q = $12,000
Q = $12,000 ÷ $12 per unit
Q = 1,000 units
Exercise 6-2 (continued)

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12 Managerial Accounting, 12th Edition
Exercise 6-3 (10 minutes)

1. The company’s contribution margin (CM) ratio is:

Total sales............................................. $300,000
Total variable expenses........................ 240,000
= Total contribution margin.................. 60,000
÷ Total sales.......................................... $300,000
= CM ratio............................................ 20%

2. The change in net operating income from an increase in total sales of $1,500 can be
estimated by using the CM ratio as follows:
Change in total sales......................................... $1,500
× CM ratio........................................................ 20%
= Estimated change in net operating income.... $ 300
This computation can be verified as follows:
Total sales................................. $300,000
÷ Total units sold...................... 40,000 units
= Selling price per unit............. $7.50 per unit

Increase in total sales................ $1,500

÷ Selling price per unit............. $7.50 per unit
= Increase in unit sales............. 200 units
Original total unit sales............. 40,000 units
New total unit sales.................. 40,200 units
Original New
Total unit sales.......................... 40,000 40,200
Sales.......................................... $300,000 $301,500
Variable expenses..................... 240,000 241,200
Contribution margin................. 60,000 60,300
Fixed expenses.......................... 45,000 45,000
Net operating income............... $ 15,000 $ 15,300
Exercise 6-4 (20 minutes)

1. The following table shows the effect of the proposed change in monthly advertising budget:
Sales With
Additional
Current Advertising
Sales Budget Difference
Sales.......................................... $225,000 $240,000 $15,000
Variable expenses..................... 135,000 144,000 9,000
Contribution margin................. 90,000 96,000 6,000
Fixed expenses.......................... 75,000 83,000 8,000
Net operating income............... $ 15,000 $ 13,000 $(2,000)
Assuming that there are no other important factors to be considered, the increase in the
advertising budget should not be approved since it would lead to a decrease in net operating
income of $2,000.

Alternative Solution 1
Expected total contribution margin:
$240,000 × 40% CM ratio..................................... $96,000
Present total contribution margin:
$225,000 × 40% CM ratio..................................... 90,000
Incremental contribution margin............................... 6,000
Change in fixed expenses:
Less incremental advertising expense.................... 8,000
Change in net operating income................................ $(2,000)

Alternative Solution 2
Incremental contribution margin:
$15,000 × 40% CM ratio...................................... $ 6,000
Less incremental advertising expense....................... 8,000
Change in net operating income................................ $(2,000)

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14 Managerial Accounting, 12th Edition
Exercise 6-4 (continued)

2. The $3 increase in variable costs will cause the unit contribution margin to decrease from
$30 to $27 with the following impact on net operating income:
Expected total contribution margin with the higher-quality
components:
3,450 units × $27 per unit........................................................ $93,150
Present total contribution margin:
3,000 units × $30 per unit........................................................ 90,000
Change in total contribution margin............................................ $ 3,150
Assuming no change in fixed costs and all other factors remain the same, the higher-quality
components should be used.
Exercise 6-5 (20 minutes)

1. The equation method yields the break-even point in unit sales, Q, as follows:
Sales = Variable expenses + Fixed expenses + Profits
$8Q = $6Q + $5,500 + $0
$2Q = $5,500
Q = $5,500 ÷ $2 per basket
Q = 2,750 baskets

2. The equation method can be used to compute the break-even point in sales dollars, X, as
follows:
Percent of
Per Unit Sales
Sales price.................................... $8 100%
Variable expenses........................ 6 75%
Contribution margin.................... $2 25%
Sales = Variable expenses + Fixed expenses + Profits
X = 0.75X + $5,500 + $0
0.25X = $5,500
X = $5,500 ÷ 0.25
X = $22,000

3. The contribution margin method gives an answer that is identical to the equation method for
the break-even point in unit sales:
Break-even point in units sold = Fixed expenses ÷ Unit CM
= $5,500 ÷ $2 per basket
= 2,750 baskets

4. The contribution margin method also gives an answer that is identical to the equation method
for the break-even point in dollar sales:
Break-even point in sales dollars = Fixed expenses ÷ CM ratio
= $5,500 ÷ 0.25
=$22,000

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16 Managerial Accounting, 12th Edition
Exercise 6-6 (10 minutes)

1. The equation method yields the required unit sales, Q, as follows:

Sales = Variable expenses + Fixed expenses + Profits
$140Q = $60Q + $40,000+ $6,000
$80Q = $46,000
Q = $46,000 ÷ $80 per unit
Q = 575 units

2. The contribution margin yields the required unit sales as follows:

Exercise 6-7 (10 minutes)

1. To compute the margin of safety, we must first compute the break-even unit sales.
Sales = Variable expenses + Fixed expenses + Profits
$25Q = $15Q + $8,500 + $0
$10Q = $8,500
Q = $8,500 ÷ $10 per unit
Q = 850 units
Sales (at the budgeted volume of 1,000 units)......................... $25,000
Break-even sales (at 850 units)................................................. 21,250
Margin of safety (in dollars)..................................................... $ 3,750

2. The margin of safety as a percentage of sales is as follows:

Margin of safety (in dollars)............................................ $3,750
÷ Sales.............................................................................. $25,000
Margin of safety as a percentage of sales........................ 15.0%

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18 Managerial Accounting, 12th Edition
Exercise 6-8 (20 minutes)

1. The company’s degree of operating leverage would be computed as follows:

Contribution margin............................. $36,000
÷ Net operating income........................ $12,000
Degree of operating leverage................ 3.0

2. A 10% increase in sales should result in a 30% increase in net operating income, computed
as follows:
Degree of operating leverage................................................................ 3.0
× Percent increase in sales.................................................................... 10%
Estimated percent increase in net operating income............................ 30%

3. The new income statement reflecting the change in sales would be:
Percent of
Amount Sales
Sales.......................................... $132,000 100%
Variable expenses..................... 92,400 70%
Contribution margin................. 39,600 30%
Fixed expenses.......................... 24,000
Net operating income............... $ 15,600
Net operating income reflecting change in sales............................... $15,600
Original net operating income........................................................... $12,000
Percent change in net operating income............................................ 30%
Exercise 6-9 (20 minutes)

1. The overall contribution margin ratio can be computed as follows:

2. The overall break-even point in sales dollars can be computed as follows:

3. To construct the required income statement, we must first determine the relative sales mix for
the two products:
Predator Runway Total
Original dollar sales.................. $100,000 $50,000 $150,000
Percent of total.......................... 67% 33% 100%
Sales at break-even................... $75,000 $37,500 $112,500
Predator Runway Total
Sales.......................................... $75,000 $37,500 $112,500
Variable expenses*................... 18,750 3,750 22,500
Contribution margin................. $56,250 $33,750 90,000
Fixed expenses.......................... 90,000
Net operating income............... $ 0
*Predator variable expenses: ($75,000/$100,000) × $25,000 = $18,750
Runway variable expenses: ($37,500/$50,000) × $5,000 = $3,750

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20 Managerial Accounting, 12th Edition
Exercise 6-10 (30 minutes)

1. Sales = Variable expenses + Fixed expenses + Profits

$40Q = $28Q + $150,000 + $0
$12Q = $150,000
Q = $150,000 ÷ $12 per unit
Q = 12,500 units, or at $40 per unit, $500,000

Alternatively:

or, at $40 per unit, $500,000.

2. The contribution margin at the break-even point is $150,000 since at that point it must equal
the fixed expenses.

Total Unit
Sales (14,000 units × $40 per unit)...................................... $560,000 $40
Variable expenses
(14,000 units × $28 per unit)............................................ 392,000 28
Contribution margin
(14,000 units × $12 per unit)............................................ 168,000 $12
Fixed expenses..................................................................... 150,000
Net operating income........................................................... $ 18,000
Exercise 6-10 (continued)

4. Margin of safety in dollar terms:

Margin of safety in percentage terms:

5. The CM ratio is 30%.

Expected total contribution margin: $680,000 × 30%.............................. $204,000
Present total contribution margin: $600,000 × 30%.................................. 180,000
Increased contribution margin................................................................... $ 24,000

Alternative solution:
$80,000 incremental sales × 30% CM ratio = $24,000
Since in this case the company’s fixed expenses will not change, monthly net operating
income will increase by the amount of the increased contribution margin, $24,000.

