CH 5 CVP

CHAPTER 5
FPO
Cost-Volume-Profit Relationships
Kid Rock and Live Nation Entertainment Pull the
CVP Levers
LEARNING OBJECTIVES
BUSINESS FOCUS
After studying Chapter 5, you should be able to:
LO5–1 Explain how changes in activity affect

contribution margin and net operating
income.
LO5–2 Prepare and interpret a cost-volume-
profit (CVP) graph and a profit graph.
LO5–3 Use the contribution margin ratio
(CM ratio) to compute changes in
contribution margin and net operating
income resulting from changes in
sales volume.
© Everett Collection Inc/Alamy

LO5–4 Show the effects on net operating
income of changes in variable costs,
fixed costs, selling price, and volume.
Live Nation Entertainment (LNE) owns and operates outdoor amphi-
theaters. When hosting music concerts the company usually pays a LO5–5 Determine the break-even point.
large amount of guaranteed upfront compensation to musical artists to LO5–6 Determine the level of sales needed
safeguard them from poor attendance. However, rapper-turned-country to achieve a desired target profit.
rocker Kid Rock suggested a different financial arrangement. In exchange LO5–7 Compute the margin of safety and
for bypassing his up-front fee (which usually ranged between $250,000 explain its significance.
and $350,000) and agreeing to share a portion of his ticket revenues with LO5–8 Compute the degree of operating
LNE, Kid Rock asked for a share of the revenues from food, drinks, and leverage at a particular level of sales and
parking. He then lowered his ticket prices to $20 in an effort to increase explain how it can be used to predict
attendance and the amount of discretionary spending per customer for changes in net operating income.
food, drinks, and his $20 concert T-shirts. Kid Rock’s ultimate goal was LO5–9 Compute the break-even point for a
to design a financial model that gave fans a more affordable evening of multiproduct company and explain
entertainment while still providing his band and LNE adequate profits. ■ the effects of shifts in the sales mix
on contribution margin and the break-
Source: John Jurgensen, “Kid Rock’s Plan to Change the Economics of Touring,” The Wall Street Journal, even point.
June 7, 2013, pp. D1–D8.
LO5–10 (Appendix 5A) Analyze a mixed cost
using a scattergraph plot and the
high-low method.
LO5–11 (Appendix 5A) Analyze a mixed cost
using a scattergraph plot and the
least-squares regression method.
196
Cost-Volume-Profit Relationships 197
C
ost-volume-profit (CVP) analysis helps managers make many
important decisions such as what products and services to offer, what prices to
charge, what marketing strategy to use, and what cost structure to maintain. Its pri-
mary purpose is to estimate how profits are affected by the following five factors:
1. Selling prices.
2. Sales volume.
3. Unit variable costs.
4. Total fixed costs.
5. Mix of products sold.
To simplify CVP calculations, managers typically adopt the following assumptions
with respect to these factors1:
1. Selling price is constant. The price of a product or service will not change as volume
changes.
2. Costs are linear and can be accurately divided into variable and fixed components.
The variable costs are constant per unit and the fixed costs are constant in total over
the entire relevant range.
3. In multiproduct companies, the mix of products sold remains constant.
While these assumptions may be violated in practice, the results of CVP analysis
are often “good enough” to be quite useful. Perhaps the greatest danger lies in relying on
simple CVP analysis when a manager is contemplating a large change in sales volume
that lies outside the relevant range. However, even in these situations the CVP model can
be adjusted to take into account anticipated changes in selling prices, variable costs per
unit, total fixed costs, and the sales mix that arise when the estimated sales volume falls
outside the relevant range.
To help explain the role of CVP analysis in business decisions, we’ll now turn our
attention to the case of Acoustic Concepts, Inc., a company founded by Prem Narayan.
MANAGERIAL
Prem, who was a graduate student in engineering at the time, started Acoustic Concepts, ACCOUNTING IN ACTION
Inc., to market a radical new speaker he had designed for automobile sound systems. The THE ISSUE
speaker, called the Sonic Blaster, uses an advanced microprocessor and proprietary soft-
ware to boost amplification to awesome levels. Prem contracted with a Taiwanese elec-
tronics manufacturer to produce the speaker. With seed money provided by his family,
Prem placed an order with the manufacturer and ran advertisements in auto magazines.
The Sonic Blaster was an immediate success, and sales grew to the point that Prem
moved the company’s headquarters out of his apartment and into rented quarters in a
nearby industrial park. He also hired a receptionist, an accountant, a sales manager, and
a small sales staff to sell the speakers to retail stores. The accountant, Bob Luchinni, had
worked for several small companies where he had acted as a business advisor as well as
accountant and bookkeeper. The following discussion occurred soon after Bob was hired:
Prem: Bob, I’ve got a lot of questions about the company’s finances that I hope you can
help answer.
Bob: We’re in great shape. The loan from your family will be paid off within a few
months.
Prem: I know, but I am worried about the risks I’ve taken on by expanding operations.
What would happen if a competitor entered the market and our sales slipped? How
far could sales drop without putting us into the red? Another question I’ve been try-
ing to resolve is how much our sales would have to increase to justify the big market-
ing campaign the sales staff is pushing for.
Bob: Marketing always wants more money for advertising.
1
One additional assumption often used in manufacturing companies is that inventories do not change.
The number of units produced equals the number of units sold.
198 Chapter 5
Prem: And they are always pushing me to drop the selling price on the speaker. I
agree with them that a lower price will boost our sales volume, but I’m not sure the
increased volume will offset the loss in revenue from the lower price.
Bob: It sounds like these questions are all related in some way to the relationships
among our selling prices, our costs, and our volume. I shouldn’t have a problem com-
ing up with some answers.
Prem: Can we meet again in a couple of days to see what you have come up with?
Bob: Sounds good. By then I’ll have some preliminary answers for you as well as a
model you can use for answering similar questions in the future.
The Basics of Cost-Volume-Profit (CVP) Analysis

Bob Luchinni’s preparation for his forthcoming meeting with Prem Narayan begins
with the contribution format income statement that was introduced in an earlier chap-
ter. The contribution income statement emphasizes the behavior of costs and therefore
is extremely helpful to managers in judging the impact on profits of changes in selling
price, cost, or volume. Bob will base his analysis on the following contribution income
statement he prepared last month:
Acoustic Concepts, Inc.
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (400 speakers) . . . . . . . . . . . . . . . . . . . . . . $100,000 $ 250
Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . 60,000 150
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . 40,000 $ 100
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Net operating income. . . . . . . . . . . . . . . . . . . . . . $ 5,000
Notice that sales, variable expenses, and contribution margin are expressed on a per
unit basis as well as in total on this contribution income statement. The per unit figures
will be very helpful to Bob in some of his calculations. Note that this contribution income
statement has been prepared for management’s use inside the company and would not
ordinarily be made available to those outside the company.
Contribution Margin
LO5–1 Contribution margin is the amount remaining from sales revenue after variable expenses have
Explain how changes in been deducted. Thus, it is the amount available to cover fixed expenses and then to provide
activity affect contribution profits for the period. Notice the sequence here—contribution margin is used first to cover the
margin and net operating fixed expenses, and then whatever remains goes toward profits. If the contribution margin is
income. not sufficient to cover the fixed expenses, then a loss occurs for the period. To illustrate with
an extreme example, assume that Acoustic Concepts sells only one speaker during a particular
month. The company’s income statement would appear as follows:
Sales of 1 Speaker
Total Per Unit
Sales (1 speaker). . . . . . . . . . . . . . . . . . . . . . . . . . $ 250 $ 250
Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . 150 150
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . 100 $ 100
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Net operating loss. . . . . . . . . . . . . . . . . . . . . . . . . $ (34,900)
For each additional speaker the company sells during the month, $100 more in con-
tribution margin becomes available to help cover the fixed expenses. If a second speaker
is sold, for example, then the total contribution margin will increase by $100 (to a total of
$200) and the company’s loss will decrease by $100, to $34,800:

Sales of 2 Speakers
Total Per Unit
Sales (2 speakers) . . . . . . . . . . . . . . . . . . . . . . . . . $ 500 $ 250
Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . 300 150
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . 200 $ 100
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Net operating loss. . . . . . . . . . . . . . . . . . . . . . . . . $(34,800)
If enough speakers can be sold to generate $35,000 in contribution margin, then all
of the fixed expenses will be covered and the company will break even for the month—
that is, it will show neither profit nor loss but just cover all of its costs. To reach the
break-even point, the company will have to sell 350 speakers in a month because each
speaker sold yields $100 in contribution margin:

Sales of 350 Speakers
Total Per Unit
Sales (350 speakers) . . . . . . . . . . . . . . . . . . . . . . . $87,500 $ 250
Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . . 52,500 150
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . 35,000 $ 100
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Net operating income. . . . . . . . . . . . . . . . . . . . . . . $ 0
Computation of the break-even point is discussed in detail later in the chapter; for the
moment, note that the break-even point is the level of sales at which profit is zero.
Once the break-even point has been reached, net operating income will increase by
the amount of the unit contribution margin for each additional unit sold. For example, if
351 speakers are sold in a month, then the net operating income for the month will be $100
because the company will have sold 1 speaker more than the number needed to break even:

Sales of 351 Speakers
Total Per Unit
Sales (351 speakers) . . . . . . . . . . . . . . . . . . . . . . . $87,750 $250
Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . . 52,650 150
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . 35,100 $100
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Net operating income. . . . . . . . . . . . . . . . . . . . . . . $ 100
If 352 speakers are sold (2 speakers above the break-even point), the net operat-
ing income for the month will be $200. If 353 speakers are sold (3 speakers above the
break-even point), the net operating income for the month will be $300, and so forth. To
estimate the profit at any sales volume above the break-even point, multiply the number
of units sold in excess of the break-even point by the unit contribution margin. The result
200 Chapter 5
represents the anticipated profits for the period. Or, to estimate the effect of a planned
increase in sales on profits, simply multiply the increase in units sold by the unit contri-
bution margin. The result will be the expected increase in profits. To illustrate, if Acous-
tic Concepts is currently selling 400 speakers per month and plans to increase sales to
425 speakers per month, the anticipated impact on profits can be computed as follows:
Additional speakers to be sold . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Contribution margin per speaker . . . . . . . . . . . . . . . . . . . . . . . . × $100
Increase in net operating income. . . . . . . . . . . . . . . . . . . . . . . . $2,500
These calculations can be verified as follows:
Sales Volume
400 425 Difference
Speakers Speakers (25 Speakers) Per Unit
Sales (@ $250 per speaker) . . . . . $100,000 $106,250 $6,250 $ 250
Variable expenses
(@ $150 per speaker) . . . . . . . . 60,000 63,750 3,750 150
Contribution margin . . . . . . . . . . . . 40,000 42,500 2,500 $ 100
Fixed expenses . . . . . . . . . . . . . . . . 35,000 35,000 0
Net operating income . . . . . . . . . . $ 5,000 $ 7,500 $2,500
To summarize, if sales are zero, the company’s loss would equal its fixed expenses.
Each unit that is sold reduces the loss by the amount of the unit contribution margin.
Once the break-even point has been reached, each additional unit sold increases the com-
pany’s profit by the amount of the unit contribution margin.
CVP Relationships in Equation Form

The contribution format income statement can be expressed in equation form as follows:
Profit = (Sales − Variable expenses) − Fixed expenses
For brevity, we use the term profit to stand for net operating income in equations.
When a company has only a single product, as at Acoustic Concepts, we can further
refine the equation as follows:
Sales = Selling price per unit × Quantity sold = P × Q
Variable expenses = Variable expenses per unit × Quantity sold = V × Q
Profit = (P × Q − V × Q) − Fixed expenses
We can do all of the calculations of the previous section using this simple equation. For
example, earlier we computed that the net operating income (profit) at sales of 351 speakers
would be $100. We can arrive at the same conclusion using the above equation as follows:
Profit = ($250 × 351 − $150 × 351) − $35,000
= ($250 − $150) × 351 − $35,000
= ($100) × 351 − $35,000
= $35,100 − $35,000
= $100
It is often useful to express the simple profit equation in terms of the unit contribu-
tion margin (Unit CM) as follows:
Unit CM = Selling price per unit − Variable expenses per unit = P − V

Profit = (P − V) × Q − Fixed expenses
Profit = Unit CM × Q − Fixed expenses
We could also have used this equation to determine the profit at sales of 351 speakers as
follows:

= $100 × 351 − $35,000
= $35,100 − $35,000
= $100
For those who are comfortable with algebra, the quickest and easiest approach to
solving the problems in this chapter may be to use the simple profit equation in one of
its forms.
CVP Relationships in Graphic Form

The relationships among revenue, cost, profit, and volume are illustrated on a cost- LO5–2
volume-profit (CVP) graph. A CVP graph highlights CVP relationships over wide Prepare and interpret a cost-
ranges of activity. To help explain his analysis to Prem Narayan, Bob Luchinni prepared volume-profit (CVP) graph and
a CVP graph for Acoustic Concepts. a profit graph.
Preparing the CVP Graph In a CVP graph (sometimes called a break-even chart),
unit volume is represented on the horizontal (X) axis and dollars on the vertical (Y) axis.
Preparing a CVP graph involves the three steps depicted in Exhibit 5–1:
1. Draw a line parallel to the volume axis to represent total fixed expense. For Acoustic
Concepts, total fixed expenses are $35,000.
2. Choose some volume of unit sales and plot the point representing total expense (fixed
and variable) at the sales volume you have selected. In Exhibit 5–1, Bob Luchinni
chose a volume of 600 speakers. Total expense at that sales volume is:
Fixed expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000

Variable expense (600 speakers × $150 per speaker) . . . . . . . . . . . . 90,000
Total expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $125,000
After the point has been plotted, draw a line through it back to the point where the
fixed expense line intersects the dollars axis.
3. Again choose some sales volume and plot the point representing total sales dollars
at the activity level you have selected. In Exhibit 5–1, Bob Luchinni again chose a
volume of 600 speakers. Sales at that volume total $150,000 (600 speakers × $250
per speaker). Draw a line through this point back to the origin.
The interpretation of the completed CVP graph is given in Exhibit 5–2. The antici-
pated profit or loss at any given level of sales is measured by the vertical distance
between the total revenue line (sales) and the total expense line (variable expense plus
fixed expense).
202 Chapter 5
EXHIBIT 5–1 $175,000

Preparing the CVP Graph Step 3
(total sales revenue)
$150,000
$125,000
Step 2
(total expense)
$100,000
$75,000
$50,000 Step 1
(fixed expense)
$25,000
$0
0 100 200 300 400 500 600 700 800
Volume in speakers sold
EXHIBIT 5–2 $175,000

The Completed CVP Graph Total
revenue
$150,000
Profit
area
$125,000
Break-even point:
350 speakers or
Variable expense at
$87,500 in sales Total
$150 per speaker

$100,000 expense
$75,000
$50,000
Loss
area
Total fixed
expense,
$25,000
$35,000
$0
0 100 200 300 400 500 600 700
The break-even point is where the total revenue and total expense lines cross. The
break-even point of 350 speakers in Exhibit 5–2 agrees with the break-even point com-
puted earlier.
When sales are below the break-even point—in this case, 350 units—the company
suffers a loss. Note that the loss (represented by the vertical distance between the total
$40,000 EXHIBIT 5–3

The Profit Graph
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000 Break-even point:
350 speakers
$5,000
Profit
$0
–$5,000
–$10,000
–$15,000
–$20,000
–$25,000
–$30,000
–$35,000
–$40,000
0 100 200 300 400 500 600 700 800
expense and total revenue lines) gets bigger as sales decline. When sales are above the break-
even point, the company earns a profit and the size of the profit (represented by the vertical
distance between the total revenue and total expense lines) increases as sales increase.
An even simpler form of the CVP graph, which we call a profit graph, is presented in
Exhibit 5–3. That graph is based on the following equation:
In the case of Acoustic Concepts, the equation can be expressed as:
Profit = $100 × Q − $35,000
Because this is a linear equation, it plots as a single straight line. To plot the line,
compute the profit at two different sales volumes, plot the points, and then connect
them with a straight line. For example, when the sales volume is zero (i.e., Q = 0),
the profit is − $35,000 (= $100 × 0 − $35,000). When Q is 600, the profit is $25,000
(= $100 × 600 − $35,000). These two points are plotted in Exhibit 5–3 and a straight line
has been drawn through them.
The break-even point on the profit graph is the volume of sales at which profit is zero
and is indicated by the dashed line on the graph. Note that the profit steadily increases to
the right of the break-even point as the sales volume increases and that the loss becomes
steadily worse to the left of the break-even point as the sales volume decreases.
Contribution Margin Ratio (CM Ratio) and the Variable

Expense Ratio
In the previous section, we explored how CVP relationships can be visualized. This sec-
tion begins by defining the contribution margin ratio and the variable expense ratio.
Then it demonstrates how to use the contribution margin ratio in CVP calculations.
204 Chapter 5
As a first step in defining these two terms, we have added a column to Acoustic
Concepts’ contribution format income statement that expresses sales, variable expenses,
and contribution margin as a percentage of sales:
Percent
Total Per Unit of Sales
Sales (400 speakers) . . . . . . . . . . . . . $100,000 $ 250 100%
Variable expenses. . . . . . . . . . . . . . . . 60,000 150 60%
Contribution margin . . . . . . . . . . . . . . 40,000 $ 100 40%
Fixed expenses . . . . . . . . . . . . . . . . . . 35,000
Net operating income. . . . . . . . . . . . . $ 5,000
The contribution margin as a percentage of sales is referred to as the contribution

margin ratio (CM ratio). This ratio is computed as follows:
Contribution margin
CM ratio = _________________
Sales
For Acoustic Concepts, the computations are:
Total contribution margin $40,000

CM ratio = _____________________ = ________ = 40%
Total sales $100,000
In a company such as Acoustic Concepts that has only one product, the CM ratio can also
be computed on a per unit basis as follows:
Unit contribution margin $100

CM ratio = _____________________ = _____ = 40%
Unit selling price $250
Similarly, the variable expenses as a percentage of sales is referred to as the variable
expense ratio. This ratio is computed as follows:
Variable expenses
Variable expense ratio = _______________
Sales
For Acoustic Concepts, the computations are:

Total variable expenses $60,000
Variable expense ratio = ____________________ = ________ = 60%
Total sales $100,000
Because Acoustic Concepts has only one product, the variable expense ratio can also be
computed on a per unit basis as follows:
Variable expense per unit $150

Variable expense ratio = _____________________ = _____ = 60%
Having defined the two terms, it bears emphasizing that the contribution margin ratio and
the variable expense ratio can be mathematically related to one another:
Contribution margin
CM ratio = _________________
Sales
Sales − Variable expenses
CM ratio = _____________________
Sales
CM ratio = 1 − Variable expense ratio
So, in the case of Acoustic Concepts, this relationship would be as follows:
CM ratio = 1 − Variable expense ratio

= 1 − 60 %
= 40 %
Applications of the Contribution Margin Ratio The CM ratio shows how the
contribution margin will be affected by a change in total sales. Acoustic Concepts’ CM LO5–3
ratio of 40% means that for each dollar increase in sales, total contribution margin will Use the contribution margin
increase by 40 cents ($1 sales × CM ratio of 40%). Net operating income will also ratio (CM ratio) to compute
increase by 40 cents, assuming that fixed costs are not affected by the increase in sales. changes in contribution
Generally, the effect of a change in sales on the contribution margin is expressed in equa- margin and net operating
income resulting from
tion form as:
changes in sales volume.
Change in contribution margin = CM ratio × Change in sales
As this illustration suggests, the impact on net operating income of any given dollar
change in total sales can be computed by applying the CM ratio to the dollar change.
For example, if Acoustic Concepts plans a $30,000 increase in sales during the coming
month, the contribution margin should increase by $12,000 ($30,000 increase in sales ×
CM ratio of 40%). As we noted above, net operating income also will increase by $12,000
if fixed costs do not change. This is verified by the following table:
Sales Volume
Percent
Present Expected Increase of Sales
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $130,000 $30,000 100%
Variable expenses . . . . . . . . . . . . . . . . . 60,000 78,000* 18,000 60%
Contribution margin . . . . . . . . . . . . . . . . 40,000 52,000 12,000 40%
Fixed expenses . . . . . . . . . . . . . . . . . . . . 35,000 35,000 0
Net operating income . . . . . . . . . . . . . . $ 5,000 $ 17,000 $12,000
*
$130,000 expected sales ÷ $250 per unit = 520 units. 520 units × $150 per unit = $78,000.
The relation between profit and the CM ratio can also be expressed using the
following equation:
Profit = CM ratio × Sales − Fixed expenses2
or, in terms of changes,
Change in profit = CM ratio × Change in sales − Change in fixed expenses
2
This equation can be derived using the basic profit equation and the definition of the CM ratio as
follows:
Profit = (Sales − Variable expenses) − Fixed expenses
Profit = Contribution margin − Fixed expenses
Contribution margin
Profit = _________________ × Sales − Fixed expenses
Sales
Profit = CM ratio × Sales − Fixed expenses
206 Chapter 5
For example, at sales of $130,000, the profit is expected to be $17,000 as

shown below:
Profit = CM ratio × Sales – Fixed expenses
= 0.40 × $130,000 – $35,000
= $52,000 – $35,000
= $17,000
Again, if you are comfortable with algebra, this approach will often be quicker and easier
than constructing contribution format income statements.
The CM ratio is particularly valuable in situations where the dollar sales of one product
must be traded off against the dollar sales of another product. In this situation, products that
yield the greatest amount of contribution margin per dollar of sales should be emphasized.
LO5–4 Additional Applications of CVP Concepts

Show the effects on net Having demonstrated how to use the contribution margin ratio in CVP calculations, Bob
operating income of changes
Luchinni, the accountant at Acoustic Concepts, wanted to offer the company’s president,
in variable costs, fixed costs,
selling price, and volume.
Prem Narayan, five additional examples of how CVP analysis can be used to answer the
types of questions that their company is facing. So, he began by reminding Prem that
the company’s fixed expenses are $35,000 per month and he restated the following key
pieces of data:
Percent
Per Unit of Sales
Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $250 100%
Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . 150 60%
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . $100 40%
Example 1: Change in Fixed Cost and Sales Volume Acoustic Concepts is cur-
rently selling 400 speakers per month at $250 per speaker for total monthly sales of
$100,000. The sales manager feels that a $10,000 increase in the monthly advertising
budget would increase monthly sales by $30,000 to a total of 520 units. Should the adver-
tising budget be increased? The table below shows the financial impact of the proposed
change in the monthly advertising budget.
Sales with
Additional
Current Advertising Percent
Sales Budget Difference of Sales
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $130,000 $ 30,000 100%
Variable expenses. . . . . . . . . . . . . . . . 60,000 78,000* 18,000 60%
Contribution margin . . . . . . . . . . . . . . 40,000 52,000 12,000 40%
Fixed expenses . . . . . . . . . . . . . . . . . . 35,000 45,000† 10,000
Net operating income. . . . . . . . . . . . . $ 5,000 $ 7,000 $ 2,000
*520 units × $150 per unit = $78,000.

†$35,000 + additional $10,000 monthly advertising budget = $45,000.
Assuming no other factors need to be considered, the increase in the advertising bud-
get should be approved because it would increase net operating income by $2,000. There
are two shorter ways to arrive at this solution. The first alternative solution follows:
Alternative Solution 1
Expected total contribution margin:
$130,000 × 40% CM ratio . . . . . . . . . . . . . . . . . . . . . . . . . . $52,000
Present total contribution margin:
$100,000 × 40% CM ratio. . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Increase in total contribution margin . . . . . . . . . . . . . . . . . . . . 12,000
Change in fixed expenses:
Less incremental advertising expense . . . . . . . . . . . . . . . . 10,000
Increased net operating income. . . . . . . . . . . . . . . . . . . . . . . . $ 2,000
Because in this case only the fixed costs and the sales volume change, the solution
can also be quickly derived as follows:
Alternative Solution 2
Incremental contribution margin:
$30,000 × 40% CM ratio . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000
Less incremental advertising expense . . . . . . . . . . . . . . . . . . 10,000
Increased net operating income. . . . . . . . . . . . . . . . . . . . . . . . $ 2,000
Notice that this approach does not depend on knowledge of previous sales. Also note
that it is unnecessary under either shorter approach to prepare an income statement. Both
of the alternative solutions involve incremental analysis—that is, they consider only
the costs and revenues that will change if the new program is implemented. Although in
each case a new income statement could have been prepared, the incremental approach is
simpler and more direct and focuses attention on the specific changes that would occur as
a result of the decision.
Example 2: Change in Variable Costs and Sales Volume Refer to the original
data. Recall that Acoustic Concepts is currently selling 400 speakers per month. Prem is
considering the use of higher-quality components, which would increase variable costs
(and thereby reduce the contribution margin) by $10 per speaker. However, the sales man-
ager predicts that using higher-quality components would increase sales to 480 speakers
per month. Should the higher-quality components be used?
The $10 increase in variable costs would decrease the unit contribution margin by
$10—from $100 down to $90.
Solution
Expected total contribution margin
with higher-quality components:
480 speakers × $90 per speaker . . . . . . . . . . . . . . . . . . . . $43,200
400 speakers × $100 per speaker . . . . . . . . . . . . . . . . . . . 40,000
Increase in total contribution margin . . . . . . . . . . . . . . . . . . . . $ 3,200
According to this analysis, the higher-quality components should be used. Because

fixed costs would not change, the $3,200 increase in contribution margin shown above
should result in a $3,200 increase in net operating income.
Example 3: Change in Fixed Cost, Selling Price, and Sales Volume Refer to the
original data and recall again that Acoustic Concepts is currently selling 400 speakers per
month. To increase sales, the sales manager would like to cut the selling price by $20 per
208 Chapter 5
speaker and increase the advertising budget by $15,000 per month. The sales manager
believes that if these two steps are taken, unit sales will increase by 50% to 600 speakers
per month. Should the changes be made?
A decrease in the selling price of $20 per speaker would decrease the unit contribu-
tion margin by $20 down to $80.
Solution
Expected total contribution margin with lower selling price:
Incremental contribution margin. . . . . . . . . . . . . . . . . . . . . . . . 8,000
Less incremental advertising expense . . . . . . . . . . . . . . . . 15,000
Reduction in net operating income . . . . . . . . . . . . . . . . . . . . . $ (7,000)
According to this analysis, the changes should not be made. The $7,000 reduction
in net operating income that is shown above can be verified by preparing comparative
contribution format income statements as shown here:
Present 400 Expected 600

Speakers Speakers
per Month per Month
Total Per Unit Total Per Unit Difference
Sales . . . . . . . . . . . . . . . . . . . $100,000 $ 250 $138,000 $ 230 $38,000
Variable expenses. . . . . . . . 60,000 150 90,000 150 30,000
Contribution margin . . . . . . 40,000 $ 100 48,000 $ 80 8,000
Fixed expenses . . . . . . . . . . 35,000 50,000* 15,000
Net operating income (loss) $ 5,000 $ (2,000) $ (7,000)
*35,000 + Additional monthly advertising budget of $15,000 = $50,000.
Example 4: Change in Variable Cost, Fixed Cost, and Sales Volume Refer to
Acoustic Concepts’ original data. As before, the company is currently selling 400 speakers
per month. The sales manager would like to pay salespersons a sales commission of $15 per
speaker sold, rather than the flat salaries that now total $6,000 per month. The sales manager
is confident that the change would increase monthly sales by 15% to 460 speakers per month.
Should the change be made?
Solution Changing the sales staff’s compensation from salaries to commissions would
affect both variable and fixed expenses. Variable expenses per unit would increase by
$15, from $150 to $165, and the unit contribution margin would decrease from $100 to
$85. Fixed expenses would decrease by $6,000, from $35,000 to $29,000.
Expected total contribution margin

with sales staff on commissions:
Decrease in total contribution margin . . . . . . . . . . . . . . . . . . . (900)
Add salaries avoided if a commission is paid. . . . . . . . . . . 6,000
Increase in net operating income. . . . . . . . . . . . . . . . . . . . . . . $ 5,100
According to this analysis, the changes should be made. Again, the same answer can
be obtained by preparing comparative contribution income statements:
Present 400 Expected 460

Speakers Speakers
per Month per Month
Total Per Unit Total Per Unit Difference
Sales . . . . . . . . . . . . . . . . . . . $100,000 $ 250 $115,000 $ 250 $15,000
Variable expenses. . . . . . . . 60,000 150 75,900 165 15,900
Contribution margin . . . . . . 40,000 $ 100 39,100 $ 85 900
Fixed expenses . . . . . . . . . . 35,000 29,000 (6,000)*
Net operating income. . . . . $ 5,000 $ 10,100 $ 5,100
*Note: A reduction in fixed expenses has the effect of increasing net operating income.
Example 5: Change in Selling Price Refer to the original data where Acoustic Con-
cepts is currently selling 400 speakers per month. The company has an opportunity to
make a bulk sale of 150 speakers to a wholesaler if an acceptable price can be negotiated.
This sale would not alter the company’s regular sales and would not affect the company’s
total fixed expenses. What price per speaker should be quoted to the wholesaler if Acous-
tic Concepts is seeking a profit of $3,000 on the bulk sale?
Solution
Variable cost per speaker . . . . . . . . . . . . . . . . . . . $150

Desired profit per speaker: . . . . . . . . . . . . . . . . . .
$3,000 ÷ 150 speakers . . . . . . . . . . . . . . . . . . . 20
Quoted price per speaker . . . . . . . . . . . . . . . . . . . $170
Notice that fixed expenses are not included in the computation. This is because fixed
expenses are not affected by the bulk sale, so all of the additional contribution margin
increases the company’s profits.
IN BUSINESS
NEWSPAPER CIRCULARS: STILL WORTH THE INVESTMENT
In the digital era, it might be easy to assume that retailers should abandon the advertising
inserts (called newspaper circulars) that accompany print newspapers. However, Wanderful
Media estimates that 80% of people who read print newspapers look at the circulars inside,
whereas only 1% of online readers click through to digital circulars. Walmart acquainted itself
with these statistics when it discontinued print circulars in Fargo, North Dakota, Madison, Wis-
consin, and Tucson, Arizona and redirected its advertising dollars in those markets to digital
media. The ensuing drop in sales motivated Walmart to immediately reinstate its circular ads in
print newspapers. © Robert Barnes/Getty Images
Kohl’s hopes to decrease the cost of producing and distributing its circulars by 40% while
largely retaining its existing sales volumes. Its plan is to use data from past purchases to iden-
tify the zip codes with the highest concentrations of loyal Kohl’s shoppers and then to limit its
distribution of circulars to the most profitable zip codes (rather than relying on more expensive
mass distribution in all zip codes). The company will probably use cost-volume-profit analysis to
determine if its plan increases profits.
Source: Suzanne Kapner, “Retailers Can’t Shake Their Circular Habit,” The Wall Street Journal, March 12, 2015, p. B8.
210 Chapter 5
Break-Even and Target Profit Analysis

Managers use break-even and target profit analysis to answer questions such as how much
would we have to sell to avoid incurring a loss or how much would we have to sell to
make a profit of $10,000 per month? We’ll discuss break-even analysis first followed by
target profit analysis.
Break-Even Analysis
LO5–5 Earlier in the chapter we defined the break-even point as the level of sales at which the
Determine the break-even company’s profit is zero. To calculate the break-even point (in unit sales and dollar sales),
point. managers can use either of two approaches, the equation method or the formula method.
We’ll demonstrate both approaches using the data from Acoustic Concepts.
The Equation Method

The equation method relies on the basic profit equation introduced earlier in the chap-
ter. Because Acoustic Concepts has only one product, we’ll use the contribution margin
form of this equation to perform the break-even calculations. Remembering that Acoustic
Concepts’ unit contribution margin is $100, and its fixed expenses are $35,000, the com-
pany’s break-even point is computed as follows:
Profit = Unit CM × Q − Fixed expense

$0 = $100 × Q − $35,000
$100 × Q = $0 + $35,000
Q = $35,000 ÷ $100
Q = 350
Thus, as we determined earlier in the chapter, Acoustic Concepts will break even (or earn
zero profit) at a sales volume of 350 speakers per month.
The Formula Method The formula method is a shortcut version of the equation
method. It centers on the idea discussed earlier in the chapter that each unit sold provides
a certain amount of contribution margin that goes toward covering fixed expenses. In a
single product situation, the formula for computing the unit sales to break even is:
Fixed expenses 3
Unit sales to break even = ______________
Unit CM
In the case of Acoustic Concepts, the unit sales needed to break even is computed as
follows:
Fixed expenses
Unit sales to break even = _____________
Unit CM
$35,000
= _______
$100
= 350
3
This formula can be derived as follows:
$0 = Unit CM × Q − Fixed expenses
Unit CM × Q = $0 + Fixed expenses
Q = Fixed expenses ÷ Unit CM
Notice that 350 units is the same answer that we got when using the equation method.
This will always be the case because the formula method and equation method are
mathematically equivalent. The formula method simply skips a few steps in the equa-
tion method.
Break-Even in Dollar Sales In addition to finding the break-even point in unit sales,
we can also find the break-even point in dollar sales using three methods. First, we
could solve for the break-even point in unit sales using the equation method or formula
method and then simply multiply the result by the selling price. In the case of Acoustic
Concepts, the break-even point in dollar sales using this approach would be computed as
350 speakers × $250 per speaker, or $87,500 in total sales.
Second, we can use the equation method to compute the break-even point in dollar
sales. Remembering that Acoustic Concepts’ contribution margin ratio is 40% and its
fixed expenses are $35,000, the equation method calculates the break-even point in dollar
sales as follows:

$0 = 0.40 × Sales − $35,000
0.40 × Sales = $0 + $35,000
Sales = $35,000 ÷ 0.40
Sales = $87,500
Third, we can use the formula method to compute the dollar sales needed to break
even as shown below:
Fixed expenses 4
Dollar sales to break even = ______________
CM ratio
In the case of Acoustic Concepts, the computations are performed as follows:
Fixed expenses
Dollar sales to break even = _____________
CM ratio
$35,000
= _______
0.40
= $87,500
Again, you’ll notice that the break-even point in dollar sales ($87,500) is the same
under all three methods. This will always be the case because these methods are math-
ematically equivalent.
Target Profit Analysis LO5–6

Target profit analysis is one of the key uses of CVP analysis. In target profit analysis, Determine the level of sales
we estimate what sales volume is needed to achieve a specific target profit. For exam- needed to achieve a desired
target profit.
ple, suppose Prem Narayan of Acoustic Concepts, Inc., would like to estimate the sales
needed to attain a target profit of $40,000 per month. To determine the unit sales and
4
This formula can be derived as follows:
$0 = CM ratio × Sales − Fixed expenses
CM ratio × Sales = $0 + Fixed expenses
Sales = Fixed expenses ÷ CM ratio
212 Chapter 5
dollar sales needed to achieve a target profit, we can rely on the same two approaches that
we have been discussing thus far, the equation method or the formula method.
The Equation Method To compute the unit sales required to achieve a target profit of
$40,000 per month, Acoustic Concepts can use the same profit equation that was used for
its break-even analysis. Remembering that the company’s contribution margin per unit is
$100 and its total fixed expenses are $35,000, the equation method could be applied as
follows:

$40,000 = $140 × Q − $35,000
$100 × Q = $40,000 + $35,000
Q = $75,000 ÷ $100
Q = 750
Thus, the target profit can be achieved by selling 750 speakers per month. Notice that
the only difference between this equation and the equation used for Acoustic Concepts’
break-even calculation is the profit figure. In the break-even scenario, the profit is $0,
whereas in the target profit scenario the profit is $40,000.
The Formula Method In general, in a single product situation, we can compute the
sales volume required to attain a specific target profit using the following formula:
Target profit + Fixed expenses

Unit sales to attain the target profit = _________________________
Unit CM
In the case of Acoustic Concepts, the unit sales needed to attain a target profit of
40,000 is computed as follows:
Unit sales to attain the target profit = _________________________
Unit CM
$40,000 + $35,000
= _______________
$100
= 750
Target Profit Analysis in Terms of Dollar Sales When quantifying the dollar sales
needed to attain a target profit we can apply the same three methods that we used for cal-
culating the dollar sales needed to break even. First, we can solve for the unit sales needed
to attain the target profit using the equation method or formula method and then simply
multiply the result by the selling price. In the case of Acoustic Concepts, the dollar sales
to attain its target profit would be computed as 750 speakers × $250 per speaker, or
$187,500 in total sales.
Second, we can use the equation method to compute the dollar sales needed to attain
the target profit. Remembering that Acoustic Concepts’ target profit is $40,000, its con-
tribution margin ratio is 40%, and its fixed expenses are $35,000, the equation method
calculates the answer as follows:

$40,000 = 0.40 × Sales − $35,000
0.40 × Sales = $40,000 + $35,000
Sales = $75,000 ÷ 0.40
Sales = $187,500
Third, we can use the formula method to compute the dollar sales needed to attain the
target profit as shown below:

Dollar sales to attain the target profit = _________________________
CM ratio
In the case of Acoustic Concepts, the computations would be:

Dollar sales to attain the target profit = _________________________
CM ratio
$40,000 + $35,000
= _______________
0.40
= $187,500
Again, you’ll notice that the answers are the same regardless of which method we
use. This is because all of the methods discussed are simply different roads to the same
destination.
IN BUSINESS
WOULD YOU PAY $800 FOR A PAIR OF SNEAKERS?
Some companies rely on sales volume to drive profits whereas others rely on scarcity to
increase margins and profits. Buscemi sneakers burst on to the market for $760 a pair and soon
climbed to $865 a pair. The company purposely limits production to drive up its prices. It initially
produced a batch of 600 pairs of sneakers that sold out in days. Then the company released
4,000 additional pairs that were sold out by the time pop star Justin Bieber posted a picture of
his gold-colored Buscemis on Instagram. Its next step was to release 8,000 more pairs to about
50 stores. Although Buscemi could almost certainly increase production and unit sales, the
company chooses to limit availability to add to the mystique (and price) of the brand.
© Astrid Stawiarz/Goodman’s Men’s Store/
Source: Hannah Karp, “An $800 Sneaker Plays Hard to Get,” The Wall Street Journal, July 28, 2014, pp. B1 and B7. Getty Images
The Margin of Safety LO5–7

The margin of safety is the excess of budgeted or actual sales dollars over the break- Compute the margin of safety
even volume of sales dollars. It is the amount by which sales can drop before losses are and explain its significance.
incurred. The higher the margin of safety, the lower the risk of not breaking even and
incurring a loss. The formula for the margin of safety is:
Margin of safety in dollars = Total budgeted (or actual) sales − Break‐even sales
The margin of safety also can be expressed in percentage form by dividing the mar-
gin of safety in dollars by total dollar sales:
Margin of safety in dollars

Margin of safety percentage = ___________________________________________
Total budgeted (or actual) sales in dollars
The calculation of the margin of safety for Acoustic Concepts is:
Sales (at the current volume of 400 speakers) (a) . . . . . . . $100,000

Break-even sales (at 350 speakers) . . . . . . . . . . . . . . . . . . . 87,500
Margin of safety in dollars (b) . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,500
Margin of safety percentage, (b) ÷ (a) . . . . . . . . . . . . . . . . . . 12.5%
214 Chapter 5
This margin of safety means that at the current level of sales and with the company’s cur-
rent prices and cost structure, a reduction in sales of $12,500, or 12.5%, would result in
just breaking even.
In a single-product company like Acoustic Concepts, the margin of safety also can be
expressed in terms of the number of units sold by dividing the margin of safety in dollars
by the selling price per unit. In this case, the margin of safety is 50 speakers ($12,500 ÷
$250 per speaker = 50 speakers).
MANAGERIAL
ACCOUNTING IN ACTION Prem Narayan and Bob Luchinni met to discuss the results of Bob’s analysis.
THE WRAP-UP
Prem: Bob, everything you have shown me is pretty clear. I can see what impact the
sales manager’s suggestions would have on our profits. Some of those suggestions
are quite good and others are not so good. I am concerned that our margin of safety is
only 50 speakers. What can we do to increase this number?
Bob: Well, we have to increase total sales or decrease the break-even point or both.
Prem: And to decrease the break-even point, we have to either decrease our fixed
expenses or increase our unit contribution margin?
Bob: Exactly.
Prem: And to increase our unit contribution margin, we must either increase our selling
price or decrease the variable cost per unit?
Bob: Correct.
Prem: So what do you suggest?
Bob: Well, the analysis doesn’t tell us which of these to do, but it does indicate we have
a potential problem here.
Prem: If you don’t have any immediate suggestions, I would like to call a general meeting
next week to discuss ways we can work on increasing the margin of safety. I think every-
one will be concerned about how vulnerable we are to even small downturns in sales.
CVP Considerations in Choosing a Cost Structure

Cost structure refers to the relative proportion of fixed and variable costs in an organiza-
tion. Managers often have some latitude in trading off between these two types of costs.
For example, fixed investments in automated equipment can reduce variable labor costs.
In this section, we discuss the choice of a cost structure. We also introduce the concept of
operating leverage.
Cost Structure and Profit Stability

Which cost structure is better—high variable costs and low fixed costs, or the oppo-
site? No single answer to this question is possible; each approach has its advantages. To
show what we mean, refer to the following contribution format income statements for two
blueberry farms. Bogside Farm depends on migrant workers to pick its berries by hand,
whereas Sterling Farm has invested in expensive berry-picking machines. Consequently,
Bogside Farm has higher variable costs, but Sterling Farm has higher fixed costs:
Bogside Farm Sterling Farm

Amount Percent Amount Percent
Sales . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 100% $100,000 100%
Variable expenses. . . . . . . . . . . . . . 60,000 60% 30,000 30%
Contribution margin . . . . . . . . . . . . 40,000 40% 70,000 70%
Fixed expenses . . . . . . . . . . . . . . . . 30,000 60,000
Net operating income. . . . . . . . . . . $ 10,000 $ 10,000
Which farm has the better cost structure? The answer depends on many factors,
including the long-run trend in sales, year-to-year fluctuations in the level of sales, and
the attitude of the owners toward risk. If sales are expected to exceed $100,000 in the
future, then Sterling Farm probably has the better cost structure. The reason is that its CM
ratio is higher, and its profits will therefore increase more rapidly as sales increase. To
illustrate, assume that each farm experiences a 10% increase in sales without any increase
in fixed costs. The new contribution income statements would be as follows:

Amount Percent Amount Percent
Sales . . . . . . . . . . . . . . . . . . . . . . . . . $110,000 100% $110,000 100%
Variable expenses. . . . . . . . . . . . . . 66,000 60% 33,000 30%
Contribution margin . . . . . . . . . . . . 44,000 40% 77,000 70%
Fixed expenses . . . . . . . . . . . . . . . . 30,000 60,000
Net operating income. . . . . . . . . . . $ 14,000 $ 17,000
Sterling Farm has experienced a greater increase in net operating income due to its higher
CM ratio even though the increase in sales was the same for both farms.
What if sales drop below $100,000? What are the farms’ break-even points? What are
their margins of safety? The computations needed to answer these questions are shown
below using the formula method:

Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 $ 60,000
Contribution margin ratio . . . . . . . . . . . . . . . . . . . . ÷ 0.40 ÷ 0.70
Dollar sales to break even . . . . . . . . . . . . . . . . . . . $ 75,000 $ 85,714
Total current sales (a) . . . . . . . . . . . . . . . . . . . . . . . $100,000 $100,000
Break-even sales. . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000 85,714
Margin of safety in sales dollars (b) . . . . . . . . . . . $ 25,000 $ 14,286
Margin of safety percentage (b) ÷ (a) . . . . . . . . . . 25.0% 14.3%
Bogside Farm’s margin of safety is greater and its contribution margin ratio is lower
than Sterling Farm. Therefore, Bogside Farm is less vulnerable to downturns than Ster-
ling Farm. Due to its lower contribution margin ratio, Bogside Farm will not lose con-
tribution margin as rapidly as Sterling Farm when sales decline. Thus, Bogside Farm’s
profit will be less volatile. We saw earlier that this is a drawback when sales increase, but
it provides more protection when sales drop. And because its break-even point is lower,
Bogside Farm can suffer a larger sales decline before losses emerge.
To summarize, without knowing the future, it is not obvious which cost structure
is better. Both have advantages and disadvantages. Sterling Farm, with its higher fixed
costs and lower variable costs, will experience wider swings in net operating income as
sales fluctuate, with greater profits in good years and greater losses in bad years. Bog-
side Farm, with its lower fixed costs and higher variable costs, will enjoy greater profit
stability and will be more protected from losses during bad years, but at the cost of lower
net operating income in good years. Moreover, if the higher fixed costs in Sterling Farm
reflect greater capacity, Sterling Farm will be better able than Bogside Farm to profit
from unexpected surges in demand. LO5–8
Compute the degree of
operating leverage at a
Operating Leverage particular level of sales and
explain how it can be used
A lever is a tool for multiplying force. Using a lever, a massive object can be moved with to predict changes in net
only a modest amount of force. In business, operating leverage serves a similar purpose. operating income.
Operating leverage is a measure of how sensitive net operating income is to a given
216 Chapter 5
percentage change in dollar sales. Operating leverage acts as a multiplier. If operating

leverage is high, a small percentage increase in sales can produce a much larger percent-
age increase in net operating income.
Operating leverage can be illustrated by returning to the data for the two blueberry
farms. We previously showed that a 10% increase in sales (from $100,000 to $110,000 in
each farm) results in a 70% increase in the net operating income of Sterling Farm (from
$10,000 to $17,000) and only a 40% increase in the net operating income of Bogside
Farm (from $10,000 to $14,000). Thus, for a 10% increase in sales, Sterling Farm experi-
ences a much greater percentage increase in profits than does Bogside Farm. Therefore,
Sterling Farm has greater operating leverage than Bogside Farm.
The degree of operating leverage at a given level of sales is computed by the fol-
lowing formula:
Contribution margin
Degree of operating leverage = __________________
Net operating income
The degree of operating leverage is a measure, at a given level of sales, of how a percent-
age change in sales volume will affect profits. To illustrate, the degree of operating lever-
age for the two farms at $100,000 sales would be computed as follows:
$40,000
Bogside Farm : _______ = 4
$10,000
$70,000
Sterling Farm : _______ = 7
$10,000
Because the degree of operating leverage for Bogside Farm is 4, the farm’s net operat-
ing income grows four times as fast as its sales. In contrast, Sterling Farm’s net operat-
ing income grows seven times as fast as its sales. Thus, if sales increase by 10%, then
we can expect the net operating income of Bogside Farm to increase by four times this
amount, or by 40%, and the net operating income of Sterling Farm to increase by seven
times this amount, or by 70%. In general, this relation between the percentage change
in sales and the percentage change in net operating income is given by the following
formula:
Percentage change in Degree of Percentage

= ×
net operating income operating leverage change in sales
Bogside Farm : Percentage change in net operating income = 4 × 10% = 40%

Sterling Farm : Percentage change in net operating income = 7 × 10% = 70%
What is responsible for the higher operating leverage at Sterling Farm? The only
difference between the two farms is their cost structure. If two companies have the same
total revenue and same total expense but different cost structures, then the company with
the higher proportion of fixed costs in its cost structure will have higher operating lever-
age. Referring back to the original data, when both farms have sales of $100,000 and
total expenses of $90,000, one-third of Bogside Farm’s costs are fixed but two-thirds of
Sterling Farm’s costs are fixed. As a consequence, Sterling’s degree of operating leverage
is higher than Bogside’s.
The degree of operating leverage is not a constant; it is greatest at sales levels near
the break-even point and decreases as sales and profits rise. The following table shows
the degree of operating leverage for Bogside Farm at various sales levels. (Data used ear-
lier for Bogside Farm are shown in color.)
Sales . . . . . . . . . . . . . . . . . . . . . . $75,000 $80,000 $100,000 $150,000 $225,000

Variable expenses . . . . . . . . . . 45,000 48,000 60,000 90,000 135,000
Contribution margin (a) . . . . . . 30,000 32,000 40,000 60,000 90,000
Fixed expenses . . . . . . . . . . . . . 30,000 30,000 30,000 30,000 30,000
Net operating income (b) . . . . . $ 0 $ 2,000 $ 10,000 $ 30,000 $ 60,000
Degree of operating
leverage, (a) ÷ (b) . . . . . . . . . ∞ 16 4 2 1.5
Thus, a 10% increase in sales would increase profits by only 15% (10% × 1.5) if sales
were previously $225,000, as compared to the 40% increase we computed earlier at the
$100,000 sales level. The degree of operating leverage will continue to decrease the far-
ther the company moves from its break-even point. At the break-even point, the degree
of operating leverage is infinitely large ($30,000 contribution margin ÷ $0 net operating
income = ∞).
The degree of operating leverage can be used to quickly estimate what impact vari-
ous percentage changes in sales will have on profits, without the necessity of preparing
detailed contribution format income statements. As shown by our examples, the effects of
operating leverage can be dramatic. If a company is near its break-even point, then even
small percentage increases in sales can yield large percentage increases in profits. This
explains why management will often work very hard for only a small increase in sales
volume. If the degree of operating leverage is 5, then a 6% increase in sales would trans-
late into a 30% increase in profits.
IN BUSINESS
COMPARING THE COST STRUCTURES OF TWO ONLINE GROCERS
Perhaps the biggest flop of the dot.com era was an online grocer called Webvan. The com-
pany burned through $800 million in cash before filing for bankruptcy in 2001 and halting
operations. Part of Webvan’s downfall was a cost structure heavily skewed towards fixed
costs. For example, Webvan stored huge amounts of inventory in refrigerated warehouses
that cost $40 million each to build. The company had 4,500 salaried employees with ben-
efits (including warehouse workers and delivery personnel) and a fleet of its own delivery
trucks.
Fast forward more than 15 years, and now Instacart Inc. is trying to become a profitable © MachineHeadz/Getty Images RF
online grocer. Only this time Instacart is avoiding the kinds of huge fixed cost investments
that plagued Webvan. Instead of hiring salaried employees with benefits, Instacart uses driv-
ers who are independent contractors to deliver groceries to customers. The company pays
its drivers $10 per order delivered plus additional compensation based on order size and
delivery speed. Since the drivers use their own vehicles to pick up groceries directly from
the supermarket, it eliminates the need for a fleet of delivery trucks, as well as the need for
expensive refrigerated warehouses and the associated working capital tied up in perishable
inventories.
Source: Greg Benninger, “Rebuilding History’s Biggest Dot-Com Bust,” The Wall Street Journal, January 13, 2015, pp. B1–B2.
218 Chapter 5
Structuring Sales Commissions

Companies usually compensate salespeople by paying them a commission based on
sales, a salary, or a combination of the two. Commissions based on sales dollars can lead
to lower profits. To illustrate, consider Pipeline Unlimited, a producer of surfing equip-
ment. Salespersons sell the company’s products to retail sporting goods stores throughout
North America and the Pacific Basin. Data for two of the company’s surfboards, the XR7
and Turbo models, appear below:
Model
XR7 Turbo
Selling price . . . . . . . . . . . . . . . . . . . . . . . . . $695 $ 749
Variable expenses. . . . . . . . . . . . . . . . . . . . 344 410
Contribution margin . . . . . . . . . . . . . . . . . . $351 $ 339
Which model will salespeople push hardest if they are paid a commission of 10% of sales
revenue? The answer is the Turbo because it has the higher selling price and hence the
larger commission. On the other hand, from the standpoint of the company, profits will
be greater if salespeople steer customers toward the XR7 model because it has the higher
contribution margin.
To eliminate such conflicts, commissions can be based on contribution margin
rather than on selling price. If this is done, the salespersons will want to sell the mix of
products that maximizes contribution margin. Providing that fixed costs remain
constant, maximizing the contribution margin will also maximize the company’s profit.5
In effect, by maximizing their own compensation, salespersons will also maximize the
company’s profit.
Sales Mix
Before concluding our discussion of CVP concepts, we need to consider the impact of
LO5–9
Compute the break-even
changes in sales mix on a company’s profit.
point for a multiproduct
company and explain the The Definition of Sales Mix
effects of shifts in the sales
mix on contribution margin
The term sales mix refers to the relative proportions in which a company’s products are
and the break-even point. sold. The idea is to achieve the combination, or mix, that will yield the greatest profits.
Most companies have many products, and often these products are not equally profitable.
Hence, profits will depend to some extent on the company’s sales mix. Profits will be
greater if high-margin rather than low-margin items make up a relatively large proportion
of total sales.
Changes in the sales mix can cause perplexing variations in a company’s profits. A
shift in the sales mix from high-margin items to low-margin items can cause total profits
to decrease even though total sales may increase. Conversely, a shift in the sales mix
from low-margin items to high-margin items can cause the reverse effect—total profits
may increase even though total sales decrease. It is one thing to achieve a particular sales
volume; it is quite another to sell the most profitable mix of products.
5
This also assumes the company has no production constraint. If it does, the sales commissions should
be modified.
IN BUSINESS
NETBOOK SALES CANNIBALIZE PC SALES
When computer manufacturers introduced the “netbook,” they expected it to serve as a
consumer’s third computer—complementing home and office personal computers (PCs)
rather than replacing them. However, when the economy soured many customers decided
to buy lower-priced netbooks instead of PCs, which in turn adversely affected the financial
performance of many companies. For example, when Microsoft failed to achieve its sales
goals, the company partially blamed growing netbook sales and declining PC sales for its
troubles. Microsoft’s Windows operating system for netbooks sells for $15–$25 per device,
which is less than half the cost of the company’s least expensive Windows operating sys-
tem for PCs.
Source: Olga Kharif, “Small, Cheap—and Frighteningly Popular,” BusinessWeek, December 8, 2008, p. 64.
Sales Mix and Break-Even Analysis