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22 Managerial Accounting, 12th Edition
Exercise 6-11 (30 minutes)

1. The contribution margin per person would be:

Price per ticket.............................................................................. $30
Variable expenses:
Dinner....................................................................................... $7
Favors and program.................................................................. 3 10
Contribution margin per person................................................... $20
The fixed expenses of the Extravaganza total $8,000; therefore, the break-even point would
be computed as follows:
Sales = Variable expenses + Fixed expense + Profits
$30Q = $10Q + $8,000 + $0
$20Q = $8,000
Q = $8,000 ÷ $20 per person
Q = 400 persons; or, at $30 per person, $12,000

Alternative solution:

or, at $30 per person, $12,000.

2. Variable cost per person ($7 + $3)................................................. $10

Fixed cost per person ($8,000 ÷ 250 persons)................................ 32
Ticket price per person to break even............................................. $42
Exercise 6-11 (continued)

3. Cost-volume-profit graph:

Total Sales

Break-even point: 400 persons,

or $12,000 in sales

Total Expenses

Fixed Expenses

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24 Managerial Accounting, 12th Edition
Exercise 6-12 (20 minutes)

Total Per Unit

1. Sales (30,000 units × 1.15 = 34,500 units)......................... $172,500 $5.00
Variable expenses............................................................... 103,500 3.00
Contribution margin........................................................... 69,000 $2.00
Fixed expenses.................................................................... 50,000
Net operating income......................................................... $ 19,000

2. Sales (30,000 units × 1.20 = 36,000 units)......................... $162,000 $4.50

Variable expenses............................................................... 108,000 3.00
Contribution margin........................................................... 54,000 $1.50
Fixed expenses.................................................................... 50,000
Net operating income......................................................... $ 4,000

3. Sales (30,000 units × 0.95 = 28,500 units)......................... $156,750 $5.50

Variable expenses............................................................... 85,500 3.00
Contribution margin........................................................... 71,250 $2.50
Fixed expenses ($50,000 + $10,000).................................. 60,000
Net operating income......................................................... $ 11,250

4. Sales (30,000 units × 0.90 = 27,000 units)......................... $151,200 $5.60

Variable expenses............................................................... 86,400 3.20
Contribution margin........................................................... 64,800 $2.40
Fixed expenses.................................................................... 50,000
Net operating income......................................................... $ 14,800
Exercise 6-13 (20 minutes)

a. Case #1 Case #2
Number of units sold................ 9,000 * 14,000
Sales.......................................... $270,000 * $30 $350,000 * $25
Variable expenses..................... 162,000 * 18 140,000 10
Contribution margin................. 108,000 $12 210,000 $15 *
Fixed expenses.......................... 90,000 * 170,000 *
Net operating income............... $ 18,000 $ 40,000 *

Case #3 Case #4
Number of units sold................ 20,000 * 5,000 *
Sales.......................................... $400,000 $20 $160,000 * $32
Variable expenses................... 280,000 * 14 90,000 18
Contribution margin................. 120,000 $6 * 70,000 $14
Fixed expenses.......................... 85,000 82,000 *
Net operating income............... $ 35,000 * $(12,000) *

b. Case #1 Case #2
Sales.......................................... $450,000 * 100% $200,000 * 100 %
Variable expenses..................... 270,000 60 130,000 * 65
Contribution margin................. 180,000 40%* 70,000 35 %
Fixed expenses.......................... 115,000 60,000 *
Net operating income............... $ 65,000 * $ 10,000

Case #3 Case #4
Sales.......................................... $700,000 100% $300,000 * 100 %
Variable expenses..................... 140,000 20 90,000 * 30
Contribution margin................. 560,000 80%* 210,000 70 %
Fixed expenses.......................... 470,000 * 225,000
Net operating income............... $ 90,000 * $ (15,000) *

*Given

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26 Managerial Accounting, 12th Edition
Exercise 6-14 (30 minutes)

1. Variable expenses: $60 × (100% – 40%) = $36.

2. a. Selling price.......................................... $60 100%

Variable expenses................................. 36 60%
Contribution margin.............................. $24 40%
Let Q = Break-even point in units.
Sales = Variable expenses + Fixed expenses + Profits
$60Q = $36Q + $360,000 + $0
$24Q = $360,000
Q = $360,000 ÷ $24 per unit
Q = 15,000 units
In sales dollars: 15,000 units × $60 per unit = $900,000

Alternative solution:
Let X = Break-even point in sales dollars.
X = 0.60X + $360,000 + $0
0.40X = $360,000
X = $360,000 ÷ 0.40
X = $900,000
In units: $900,000 ÷ $60 per unit = 15,000 units

b. $60Q = $36Q + $360,000 + $90,000

$24Q = $450,000
Q = $450,000 ÷ $24 per unit
Q = 18,750 units
In sales dollars: 18,750 units × $60 per unit = $1,125,000
Exercise 6–14 (continued)

Alternative solution:
X = 0.60X + $360,000 + $90,000
0.40X = $450,000
X = $450,000 ÷ 0.40
X = $1,125,000
In units: $1,125,000 ÷ $60 per unit = 18,750 units

c. The company’s new cost/revenue relationships will be:

Selling price........................................................... $60 100%
Variable expenses ($36 – $3)................................. 33 55%
Contribution margin............................................... $27 45%
$60Q = $33Q + $360,000 + $0
$27Q = $360,000
Q = $360,000 ÷ $27 per unit
Q = 13,333 units (rounded).
In sales dollars: 13,333 units × $60 per unit = $800,000 (rounded)

Alternative solution:
X = 0.55X + $360,000 + $0
0.45X = $360,000
X = $360,000 ÷ 0.45
X = $800,000
In units: $800,000 ÷ $60 per unit = 13,333 units (rounded)

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28 Managerial Accounting, 12th Edition
Exercise 6–14 (continued)

a.

In sales dollars: 15,000 units × $60 per unit = $900,000

Alternative solution:

In units: $900,000 ÷ $60 per unit = 15,000 units

b.

In sales dollars: 18,750 units × $60 per unit = $1,125,000

Alternative solution:

In units: $1,125,000 ÷ $60 per unit = 18,750 units

Exercise 6-14 (continued)

c.

In sales dollars: 13,333 units × $60 per unit = $800,000 (rounded)

Alternative solution:

In units: $800,000 ÷ $60 per unit = 13,333 (rounded)

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30 Managerial Accounting, 12th Edition
Exercise 6-15 (15 minutes)

1. Sales (30,000 doors).......................... $1,800,000 $60

Variable expenses.............................. 1,260,000 42
Contribution margin.......................... 540,000 $18
Fixed expenses................................... 450,000
Net operating income........................ $ 90,000

2. a. Sales of 37,500 doors represents an increase of 7,500 doors, or 25%, over present sales of
30,000 doors. Since the degree of operating leverage is 6, net operating income should
increase by 6 times as much, or by 150% (6 × 25%).

b. Expected total dollar net operating income for the next year is:
Present net operating income....................................................... $ 90,000
Expected increase in net operating income next year (150% ×
$90,000).................................................................................... 135,000
Total expected net operating income........................................... $225,000
Exercise 6-16 (30 minutes)

1. Sales = Variable expenses + Fixed expenses + Profits

$90Q = $63Q + $135,000 + $0
$27Q = $135,000
Q = $135,000 ÷ $27 per lantern
Q = 5,000 lanterns, or at $90 per lantern, $450,000 in sales

Alternative solution:

or at $90 per lantern, $450,000 in sales

2. An increase in the variable expenses as a percentage of the selling price would result in a
higher break-even point. The reason is that if variable expenses increase as a percentage of
sales, then the contribution margin will decrease as a percentage of sales. A lower CM ratio
would mean that more lanterns would have to be sold to generate enough contribution margin
to cover the fixed costs.

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32 Managerial Accounting, 12th Edition
Exercise 6-16 (continued)

Present: Proposed:
3. 8,000 Lanterns 10,000 Lanterns*
Total Per Unit Total Per Unit
Sales............................................. $720,000 $90 $810,000 $81 **
Variable expenses........................ 504,000 63 630,000 63
Contribution margin.................... 216,000 $27 180,000 $18
Fixed expenses............................. 135,000 135,000
Net operating income.................. $ 81,000 $ 45,000

* 8,000 lanterns × 1.25 = 10,000 lanterns

** $90 per lantern × 0.9 = $81 per lantern
As shown above, a 25% increase in volume is not enough to offset a 10% reduction in the
selling price; thus, net operating income decreases.

4. Sales = Variable expenses + Fixed expenses + Profits

$81Q = $63Q + $135,000 + $72,000
$18Q = $207,000
Q = $207,000 ÷ $18 per lantern
Q = 11,500 lanterns

Alternative solution:
Exercise 6-17 (30 minutes)

1. Model A100 Model B900 Total Company

Amount % Amount % Amount %
Sales........................ $700,000 100 $300,000 100 $1,000,000 100
Variable expenses... 280,000 40 90,000 30 370,000 37
Contribution mar-
gin....................... $420,000 60 $210,000 70 630,000 63 *
Fixed expenses........ 598,500
Net operating in-
come.................... $ 31,500
*630,000 ÷ $1,000,000 = 63%.

2. The break-even point for the company as a whole would be:

3. The additional contribution margin from the additional sales can be computed as follows:
$50,000 × 63% CM ratio = $31,500
Assuming no change in fixed expenses, all of this additional contribution margin should drop
to the bottom line as increased net operating income.
This answer assumes no change in selling prices, variable costs per unit, fixed expenses,
or sales mix.

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34 Managerial Accounting, 12th Edition
Problem 6-18 (60 minutes)

1. The CM ratio is 60%:

Selling price.................................... $15 100%
Variable expenses............................ 6 40%
Contribution margin........................ $9 60%

3. $45,000 increased sales × 60% CM ratio = $27,000 increased contribution margin. Since
fixed costs will not change, net operating income should also increase by $27,000.

a.

b. 6 × 15% = 90% increase in net operating income. In dollars, this increase would be 90%
× $36,000 = $32,400.
Problem 6-18 (continued)

5. Last Year: Proposed:

28,000 units 42,000 units*
Total Per Unit Total Per Unit
Sales.......................................... $420,000 $15.00 $567,000 $13.50**
Variable expenses..................... 168,000 6.00 252,000 6.00
Contribution margin................. 252,000 $ 9.00 315,000 $ 7.50
Fixed expenses.......................... 180,000 250,000
Net operating income............... $ 72,000 $ 65,000
* 28,000 units × 1.5 = 42,000 units
** $15 per unit × 0.90 = $13.50 per unit
No, the changes should not be made.

6. Expected total contribution margin:

28,000 units × 200% × $7 per unit*............................................ $392,000
Present total contribution margin:
28,000 units × $9 per unit........................................................... 252,000
Incremental contribution margin, and the amount by which ad-
vertising can be increased with net operating income remain-
ing unchanged............................................................................. $140,000
*$15 – ($6 + $2) = $7

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36 Managerial Accounting, 12th Edition
Problem 6-19 (60 minutes)

1. The CM ratio is 30%.

Total Per Unit Percentage
Sales (13,500 units)...................... $270,000 $20 100%
Variable expenses......................... 189,000 14 70%
Contribution margin..................... $ 81,000 $ 6 30%
The break-even point is:
Sales = Variable expenses + Fixed expenses + Profits
$20Q = $14Q + $90,000 + $0
$ 6Q = $90,000
Q = $90,000 ÷ $6 per unit
Q = 15,000 units
15,000 units × $20 per unit = $300,000 in sales

Alternative solution:

2. Incremental contribution margin:

$70,000 increased sales × 30% CM ratio.................................... $21,000
Less increased fixed costs:
Increased advertising cost........................................................... 8,000
Increase in monthly net operating income...................................... $13,000
Since the company presently has a loss of $9,000 per month, if the changes are adopted, the
loss will turn into a profit of $4,000 per month.
Problem 6-19 (continued)

3. Sales (27,000 units × $18 per unit*)...................................... $486,000

Variable expenses
(27,000 units × $14 per unit).............................................. 378,000
Contribution margin.............................................................. 108,000
Fixed expenses ($90,000 + $35,000)..................................... 125,000
Net operating loss.................................................................. $(17,000)
*$20 – ($20 × 0.10) = $18

4. Sales = Variable expenses + Fixed expenses + Profits

$ 20Q = $14.60Q* + $90,000 + $4,500
$5.40Q = $94,500
Q = $94,500 ÷ $5.40 per unit
Q = 17,500 units

*$14.00 + $0.60 = $14.60.

Alternative solution:

**$6.00 – $0.60 = $5.40.

5. a. The new CM ratio would be:

Per Unit Percentage
Sales.............................................................. $20 100%
Variable expenses.......................................... 7 35%
Contribution margin...................................... $13 65%

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38 Managerial Accounting, 12th Edition
Problem 6-19 (continued)

The new break-even point would be:

b. Comparative income statements follow:

Not Automated Automated
Total Per Unit % Total Per Unit %
Sales (20,000 units)............... $400,000 $20 100 $400,000 $20 100
Variable expenses.................. 280,000 14 70 140,000 7 35
Contribution margin............... 120,000 $6 30 260,000 $13 65
Fixed expenses....................... 90,000 208,000
Net operating income............. $ 30,000 $ 52,000
Problem 6-19 (continued)

c. Whether or not one would recommend that the company automate its operations depends
on how much risk he or she is willing to take, and depends heavily on prospects for future
sales. The proposed changes would increase the company’s fixed costs and its break-even
point. However, the changes would also increase the company’s CM ratio (from 30% to
65%). The higher CM ratio means that once the break-even point is reached, profits will
increase more rapidly than at present. If 20,000 units are sold next month, for example,
the higher CM ratio will generate $22,000 more in profits than if no changes are made.
The greatest risk of automating is that future sales may drop back down to present levels
(only 13,500 units per month), and as a result, losses will be even larger than at present
due to the company’s greater fixed costs. (Note the problem states that sales are erratic
from month to month.) In sum, the proposed changes will help the company if sales
continue to trend upward in future months; the changes will hurt the company if sales
drop back down to or near present levels.
Note to the Instructor: Although it is not asked for in the problem, if time permits you
may want to compute the point of indifference between the two alternatives in terms of
units sold; i.e., the point where profits will be the same under either alternative. At this
point, total revenue will be the same; hence, we include only costs in our equation:
Let Q = Point of indifference in units sold
$14Q + $90,000 = $7Q + $208,000
$7Q = $118,000
Q = $118,000 ÷ $7 per unit
Q = 16,857 units (rounded)
If more than 16,857 units are sold, the proposed plan will yield the greatest profit; if less
than 16,857 units are sold, the present plan will yield the greatest profit (or the least loss).

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40 Managerial Accounting, 12th Edition
Problem 6-20 (30 minutes)

1. Product
Sinks Mirrors Vanities Total
Percentage of total sales........... 32% 40% 28% 100%
Sales.......................................... $160,000 100% $200,000 100% $140,000 100% $500,000 100%
Variable expenses..................... 48,000 30 % 160,000 80 % 77,000 55 % 285,000 57%
Contribution margin................. $112,000 70% $ 40,000 20% $ 63,000 45% 215,000 43%*
Fixed expenses.......................... 223,600
Net operating income (loss)...... $( 8,600)
*$215,000 ÷ $500,000 = 43%.

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Solutions Manual, Chapter 6 41
Problem 6-20 (continued)

2. Break-even sales:

3. Memo to the president:

Although the company met its sales budget of $500,000 for the month, the mix of products
sold changed substantially from that budgeted. This is the reason the budgeted net operating
income was not met, and the reason the break-even sales were greater than budgeted. The
company’s sales mix was planned at 48% Sinks, 20% Mirrors, and 32% Vanities. The actual
sales mix was 32% Sinks, 40% Mirrors, and 28% Vanities.
As shown by these data, sales shifted away from Sinks, which provides our greatest
contribution per dollar of sales, and shifted strongly toward Mirrors, which provides our least
contribution per dollar of sales. Consequently, although the company met its budgeted level
of sales, these sales provided considerably less contribution margin than we had planned,
with a resulting decrease in net operating income. Notice from the attached statements that
the company’s overall CM ratio was only 43%, as compared to a planned CM ratio of 52%.
This also explains why the break-even point was higher than planned. With less average
contribution margin per dollar of sales, a greater level of sales had to be achieved to provide
sufficient contribution margin to cover fixed costs.