If a company sells more than one product, break-even analysis is more complex than dis-
cussed to this point. The reason is that different products will have different selling prices,
different costs, and different contribution margins. Consequently, the break-even point
depends on the mix in which the various products are sold. To illustrate, consider Virtual
Journeys Unlimited, a small company that sells two DVDs: the Monuments DVD, a tour
of the United States’ most popular National Monuments; and the Parks DVD, which tours
the United States’ National Parks. The company’s September sales, expenses, and break-
even point are shown in Exhibit 5–4.
As shown in the exhibit, the break-even point is $60,000 in sales, which was com-
puted by dividing the company’s fixed expenses of $27,000 by its overall CM ratio
of 45%. However, this is the break-even only if the company’s sales mix does not
change. Currently, the Monuments DVD is responsible for 20% and the Parks DVD
for 80% of the company’s dollar sales. Assuming this sales mix does not change, if
total sales are $60,000, the sales of the Monuments DVD would be $12,000 (20%
of $60,000) and the sales of the Parks DVD would be $48,000 (80% of $60,000).
As shown in Exhibit 5–4, at these levels of sales, the company would indeed break
even. But $60,000 in sales represents the break-even point for the company only if
the sales mix does not change. If the sales mix changes, then the break-even point
will also usually change. This is illustrated by the results for October in which the
sales mix shifted away from the more profitable Parks DVD (which has a 50% CM
ratio) toward the less profitable Monuments DVD (which has a 25% CM ratio). These
results appear in Exhibit 5–5.
Although sales have remained unchanged at $100,000, the sales mix is exactly the
reverse of what it was in Exhibit 5–4, with the bulk of the sales now coming from the
less profitable Monuments DVD. Notice that this shift in the sales mix has caused both
the overall CM ratio and total profits to drop sharply from the prior month even though
total sales are the same. The overall CM ratio has dropped from 45% in September
to only 30% in October, and net operating income has dropped from $18,000 to only
$3,000. In addition, with the drop in the overall CM ratio, the company’s break-even
point is no longer $60,000 in sales. Because the company is now realizing less average
contribution margin per dollar of sales, it takes more sales to cover the same amount of
fixed costs. Thus, the break-even point has increased from $60,000 to $90,000 in sales
per year.
In preparing a break-even analysis, an assumption must be made concerning the
sales mix. Usually the assumption is that it will not change. However, if the sales mix
is expected to change, then this must be explicitly considered in any CVP computations.
220 Chapter 5
EXHIBIT 5–4
Multiproduct Break-Even Analysis
Virtual Journeys Unlimited

For the Month of September
Monuments DVD Parks DVD Total
Amount Percent Amount Percent Amount Percent
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000 100% $80,000 100% $100,000 100%
Variable expenses. . . . . . . . . . . . . . . . . 15,000 75% 40,000 50% 55,000 55%
Contribution margin . . . . . . . . . . . . . . . $ 5,000 25% $40,000 50% 45,000 45%
Fixed expenses . . . . . . . . . . . . . . . . . . . 27,000
Net operating income . . . . . . . . . . . . . . $ 18,000
Computation of the break-even point:

Fixed expenses $27,000
= = $60,000
Overall CM ratio 0.45
Verification of the break-even point:
Current dollar sales . . . . . . . . . . . . . . $20,000 $80,000 $100,000
Percentage of total dollar sales . . . . 20% 80% 100%
Sales at the break-even point . . . . . . $12,000 $48,000 $60,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000 100% $48,000 100% $ 60,000 100%
Variable expenses. . . . . . . . . . . . . . . . 9,000 75% 24,000 50% 33,000 55%
Contribution margin . . . . . . . . . . . . . . $ 3,000 25% $24,000 50% 27,000 45%
Fixed expenses . . . . . . . . . . . . . . . . . . 27,000
Net operating income . . . . . . . . . . . . . $ 0
EXHIBIT 5–5
Multiproduct Break-Even Analysis: A Shift in Sales Mix (see Exhibit 5–4)
Virtual Journeys Unlimited

For the Month of October
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 100% $20,000 100% $100,000 100%
Variable expenses. . . . . . . . . . . . . . . . . 60,000 75% 10,000 50% 70,000 70%
Contribution margin . . . . . . . . . . . . . . . $20,000 25% $10,000 50% 30,000 30%
Fixed expenses . . . . . . . . . . . . . . . . . . . 27,000
Net operating income . . . . . . . . . . . . . . $ 3,000
Computation of the break-even point:

Fixed expenses $27,000
Overall CM ratio = 0.30 = $90,000
Summary
CVP analysis is based on a simple model of how profits respond to prices, costs, and volume. This
model can be used to answer a variety of critical questions such as what is the company’s break-
even volume, what is its margin of safety, and what is likely to happen if specific changes are made
in prices, costs, and volume.
A CVP graph depicts the relationships between unit sales on the one hand and fixed
expenses, variable expenses, total expenses, total sales, and profits on the other hand. The profit
graph is simpler than the CVP graph and shows how profits depend on sales. The CVP and
profit graphs are useful for developing intuition about how costs and profits respond to changes
in sales.
The contribution margin ratio is the ratio of contribution margin to sales. This ratio can be
used to quickly estimate what impact a change in total sales would have on net operating income.
The ratio is also useful in break-even analysis.
Break-even analysis is used to estimate the sales needed to break even. The unit sales required
to break even can be estimated by dividing the fixed expense by the unit contribution margin.
Target profit analysis is used to estimate the sales needed to attain a specified target profit. The unit
sales required to attain the target profit can be estimated by dividing the sum of the target profit and
fixed expense by the unit contribution margin.
The margin of safety is the amount by which the company’s budgeted (or actual) sales exceeds
break-even sales.
The degree of operating leverage allows quick estimation of what impact a given percentage
change in sales would have on the company’s net operating income. The higher the degree of oper-
ating leverage, the greater is the impact on the company’s profits. The degree of operating leverage
is not constant—it depends on the company’s current level of sales.
The profits of a multiproduct company are affected by its sales mix. Changes in the sales mix
can affect the break-even point, margin of safety, and other critical factors.
Review Problem: CVP Relationships

Voltar Company manufactures and sells a specialized cordless telephone for high electromagnetic
radiation environments. The company’s contribution format income statement for the most recent
year is given below:
Total Per Unit Percent of Sales

Sales (20,000 units) . . . . . . . . . . . $1,200,000 $ 60 100%
Variable expenses. . . . . . . . . . . . . 900,000 45 ? %
Contribution margin . . . . . . . . . . . 300,000 $ 15 ? %
Fixed expenses . . . . . . . . . . . . . . . 240,000
Net operating income. . . . . . . . . . $ 60,000
Management is anxious to increase the company’s profit and has asked for an analysis of a
number of items.
Required:
1. Compute the company’s CM ratio and variable expense ratio.
2. Compute the company’s break-even point in both unit sales and dollar sales. Use the equation
method.
3. Assume that sales increase by $400,000 next year. If cost behavior patterns remain unchanged,
by how much will the company’s net operating income increase? Use the CM ratio to com-
pute your answer.
4. Refer to the original data. Assume that next year management wants the company to earn a
profit of at least $90,000. How many units will have to be sold to earn this target profit?
5. Refer to the original data. Compute the company’s margin of safety in both dollar and per-
centage form.
222 Chapter 5
6. a. Compute the company’s degree of operating leverage at the present level of sales.
b. Assume that through a more intense effort by the sales staff, the company’s sales increase
by 8% next year. By what percentage would you expect net operating income to increase?
Use the degree of operating leverage to obtain your answer.
c. Verify your answer to (b) by preparing a new contribution format income statement
showing an 8% increase in sales.
7. Refer to the original data. In an effort to increase sales and profits, management is considering
the use of a higher-quality speaker. The higher-quality speaker would increase variable costs
by $3 per unit, but management could eliminate one quality inspector who is paid a salary of
$30,000 per year. The sales manager estimates that the higher-quality speaker would increase
annual sales by at least 20%.
a. Assuming that changes are made as described above, prepare a projected contribution
format income statement for next year. Show data on a total, per unit, and percentage
basis.
b. Compute the company’s new break-even point in both unit sales and dollar sales. Use the
formula method.
c. Would you recommend that the changes be made?
Solution to Review Problem

1. Unit contribution margin $15
CM ratio = _____________________ = ____ = 25%
Variable expense ____
_______________ $45
Variable expense ratio = = = 75%
Selling price $60
2. Profit = Unit CM × Q − Fixed expenses
$0 = $15 × Q − $240,000
$15Q = $240,000
Q = $240,000 ÷ $15
Q = 16,000 units; or, at $60 per unit, $960,000
3. Increase in sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000

Contribution margin ratio . . . . . . . . . . . . . . . . . . . . . × 25%
Expected increase in contribution margin . . . . . . . $100,000
Because the fixed expenses are not expected to change, net operating income will increase by the
entire $100,000 increase in contribution margin computed above.
4. Equation method:

$90,000 = $15 × Q − $240,000
$15Q = $90,000 + $240,000
Q = $330,000 ÷ $15
Q = 22,000 units
Formula method:
Target profit + Fixed expenses ________________

Unit sales to attain _________________________ $90,000 + $240,000
= = = 22,000 units
the target profit Contribution margin per unit $15 per unit
5. Margin of safety in dollars = Total sales − Break-even sales

= $1,200,000 − $960,000 = $240,000
Margin of safety in dollars $240,000
Margin of safety percentage = ______________________ = __________ = 20%
Total sales $1,200,000
Contribution margin $300,000

6. a. Degree of operating leverage = __________________ = ________ = 5
Net operating income $60,000
b.
Expected increase in sales . . . . . . . . . . . . . . . . . . . . . . . . . . 8%
Degree of operating leverage. . . . . . . . . . . . . . . . . . . . . . . . ×5
Expected increase in net operating income . . . . . . . . . . . . 40%
c. If sales increase by 8%, then 21,600 units (20,000 × 1.08 = 21,600) will be sold next
year. The new contribution format income statement would be as follows:

Sales (21,600 units) . . . . . . . . . . . $1,296,000 $ 60 100%
Variable expenses . . . . . . . . . . . . 972,000 45 75%
Contribution margin . . . . . . . . . . . 324,000 $ 15 25%
Fixed expenses . . . . . . . . . . . . . . . 240,000
Net operating income . . . . . . . . . $ 84,000
Thus, the $84,000 expected net operating income for next year represents a 40% increase over the
$60,000 net operating income earned during the current year:
$84,000 − $60,000 _______
_______________ $24,000
= = 40% increase
$60,000 $60,000
Note that the increase in sales from 20,000 to 21,600 units has increased both total sales and total
variable expenses.
7. a. A 20% increase in sales would result in 24,000 units being sold next year: 20,000 units ×
1.20 = 24,000 units.

Sales (24,000 units) . . . . . . . . . . $1,440,000 $60 100%
Variable expenses. . . . . . . . . . . . 1,152,000 48* 80%
Contribution margin . . . . . . . . . . 288,000 $12 20%
Fixed expenses . . . . . . . . . . . . . . 210,000†
Net operating income. . . . . . . . . $ 78,000
*
$45 + $3 = $48; $48 ÷ $60 = 80%.
†
$240,000 − $30,000 = $210,000.
Note that the change in per unit variable expenses results in a change in both the per unit con-
tribution margin and the CM ratio.
Fixed expenses
b. Unit sales to break even = _____________________
Unit contribution margin
$210,000
= _______________ = 17,500 units
$12 per unit
Fixed expenses
Dollar sales to break even = _____________
CM ratio
$210,000
= ________ = $1,050,000
0.20
c. Yes, based on these data, the changes should be made. The changes increase the com-
pany’s net operating income from the present $60,000 to $78,000 per year. Although the
changes also result in a higher break-even point (17,500 units as compared to the present
16,000 units), the company’s margin of safety actually becomes greater than before:
Margin of safety in dollars = Total sales − Break-even sales

= $1,440,000 − $1,050,000 = $390,000
As shown in (5), the company’s present margin of safety is only $240,000. Thus, several benefits
will result from the proposed changes.
224 Chapter 5
Glossary
Break-even point The level of sales at which profit is zero. (p. 199)
Contribution margin ratio (CM ratio) A ratio computed by dividing contribution margin by
sales. (p. 204)
Cost-volume-profit (CVP) graph A graphical representation of the relationships between an
organization’s revenues, costs, and profits on the one hand and its sales volume on the other
hand. (201)
Degree of operating leverage A measure, at a given level of sales, of how a percentage change in
sales will affect profits. The degree of operating leverage is computed by dividing contribu-
tion margin by net operating income. (p. 216)
Incremental analysis An analytical approach that focuses only on those costs and revenues that
change as a result of a decision. (p. 207)
Margin of safety The excess of budgeted or actual dollar sales over the break-even dollar
sales. (p. 213)
Operating leverage A measure of how sensitive net operating income is to a given percentage
change in dollar sales. (p. 215)
Sales mix The relative proportions in which a company’s products are sold. Sales mix is com-
puted by expressing the sales of each product as a percentage of total sales. (p. 218)
Target profit analysis Estimating what sales volume is needed to achieve a specific target profit.
(p. 212)
Variable expense ratio A ratio computed by dividing variable expenses by sales. (p. 204)
Questions
5–1 What is the meaning of contribution margin ratio? How is this ratio useful in planning
business operations?
5–2 Often the most direct route to a business decision is an incremental analysis. What is
meant by an incremental analysis?
5–3 In all respects, Company A and Company B are identical except that Company A’s costs
are mostly variable, whereas Company B’s costs are mostly fixed. When sales increase,
which company will tend to realize the greatest increase in profits? Explain.
5–4 What is the meaning of operating leverage?
5–5 What is the meaning of break-even point?
5–6 In response to a request from your immediate supervisor, you have prepared a
CVP graph portraying the cost and revenue characteristics of your company’s
product and operations. Explain how the lines on the graph and the break-even
point would change if (a) the selling price per unit decreased, (b) fixed cost increased
throughout the entire range of activity portrayed on the graph, and (c) variable cost per
unit increased.
5–7 What is the meaning of margin of safety?
5–8 What is meant by the term sales mix? What assumption is usually made concerning
sales mix in CVP analysis?
5–9 Explain how a shift in the sales mix could result in both a higher break-even point and a
lower net operating income.
Applying Excel
LO5–5, LO5–7, LO5–8 The Excel worksheet form that appears below is to be used to recreate portions of the Review
Problem relating to Voltar Company. Download the workbook containing this form from Connect,
where you will also receive instructions about how to use this worksheet form.
You should proceed to the requirements below only after completing your worksheet.
Required:
1. Check your worksheet by changing the fixed expenses to $270,000. If your worksheet is oper-
ating properly, the degree of operating leverage should be 10. If you do not get this answer,
find the errors in your worksheet and correct them. How much is the margin of safety percent-
age? Did it change? Why or why not?
2. Enter the following data from a different company into your worksheet:
Unit sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Selling price per unit. . . . . . . . . . . . . . . . . . . . . . . . $120
Variable expenses per unit . . . . . . . . . . . . . . . . . . $72
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . $420,000
226 Chapter 5
What is the margin of safety percentage? What is the degree of operating leverage?
3. Using the degree of operating leverage and without changing anything in your worksheet,
calculate the percentage change in net operating income if unit sales increase by 15%.
4. Confirm the calculations you made in part (3) above by increasing the unit sales in your
worksheet by 15%. What is the new net operating income and by what percentage did it
increase?
5. Thad Morgan, a motorcycle enthusiast, has been exploring the possibility of relaunching the
Western Hombre brand of cycle that was popular in the 1930s. The retro-look cycle would be
sold for $10,000 and at that price, Thad estimates that he could sell 600 units each year. The
variable cost to produce and sell the cycles would be $7,500 per unit. The annual fixed cost
would be $1,200,000.
a. Using your worksheet, what would be the unit sales to break even, the margin of safety in
dollars, and the degree of operating leverage?
b. Thad is worried about the selling price. Rumors are circulating that other retro brands
of cycles may be revived. If so, the selling price for the Western Hombre would have to
be reduced to $9,000 to compete effectively. In that event, Thad also would reduce fixed
expenses by $300,000 by reducing advertising expenses, but he still hopes to sell 600
units per year. Do you think this is a good plan? Explain. Also, explain the degree of
operating leverage that appears on your worksheet.
The Foundational 15
LO5–1, LO5–3, LO5–4, Oslo Company prepared the following contribution format income statement based on a sales
LO5–5, LO5–6, LO5–7, volume of 1,000 units (the relevant range of production is 500 units to 1,500 units):
LO5–8
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000
Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Net operating income. . . . . . . . . . . . . . . . . . . . . . . . . $ 2,000
Required:
(Answer each question independently and always refer to the original data unless instructed
otherwise.)
1. What is the contribution margin per unit?
2. What is the contribution margin ratio?
3. What is the variable expense ratio?
4. If sales increase to 1,001 units, what would be the increase in net operating income?
5. If sales decline to 900 units, what would be the net operating income?
6. If the selling price increases by $2 per unit and the sales volume decreases by 100 units, what
would be the net operating income?
7. If the variable cost per unit increases by $1, spending on advertising increases by $1,500, and
unit sales increase by 250 units, what would be the net operating income?
8. What is the break-even point in unit sales?
9. What is the break-even point in dollar sales?
10. How many units must be sold to achieve a target profit of $5,000?
11. What is the margin of safety in dollars? What is the margin of safety percentage?
12. What is the degree of operating leverage?
13. Using the degree of operating leverage, what is the estimated percent increase in net operating
income of a 5% increase in sales?
14. Assume that the amounts of the company’s total variable expenses and total fixed expenses
were reversed. In other words, assume that the total variable expenses are $6,000 and the
total fixed expenses are $12,000. Under this scenario and assuming that total sales remain the
same, what is the degree of operating leverage?
15. Using the degree of operating leverage that you computed in the previous question, what is the
estimated percent increase in net operating income of a 5% increase in sales?
Exercises
EXERCISE 5–1 The Effect of Changes in Activity on Net Operating Income LO5–1
Whirly Corporation’s contribution format income statement for the most recent month is shown
below:
Total Per Unit

Sales (10,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $350,000 $ 35.00
Variable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 20.00
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 $ 15.00
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135,000
Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15,000
Required:
(Consider each case independently):
1. What would be the revised net operating income per month if the sales volume increases by
100 units?
2. What would be the revised net operating income per month if the sales volume decreases by
100 units?
3. What would be the revised net operating income per month if the sales volume is 9,000 units?
EXERCISE 5–2 Prepare a Cost-Volume-Profit (CVP) Graph LO5–2

Karlik Enterprises distributes a single product whose selling price is $24 per unit and whose vari-
able expense is $18 per unit. The company’s monthly fixed expense is $24,000.
Required:
1. Prepare a cost-volume-profit graph for the company up to a sales level of 8,000 units.
2. Estimate the company’s break-even point in unit sales using your cost-volume-profit graph.
EXERCISE 5–3 Prepare a Profit Graph LO5–2

Jaffre Enterprises distributes a single product whose selling price is $16 per unit and whose vari-
able expense is $11 per unit. The company’s fixed expense is $16,000 per month.
Required:
1. Prepare a profit graph for the company up to a sales level of 4,000 units.
2. Estimate the company’s break-even point in unit sales using your profit graph.
EXERCISE 5–4 Computing and Using the CM Ratio LO5–3

Last month when Holiday Creations, Inc., sold 50,000 units, total sales were $200,000, total vari-
able expenses were $120,000, and fixed expenses were $65,000.
Required:
1. What is the company’s contribution margin (CM) ratio?
2. What is the estimated change in the company’s net operating income if it can increase total
sales by $1,000?
EXERCISE 5–5 Changes in Variable Costs, Fixed Costs, Selling Price, and Volume LO5–4
Data for Hermann Corporation are shown below:
Per Unit Percent of Sales