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42 Managerial Accounting, 12th Edition
Problem 6-21 (60 minutes)

1. Sales = Variable expenses + Fixed expenses + Profits

$40Q = $25Q + $300,000 + $0
$15Q = $300,000
Q = $300,000 ÷ $15 per shirt
Q = 20,000 shirts
20,000 shirts × $40 per shirt = $800,000

Alternative solution:

2. See the graph on the following page.

3. The simplest approach is:

Break-even sales................................. 20,000 shirts
Actual sales........................................ 19,000 shirts
Sales short of break-even................... 1,000 shirts
1,000 shirts × $15 contribution margin per shirt = $15,000 loss

Alternative solution:
Sales (19,000 shirts × $40 per shirt)...................................................... $760,000
Variable expenses (19,000 shirts × $25 per shirt)................................. 475,000
Contribution margin.............................................................................. 285,000
Fixed expenses...................................................................................... 300,000
Net operating loss.................................................................................. $(15,000)

© The McGraw-Hill Companies, Inc., 2008. All rights reserved.

Solutions Manual, Chapter 6 43
Problem 6-21 (continued)

2. Cost-volume-profit graph:

Total Sales

Break-even point: 20,000 shirts,

or $800,000 in sales
Total Expenses

Fixed Expenses

© The McGraw-Hill Companies, Inc., 2008. All rights reserved.

44 Managerial Accounting, 12th Edition
Problem 6-21 (continued)

4. The variable expenses will now be $28 ($25 + $3) per shirt, and the contribution margin will
be $12 ($40 – $28) per shirt.

Sales = Variable expenses + Fixed expenses + Profits

$40Q = $28Q + $300,000 + $0
$12Q = $300,000
Q = $300,000 ÷ $12 per shirt
Q = 25,000 shirts

25,000 shirts × $40 per shirt = $1,000,000 in sales

Alternative solution:

5. The simplest approach is:

Actual sales.................................................... 23,500 shirts
Break-even sales............................................. 20,000 shirts
Excess over break-even sales......................... 3,500 shirts
3,500 shirts × $12 per shirt* = $42,000 profit
*$15 present contribution margin – $3 commission = $12 per shirt

© The McGraw-Hill Companies, Inc., 2008. All rights reserved.

Solutions Manual, Chapter 6 45
Problem 6-21 (continued)

Alternative solution:
Sales (23,500 shirts × $40 per shirt)................................................ $940,000
Variable expenses [(20,000 shirts × $25 per shirt) + (3,500 shirts
× $28 per shirt)]........................................................................... 598,000
Contribution margin........................................................................ 342,000
Fixed expenses................................................................................ 300,000
Net operating income...................................................................... $ 42,000

6. a. The new variable expense will be $18 per shirt (the invoice price).
Sales = Variable expenses + Fixed expenses + Profits
$40Q = $18Q + $407,000 + $0
$22Q = $407,000
Q = $407,000 ÷ $22 per shirt
Q = 18,500 shirts
18,500 shirts × $40 shirt = $740,000 in sales

b. Although the change will lower the break-even point from 20,000 shirts to 18,500 shirts,
the company must consider whether this reduction in the break-even point is more than
offset by the possible loss in sales arising from having the sales staff on a salaried basis.
Under a salary arrangement, the sales staff may have far less incentive to sell than under
the present commission arrangement, resulting in a loss of sales and a reduction in profits.
Although it generally is desirable to lower the break-even point, management must
consider the other effects of a change in the cost structure. The break-even point could be
reduced dramatically by doubling the selling price per shirt, but it does not necessarily
follow that this would increase the company’s profit.

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46 Managerial Accounting, 12th Edition
Problem 6-22 (45 minutes)

1. Sales (25,000 units × SFr 90 per unit)............................................ SFr 2,250,000

Variable expenses
(25,000 units × SFr 60 per unit).................................................. 1,500,000
Contribution margin....................................................................... 750,000
Fixed expenses................................................................................ 840,000
Net operating loss........................................................................... SFr (90,000)

28,000 units × SFr 90 per unit = SFr 2,520,000 to break even.

3. Unit Unit Vari-

Sales able Ex- Unit Contribution Volume Total Contribu- Net Operating In-
Price pense Margin (Units) tion Margin Fixed Expenses come
SFr 90 SFr 60 SFr 30 25,000 SFr 750,000 SFr 840,000 SFr (90,000)
88 60 28 30,000 840,000 840,000 0
86 60 26 35,000 910,000 840,000 70,000
84 60 24 40,000 960,000 840,000 120,000
82 60 22 45,000 990,000 840,000 150,000
80 60 20 50,000 1,000,000 840,000 160,000
78 60 18 55,000 990,000 840,000 150,000

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Solutions Manual, Chapter 6 47
Problem 6-22 (continued)

Thus, the maximum profit is SFr 160,000. This level of profit can be earned by selling
50,000 units at a selling price of SFr 80 per unit.

4. At a selling price of SFr 80 per unit, the contribution margin is SFr 20 per unit. Therefore:

This break-even point is different from the break-even point in (2) because of the change in
selling price. With the change in selling price, the unit contribution margin drops from SFr 30
to SFr 20, thereby driving up the break-even point.

© The McGraw-Hill Companies, Inc., 2008. All rights reserved.

48 Managerial Accounting, 12th Edition
Problem 6-23 (60 minutes)

1. Sales = Variable expenses + Fixed expenses + Profits

$2.00Q = $0.80Q + $60,000 + $0
$1.20Q = $60,000
Q = $60,000 ÷ $1.20 per pair
Q = 50,000 pairs

50,000 pairs × $2 per pair = $100,000 in sales.

Alternative solution:

2. See the graph on the following page.

3. Sales = Variable expenses + Fixed expenses + Profits

$2.00Q = $0.80Q + $60,000 + $9,000
$1.20Q = $69,000
Q = $69,000 ÷ $1.20 per pair
Q = 57,500 pairs

Alternative solution:

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Solutions Manual, Chapter 6 49
Problem 6-23 (continued)

2. Cost-volume-profit graph:

Total Sales

Break-even point: 50,000 pairs,

or $100,000 in sales

Total Expenses

Fixed Expenses

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50 Managerial Accounting, 12th Edition
Problem 6-23 (continued)

4. Incremental contribution margin:

$20,000 increased sales × 60% CM ratio.................................... $12,000
Less incremental fixed salary cost.................................................. 8,000
Increased net operating income...................................................... $ 4,000
Yes, the position should be converted to a full-time basis.

5. a. Degree of operating leverage:

b. 5 × 20% sales increase = 100% increase in net operating income. Thus, net operating
income would double next year, going from $15,000 to $30,000.

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Solutions Manual, Chapter 6 51
Problem 6-24 (30 minutes)

1. The contribution margin per stein would be:

Selling price.................................................................................... $30
Variable expenses:
Purchase cost of the steins........................................................... $15
Commissions to the student salespersons................................... 6 21
Contribution margin........................................................................ $ 9
Since there are no fixed costs, the number of unit sales needed to yield the desired $7,200 in
profits can be obtained by dividing the target profit by the unit contribution margin:

2. Since an order has been placed, there is now a “fixed” cost associated with the purchase price
of the steins (i.e., the steins can’t be returned). For example, an order of 200 steins requires a
“fixed” cost (investment) of $3,000 (200 steins × $15 per stein = $3,000). The variable costs
drop to only $6 per stein, and the new contribution margin per stein becomes:
Selling price........................................................................ $30
Variable expenses (commissions only)............................... 6
Contribution margin............................................................ $24

Since the “fixed” cost of $3,000 must be recovered before Mr. Marbury shows any profit, the
break-even computation would be:

If a quantity other than 200 steins were ordered, the answer would change accordingly.