Selling price $90 100%
Variable expenses 63 70
Contribution margin $27 30%
Fixed expenses are $30,000 per month and the company is selling 2,000 units per month.
228 Chapter 5
Required:
1. How much will net operating income increase (decrease) per month if the monthly advertising
budget increases by $5,000 and monthly sales increase by $9,000?
2. Refer to the original data. How much will net operating income increase (decrease) per month
if the company uses higher-quality components that increase the variable expense by $2 per
unit and increase unit sales by 10%.
EXERCISE 5–6 Break-Even Analysis LO5–5

Mauro Products distributes a single product, a woven basket whose selling price is $15 per unit and
whose variable expense is $12 per unit. The company’s monthly fixed expense is $4,200.
Required:
1. Calculate the company’s break-even point in unit sales.
2. Calculate the company’s break-even point in dollar sales.
3. If the company’s fixed expenses increase by $600, what would become the new break-even
point in unit sales? In dollar sales?.
EXERCISE 5–7 Target Profit Analysis LO5–6

Lin Corporation has a single product whose selling price is $120 per unit and whose variable
expense is $80 per unit. The company’s monthly fixed expense is $50,000.
Required:
1. Calculate the unit sales needed to attain a target profit of $10,000.
2. Calculate the dollar sales needed to attain a target profit of $15,000.
EXERCISE 5–8 Compute the Margin of Safety LO5–7

Molander Corporation is a distributor of a sun umbrella used at resort hotels. Data concerning the
next month’s budget appear below:
Selling price per unit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30

Variable expense per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20
Fixed expense per month . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,500
Unit sales per month. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Required:
1. What is the company’s margin of safety?
2. What is the company’s margin of safety as a percentage of its sales?
EXERCISE 5–9 Compute and Use the Degree of Operating Leverage LO5–8
Engberg Company installs lawn sod in home yards. The company’s most recent monthly contribu-
tion format income statement follows:
Amount Percent of Sales

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 100%
Variable expenses . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 40%
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . 48,000 60%
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,000
Net operating income . . . . . . . . . . . . . . . . . . . . . . $10,000
Required:
1. What is the company’s degree of operating leverage?
2. Using the degree of operating leverage, estimate the impact on net operating income of a 5%
increase in sales.
3. Verify your estimate from part (2) above by constructing a new contribution format income
statement for the company assuming a 5% increase in sales.
EXERCISE 5–10 Multiproduct Break-Even Analysis LO5–9

Lucido Products markets two computer games: Claimjumper and Makeover. A contribution format
income statement for a recent month for the two games appears below:
Claimjumper Makeover Total

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000 $ 70,000 $100,000
Variable expenses. . . . . . . . . . . . . . . . 20,000 50,000 70,000
Contribution margin . . . . . . . . . . . . . . $10,000 $ 20,000 30,000
Fixed expenses . . . . . . . . . . . . . . . . . . 24,000
Net operating income. . . . . . . . . . . . . $ 6,000
Required:
1. What is the overall contribution margin (CM) ratio for the company?
2. What is the company’s overall break-even point in dollar sales?
3. Verify the overall break-even point for the company by constructing a contribution format
income statement showing the appropriate levels of sales for the two products.
EXERCISE 5–11 Missing Data; Basic CVP Concepts LO5–1, LO5–9

Fill in the missing amounts in each of the eight case situations below. Each case is independent of
the others. (Hint: One way to find the missing amounts would be to prepare a contribution format
income statement for each case, enter the known data, and then compute the missing items.)
a. Assume that only one product is being sold in each of the four following case situations:
Contribution Net Operating

Units Variable Margin Fixed Income
Case Sold Sales Expenses per Unit Expenses (Loss)
1. . . . . . . . . . . 15,000 $180,000 $120,000 ? $50,000 ?
2. . . . . . . . . . . ? $100,000 ? $10 $32,000 $8,000
3. . . . . . . . . . . 10,000 ? $70,000 $13 ? $12,000
4. . . . . . . . . . . 6,000 $300,000 ? ? $100,000 $(10,000)
b. Assume that more than one product is being sold in each of the four following case situations:
Average
Contribution Net Operating
Variable Margin Fixed Income
Case Sales Expenses Ratio Expenses (Loss)
1 . . . . . . . . . . . . . . . . . . . . . $500,000 ? 20% ? $7,000
2 . . . . . . . . . . . . . . . . . . . . . $400,000 $260,000 ? $100,000 ?
3. . . . . . . . . . . . . . . . . . . . . ? ? 60% $130,000 $20,000
4 . . . . . . . . . . . . . . . . . . . . . $600,000 $420,000 ? ? $(5,000)
EXERCISE 5–12 Multiproduct Break-Even Analysis LO5–9

Olongapo Sports Corporation distributes two premium golf balls—Flight Dynamic and Sure Shot.
Monthly sales and the contribution margin ratios for the two products follow:
Product
Flight Dynamic Sure Shot Total
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000 $250,000 $400,000
CM ratio . . . . . . . . . . . . . . . . . . . . . . . 80% 36% ?
Fixed expenses total $183,750 per month.

230 Chapter 5
Required:
1. Prepare a contribution format income statement for the company as a whole. Carry computa-
tions to one decimal place.
2. What is the company’s break-even point in dollar sales based on the current sales mix?
3. If sales increase by $100,000 a month, by how much would you expect the monthly net oper-
ating income to increase? What are your assumptions?
EXERCISE 5–13 Changes in Selling Price, Sales Volume, Variable Cost per Unit, and Total Fixed
Costs LO5–1, LO5–4
Miller Company’s contribution format income statement for the most recent month is shown below:
Total Per Unit

Sales (20,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 $15.00
Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000 9.00
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 $ 6.00
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000
Net operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000
Required:
(Consider each case independently):
1. What is the revised net operating income if unit sales increase by 15%?
2. What is the revised net operating income if the selling price decreases by $1.50 per unit and
the number of units sold increases by 25%?
3. What is the revised net operating income if the selling price increases by $1.50 per unit, fixed
expenses increase by $20,000, and the number of units sold decreases by 5%?
4. What is the revised net operating income if the selling price per unit increases by 12%,
variable expenses increase by 60 cents per unit, and the number of units sold decreases
by 10%?
EXERCISE 5–14 Break-Even and Target Profit Analysis LO5–3, LO5–4, LO5–5, LO5–6
Lindon Company is the exclusive distributor for an automotive product that sells for $40 per unit
and has a CM ratio of 30%. The company’s fixed expenses are $180,000 per year. The company
plans to sell 16,000 units this year.
Required:
1. What are the variable expenses per unit?
2. What is the break-even point in unit sales and in dollar sales?
3. What amount of unit sales and dollar sales is required to attain a target profit of $60,000
per year?
4. Assume that by using a more efficient shipper, the company is able to reduce its variable
expenses by $4 per unit. What is the company’s new break-even point in unit sales and in
dollar sales? What dollar sales is required to attain a target profit of $60,000?
EXERCISE 5–15 Operating Leverage LO5–1, LO5–8

Magic Realm, Inc., has developed a new fantasy board game. The company sold 15,000 games last
year at a selling price of $20 per game. Fixed expenses associated with the game total $182,000
per year, and variable expenses are $6 per game. Production of the game is entrusted to a printing
contractor. Variable expenses consist mostly of payments to this contractor.
Required:
1. Prepare a contribution format income statement for the game last year and compute the degree
of operating leverage.
2. Management is confident that the company can sell 18,000 games next year (an increase of
3,000 games, or 20%, over last year). Given this assumption:
a. What is the expected percentage increase in net operating income for next year?
b. What is the expected amount of net operating income for next year? (Do not prepare an
income statement; use the degree of operating leverage to compute your answer.)
EXERCISE 5–16 Break-Even Analysis and CVP Graphing LO5–2, LO5–4, LO5–5
The Hartford Symphony Guild is planning its annual dinner-dance. The dinner-dance committee
has assembled the following expected costs for the event:
Dinner (per person) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18

Favors and program (per person) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2
Band . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,800
Rental of ballroom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900
Professional entertainment during intermission. . . . . . . . . . . . . . . . $1,000
Tickets and advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,300
The committee members would like to charge $35 per person for the evening’s activities.
Required:
1. What is the break-even point for the dinner-dance (in terms of the number of persons who
must attend)?
2. Assume that last year only 300 persons attended the dinner-dance. If the same number attend
this year, what price per ticket must be charged in order to break even?
3. Refer to the original data ($35 ticket price per person). Prepare a CVP graph for the dinner-
dance from zero tickets up to 600 tickets sold.
EXERCISE 5–17 Break-Even and Target Profit Analysis LO5–4, LO5–5, LO5–6
Outback Outfitters sells recreational equipment. One of the company’s products, a small camp
stove, sells for $50 per unit. Variable expenses are $32 per stove, and fixed expenses associated
with the stove total $108,000 per month.
Required:
1. What is the break-even point in unit sales and in dollar sales?
2. If the variable expenses per stove increase as a percentage of the selling price, will it result in a
higher or a lower break-even point? Why? (Assume that the fixed expenses remain unchanged.)
3. At present, the company is selling 8,000 stoves per month. The sales manager is convinced
that a 10% reduction in the selling price would result in a 25% increase in monthly sales of
stoves. Prepare two contribution format income statements, one under present operating con-
ditions, and one as operations would appear after the proposed changes. Show both total and
per unit data on your statements.
4. Refer to the data in (3) above. How many stoves would have to be sold at the new selling price
to attain a target profit of $35,000 per month?
EXERCISE 5–18 Break-Even and Target Profit Analysis; Margin of Safety; CM Ratio LO5–1, LO5–3,
LO5–5, LO5–6, LO5–7
Menlo Company distributes a single product. The company’s sales and expenses for last month
follow:
Total Per Unit

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $450,000 $30
Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000 12
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000 $18
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216,000
Net operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 54,000
Required:
1. What is the monthly break-even point in unit sales and in dollar sales?
2. Without resorting to computations, what is the total contribution margin at the break-even point?
3. How many units would have to be sold each month to attain a target profit of $90,000? Verify
your answer by preparing a contribution format income statement at the target sales level.
4. Refer to the original data. Compute the company’s margin of safety in both dollar and percent-
age terms.
5. What is the company’s CM ratio? If sales increase by $50,000 per month and there is no change
in fixed expenses, by how much would you expect monthly net operating income to increase?
232 Chapter 5
Problems
PROBLEM 5–19 Break-Even Analysis; Pricing LO5–1, LO5–4, LO5–5
Minden Company introduced a new product last year for which it is trying to find an optimal sell-
ing price. Marketing studies suggest that the company can increase sales by 5,000 units for each
$2 reduction in the selling price. The company’s present selling price is $70 per unit, and variable
expenses are $40 per unit. Fixed expenses are $540,000 per year. The present annual sales volume
(at the $70 selling price) is 15,000 units.
Required:
1. What is the present yearly net operating income or loss?
2. What is the present break-even point in unit sales and in dollar sales?
3. Assuming that the marketing studies are correct, what is the maximum annual profit that the
company can earn? At how many units and at what selling price per unit would the company
generate this profit?
4. What would be the break-even point in unit sales and in dollar sales using the selling price you
determined in (3) above (e.g., the selling price at the level of maximum profits)? Why is this
break-even point different from the break-even point you computed in (2) above?
PROBLEM 5–20 CVP Applications: Break-Even Analysis; Cost Structure; Target Sales LO5–1, LO5–3,
LO5–4, LO5–5, LO5–6, LO5–8
Northwood Company manufactures basketballs. The company has a ball that sells for $25. At
present, the ball is manufactured in a small plant that relies heavily on direct labor workers. Thus,
variable expenses are high, totaling $15 per ball, of which 60% is direct labor cost.
Last year, the company sold 30,000 of these balls, with the following results:
Sales (30,000 balls) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $750,000

Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000
Net operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 90,000
Required:
1. Compute (a) the CM ratio and the break-even point in balls, and (b) the degree of operating
leverage at last year’s sales level.
2. Due to an increase in labor rates, the company estimates that variable expenses will increase
by $3 per ball next year. If this change takes place and the selling price per ball remains con-
stant at $25, what will be the new CM ratio and break-even point in balls?
3. Refer to the data in (2) above. If the expected change in variable expenses takes place, how
many balls will have to be sold next year to earn the same net operating income, $90,000, as
last year?
4. Refer again to the data in (2) above. The president feels that the company must raise the sell-
ing price of its basketballs. If Northwood Company wants to maintain the same CM ratio
as last year, what selling price per ball must it charge next year to cover the increased labor
costs?
5. Refer to the original data. The company is discussing the construction of a new, automated
manufacturing plant. The new plant would slash variable expenses per ball by 40%, but it
would cause fixed expenses per year to double. If the new plant is built, what would be the
company’s new CM ratio and new break-even point in balls?
6. Refer to the data in (5) above.
a. If the new plant is built, how many balls will have to be sold next year to earn the same
net operating income, $90,000, as last year?
b. Assume the new plant is built and that next year the company manufactures and sells
30,000 balls (the same number as sold last year). Prepare a contribution format income
statement and compute the degree of operating leverage.
c. If you were a member of top management, would you have been in favor of constructing
the new plant? Explain.
PROBLEM 5–21 Sales Mix; Multiproduct Break-Even Analysis LO5–9

Gold Star Rice, Ltd., of Thailand exports Thai rice throughout Asia. The company grows three
varieties of rice—White, Fragrant, and Loonzain. Budgeted sales by product and in total for the
coming month are shown below:
Product
White Fragrant Loonzain Total
Percentage of total sales . . . . . . . . . . . . . . . . . . . . . 20% 52% 28% 100%

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000 100% $390,000 100% $210,000 100% $750,000 100%
Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . 108,000 72% 78,000 20% 84,000 40% 270,000 36%
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,000 28% $312,000 80% $126,000 60% 480,000 64%
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449,280
Net operating income. . . . . . . . . . . . . . . . . . . . . . . . $ 30,720
Dollar sales to _____________

Fixed expenses ________
$449,280
= = = $702,000
break-even CM ratio 0.64
As shown by these data, net operating income is budgeted at $30,720 for the month and the
estimated break-even sales is $702,000.
Assume that actual sales for the month total $750,000 as planned. Actual sales by product are:
White, $300,000; Fragrant, $180,000; and Loonzain, $270,000.
Required:
1. Prepare a contribution format income statement for the month based on the actual sales data.
Present the income statement in the format shown above.
2. Compute the break-even point in dollar sales for the month based on your actual data.
3. Considering the fact that the company met its $750,000 sales budget for the month, the presi-
dent is shocked at the results shown on your income statement in (1) above. Prepare a brief
memo for the president explaining why the net operating income (loss) and the break-even
point in dollar sales are different from what was budgeted.
PROBLEM 5–22 CVP Applications; Contribution Margin Ratio; Break-Even Analysis; Cost
Structure LO5–1, LO5–3, LO5–4, LO5–5, LO5–6
Due to erratic sales of its sole product—a high-capacity battery for laptop computers—PEM,
Inc., has been experiencing financial difficulty for some time. The company’s contribution format
income statement for the most recent month is given below:
Sales (19,500 units × $30 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . $ 585,000

Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409,500
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175,500
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000
Net operating loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (4,500)
Required:
1. Compute the company’s CM ratio and its break-even point in unit sales and dollar sales.
2. The president believes that a $16,000 increase in the monthly advertising budget, combined
with an intensified effort by the sales staff, will result in an $80,000 increase in monthly sales.
If the president is right, what will be the increase (decrease) in the company’s monthly net
operating income?
3. Refer to the original data. The sales manager is convinced that a 10% reduction in the selling
price, combined with an increase of $60,000 in the monthly advertising budget, will double
unit sales. If the sales manager is right, what will be the revised net operating income (loss)?
4. Refer to the original data. The Marketing Department thinks that a fancy new package for the
laptop computer battery would grow sales. The new package would increase packaging costs
by 75 cents per unit. Assuming no other changes, how many units would have to be sold each
month to attain a target profit of $9,750?
234 Chapter 5
5. Refer to the original data. By automating, the company could reduce variable expenses by
$3 per unit. However, fixed expenses would increase by $72,000 each month.
a. Compute the new CM ratio and the new break-even point in unit sales and dollar sales.
b. Assume that the company expects to sell 26,000 units next month. Prepare two contribu-
tion format income statements, one assuming that operations are not automated and one
assuming that they are. (Show data on a per unit and percentage basis, as well as in total,
for each alternative.)
c. Would you recommend that the company automate its operations? Explain.
PROBLEM 5–23 CVP Applications; Contribution Margin Ratio: Degree of Operating Leverage LO5–1,
LO5–3, LO5–4, LO5–5, LO5–8
Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for $20 per unit. Vari-
able expenses are $8 per unit, and fixed expenses total $180,000 per year. Its operating results for
last year were as follows:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400,000
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000
Required:
Answer each question independently based on the original data:
1. What is the product’s CM ratio?
2. Use the CM ratio to determine the break-even point in dollar sales.
3. If this year’s sales increase by $75,000 and fixed expenses do not change, how much will net
operating income increase?
4. a. What is the degree of operating leverage based on last year’s sales?
b. Assume the president expects this year’s sales to increase by 20%. Using the degree of
operating leverage from last year, what percentage increase in net operating income will
the company realize this year?
5. The sales manager is convinced that a 10% reduction in the selling price, combined with a
$30,000 increase in advertising, would increase this year’s unit sales by 25%. If the sales man-
ager is right, what would be this year’s net operating income if his ideas are implemented? Do
you recommend implementing the sales manager’s suggestions? Why?
6. The president does not want to change the selling price. Instead, he wants to increase the sales
commission by $1 per unit. He thinks that this move, combined with some increase in adver-
tising, would increase this year’s sales by 25%. How much could the president increase this
year’s advertising expense and still earn the same $60,000 net operating income as last year?
PROBLEM 5–24 Break-Even and Target Profit Analysis LO5–5, LO5–6