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52 Managerial Accounting, 12th Edition
Problem 6-25 (45 minutes)

1. a. Alvaro Bazan Total

Euros % Euros % Euros %
Sales....................................... €800 100 €480 100 €1,280 100
Variable expenses 480 60 96 20 576 45
Contribution margin............... €320 40 €384 80 704 55
Fixed expenses....................... 660
Net operating income............. € 44

b. Break-even sales = Fixed expenses ÷ CM ratio

= €660 ÷ 0.55 = €1,200

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Solutions Manual, Chapter 6 53
Problem 6-25 (continued)

2. a. Alvaro Bazan Cano Total

Euros % Euros % Euros % Euros %
Sales............................................. €800 100 €480 100 €320 100 €1,600 100
Variable expenses........................ 480 60 96 20 240 75 816 51
Contribution margin..................... €320 40 €384 80 € 80 25 784 49
Fixed expenses............................. 660
Net operating income................... € 124

© The McGraw-Hill Companies, Inc., 2008. All rights reserved.

54 Managerial Accounting, 12th Edition
Problem 6-25 (continued)

b. Break-even sales = Fixed expenses ÷ CM ratio

= €660 ÷ 0.49
= €1,347 (rounded)

3. The reason for the increase in the break-even point can be traced to the decrease in the
company’s average contribution margin ratio when the third product is added. Note from the
income statements above that this ratio drops from 55% to 49% with the addition of the third
product. This product, called Cano, has a CM ratio of only 25%, which causes the average
contribution margin ratio to fall.
This problem shows the somewhat tenuous nature of break-even analysis when more than
one product is involved. The manager must be very careful of his or her assumptions
regarding sales mix when making decisions such as adding or deleting products.
It should be pointed out to the president that even though the break-even point is higher with
the addition of the third product, the company’s margin of safety is also greater. Notice that
the margin of safety increases from €80 to €253 or from 6.25% to 15.81%. Thus, the addition
of the new product shifts the company much further from its break-even point, even though
the break-even point is higher.

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Solutions Manual, Chapter 6 55
Problem 6-26 (60 minutes)

1. April's Income Statement:

Standard Deluxe Pro Total
Amount % Amount % Amount % Amount %
Sales.......................................... $80,000 100 $60,000 100 $450,000 100 $590,000 100
Variable expenses:
Production............................. 44,000 55 27,000 45 157,500 35 228,500 38.7
Selling................................... 4,000 5 3,000 5 22,500 5 29,500 5.0
Total variable expenses............. 48,000 60 30,000 50 180,000 40 258,000 43.7
Contribution margin.................. $32,000 40 $30,000 50 $270,000 60 332,000 56.3
Fixed expenses:
Production.............................. 120,000
Advertising............................ 100,000
Administrative....................... 50,000
Total fixed expenses................... 270,000
Net operating income................. $ 62,000

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56 Managerial Accounting, 12th Edition
Problem 6-26 (continued)

May's Income Statement:

Standard Deluxe Pro Total

Amount % Amount % Amount % Amount %
Sales......................................... $320,000 100 $60,000 100 $270,000 100 $650,000 100
Variable expenses:
Production............................ 176,000 55 27,000 45 94,500 35 297,500 45.8
Selling.................................. 16,000 5 3,000 5 13,500 5 32,500 5.0
Total variable expenses............ 192,000 60 30,000 50 108,000 40 330,000 50.8
Contribution margin................. $128,000 40 $30,000 50 $162,000 60 320,000 49.2
Fixed expenses:
Production............................ 120,000
Advertising........................... 100,000
Administrative...................... 50,000
Total fixed expenses................. 270,000
Net operating income............... $ 50,000

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Solutions Manual, Chapter 6 57
Problem 6-26 (continued)

2. The sales mix has shifted over the last month from a greater concentration of Pro rackets to a
greater concentration of Standard rackets. This shift has caused a decrease in the company’s
overall CM ratio from 56.3% in April to only 49.2% in May. For this reason, even though
total sales (both in units and in dollars) is greater, net operating income is lower than last
month in the division.

3. The break-even in dollar sales can be computed as follows:

4. May’s break-even point has gone up. The reason is that the division’s overall CM ratio has
declined for May as stated in (2) above. Unchanged fixed expenses divided by a lower
overall CM ratio would yield a higher break-even point in sales dollars.

5. Standard Pro
Increase in sales......................................................... $20,000 $20,000
Multiply by the CM ratio........................................... × 40% × 60%
Increase in net operating income*............................. $ 8,000 $12,000
*Assuming that fixed costs do not change.

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58 Managerial Accounting, 12th Edition
Problem 6-27 (75 minutes)

1. a. Selling price................................... $37.50 100%

Variable expenses.......................... 22.50 60%
Contribution margin...................... $15.00 40%

Sales = Variable expenses + Fixed expenses + Profits

$37.50Q = $22.50Q + $480,000 + $0
$15.00Q = $480,000
Q = $480,000 ÷ $15.00 per skateboard
Q = 32,000 skateboards

Alternative solution:

b. The degree of operating leverage would be:

2. The new CM ratio will be:

Selling price.......................................... $37.50 100%
Variable expenses.................................. 25.50 68%
Contribution margin.............................. $12.00 32%

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Solutions Manual, Chapter 6 59
Problem 6-27 (continued)

The new break-even point will be:

Sales = Variable expenses + Fixed expenses + Profits
$37.50Q = $25.50Q + $480,000 + $0
$12.00Q = $480,000
Q = $480,000 ÷ $12.00 per skateboard
Q = 40,000 skateboards

Alternative solution:

3. Sales = Variable expenses + Fixed expenses + Profits

$37.50Q = $25.50Q + $480,000 + $120,000
$12.00Q = $600,000
Q = $600,000 ÷ $12.00 per skateboard
Q = 50,000 skateboards

Alternative solution:

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60 Managerial Accounting, 12th Edition
Problem 6-27 (continued)

Thus, sales will have to increase by 10,000 skateboards (50,000 skateboards, less 40,000
skateboards currently being sold) to earn the same amount of net operating income as earned
last year. The computations above and in part (2) show quite clearly the dramatic effect that
increases in variable costs can have on an organization. These effects from a $3 per unit
increase in labor costs for Tyrene Company are summarized below:
Present Expected
Break-even point (in skateboards)................................ 32,000 40,000
Sales (in skateboards) needed to earn net operating in-
come of $120,000...................................................... 40,000 50,000
Note particularly that if variable costs do increase next year, then the company will just break
even if it sells the same number of skateboards (40,000) as it did last year.

4. The contribution margin ratio last year was 40%. If we let P equal the new selling price, then:
P = $25.50 + 0.40P
0.60P = $25.50
P = $25.50 ÷ 0.60
P = $42.50
To verify: Selling price............................................. $42.50 100%
Variable expenses.................................... 25.50 60%
Contribution margin................................ $17.00 40%
Therefore, to maintain a 40% CM ratio, a $3 increase in variable costs would require a $5
increase in the selling price.

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Solutions Manual, Chapter 6 61
Problem 6-27 (continued)

5. The new CM ratio would be:

Selling price....................................... $37.50 100%
Variable expenses............................... 13.50 * 36%
Contribution margin........................... $24.00 64%
*$22.50 – ($22.50 × 40%) = $13.50
The new break-even point would be:
Sales = Variable expenses + Fixed expenses + Profits
$37.50Q = $13.50Q + $912,000* + $0
$24.00Q = $912,000
Q = $912,000 ÷ $24.00 per skateboard
Q = 38,000 skateboards
*$480,000 × 1.9 = $912,000

Alternative solution:

Although this break-even figure is greater than the company’s present break-even figure of
32,000 skateboards [see part (1) above], it is less than the break-even point will be if the
company does not automate and variable labor costs rise next year [see part (2) above].

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62 Managerial Accounting, 12th Edition
Problem 6-27 (continued)

6. a. Sales = Variable expenses + Fixed expenses + Profits

$37.50Q = $13.50Q + $912,000* + $120,000
$24.00Q = $1,032,000
Q = $1,032,000 ÷ $24.00 per skateboard
Q = 43,000 skateboards

*480,000 × 1.9 = $912,000

Alternative solution:

Thus, the company will have to sell 3,000 more skateboards (43,000 – 40,000 = 3,000)
than now being sold to earn a profit of $120,000 each year. However, this is still far less
than the 50,000 skateboards that would have to be sold to earn a $120,000 profit if the
plant is not automated and variable labor costs rise next year [see part (3) above].

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Solutions Manual, Chapter 6 63
Problem 6-27 (continued)

b. The contribution income statement would be:

Sales
(40,000 skateboards × $37.50 per skateboard)........................... $1,500,000
Variable expenses
(40,000 skateboards × $13.50 per skateboard)........................... 540,000
Contribution margin....................................................................... 960,000
Fixed expenses............................................................................... 912,000
Net operating income..................................................................... $ 48,000

c. This problem shows the difficulty faced by many firms today. Variable costs for labor are
rising, yet because of competitive pressures it is often difficult to pass these cost increases
along in the form of a higher price for products. Thus, firms are forced to automate (to
some degree) resulting in higher operating leverage, often a higher break-even point, and
greater risk for the company.
There is no clear answer as to whether one should have been in favor of constructing the
new plant. However, this question provides an opportunity to bring out points such as in
the preceding paragraph and it forces students to think about the issues.

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64 Managerial Accounting, 12th Edition
Problem 6-28 (30 minutes)

1. The numbered components are as follows:

(1) Dollars of revenue and costs.
(2) Volume of output, expressed in units,% of capacity, sales, or some other
measure of activity.
(3) Total expense line.
(4) Variable expense area.
(5) Fixed expense area.
(6) Break-even point.
(7) Loss area.
(8) Profit area.
(9) Revenue line.

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Solutions Manual, Chapter 6 65
Problem 6-28 (continued)

2. a. Line 3: Remain unchanged.

Line 9: Have a flatter slope.
Break-even point: Increase.
b. Line 3: Have a steeper slope.
Line 9: Remain unchanged.
Break-even point: Increase.
c. Line 3: Shift downward.
Line 9: Remain unchanged.
Break-even point: Decrease.
d. Line 3: Remain unchanged.
Line 9: Remain unchanged.
Break-even point: Remain unchanged.
e. Line 3: Shift upward and have a flatter slope.
Line 9: Remain unchanged.
Break-even point: Probably change, but the direction is uncertain.
f. Line 3: Have a flatter slope.
Line 9: Have a flatter slope.
Break-even point: Remain unchanged in terms of units; decrease in terms of
total dollars of sales.
g. Line 3: Shift upward.
Line 9: Remain unchanged.
Break-even point: Increase.
h. Line 3: Shift downward and have a steeper slope.
Line 9: Remain unchanged.
Break-even point: Probably change, but the direction is uncertain.

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66 Managerial Accounting, 12th Edition
Problem 6-29 (30 minutes)

1. The contribution margin per unit on the first 30,000 units is:
Per Unit
Selling price.......................................... $2.50
Variable expenses.................................. 1.60
Contribution margin.............................. $0.90
The contribution margin per unit on anything over 30,000 units is:
Per Unit
Selling price.......................................... $2.50
Variable expenses.................................. 1.75
Contribution margin.............................. $0.75
Thus, for the first 30,000 units sold, the total amount of contribution margin generated would
be:
30,000 units × $0.90 per unit = $27,000.

Since the fixed costs on the first 30,000 units total $40,000, the $27,000 contribution margin
above is not enough to permit the company to break even. Therefore, in order to break even,
more than 30,000 units will have to be sold. The fixed costs that will have to be covered by
the additional sales are:
Fixed costs on the first 30,000 units...................................................... $40,000
Less contribution margin from the first 30,000 units............................ 27,000
Remaining unrecovered fixed costs...................................................... 13,000
Add monthly rental cost of the additional space needed to produce
more than 30,000 units...................................................................... 2,000
Total fixed costs to be covered by remaining sales............................... $15,000

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Solutions Manual, Chapter 6 67
Problem 6-29 (continued)

The additional sales of units required to cover these fixed costs would be:

Therefore, a total of 50,000 units (30,000 + 20,000) must be sold for the company to break
even. This number of units would equal total sales of:
50,000 units × $2.50 per unit = $125,000 in total sales.

Thus, the company must sell 12,000 units above the break-even point to earn a profit of
$9,000 each month. These units, added to the 50,000 units required to break even, would
equal total sales of 62,000 units each month to reach the target profit figure.

3. If a bonus of $0.15 per unit is paid for each unit sold in excess of the break-even point, then
the contribution margin on these units would drop from $0.75 to only $0.60 per unit.
The desired monthly profit would be:
25% × ($40,000 + $2,000) = $10,500
Thus,

Therefore, the company must sell 17,500 units above the break-even point to earn a profit of
$10,500 each month. These units, added to the 50,000 units required to break even, would
equal total sales of 67,500 units each month.

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68 Managerial Accounting, 12th Edition
Problem 6-30 (60 minutes)

1. The income statements would be:

Present Proposed
Per Per
Amount Unit % Amount Unit %
Sales.................................... $800,000 $20 100 $800,000 $20 100
Variable expenses................ 560,000 14 70 320,000 8 * 40
Contribution margin............ 240,000 $6 30 480,000 $12 60
Fixed expenses.................... 192,000 432,000
Net operating
income............................. $ 48,000 $ 48,000
*$14 – $6 = $8

2. a. Present Proposed
Degree of operating leverage....

b.
Break-even point in
dollars....................................

c.
Margin of safety =
Total sales –
Break-even sales:
$800,000 – $640,000............ $160,000
$800,000 – $720,000............ $80,000
Margin of safety percentage =
Margin of safety ÷
Total sales:
$160,000 ÷ $800,000............ 20%
$80,000 ÷ $800,000.............. 10%

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Solutions Manual, Chapter 6 69
Problem 6-30 (continued)

3. The major factor would be the sensitivity of the company’s operations to cyclical movements
in the economy. In years of strong economic activity, the company will be better off with the
new equipment. The new equipment will increase the CM ratio and, as a consequence, profits
would rise more rapidly in years with strong sales. However, the company will be worse off
with the new equipment in years in which sales drop. The greater fixed costs of the new
equipment will result in losses being incurred more quickly and they will be deeper. Thus,
management must decide whether the potential greater profits in good years is worth the risk
of deeper losses in bad years.

4. No information is given in the problem concerning the new variable expenses or the new
contribution margin ratio. Both of these items must be determined before the new break-even
point can be computed. The computations are:
New variable expenses:
Sales = Variable expenses + Fixed expenses + Profits
$1,200,000* = Variable expenses + $240,000 + $60,000**
$900,000 = Variable expenses
* New level of sales: $800,000 × 1.5 = $1,200,000
** New level of net operating income: $48,000 × 1.25 = $60,000
New CM ratio:
Sales...................................................... $1,200,000 100%
Variable expenses.................................. 900,000 75%
Contribution margin.............................. $ 300,000 25%
With the above data, the new break-even point can be computed:

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70 Managerial Accounting, 12th Edition
Problem 6-30 (continued)

The greatest risk is that the marketing manager’s estimates of increases in sales and net
operating income will not materialize and that sales will remain at their present level. Note
that the present level of sales is $800,000, which is well below the break-even level of sales
under the new marketing method.
It would be a good idea to compare the new marketing strategy to the current situation more
directly. What level of sales would be needed under the new method to generate at least the
$48,000 in profits the company is currently earning each month? The computations are:

Thus, sales would have to increase by at least 44% ($1,152,000 is 44% higher than $800,000)
in order to make the company better off with the new marketing strategy than with the
current situation. This appears to be extremely risky.

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Solutions Manual, Chapter 6 71
CASE 6-31 (60 minutes)
1. The overall break-even sales can be determined using the CM ratio.
Frog Minnow Worm Total
Sales....................................... $200,000 $280,000 $240,000 $720,000
Variable expenses.................. 120,000 160,000 150,000 430,000
Contribution margin.............. $ 80,000 $120,000 $ 90,000 290,000
Fixed expenses....................... 282,000
Net operating income............ $ 8,000

2. The issue is what to do with the common fixed cost when computing the break-evens for the
individual products. The correct approach is to ignore the common fixed costs. If the
common fixed costs are included in the computations, the break-even points will be
overstated for individual products and managers may drop products that in fact are profitable.

a. The break-even points for each product can be computed using the contribution margin
approach as follows:
Frog Minnow Worm
Unit selling price.............................. $2.00 $1.40 $0.80
Variable cost per unit........................ 1.20 0.80 0.50
Unit contribution margin (a)............ $0.80 $0.60 $0.30
Product fixed expenses (b)............... $18,000 $96,000 $60,000
Break-even point in units sold
(b)÷(a)........................................... 22,500 160,000 200,000

b. If the company were to sell exactly the break-even quantities computed above, the
company would lose $108,000—the amount of the common fixed cost. This occurs
because the common fixed costs have been ignored in the calculations of the break-evens.