The Shirt Works sells a large variety of tee shirts and sweatshirts. Steve Hooper, the owner, is
thinking of expanding his sales by hiring high school students, on a commission basis, to sell
sweatshirts bearing the name and mascot of the local high school.
These sweatshirts would have to be ordered from the manufacturer six weeks in advance, and
they could not be returned because of the unique printing required. The sweatshirts would cost
Hooper $8 each with a minimum order of 75 sweatshirts. Any additional sweatshirts would have to
be ordered in increments of 75.
Since Hooper’s plan would not require any additional facilities, the only costs associated with
the project would be the costs of the sweatshirts and the costs of the sales commissions. The selling
price of the sweatshirts would be $13.50 each. Hooper would pay the students a commission of
$1.50 for each shirt sold.
Required:
1. What level of unit sales and dollar sales is needed to attain a target profit of $1,200?
2. Assume that Hooper places an initial order for 75 sweatshirts. What is his break-even point in
unit sales and dollar sales?
PROBLEM 5–25 Changes in Fixed and Variable Costs; Break-Even and Target Profit Analysis LO5–4,
LO5–5, LO5–6
Neptune Company produces toys and other items for use in beach and resort areas. A small, inflat-
able toy has come onto the market that the company is anxious to produce and sell. The new toy
will sell for $3 per unit. Enough capacity exists in the company’s plant to produce 16,000 units of
the toy each month. Variable expenses to manufacture and sell one unit would be $1.25, and fixed
expenses associated with the toy would total $35,000 per month.
The company’s Marketing Department predicts that demand for the new toy will exceed
the 16,000 units that the company is able to produce. Additional manufacturing space can be
rented from another company at a fixed expense of $1,000 per month. Variable expenses in the
rented facility would total $1.40 per unit, due to somewhat less efficient operations than in the
main plant.
Required:
1. What is the monthly break-even point for the new toy in unit sales and dollar sales.
2. How many units must be sold each month to attain a target profit of $12,000 per month?
3. If the sales manager receives a bonus of 10 cents for each unit sold in excess of the break-even
point, how many units must be sold each month to attain a target profit that equals a 25%
return on the monthly investment in fixed expenses?
PROBLEM 5–26 CVP Applications; Break-Even Analysis; Graphing LO5–1, LO5–2, LO5–4, LO5–5
The Fashion Shoe Company operates a chain of women’s shoe shops that carry many styles of
shoes that are all sold at the same price. Sales personnel in the shops are paid a sales commission
on each pair of shoes sold plus a small base salary.
The following data pertains to Shop 48 and is typical of the company’s many outlets:
Per Pair of
Shoes
Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30.00
Variable expenses:
Invoice cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13.50
Sales commission . . . . . . . . . . . . . . . . . . . . . . . . . . 4.50
Total variable expenses . . . . . . . . . . . . . . . . . . . . . . . $18.00
Annual
Fixed expenses:
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Total fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . $ 150,000
Required:
1. What is Shop 48’s annual break-even point in unit sales and dollar sales?
2. Prepare a CVP graph showing cost and revenue data for Shop 48 from zero shoes up to 17,000
pairs of shoes sold each year. Clearly indicate the break-even point on the graph.
3. If 12,000 pairs of shoes are sold in a year, what would be Shop 48’s net operating income
(loss)?
4. The company is considering paying the Shop 48 store manager an incentive commission of
75 cents per pair of shoes (in addition to the salesperson’s commission). If this change is
made, what will be the new break-even point in unit sales and dollar sales?
5. Refer to the original data. As an alternative to (4) above, the company is considering paying
the Shop 48 store manager 50 cents commission on each pair of shoes sold in excess of the
break-even point. If this change is made, what will be Shop 48’s net operating income (loss) if
15,000 pairs of shoes are sold?
6. Refer to the original data. The company is considering eliminating sales commissions entirely
in its shops and increasing fixed salaries by $31,500 annually. If this change is made, what
will be Shop 48’s new break-even point in unit sales and dollar sales? Would you recommend
that the change be made? Explain.
236 Chapter 5
PROBLEM 5–27 Sales Mix; Break-Even Analysis; Margin of Safety LO5–7, LO5–9
Island Novelties, Inc., of Palau makes two products—Hawaiian Fantasy and Tahitian Joy. Each
product’s selling price, variable expense per unit and annual sales volume are as follows:
Hawaiian Tahitian
Fantasy Joy
Selling price per unit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15 $100
Variable expense per unit . . . . . . . . . . . . . . . . . . . . . . . . . . $9 $20
Number of units sold annually. . . . . . . . . . . . . . . . . . . . . . . 20,000 5,000
Fixed expenses total $475,800 per year.

Required:
1. Assuming the sales mix given above, do the following:
a. Prepare a contribution format income statement showing both dollar and percent col-
umns for each product and for the company as a whole.
b. Compute the company’s break-even point in dollar sales. Also, compute its margin of
safety in dollars and its margin of safety percentage.
2. The company has developed a new product called Samoan Delight that sells for $45 each and
that has variable expenses of $36 per unit. If the company can sell 10,000 units of Samoan
Delight without incurring any additional fixed expenses:
a. Prepare a revised contribution format income statement that includes Samoan Delight.
Assume that sales of the other two products does not change.
b. Compute the company’s revised break-even point in dollar sales. Also, compute its
revised margin of safety in dollars and margin of safety percentage.
3. The president of the company examines your figures and says, “There’s something strange
here. Our fixed expenses haven’t changed and you show greater total contribution margin
if we add the new product, but you also show our break-even point going up. With greater
contribution margin, the break-even point should go down, not up. You’ve made a mistake
somewhere.” Explain to the president what has happened.
PROBLEM 5–28 Sales Mix; Commission Structure; Multiproduct Break-Even Analysis LO5–9
Carbex, Inc., produces cutlery sets out of high-quality wood and steel. The company makes a Stan-
dard set and a Deluxe set and sells them to retail department stores throughout the country. The
Standard set sells for $60, and the Deluxe set sells for $75. The variable expenses associated with
each set are given below.
Standard Deluxe
Variable production costs . . . . . . . . . . . . . . . . . . . . . . . . . . . $15.00 $30.00
Sales commissions (15% of sales price) . . . . . . . . . . . . . . . $9.00 $11.25
The company’s fixed expenses each month are:
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $105,000
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $21,700
Administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $63,000
Mary Parsons, the financial vice president, watches sales commissions carefully and has noted that
they have risen steadily over the last year. For this reason, she was shocked to find that even though
sales have increased, profits for the current month—May—are down substantially from April.
Sales, in sets, for the last two months are given below:
Standard Deluxe Total

April . . . . . . . . . . . . . . . . . . . . . . . 4,000 2,000 6,000
May . . . . . . . . . . . . . . . . . . . . . . . 1,000 5,000 6,000
Required:
1. Prepare contribution format income statements for April and May. Use the following headings:
Standard Deluxe Total

Sales . . . . . . . .
Etc. . . . . . . . . .
Place the fixed expenses only in the Total column. Do not show percentages for the fixed
expenses.
2. Explain the difference in net operating incomes between the two months, even though the
same total number of sets was sold in each month.
3. What can be done to the sales commissions to improve the sales mix?
a. Using April’s sales mix, what is the break-even point in dollar sales?
b. Without doing any calculations, explain whether the break-even point in May would be
higher or lower than the break-even point in April. Why?
PROBLEM 5–29 Changes in Cost Structure; Break-Even Analysis; Operating Leverage; Margin of
Safety LO5–4, LO5–5, LO5–7, LO5–8
Morton Company’s contribution format income statement for last month is given below:
Sales (15,000 units × $30 per unit) . . . . . . . . . . . . . $450,000

Variable expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . 315,000
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . 135,000
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Net operating income. . . . . . . . . . . . . . . . . . . . . . . . . $ 45,000
The industry in which Morton Company operates is quite sensitive to cyclical movements in the
economy. Thus, profits vary considerably from year to year according to general economic con-
ditions. The company has a large amount of unused capacity and is studying ways of improving
profits.
Required:
1. New equipment has come onto the market that would allow Morton Company to automate
a portion of its operations. Variable expenses would be reduced by $9 per unit. However,
fixed expenses would increase to a total of $225,000 each month. Prepare two contribution
format income statements, one showing present operations and one showing how opera-
tions would appear if the new equipment is purchased. Show an Amount column, a Per Unit
column, and a Percent column on each statement. Do not show percentages for the fixed
expenses.
2. Refer to the income statements in (1). For the present operations and the proposed new opera-
tions, compute (a) the degree of operating leverage, (b) the break-even point in dollar sales,
and (c) the margin of safety in dollars and the margin of safety percentage.
3. Refer again to the data in (1). As a manager, what factor would be paramount in your mind in
deciding whether to purchase the new equipment? (Assume that enough funds are available to
make the purchase.)
4. Refer to the original data. Rather than purchase new equipment, the marketing manager
argues that the company’s marketing strategy should be changed. Rather than pay sales
commissions, which are currently included in variable expenses, the company would pay
salespersons fixed salaries and would invest heavily in advertising. The marketing man-
ager claims this new approach would increase unit sales by 30% without any change in
selling price; the company’s new monthly fixed expenses would be $180,000; and its net
operating income would increase by 20%. Compute the company’s break-even point in dol-
lar sales under the new marketing strategy. Do you agree with the marketing manager’s
proposal?
238 Chapter 5
PROBLEM 5–30 Graphing; Incremental Analysis; Operating Leverage LO5–2, LO5–4, LO5–5, LO5–6, LO5–8
Angie Silva has recently opened The Sandal Shop in Brisbane, Australia, a store that specializes
in fashionable sandals. In time, she hopes to open a chain of sandal shops. As a first step, she has
gathered the following data for her new store:
Sales price per pair of sandals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40

Variable expenses per pair of sandals. . . . . . . . . . . . . . . . . . . . . . . . . . 16
Contribution margin per pair of sandals . . . . . . . . . . . . . . . . . . . . . . . . $24
Fixed expenses per year:
Building rental . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,000
Equipment depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000
Total fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000
Required:
1. What is the break-even point in unit sales and dollar sales?
2. Prepare a CVP graph or a profit graph for the store from zero pairs up to 4,000 pairs of sandals
sold each year. Indicate the break-even point on your graph.
3. Angie has decided that she must earn a profit of $18,000 the first year to justify her time and
effort. How many pairs of sandals must be sold to attain this target profit?
4. Angie now has two salespersons working in the store—one full time and one part time. It will
cost her an additional $8,000 per year to convert the part-time position to a full-time position.
Angie believes that the change would increase annual sales by $25,000. Should she convert
the position? Use the incremental approach. (Do not prepare an income statement.)
5. Refer to the original data. During the first year, the store sold only 3,000 pairs of sandals and
reported the following operating results:
Sales (3,000 pairs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 120,000
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
a. What is the store’s degree of operating leverage?

b. Angie is confident that with a more intense sales effort and with a more creative advertis-
ing program she can increase sales by 50% next year. Using the degree of operating lever-
age, what would be the expected percentage increase in net operating income if Angie is
able to increase sales by 50%?
PROBLEM 5–31 Interpretive Questions on the CVP Graph LO5–2, LO5–5

A CVP graph such as the one shown below is a useful technique for showing relationships among
an organization’s costs, volume, and profits.
1
4
9
3
7
5
2
Required:
1. Identify the numbered components in the CVP graph.
2. State the effect of each of the following actions on line 3, line 9, and the break-even point. For
line 3 and line 9, state whether the action will cause the line to:
Remain unchanged.
Shift upward.
Shift downward.
Have a steeper slope (i.e., rotate upward).
Have a flatter slope (i.e., rotate downward).
Shift upward and have a steeper slope.
Shift upward and have a flatter slope.
Shift downward and have a steeper slope.
Shift downward and have a flatter slope.
In the case of the break-even point, state whether the action will cause the break-even point to:
Remain unchanged.
Increase.
Decrease.
Probably change, but the direction is uncertain.
Treat each case independently.
x. Example. Fixed expenses are reduced by $5,000 per period.
Answer (see choices above): Line 3: Shift downward.
Line 9: Remain unchanged.
Break-even point: Decrease.
a. The unit selling price is increased from $18 to $20.
b. Unit variable expenses are decreased from $12 to $10.
c. Fixed expenses are increased by $3,000 per period.
d. Two thousand more units are sold during the period than were budgeted.
e. Due to paying salespersons a commission rather than a flat salary, fixed expenses are
reduced by $8,000 per period and unit variable expenses are increased by $3.
f. Due to an increase in the cost of materials, both unit variable expenses and the selling
price are increased by $2.
g. Advertising costs are increased by $10,000 per period, resulting in a 10% increase in the
number of units sold.
h. Due to automating an operation previously done by workers, fixed expenses are increased
by $12,000 per period and unit variable expenses are reduced by $4.
Cases
CASE 5–32 Break-Even Analysis for Individual Products in a Multiproduct Company LO5–5, LO5–9
Cheryl Montoya picked up the phone and called her boss, Wes Chan, the vice president of market-
ing at Piedmont Fasteners Corporation: “Wes, I’m not sure how to go about answering the ques-
tions that came up at the meeting with the president yesterday.”
“What’s the problem?”
“The president wanted to know the break-even point for each of the company’s products, but I
am having trouble figuring them out.”
“I’m sure you can handle it, Cheryl. And, by the way, I need your analysis on my desk tomor-
row morning at 8:00 sharp in time for the follow-up meeting at 9:00.”
Piedmont Fasteners Corporation makes three different clothing fasteners in its manufacturing
facility in North Carolina. Data concerning these products appear below:
Velcro Metal Nylon

Annual sales volume. . . . . . . . . . . . . . . . . . . . 100,000 200,000 400,000
Unit selling price . . . . . . . . . . . . . . . . . . . . . . . $1.65 $1.50 $0.85
Variable expense per unit . . . . . . . . . . . . . . . $1.25 $0.70 $0.25
Total fixed expenses are $400,000 per year.

240 Chapter 5
All three products are sold in highly competitive markets, so the company is unable to raise
prices without losing an unacceptable numbers of customers.
The company has an extremely effective lean production system, so there are no beginning or
ending work in process or finished goods inventories.
Required:
1. What is the company’s over-all break-even point in dollar sales?
2. Of the total fixed expenses of $400,000, $20,000 could be avoided if the Velcro product
is dropped, $80,000 if the Metal product is dropped, and $60,000 if the Nylon product is
dropped. The remaining fixed expenses of $240,000 consist of common fixed expenses such
as administrative salaries and rent on the factory building that could be avoided only by going
out of business entirely.
a. What is the break-even point in unit sales for each product?
b. If the company sells exactly the break-even quantity of each product, what will be the
overall profit of the company? Explain this result.
CASE 5–33 Cost Structure; Break-Even and Target Profit Analysis LO5–4, LO5–5, LO5–6
Pittman Company is a small but growing manufacturer of telecommunications equipment. The
company has no sales force of its own; rather, it relies completely on independent sales agents to
market its products. These agents are paid a sales commission of 15% for all items sold.
Barbara Cheney, Pittman’s controller, has just prepared the company’s budgeted income state-
ment for next year as follows:
Pittman Company
Budgeted Income Statement
For the Year Ended December 31
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,000,000
Manufacturing expenses:
Variable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,200,000
Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . 2,340,000 9,540,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,460,000
Selling and administrative expenses:
Commissions to agents . . . . . . . . . . . . . . . . . . 2,400,000
Fixed marketing expenses. . . . . . . . . . . . . . . . 120,000*
Fixed administrative expenses . . . . . . . . . . . . 1,800,000 4,320,000
Net operating income. . . . . . . . . . . . . . . . . . . . . . 2,140,000
Fixed interest expenses . . . . . . . . . . . . . . . . . . . . 540,000
Income before income taxes. . . . . . . . . . . . . . . . 1,600,000
Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . 480,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,120,000
*Primarily depreciation on storage facilities.
As Barbara handed the statement to Karl Vecci, Pittman’s president, she commented, “I went
ahead and used the agents’ 15% commission rate in completing these statements, but we’ve just
learned that they refuse to handle our products next year unless we increase the commission rate
to 20%.”
“That’s the last straw,” Karl replied angrily. “Those agents have been demanding more and
more, and this time they’ve gone too far. How can they possibly defend a 20% commission rate?”
“They claim that after paying for advertising, travel, and the other costs of promotion, there’s
nothing left over for profit,” replied Barbara.
“I say it’s just plain robbery,” retorted Karl. “And I also say it’s time we dumped those guys and
got our own sales force. Can you get your people to work up some cost figures for us to look at?”
“We’ve already worked them up,” said Barbara. “Several companies we know about pay a
7.5% commission to their own salespeople, along with a small salary. Of course, we would have
to handle all promotion costs, too. We figure our fixed expenses would increase by $2,400,000 per
year, but that would be more than offset by the $3,200,000 (20% × $16,000,000) that we would
avoid on agents’ commissions.”
The breakdown of the $2,400,000 cost follows:

Salaries:
Sales manager. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Salespersons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000
Travel and entertainment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,400,000
“Super,” replied Karl. “And I noticed that the $2,400,000 equals what we’re paying the agents
under the old 15% commission rate.”
“It’s even better than that,” explained Barbara. “We can actually save $75,000 a year because
that’s what we’re paying our auditors to check out the agents’ reports. So our overall administrative
expenses would be less.”
“Pull all of these numbers together and we’ll show them to the executive committee tomor-
row,” said Karl. “With the approval of the committee, we can move on the matter immediately.”
Required:
1. Compute Pittman Company’s break-even point in dollar sales for next year assuming:
a. The agents’ commission rate remains unchanged at 15%.
b. The agents’ commission rate is increased to 20%.
c. The company employs its own sales force.
2. Assume that Pittman Company decides to continue selling through agents and pays the 20%
commission rate. Determine the dollar sales that would be required to generate the same net
income as contained in the budgeted income statement for next year.
3. Determine the dollar sales at which net income would be equal regardless of whether
Pittman Company sells through agents (at a 20% commission rate) or employs its own sales
force.
4. Compute the degree of operating leverage that the company would expect to have at the end of
next year assuming:
a. The agents’ commission rate remains unchanged at 15%.
b. The agents’ commission rate is increased to 20%.
c. The company employs its own sales force.
Use income before income taxes in your operating leverage computation.
5. Based on the data in (1) through (4) above, make a recommendation as to whether the com-
pany should continue to use sales agents (at a 20% commission rate) or employ its own sales
force. Give reasons for your answer.
(CMA, adapted)
Appendix 5A: Analyzing Mixed Costs