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72 Managerial Accounting, 12th Edition
Case 6-31 (continued)

The fact that the company loses $108,000 if it operates at the level of sales indicated by
the break-evens for the individual products can be verified as follows:
Frog Minnow Worm Total
Unit sales............................ 22,500 160,000 200,000
Sales.................................... $45,000 $224,000 $160,000 $ 429,000
Variable expenses............... 27,000 128,000 100,000 255,000
Contribution margin........... $18,000 $ 96,000 $ 60,000 174,000
Fixed expenses.................... 282,000
Net operating loss............... $(108,000)

At this point, many students conclude that something is wrong with their answer to part
(a) since the company loses money operating at the break-evens for the individual
products. They also worry that managers may be lulled into a false sense of security if
they are given the break-evens computed in part (a). Total sales at the individual product
break-evens is only $429,000 whereas the total sales at the overall break-even computed
in part (1) is $700,100.
Many students (and managers, for that matter) attempt to resolve this apparent paradox by
allocating the common fixed costs among the products prior to computing the break-
evens for individual products. Any of a number of allocation bases could be used for this
purpose—sales, variable expenses, product-specific fixed expenses, contribution margins,
etc. (We usually take a tally of how many students allocated the common fixed costs
using each possible allocation base before proceeding.) For example, the common fixed
costs are allocated on the next page based on sales.

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Solutions Manual, Chapter 6 73
Case 6-31 (continued)

Allocation of common fixed expenses on the basis of sales revenue:

Frog Minnow Worm Total
Sales.......................................... $200,000 $280,000 $240,000 $720,000
Percentage of total sales........... 27.8% 38.9% 33.3% 100.0%
Allocated common fixed ex-
pense* .................................. $30,000 $ 42,000 $36,000 $108,000
Product fixed expenses............. 18,000 96,000 60,000 174,000
Allocated common and prod-
uct fixed expenses (a)............ $48,000 $138,000 $96,000 $282,000
Unit contribution margin (b)..... $0.80 $0.60 $0.30
“Break-even” point in units
sold (a)÷(b)............................ 60,000 230,000 320,000
*Total common fixed expense × Percentage of total sales

If the company sells 60,000 units of the Frog lure product, 230,000 units of the Minnow
lure product, and 320,000 units of the Worm lure product, the company will indeed break
even overall. However, the apparent break-evens for two of the products are above their
normal annual sales.
Frog Minnow Worm
Normal annual unit sales volume....................... 100,000 200,000 300,000
“Break-even” unit annual sales (see above)....... 60,000 230,000 320,000
“Strategic” decision............................................ retain drop drop

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74 Managerial Accounting, 12th Edition
Case 6-31 (continued)

It would be natural to interpret a break-even for a product as the level of sales below
which the company would be financially better off dropping the product. Therefore, we
should not be surprised if managers, based on the erroneous break-even calculation on the
previous page, would decide to drop the Minnow and Worm lures and concentrate on the
company’s “core competency”, which appears to be the Frog lure. However, if they were
to do that, the company would face a loss of $46,000:
Frog Minnow Worm Total
Sales....................................... $200,000 dropped dropped $200,000
Variable expenses.................. 120,000 120,000
Contribution margin.............. $ 80,000 80,000
Fixed expenses*..................... 126,000
Net operating loss.................. $(46,000)
*By dropping the two products, the company reduces its fixed expenses by only $156,000
(=$96,000 + $60,000). Therefore, the total fixed expenses would be $126,000 (=$282,000
- $156,000).
By dropping the two products, the company would have a loss of $46,000 rather than a
profit of $8,000. The reason is that the two dropped products were contributing $54,000
toward covering common fixed expenses and toward profits. This can be verified by
looking at a segmented income statement like the one that will be introduced in a later
chapter.
Frog Minnow Worm Total
Sales............................................. $200,000 $280,000 $240,000 $720,000
Variable expenses........................ 120,000 160,000 150,000 430,000
Contribution margin.................... 80,000 120,000 90,000 290,000
Product fixed expenses................ 18,000 96,000 60,000 174,000
Product segment margin.............. $ 62,000 $ 24,000 $ 30,000 116,000
Common fixed expenses.............. 108,000
Net operating income.................. $ 8,000
$54,000

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Solutions Manual, Chapter 6 75
Case 6-32 (75 minutes)

1. The contribution format income statements (in thousands of dollars) for the three alternatives are:
18% Commission 20% Commission Own Sales Force
Sales........................................................................ $30,000 100% $30,000 100% $30,000 100%
Variable expenses:
Variable cost of goods sold................................. 17,400 17,400 17,400
Commissions....................................................... 5,400 6,000 3,000
Total variable expense............................................ 22,800 76% 23,400 78% 20,400 68%
Contribution margin................................................ 7,200 24% 6,600 22% 9,600 32%
Fixed expenses:
Fixed cost of goods sold...................................... 2,800 2,800 2,800
Fixed advertising expense................................... 800 800 1,300 *
Fixed marketing staff expense............................. 1,300 **
Fixed administrative expense.............................. 3,200 3,200 3,200
Total fixed expenses................................................ 6,800 6,800 8,600
Net operating income.............................................. $ 400 ($ 200) $ 1,000
* $800,000 + $500,000 = $1,300,000
** $700,000 + $400,000 + $200,000 = $1,300,000

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76 Managerial Accounting, 12th Edition
Case 6-32 (continued)

2. Given the data above, the break-even points can be determined using total fixed expenses and
the CM ratios as follows:

a.

b.

c.

The two net operating incomes are equal when:

0.32X – $8,600,000 = 0.22X – $6,800,000
0.10X = $1,800,000
X = $1,800,000 ÷ 0.10
X = $18,000,000

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Solutions Manual, Chapter 6 77
Case 6-32 (continued)

Thus, at a sales level of $18,000,000 either plan will yield the same net operating income.
This is verified below (in thousands of dollars):
20% Commission Own Sales Force
Sales......................................... $ 18,000 100% $ 18,000 100%
Total variable expense............. 14,040 78% 12,240 68%
Contribution margin................. 3,960 22% 5,760 32%
Total fixed expenses................. 6,800 8,600
Net operating income............... $ (2,840) $ (2,840)

5. A graph showing both alternatives appears below:

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78 Managerial Accounting, 12th Edition
Case 6-32 (continued)
6.
To:President of Marston Corporation
Fm: Student’s name
Assuming that a competent sales force can be quickly hired and trained and the new sales
force is as effective as the sales agents, this is the better alternative. Using the data provided
by the controller, net operating income is higher when the company has its own sales force
unless sales fall below $18,000,000. At that level of sales and below the company would be
losing money so it is unlikely that this would be the normal situation.
The major concern I have with this recommendation is the assumption that the new sales
force will be as effective as the sales agents. The sales agents have been selling our product
for a number of years, so they are likely to have more field experience than any sales force
we hire. And, our own sales force would be selling just our product instead of a variety of
products. On the one hand, that will result in a more focused selling effort. On the other hand,
that may make it more difficult for a salesperson to get the attention of a hospital’s
purchasing agent.
The purchasing agents may prefer to deal through a small number of salespersons each of
whom sells many products rather than a large number of salespersons each of whom sells
only a single product. Even so, we can afford some decrease in sales because of the lower
cost of maintaining our own sales force. For example, assuming that the sales agents make
the budgeted sales of $30,000,000, we would have a net operating loss of $200,000 for the
year. We would do better than this with our own sales force as long as sales are greater than
$26,250,000. In other words, we could afford a fall-off in sales of $3,750,000 or 12.5% and
still be better off with our own sales force. If we are confident that our own sales force could
do at least this well relative to the sales agents, then we should certainly switch to using our
own sales force.

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Solutions Manual, Chapter 6 79
Case 6-33 (75 minutes)

1. The total annual fixed cost of the Cardiac Care Department can be computed as follows:
Annual Supervising Total Other Fixed Total Fixed
Patient-Days Aides Nurses Nurses Personnel Cost Cost
@ $36,000 @ $58,000 @ $76,000
10,000-12,000 $252,000 $870,000 $228,000 $1,350,000 $2,740,000 $4,090,000
12,001-13,750 $288,000 $870,000 $228,000 $1,386,000 $2,740,000 $4,126,000
13,751-16,500 $324,000 $928,000 $304,000 $1,556,000 $2,740,000 $4,296,000
16,501-18,250 $360,000 $928,000 $304,000 $1,592,000 $2,740,000 $4,332,000
18,251-20,750 $360,000 $986,000 $380,000 $1,726,000 $2,740,000 $4,466,000
20,751-23,000 $396,000 $1,044,000 $380,000 $1,820,000 $2,740,000 $4,560,000

2. The “break-even” can be computed for each range of activity by dividing the total fixed cost for that range of activity by the
contribution margin per patient-day, which is $300 (=$480 revenue − $180 variable cost).
(a) (b) “Break-
Annual Total Fixed Contribution Even” Within Rele-
Patient-Days Cost Margin (a) ÷ (b) vant Range?
10,000-12,000 $4,090,000 $300 13,633 No
12,001-13,750 $4,126,000 $300 13,753 No
13,751-16,500 $4,296,000 $300 14,320 Yes
16,501-18,250 $4,332,000 $300 14,440 No
18,251-20,750 $4,466,000 $300 14,887 No
20,751-23,000 $4,560,000 $300 15,200 No

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80 Managerial Accounting, 12th Edition
Case 6-33 (continued)

While a “break-even” can be computed for each range of activity (i.e., relevant range), all but one of these break-evens is bogus.
For example, within the range of 10,000 to 12,000 patient-days, the computed break-even is 13,633 (rounded) patient-days.
However, this level of activity is outside this relevant range. To serve 13,633 patient-days, the fixed costs would have to be
increased from $4,090,000 to $4,126,000 by adding one more aide. The only “break-even” that occurs within its own relevant
range is 14,320. This is the only legitimate break-even.

3. The level of activity required to earn a profit of $720,000 can be computed as follows:
Activity to At-
(a) (b) tain Target
Annual Total Fixed Target Total Fixed Cost + Contribution Profit Within Rele-
Patient-Days Cost Profit Target Profit Margin (a) ÷ (b) vant Range?
10,000-12,000 $4,090,000 $720,000 $4,810,000 $300 16,033 No
12,001-13,750 $4,126,000 $720,000 $4,846,000 $300 16,153 No
13,751-16,500 $4,296,000 $720,000 $5,016,000 $300 16,720 No
16,501-18,250 $4,332,000 $720,000 $5,052,000 $300 16,840 Yes
18,251-20,750 $4,466,000 $720,000 $5,186,000 $300 17,287 No
20,751-23,000 $4,560,000 $720,000 $5,280,000 $300 17,600 No
In this case, the only solution that is within the appropriate relevant range is 16,840 patient-days.

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Solutions Manual, Chapter 6 81
Research and Application 6-34 (120 minutes)

1. The income statement on page 50 is prepared using an absorption format. The income
statement on page 33 is prepared using a contribution format. The annual report says that the
contribution format income statement shown on page 33 is used for internal reporting
purposes; nonetheless, Benetton has chosen to include it in the annual report. The
contribution format income statement treats all cost of sales as variable costs. The selling,
general and administrative expenses shown on the absorption income statement have been
broken down into variable and fixed components in the contribution format income
statement.
It appears the Distribution and Transport expenses and the Sales Commissions have been
reclassified as variable selling costs on the contribution format income statement. The sum of
these two expenses according to the absorption income statement on page 50 is €103,561 and
€114,309 in 2004 and 2003, respectively. If these numbers are rounded to the nearest
thousand, they agree with the variable selling costs shown in the contribution format income
statements on page 33.

2. The cost of sales is included in the computation of contribution margin because the Benetton
Group primarily designs, markets, and sells apparel. The manufacturing of the products is
outsourced to various suppliers. While Benetton’s cost of sales may include some fixed costs,
the overwhelming majority of the costs are variable, as one would expect for a
merchandising company, thus the cost of sales is included in the calculation of contribution
margin.

3. The break-even computations are as follows (see page 33 of annual report):

(in millions; figures are rounded) 2003 2004
Total fixed costs............................................ €464 €436
Contribution margin ratio.............................. ÷ 0.374 ÷ 0.387
Breakeven in euros........................................ €1,241 €1,127
The break-even point in 2004 is lower than in 2003 because Benetton’s fixed costs in 2004
are lower than in 2003 and its contribution margin ratio in 2004 is higher than in 2003.

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82 Managerial Accounting, 12th Edition
Research and Application 6-34 (continued)

4. The target profit calculation is as follows:

(in millions; figures are rounded) 2004
Total fixed costs + target profit.................................... €736
Contribution margin ratio............................................. ÷ 0.387
Sales needed to achieve target profit............................ €1,902

5. The margin of safety calculations are as follows:

(in millions; figures are rounded) 2003 2004
Actual sales.................................................. €1,859 €1,686
Breakeven sales............................................ 1,241 1,127
Margin of safety........................................... €618 €559
The margin of safety has declined because the drop in sales from 2003 to 2004 (€173)
exceeds the decrease in breakeven sales from 2003 to 2004 (€114).

6. The degree of operating leverage is calculated as follows:

(in millions; figures are rounded) 2004
Contribution margin........................................................ €653
Income from operations.................................................. ÷ €217
Degree of operating leverage (rounded).......................... 3
A 6% increase in sales would result in income from operations of:
(in millions; figures are rounded) 2004
Revised sales (€1,686 ×1.06)................................................ €1,787
Contribution margin ratio...................................................... 0.387
Contribution margin.............................................................. 692
Fixed general and administrative expenses........................... 436
Income from operations........................................................ €256
The degree of operating leverage can be used to quickly determine that a 6% increase in sales
translates into an 18% increase in income from operations (6% × 3 = 18%). Rather than
preparing a revised contribution format income statement to ascertain the new income from
operations, the computation could be performed as follows:

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Solutions Manual, Chapter 6 83
Research and Application 6-34 (continued)

(in millions; figures are rounded) 2004

Actual sales...................................................................................... €217
Percentage increase in income from operations............................... 1.18
Projected income from operations................................................... €256

7. The income from operations in the first scenario would be computed as follows:
(in millions; figures are rounded) 2004
Sales (1,686 × 1.03).................................................................. €1,737
Contribution margin ratio......................................................... 0.387
Contribution margin................................................................. 672
Fixed general and administrative expenses.............................. 446
Income from operations........................................................... €226
The second scenario is more complicated because students need to break the variable selling
costs into its two components—Distribution and Transport and Sales Commissions. Using
the absorption income statement on page 50, students can determine that Sales Commissions
are about 4.4% of sales (€73,573 ÷ €1,686,351). If Sales Commissions are raised to 6%, this
is a 1.6% increase in the rate. This 1.6% should be deducted from the contribution margin
ratio as shown below:
(in millions; figures are rounded) 2004
Sales (1,686 × 1.05).................................................................. €1,770
Contribution margin ratio (0.387 − 0.016)............................... 0.371
Contribution margin................................................................. 657
Fixed general and administrative expenses.............................. 446
Income from operations........................................................... €211
The first scenario is preferable because its increase income from operations by €9 million
(€226−€217), whereas the second scenario decreases income from operations by €6 million
(€217 − €211).

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84 Managerial Accounting, 12th Edition
Research and Application 6-34 (continued)

8. The income from operations using the revised product mix is calculated as follows (the contribution margin ratios for each sector
are given on pages 36 and 37 of the annual report):
Sportswear & Manufacturing &
(in millions) Casual Equipment Other Total
Sales............................................ €1,554 €45 €87 €1,686.0
CM ratio...................................... 0.418 0.208 0.089 *0.395
CM............................................... €649.6 €9.4 €7.7 666.7
Fixed costs................................... 436.0
Income from operations.............. €230.7
*39.5% is the weighted average contribution margin ratio. Notice, it is higher than the 38.7% shown on page 33 of the annual
report.
The income from operations is higher under this scenario because the product mix has shifted towards the sector with the highest
contribution margin ratio—the Casual sector.

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86 Managerial Accounting, 12th Edition