The main body of Chapter 5 assumed that all costs could be readily classified as variable
or fixed. In reality, many costs contain both variable and fixed components—they are
mixed costs. The purpose of this appendix is to describe various methods that compa-
nies can use to separate mixed costs into their variable and fixed components, thereby
enabling cost-volume-profit (CVP) analysis.
Mixed costs are very common in most organizations. For example, the overall cost
of performing surgeries for patients at the Harvard Medical School Hospital is a mixed
cost. The costs of equipment depreciation and surgeons’ and nurses’ salaries are fixed,
but the costs of surgical gloves, power, and other supplies are variable. At Southwest
Airlines, maintenance costs are a mixed cost. The company incurs fixed costs for renting
maintenance facilities and for keeping skilled mechanics on the payroll, but the costs of
replacement parts, lubricating oils, tires, and so forth, are variable with respect to how
often and how far the company’s aircraft are flown.
The fixed portion of a mixed cost represents the minimum cost of having a service ready
and available for use. The variable portion represents the cost incurred for actual consump-
tion of the service, thus it varies in proportion to the amount of service actually consumed.
242 Chapter 5
Managers can use a variety of methods to estimate the fixed and variable compo-
nents of a mixed cost such as account analysis, the engineering approach, the high-low
method, and least-squares regression analysis. In account analysis, an account is classi-
fied as either variable or fixed based on the analyst’s prior knowledge of how the cost in
the account behaves. For example, direct materials would be classified as variable and a
building lease cost would be classified as fixed because of the nature of those costs. The
engineering approach to cost analysis involves a detailed analysis of what cost behavior
should be, based on an industrial engineer’s evaluation of the production methods to be
used, the materials specifications, labor requirements, equipment usage, production effi-
ciency, power consumption, and so on.
The high-low method and least-squares regression method estimate the fixed and
variable elements of a mixed cost by analyzing past records of cost and activity data.
Throughout the remainder of this appendix, we will define these two cost estimation
methods and use an example from Brentline Hospital to illustrate how they each derive
their respective fixed and variable cost estimates. The least-squares regression compu-
tations will be explained using Microsoft Excel because it can perform the underlying
mathematics much faster than using a pencil and a calculator.
LO5–10 Diagnosing Cost Behavior with a Scattergraph Plot

Analyze a mixed cost using Assume that Brentline Hospital is interested in predicting future monthly maintenance
a scattergraph plot and the
costs for budgeting purposes. The senior management team believes that maintenance
high-low method.
cost is a mixed cost and that the variable portion of this cost is driven by the number of
patient-days. Each day a patient is in the hospital counts as one patient-day. The hospital’s
chief financial officer gathered the following data for the most recent seven-month period:
The first step in applying the high-low method or the least-squares regression
method is to diagnose cost behavior with a scattergraph plot. The scattergraph plot of
maintenance costs versus patient-days at Brentline Hospital is shown in Exhibit 5A–1.
Two things should be noted about this scattergraph:
Activity Level: Maintenance

Month Patient-Days Cost Incurred
January . . . . . . . . . . . . . . . . . . . . . . . . . . 5,600 $7,900
February . . . . . . . . . . . . . . . . . . . . . . . . . 7,100 $8,500
March. . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 $7,400
April . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,500 $8,200
May . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,300 $9,100
June. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 $9,800
July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,200 $7,800
1. The total maintenance cost, Y, is plotted on the vertical axis. Cost is known as the
dependent variable because the amount of cost incurred during a period depends
on the level of activity for the period. (That is, as the level of activity increases, total
cost also will ordinarily increase.)
2. The activity, X (patient-days in this case), is plotted on the horizontal axis. Activity is
known as the independent variable because it causes variations in the cost.
From the scattergraph plot, it is evident that maintenance costs do increase with the number
of patient-days in an approximately linear fashion. In other words, the points lie more or less
along a straight line that slopes upward and to the right. Linear cost behavior exists whenever
a straight line is a reasonable approximation for the relation between cost and activity.
Plotting the data on a scattergraph is an essential diagnostic step that should be per-
formed before performing the high-low or least-squares regression calculations. If the
scattergraph plot reveals linear cost behavior, then it makes sense to perform the high-low
or least-squares regression calculations to separate the mixed cost into its variable and
fixed components. If the scattergraph plot does not depict linear cost behavior, then it
makes no sense to proceed any further in analyzing the data.
Y Plotting the Data EXHIBIT 5A–1

$12,000 Scattergraph Method of
Cost Analysis
$10,000
$8,000
Maintenance cost
$6,000
$4,000
$2,000
$0 X
0 2,000 4,000 6,000 8,000 10,000
Patient-days
Once we determine that the dependent and independent variables have a linear rela-
tionship, the high-low and least-squares regression methods both rely on the follow-
ing equation for a straight line (as introduced in Chapter 1) to express the relationship
between a mixed cost and the level of activity:
Y = a + bX
In this equation ,
Y = The total mixed cost
a = The total fixed cost (the vertical intercept of the line)
b = The variable cost per unit of activity (the slope of the line)
X = The level of activity
The High-Low Method

The high-low method is based on the rise-over-run formula for the slope of a straight line.
Assuming that the relation between cost and activity can be represented by a straight line,
then the slope of the straight line is equal to the variable cost per unit of activity. Conse-
quently, the following formula can be used to estimate the variable cost:
Y2 − Y1
Rise = _______
Variable cost = Slope of the line = ____
Run X2 − X1
To analyze mixed costs with the high-low method, begin by identifying the period with
the lowest level of activity and the period with the highest level of activity. The period with
the lowest activity is selected as the first point in the above formula and the period with the
highest activity is selected as the second point. Consequently, the formula becomes:
Cost at the high activity level − Cost at the low activity level
Y2 − Y1 _________________________________________________
Variable cost = _______ =
X2 − X1 High activity level − Low activity level
or
Change in cost
Variable cost = _______________
Change in activity
244 Chapter 5
Therefore, when the high-low method is used, the variable cost is estimated by dividing
the difference in cost between the high and low levels of activity by the change in activity
between those two points.
To return to the Brentline Hospital example, using the high-low method, we first
identify the periods with the highest and lowest activity—in this case, June and March.
We then use the activity and cost data from these two periods to estimate the variable cost
component as follows:
Maintenance
Patient-Days Cost Incurred
High activity level (June) . . . . . . . . . . . . . 8,000 $9,800
Low activity level (March) . . . . . . . . . . . . . 5,000 7,400
Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 $2,400
Change in cost $2,400

Variable cost = _______________ = ____________________ = $0.80 per patient-day
Change in activity 3,000 patient-days
Having determined that the variable maintenance cost is 80 cents per patient-day, we
can now determine the amount of fixed cost. This is done by taking the total cost at
either the high or the low activity level and deducting the variable cost element. In the
computation below, total cost at the high activity level is used in computing the fixed
cost element:
Fixed cost element = Total cost − Variable cost element
= $9,800 − ($0.80 per patient-day × 8,000 patient-days)
= $3,400
Given that we have estimated the variable and fixed cost elements, the maintenance cost
can now be expressed as $3,400 per month plus 80 cents per patient-day, or as:
Y = $3,400 + $0.80X
Total Total
Maintenance patient-days
Cost
The data used in this illustration are shown graphically in Exhibit 5A–2. Notice that a
straight line has been drawn through the points corresponding to the low and high levels
of activity. In essence, that is what the high-low method does—it draws a straight line
through those two points.
Sometimes the high and low levels of activity don’t coincide with the high and low
amounts of cost. For example, the period that has the highest level of activity may not
have the highest amount of cost. Nevertheless, the costs at the highest and lowest levels
of activity are always used to analyze a mixed cost under the high-low method. The rea-
son is that the analyst would like to use data that reflect the greatest possible variation in
activity.
The high-low method is very simple to apply, but it suffers from a major (and some-
times critical) defect—it utilizes only two data points. Generally, two data points are
not enough to produce accurate estimates. Additionally, the periods with the highest and
lowest activity tend to be unusual. A cost formula that is estimated solely using data from
these unusual periods may misrepresent the true cost behavior during normal periods.
Such a distortion is evident in Exhibit 5A–2. The straight line should probably be shifted
down somewhat so that it is closer to more of the data points. For these reasons, least-
squares regression will generally be more accurate than the high-low method.
Activity Patient- Maintenance EXHIBIT 5A–2

Level Days Cost High-Low Method of Analyzing a
Mixed Cost
High 8,000 $9,800
Y Low 5,000 $7,400
$12,000
Slope =
Variable cost:
$10,000 $0.80 per
Point relating to the patient-day
low activity level
$8,000
Maintenance cost
Point relating to the

high activity level
$6,000
$4,000
$2,000 Intercept =
Fixed cost:
$3,400
$0 X
0 2,000 4,000 6,000 8,000 10,000
Patient-days
The Least-Squares Regression Method

The least-squares regression method, unlike the high-low method, uses all of the data to
separate a mixed cost into its fixed and variable components. A regression line of the form LO5–11
Analyze a mixed cost using
Y = a + bX is fitted to the data, where a (the intercept) represents the total fixed cost and
a scattergraph plot and the
b (the slope) represents the variable cost per unit of activity. The basic idea underlying least-squares regression
the least-squares regression method is illustrated in Exhibit 5A–3 using hypothetical data method.
points. Notice from the exhibit that the deviations from the plotted points to the regres-
sion line are measured vertically on the graph. These vertical deviations are called the
regression errors. There is nothing mysterious about the least-squares regression method.
It simply computes the regression line that minimizes the sum of these squared errors.
While the basic idea underlying least-squares regression analysis is pretty simple,
the formulas that calculate a (the intercept) and b (the slope) are quite complex as shown
below:
n(ΣXY) − (ΣX)(ΣY)
b = _________________
n(ΣX 2) − (ΣX) 2
(ΣY) − b(ΣX)
a = ___________
n
where:
X = The level of activity (independent variable)
Y = The total mixed cost (dependent variable)
a = The total fixed cost (the vertical intercept of the line)
b = The variable cost per unit of activity (the slope of the line)
n = Number of observations
Σ = Sum across all n observations
246 Chapter 5
EXHIBIT 5A–3 Y
The Concept of Least-Squares
Regression
Actual Y
Error Regression line
Cost
Estimated Y
Y = a + bX
X
Level of activity
Fortunately, Microsoft Excel can be used to estimate the fixed cost (intercept) and vari-
able cost per unit (slope) that minimize the sum of the squared errors. Excel also provides
a statistic called the R2, which is a measure of “goodness of fit.” The R2 tells us the per-
centage of the variation in the dependent variable (cost) that is explained by variation in
the independent variable (activity). The R2 varies from 0% to 100%, and the higher the
percentage, the better.
As mentioned earlier, you should always plot the data in a scattergraph, but it is par-
ticularly important to check the data visually when the R2 is low. A quick look at the scat-
tergraph can reveal that there is little relation between the cost and the activity or that the
relation is something other than a simple straight line. In such cases, additional analysis
would be required.
Exhibit 5A–4 uses Excel to depict the Brentline Hospital data that we used earlier to
illustrate the high-low method. We’ll be using this same data set to illustrate how Excel
can be used to create a scattergraph plot and to calculate the intercept a, the slope b, and
the R2 using least-squares regression.6
EXHIBIT 5A–4
The Least-Squares Regression
Worksheet for Brentline Hospital
6
The authors wish to thank Don Schwartz, Professor of Accounting at National University, for provid-
ing suggestions that were instrumental in creating this appendix.
EXHIBIT 5A–5
A Scattergraph Plot for Brentline
Hospital Using Microsoft Excel
To prepare a scattergraph plot in Excel, begin by highlighting the data in cells B4

through C10 (as shown in Exhibit 5A–4). From the Charts group within the Insert tab,
select the “Scatter” subgroup and then click on the choice that has no lines connect-
ing the data points. This should produce a scattergraph plot similar to the one shown
in Exhibit 5A–5. Notice that the number of patient-days is plotted on the X-axis and
the maintenance cost is plotted on the Y-axis.7 As we saw verified earlier in Exhibit 5A–1,
the data is approximately linear, so it makes sense to proceed with estimating a regres-
sion equation that minimizes the sum of the squared errors.
To determine the intercept a, the slope b, and the R2, begin by right clicking on
any data point in the scattergraph plot and selecting “Add Trendline.” This should pro-
duce the screen that is shown in Exhibit 5A–6. Notice that under “Trend/Regression
Type” you should select “Linear.” Similarly, under “Trendline Name” you should select
“Automatic.” Next to the word “Backward” you should input the lowest value for the
independent variable, which in this example is 5000 patient-days. Taking this particular
step instructs Excel to extend your fitted line until it intersects the Y-axis. Finally, you
should check the two boxes at the bottom of Exhibit 5A–6 that say “Display Equation
on chart” and “Display R-squared value on chart.”
Once you have established these settings, then click “Close.” As shown in
Exhibit 5A–7, this will automatically insert a line within the scattergraph plot that
minimizes the sum of the squared errors. It will also cause the estimated least-squares
regression equation and R2 to be inserted into your scattergraph plot. Instead of
depicting the results using the form Y = a + bX, Excel uses an equivalent form of
the equation depicted as Y = bX + a. In other words, Excel reverses the two terms
shown to the right of the equals sign. So, in Exhibit 5A–7, Excel shows a least-squares
regression equation of y = 0.7589x + 3,430.9. The slope b in this equation of $0.7589
represents the estimated variable maintenance cost per patient-day. The intercept a in
this equation of $3,430.90 (or approximately $3,431) represents the estimated fixed
monthly maintenance cost. Note that the R2 is approximately 0.90, which is quite good
and indicates that 90% of the variation in maintenance cost is explained by the variation
in patient-days.
7
To insert labels for the X-axis and Y-axis, go to the Layout tab in Excel. Then, within the Labels
group, select Axis Titles.
248 Chapter 5
EXHIBIT 5A–6
Trendline Options in Microsoft Excel
EXHIBIT 5A–7
Brentline Hospital: Least-
Squares Regression Results
Using Microsoft Excel
Comparing the High-Low and Least-Squares

Regression Methods
The table below compares Brentline Hospital’s cost estimates using the high-low method
and the least-squares regression method:
High-Low Least-Squares
Method Regression Method
Variable cost estimate per patient-day . . . . . . $0.800 $0.759
Fixed cost estimate per month . . . . . . . . . . . . . $3,400 $3,431
When Brentline uses the least-squares regression method to create a straight line that
minimizes the sum of the squared errors, it results in estimated fixed costs that are $31
higher than the amount derived using the high-low method. It also decreases the slope
of the straight line resulting in a lower variable cost estimate of $0.759 per patient-day
rather than $0.80 per patient-day as derived using the high-low method.
Glossary (Appendix 5A)

Account analysis A method for analyzing cost behavior in which an account is classified as either
variable or fixed based on the analyst’s prior knowledge of how the cost in the account behaves.
(p. 242)
Dependent variable A variable that responds to some causal factor; total cost is the dependent
variable, as represented by the letter Y, in the equation Y = a + bX. (p. 242)
Engineering approach A detailed analysis of cost behavior based on an industrial engineer’s
evaluation of the inputs that are required to carry out a particular activity and of the prices of
those inputs. (p. 242)
High-low method A method of separating a mixed cost into its fixed and variable elements by
analyzing the change in cost between the high and low activity levels. (p. 243)
Independent variable A variable that acts as a causal factor; activity is the independent variable,
as represented by the letter X, in the equation Y = a + bX. (p. 242)
Least-squares regression method A method of separating a mixed cost into its fixed and variable
elements by fitting a regression line that minimizes the sum of the squared errors. (p. 245)
Linear cost behavior Cost behavior is said to be linear whenever a straight line is a reasonable
approximation for the relation between cost and activity. (p. 242)
R2 A measure of goodness of fit in least-squares regression analysis. It is the percentage of the varia-
tion in the dependent variable that is explained by variation in the independent variable. (p. 246)
Appendix 5A: Exercises and Problems

EXERCISE 5A–1 High-Low Method LO5–10
The Cheyenne Hotel in Big Sky, Montana, has accumulated records of the total electrical costs
of the hotel and the number of occupancy-days over the last year. An occupancy-day represents a
room rented for one day. The hotel’s business is highly seasonal, with peaks occurring during the
ski season and in the summer.
Month Occupancy-Days Electrical Costs

January . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,736 $4,127
February . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,904 $4,207
March. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,356 $5,083
April . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 960 $2,857
May . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360 $1,871
June. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 744 $2,696
July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,108 $4,670
August . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,406 $5,148
September . . . . . . . . . . . . . . . . . . . . . . . . . . 840 $2,691
October. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 $1,588
November. . . . . . . . . . . . . . . . . . . . . . . . . . . 720 $2,454
December. . . . . . . . . . . . . . . . . . . . . . . . . . . 1,364 $3,529
Required:
1. Using the high-low method, estimate the fixed cost of electricity per month and the variable
cost of electricity per occupancy-day. Round off the fixed cost to the nearest whole dollar and
the variable cost to the nearest whole cent.
2. What other factors in addition to occupancy-days are likely to affect the variation in electrical
costs from month to month?
250 Chapter 5
EXERCISE 5A–2 Least-Squares Regression LO5–11

Bargain Rental Car offers rental cars in an off-airport location near a major tourist desti-
nation in California. Management would like to better understand the variable and fixed
portions of it car washing costs. The company operates its own car wash facility in which
each rental car that is returned is thoroughly cleaned before being released for rental
to another customer. Management believes that the variable portion of its car washing
costs relates to the number of rental returns. Accordingly, the following data have been
compiled:
Month Rental Returns Car Wash Costs

January . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,380 $10,825
February . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,421 $11,865
March. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,586 $11,332
April . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,725 $12,422
May . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,968 $13,850
June. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,281 $14,419
July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,353 $14,935
August . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,489 $15,738
September . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,057 $13,563
October. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,876 $11,889
November. . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,735 $12,683
December. . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,983 $13,796
Required:
1. Prepare a scattergraph plot. (Place car wash costs on the vertical axis and rental returns on the
horizontal axis.)
2. Using least-squares regression, estimate the variable cost per rental return and the monthly
fixed cost incurred to wash cars. The total fixed cost should be estimated to the nearest dollar
and the variable cost per rental return to the nearest cent.
EXERCISE 5A–3 Cost Behavior; High-Low Method LO5–10

Hoi Chong Transport, Ltd., operates a fleet of delivery trucks in Singapore. The company has
determined that if a truck is driven 105,000 kilometers during a year, the average operating cost
is 11.4 cents per kilometer. If a truck is driven only 70,000 kilometers during a year, the average
operating cost increases to 13.4 cents per kilometer.
Required:
1. Using the high-low method, estimate the variable operating cost per kilometer and the annual
fixed operating cost associated with the fleet of trucks.
2. Express the variable and fixed costs in the form Y = a + bX.
3. If a truck were driven 80,000 kilometers during a year, what total operating cost would you
expect to be incurred?
EXERCISE 5A–4 High-Low Method; Scattergraph Analysis LO5–10

Archer Company is a wholesaler of custom-built air-conditioning units for commercial buildings.
It gathered the following monthly data relating to units shipped and total shipping expense:
Units Total Shipping

Month Shipped Expense
January . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 $1,800
February . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 $2,300
March. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 $1,700
April . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 $2,000
May . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 $2,300
June. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 $2,700
July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 $1,200
Required:
1. Prepare a scattergraph using the data given above. Plot cost on the vertical axis and activity
on the horizontal axis. Is there an approximately linear relationship between shipping expense
and the number of units shipped?
2. Using the high-low method, estimate the cost formula for shipping expense. Draw a straight
line through the high and low data points shown in the scattergraph that you prepared in
requirement (1). Make sure your line intersects the Y-axis.
3. Comment on the accuracy of your high-low estimates assuming a least-squares regression
analysis estimated the total fixed costs to be $910.71 per month and the variable cost to be
$217.86 per unit. How would the straight line that you drew in requirement 2 differ from a
straight line that minimizes the sum of the squared errors?
4. What factors, other than the number of units shipped, are likely to affect the company’s ship-
ping expense? Explain.
EXERCISE 5A–5 Least-Squares Regression LO5–11

George Caloz & Frères, located in Grenchen, Switzerland, makes luxury custom watches in small
lots. One of the company’s products, a platinum diving watch, goes through an etching process.
The company has recorded etching costs as follows over the last six weeks:
Week Units Total Etching Cost

1. . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 $ 18
2. . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 17
3. . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 25
4. . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 20
5. . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 24
6. . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 16
30 $120
For planning purposes, management would like to know the variable etching cost per unit and
the total fixed etching cost per week.
Required:
1. Prepare a scattergraph plot. (Plot etching costs on the vertical axis and units on the horizontal
axis.)
2. Using the least-squares regression method, estimate the variable etching cost per unit and the
total fixed etching cost per week. Express these estimates in the form Y = a + bX.
3. If the company processes five units next week, what would be the expected total etching cost?
(Round your answer to the nearest cent.)
PROBLEM 5A–6 Least-Squares Regression; Scattergraph; Comparison of Activity Bases LO5–11

The Hard Rock Mining Company is developing cost formulas for management planning and deci-
sion-making purposes. The company’s cost analyst has concluded that utilities cost is a mixed
cost, and he is attempting to find a base that correlates with the cost. The controller has suggested
that tons mined might be a good base to use in developing a cost formula. The production super-
intendent disagrees; she thinks that direct labor-hours would be a better base. The cost analyst has
decided to try both bases and has assembled the following information:
Direct
Quarter Tons Mined Labor-Hours Utilities Cost
Year 1:
First . . . . . . . . . 15,000 5,000 $50,000
Second . . . . . . 11,000 3,000 $45,000
Third . . . . . . . . 21,000 4,000 $60,000
Fourth . . . . . . . 12,000 6,000 $75,000
Year 2:
First . . . . . . . . . 18,000 10,000 $100,000
Second . . . . . . 25,000 9,000 $105,000
Third . . . . . . . . 30,000 8,000 $85,000
Fourth . . . . . . . 28,000 11,000 $120,000
252 Chapter 5
Required:
1. Using tons mined as the independent variable, prepare a scattergraph that plots tons mined on
the horizontal axis and utilities cost on the vertical axis. Using the least-squares regression
method, estimate the variable utilities cost per ton mined and the total fixed utilities cost per
quarter. Express these estimates in the form Y = a + bX.
2. Using direct labor-hours as the independent variable, prepare a scattergraph that plots direct
labor-hours on the horizontal axis and utilities cost on the vertical axis. Using the least-squares
regression method, estimate the variable utilities cost per ton mined and the total fixed utili-
ties cost per quarter. Express these estimates in the form Y = a + bX.
3. Would you recommend that the company use tons mined or direct labor-hours as a base for
planning utilities cost?
PROBLEM 5A–7 Cost Behavior; High-Low Method; Contribution Format Income Statement LO5–10
Morrisey & Brown, Ltd., of Sydney is a merchandising company that is the sole distributor of
a product that is increasing in popularity among Australian consumers. The company’s income
statements for the three most recent months follow:
Morrisey & Brown, Ltd.

Income Statements
For the Three Months Ended September 30
July August September

Sales in units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 4,500 5,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400,000 $ 450,000 $500,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240,000 270,000 300,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000 180,000 200,000
Selling and administrative expenses:
Advertising expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 21,000 21,000
Shipping expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000 36,000 38,000
Salaries and commissions . . . . . . . . . . . . . . . . . . . . . . . . . . 78,000 84,000 90,000
Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 6,000 6,000
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 15,000 15,000
Total selling and administrative expenses . . . . . . . . . . . . . . 154,000 162,000 170,000
Net operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000 $ 18,000 $ 30,000
Required:
1. By analyzing the data from the company’s income statements, classify each of its expenses
(including cost of goods sold) as either variable, fixed, or mixed.
2. Using the high-low method, separate each mixed expense into variable and fixed elements.
Express the variable and fixed portions of each mixed expense in the form Y = a + bX.
3. Redo the company’s income statement at the 5,000-unit level of activity using the contribu-
tion format.
PROBLEM 5A–8 High-Low Method; Predicting Cost LO5–10

Nova Company’s total overhead cost at various levels of activity are presented below:
Total
Machine- Overhead
Month Hours Cost
April . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 $198,000
May . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 $174,000
June. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 $222,000
July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 $246,000
Assume that the total overhead cost above consists of utilities, supervisory salaries, and main-
tenance. The breakdown of these costs at the 60,000 machine-hour level of activity is:
Utilities (variable) . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,000

Supervisory salaries (fixed) . . . . . . . . . . . . . . . . . . 21,000
Maintenance (mixed). . . . . . . . . . . . . . . . . . . . . . . . 105,000
Total overhead cost. . . . . . . . . . . . . . . . . . . . . . . . . $174,000
Nova Company’s management wants to break down the maintenance cost into its variable and
fixed cost elements.
Required:
1. Estimate how much of the $246,000 of overhead cost in July was maintenance cost. (Hint: to
do this, it may be helpful to first determine how much of the $246,000 consisted of utilities
and supervisory salaries. Think about the behavior of variable and fixed costs.)
2. Using the high-low method, estimate a cost formula for maintenance in the form Y = a + bX .
3. Express the company’s total overhead cost in the form Y = a + bX.
4. What total overhead cost would you expect to be incurred at an activity level of 75,000
machine-hours?
PROBLEM 5A–9 High-Low Method; Contribution Format Income Statement LO5–10

Milden Company is a distributor who wants to start using a contribution format income statement
for planning purposes. The company has analyzed its expenses and developed the following cost
formulas:
Cost Cost Formula

Cost of good sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $35 per unit sold
Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . $210,000 per quarter
Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6% of sales
Shipping expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Administrative salaries . . . . . . . . . . . . . . . . . . . . . . . . . . $145,000 per quarter
Insurance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,000 per quarter
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . $76,000 per quarter
Because shipping expense is a mixed cost, the company needs to estimate the variable ship-
ping expense per unit sold and the fixed shipping expense per quarter using the following data:
Units Shipping
Quarter Sold Expense
Year 1:
First . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 $119,000
Second . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 $175,000
Third . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 $190,000
Fourth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 $164,000
Year 2:
First . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000 $130,000
Second . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 $185,000
Third . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 $210,000
Fourth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 $147,000
Required:
1. Using the high-low method, estimate a cost formula for shipping expense in the form Y = a +
bX.
2. In the first quarter of Year 3, the company plans to sell 12,000 units at a selling price of $100
per unit. Prepare a contribution format income statement for the quarter.
254 Chapter 5
PROBLEM 5A–10 Least-Squares Regression Method; Scattergraph; Cost Behavior LO5–11

Professor John Morton has just been appointed chairperson of the Finance Department at Westland
University. In reviewing the department’s cost records, Professor Morton has found the following
total cost associated with Finance 101 over the last five terms:
Number of
Term Sections Offered Total Cost
Fall, last year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 $10,000
Winter, last year . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 $14,000
Summer, last year . . . . . . . . . . . . . . . . . . . . . . . . . 2 $7,000
Fall, this year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 $13,000
Winter, this year . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 $9,500
Professor Morton knows that there are some variable costs, such as amounts paid to graduate
assistants, associated with the course. He would like to have the variable and fixed costs separated
for planning purposes.
Required:
1. Prepare a scattergraph plot. (Plot total cost on the vertical axis and number of sections offered
on the horizontal axis.)
2. Using the least-squares regression method, estimate the variable cost per section and the total
fixed cost per term for Finance 101. Express these estimates in the form Y = a + bX.
3. Assume that because of the small number of sections offered during the Winter Term this
year, Professor Morton will have to offer eight sections of Finance 101 during the Fall Term.
Compute the expected total cost for Finance 101. Can you see any problem with using the cost
formula from (2) above to derive this total cost figure? Explain.
CASE 5A–11 Mixed Cost Analysis and the Relevant Range LO5–10
The Ramon Company is a manufacturer that is interested in developing a cost formula to estimate
the variable and fixed components of its monthly manufacturing overhead costs. The company
wishes to use machine-hours as its measure of activity and has gathered the data below for this
year and last year:
Last Year This Year

Machine- Overhead Machine- Overhead
Month Hours Costs Hours Costs
January . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 $84,000 21,000 $86,000
February . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 $99,000 24,000 $93,000
March. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000 $89,500 23,000 $93,000
April . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000 $90,000 22,000 $87,000
May . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,500 $81,500 20,000 $80,000
June. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000 $75,500 18,000 $76,500
July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 $70,500 12,000 $67,500
August . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 $64,500 13,000 $71,000
September . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 $69,000 15,000 $73,500
October. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 $75,000 17,000 $72,500
November. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 $71,500 15,000 $71,000
December. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000 $78,000 18,000 $75,000
The company leases all of its manufacturing equipment. The lease arrangement calls for a flat
monthly fee up to 19,500 machine-hours. If the machine-hours used exceeds 19,500, then the fee
becomes strictly variable with respect to the total number of machine-hours consumed during the
month. Lease expense is a major element of overhead cost.
Required:
1. Using the high-low method, estimate a manufacturing overhead cost formula in the form Y = a + bX.
2. Prepare a scattergraph using all of the data for the two-year period. Fit a straight line or lines
to the plotted points using a ruler. Describe the cost behavior pattern revealed by your scat-
tergraph plot.
3. Assume a least-squares regression analysis using all of the given data points estimated the
total fixed cost to be $40,102 and the variable cost to be $2.13 per machine-hour. Do you have
any concerns about the accuracy of the high-low estimates that you have computed or the
least-squares regression estimates that have been provided?
4. Assume that the company consumes 22,500 machine-hours during a month. Using the high-
low method, estimate the total overhead cost that would be incurred at this level of activity. Be
sure to consider only the data points contained in the relevant range of activity when perform-
ing your computations.
5. Comment on the accuracy of your high-low estimates assuming a least-squares regression
analysis using only the data points in the relevant range of activity estimated the total fixed
cost to be $10,090 and the variable cost to be $3.53 per machine-hour.
CASE 5A–12 Analysis of Mixed Costs in a Pricing Decision LO5–11

Maria Chavez owns a catering company that serves food and beverages at parties and business
functions. Chavez’s business is seasonal, with a heavy schedule during the summer months and
holidays and a lighter schedule at other times.
One of the major events Chavez’s customers request is a cocktail party. She offers a standard
cocktail party and has estimated the cost per guest as follows:
Food and beverages . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15.00

Labor (0.5 hrs. @ $10.00/hr.) . . . . . . . . . . . . . . . . . . . . 5.00
Overhead (0.5 hrs. @ $13.98/hr.) . . . . . . . . . . . . . . . . 6.99
Total cost per guest. . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 26.99
The standard cocktail party lasts three hours and Chavez hires one worker for every six guests,
so that works out to one-half hour of labor per guest. These workers are hired only as needed and
are paid only for the hours they actually work.
When bidding on cocktail parties, Chavez adds a 15% markup to yield a price of about $31 per
guest. She is confident about her estimates of the costs of food and beverages and labor but is not
as comfortable with the estimate of overhead cost. The $13.98 overhead cost per labor-hour was
determined by dividing total overhead expenses for the last 12 months by total labor-hours for the
same period. Monthly data concerning overhead costs and labor-hours follow:
Labor- Overhead
Month Hours Expenses
January . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 $ 55,000
February . . . . . . . . . . . . . . . . . . . . . . . . . . 2,800 59,000
March. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 60,000
April . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200 64,000
May . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500 67,000
June. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500 71,000
July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,500 74,000
August . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500 77,000
September . . . . . . . . . . . . . . . . . . . . . . . . 7,000 75,000
October. . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500 68,000
November. . . . . . . . . . . . . . . . . . . . . . . . . 3,100 62,000
December. . . . . . . . . . . . . . . . . . . . . . . . . 6,500 73,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,600 $805,000
Chavez has received a request to bid on a 180-guest fundraising cocktail party to be given next
month by an important local charity. (The party would last the usual three hours.) She would like
to win this contract because the guest list for this charity event includes many prominent individu-
als that she would like to secure as future clients. Maria is confident that these potential customers
would be favorably impressed by her company’s services at the charity event.
256 Chapter 5
Required:
1. Prepare a scattergraph plot that puts labor-hours on the X-axis and overhead expenses on the
Y-axis. What insights are revealed by your scattergraph?
2. Use the least-squares regression method to estimate the fixed and variable components of
overhead expenses. Express these estimates in the form Y = a + bX.
3. If Chavez charges her usual price of $31 per guest for the 180-guest cocktail party, how much
contribution margin will she earn by serving this event?
4. How low could Chavez bid for the charity event in terms of a price per guest and still break
even on the event itself?
5. The individual who is organizing the charity’s fundraising event has indicated that he has
already received a bid under $30 from another catering company. Do you think Chavez should
bid below her normal $31 per guest price for the charity event? Why or why not?
(CMA, adapted)
CHAPTER 6
FPO
Variable Costing and Segment Reporting:

Tools for Management
Misguided Incentives in the Auto Industry
LEARNING OBJECTIVES
BUSINESS FOCUS
After studying Chapter 6, you should be able to:
LO6–1 Explain how variable costing

differs from absorption costing
and compute unit product costs
under each method.
LO6–2 Prepare income statements using

both variable and absorption
costing.
LO6–3 Reconcile variable costing and

© Bloomberg/Getty Images absorption costing net operating
incomes and explain why the two
When the economy tanks, automakers, such as General Motors and amounts differ.
Chrysler, often “flood the market” with a supply of vehicles that far
exceeds customer demand. They pursue this course of action even
LO6–4 Prepare a segmented income
statement that differentiates
though it tarnishes their brand image and increases their auto storage
traceable fixed costs from
costs, tire replacement costs, customer rebate costs, and advertising
common fixed costs and use it to
costs. This begs the question why would managers knowingly produce
make decisions.
more vehicles than are demanded by customers?
In the auto industry, a manager’s bonus is often influenced by her com- LO6–5 Compute companywide and
pany’s reported profits; thus, there is a strong incentive to boost profits by segment break-even points for
producing more units. How can this be done you ask? It would seem logi- a company with traceable fixed
cal that producing more units would have no impact on profits unless the costs.
units were sold, right? Wrong! As we will discover in this chapter, absorp-
tion costing—the most widely used method of determining unit product LO6–6 (Appendix 6A) Prepare an income
costs—can artificially increase profits when managers choose to increase statement using super-variable
the quantity of units produced. ■ costing and reconcile this
approach with variable costing.
Source: Marielle Segarra, “Lots of Trouble,” CFO, March 2012, pp. 29–30.
257

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CHAPTER 5

After studying Chapter 5, you should be able to:

LO5–1 Explain how changes in activity affect

© Everett Collection Inc/Alamy

The Basics of Cost-Volume-Profit (CVP) Analysis

Contribution Income Statement

Contribution Income Statement

Contribution Income Statement

Additional speakers to be sold . . . . . . . . . . . . . . . . . . . . . . . . . . 25

These calculations can be verified as follows:

CVP Relationships in Equation Form

Profit = (Sales − Variable expenses) − Fixed expenses

Unit CM = Selling price per unit − Variable expenses per unit = P − V

Profit = Unit CM × Q − Fixed expenses

CVP Relationships in Graphic Form

Fixed expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000

EXHIBIT 5–1 $175,000

EXHIBIT 5–2 $175,000

$150 per speaker

$40,000 EXHIBIT 5–3

Contribution Margin Ratio (CM Ratio) and the Variable

The contribution margin as a percentage of sales is referred to as the contribution

For Acoustic Concepts, the computations are:

Total contribution margin $40,000

Unit contribution margin $100

For Acoustic Concepts, the computations are:

Variable expense per unit $150

So, in the case of Acoustic Concepts, this relationship would be as follows:

CM ratio = 1 − Variable expense ratio

Change in contribution margin = CM ratio × Change in sales

Profit = CM ratio × Sales − Fixed expenses2

or, in terms of changes,

Change in profit = CM ratio × Change in sales − Change in fixed expenses

For example, at sales of $130,000, the profit is expected to be $17,000 as

LO5–4 Additional Applications of CVP Concepts

*520 units × $150 per unit = $78,000.

According to this analysis, the higher-quality components should be used. Because

Present 400 Expected 600

*35,000 + Additional monthly advertising budget of $15,000 = $50,000.

Expected total contribution margin

Present 400 Expected 460

Variable cost per speaker . . . . . . . . . . . . . . . . . . . $150

Break-Even and Target Profit Analysis

The Equation Method

Profit = Unit CM × Q − Fixed expense

Profit = CM ratio × Sales − Fixed expenses

In the case of Acoustic Concepts, the computations are performed as follows:

Target Profit Analysis LO5–6

Profit = Unit CM × Q − Fixed expense

Target profit + Fixed expenses

Profit = CM ratio × Sales − Fixed expenses

Target profit + Fixed expenses

In the case of Acoustic Concepts, the computations would be:

The Margin of Safety LO5–7

Margin of safety in dollars

The calculation of the margin of safety for Acoustic Concepts is:

Sales (at the current volume of 400 speakers) (a) . . . . . . . $100,000