ACCT 202: Managerial Accounting

Chapter 6
Cost-Volume-Profit Analysis:
Additional Issues

10/26/2022
Learning Objectives

1 Apply basic CVP concepts.

Explain the term sales mix and its effects on break-

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even sales.

Determine sales mix when a company has limited

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resources.

4 Indicate how operating leverage affects profitability.

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Cost-Volume-Profit Analysis (Review)
• Cost-volume-profit (CVP) analysis is the study of the effects of
changes in costs and volume on a company’s profits.
▫ Important in profit planning.
▫ Critical factor in management decisions as
 Determining product mix, and
 Maximizing use of production facilities.

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Cost-Volume-Profit Analysis (cont’d)
• CVP income statement
▫ A statement for internal use.
▫ Classifies costs and expenses as fixed or variable.

4
Break-Even Analysis
• Example
▫ Vargo Electronics’ CVP income statement shows that the fixed cost is
$200,000, and the company’s contribution margin per unit is $200.

FC
Q = = $200,000 = 1,000 units
UCM $200

FC
$ = = $200,000 = $500,000
CMR 40%

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Target Net Income
• Example
▫ Assuming Vargo’s target net income is $250,000, required sales in units
and dollars to achieve this are:

Q = FC + Target Income = $200,000 + $250,000 = 2,250 units

UCM $200

$ = FC + Target Income = $200,000 + $250,000 = $1,125,000

CMR 40%

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CVP and Changes in the Business Environment
• Assuming original camcorder sales and cost data for Vargo Video are
as follows:

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Example 1
• A competitor is offering a 10% discount on the selling price of its
camcorders. Management must decide whether to offer a similar
discount.
• Question: What effect will a 10% discount on selling price ($500 x
10% = $50) have on the breakeven level in units?

FC
Q = = $200,000 = 1,334 units (rounded)
UCM $150*

*UCM = $450 - $300 = $150

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Example 2
• Vargo’s principal supplier of raw materials has just announced a price
increase. The higher cost is expected to increase the variable cost of
camcorders by $25 per unit. Management decides to hold the line on
the selling price of the camcorders. It plans a cost-cutting program that
will save $17,500 in fixed costs per month. Vargo is currently realizing
monthly net income of $80,000 on sales of 1,400 camcorders.
• Question: What increase in units sold will be needed to maintain the
same level of net income?

FC = $200,000 – $17,500 = $182,500

UCM = $500 – ($300 + $25) = $175

Q = FC + Target Income = $182,500 + $80,000 = 1,500 units

UCM $175
Increase in units = 1,500 – 1,400 = 100 units

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Exercise 1
• Krisanne Company reports the following operating results for the
month of June 2019.

▫ To increase net income, management is considering reducing the selling

price by 10%, with no changes to unit variable costs or fixed costs.
Management is confident that this change will increase unit sales by
25%. Using the contribution margin technique, compute the break-even
point in units and dollars (a) assuming changes to sales price and
volume as described above (round the number if needed).

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Sales Mix and Break-Even Analysis
• What happens if a company manufactures and sell more than one
product?
▫ Sales mix is the relative proportion in which a company’s products are
sold
▫ Different products have different selling prices, cost structures, and
contribution margins

• When a company sells more than one product, break-even analysis

becomes more complex

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Sales Mix and Break-Even Analysis (cont’d)
• Companies can compute break-even point for a mix of two or more
products by determining the weighted-average unit contribution
margin of all the products.

• Example:
▫ Vargo Electronics sells not only camcorders but TV sets as well. Vargo
sells its two products in the following amount: 1,500 camcorders and 500
TVs. The sales mix, expressed as a function of total units sold, is as
follows.

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Sales Mix and Break-Even Analysis (cont’d)
• Additional information related to Vargo Electronics.

• Compute break-even sales in units:

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Sales Mix and Break-Even Analysis (cont’d)
• Step 1: Determine the weighted-average unit contribution margin
(WUCM).

• Step 2: use the weighted-average unit contribution margin to compute

the break-even point in units.

FC
Q = = $275,000 = 1,000 units
WUCM $275
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Sales Mix and Break-Even Analysis (cont’d)
• The break-even sales in units contributed by each division will be:
▫ 750 Camcorders (1,000 units x 75%)
▫ 250 TVs (1,000 units x 25%)

• At this level, the total contribution margin will equal the fixed costs of
$275,000.

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Exercise 2
• NoFly Corporation sells three different models of a mosquito
“zapper,” with the information as follows:
A12 B22 C124 Total
Unit price $50 $100 $400
Variable costs 35 70 300
Sales mix (units) 15,600 3,900 6,500 26,000

a) Compute the weighted-average unit contribution margin.

b) If the company has fixed cost of $269,500, how many units of each
model must the company sell in order to break even?

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Sales Mix and Break-Even Analysis (cont’d)
• The break-even sales in dollars:
▫ Kale Garden Supply Company has two divisions.

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Sales Mix and Break-Even Analysis (cont’d)
• Step 1: Determine the weighted-average contribution margin ratio
(WCMR).

• Step 2: Use the weighted-average contribution margin ratio to

compute the break-even point in dollars.

FC
$ = = $300,000 (given) = $937,500
WCMR $0.32

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Sales Mix and Break-Even Analysis (cont’d)
• The break-even sales in dollars contributed by each division will be:
▫ $187,500 come from the Indoor Plant Division ($937,500 x 20%)
▫ $750,000 come from the Outdoor Plant Division ($937,500 x 80%)

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Exercise 3
• Dixie Candle Supply makes candles. The sales mix (as a
percentage of total dollar sales) of its three product lines is birthday
candle 30%, standard tapered candle 50%, and large scented
candles 20%. The contribution margin ratio of each candle type is
shown below:
Candle Type Contribution Margin Ratio
Birthday 20%
Standard tapered 30%
Large scented 45%

a) What is the weighted-average contribution margin ratio?

b) If the company’s fixed costs are $450,000 per year, what is the dollar
amount of each type of candle that must be sold to break even?

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Determine Sales Mix with Limited Resources
• All companies have limited resources whether it be floor space, raw
materials, direct labor hours, etc.

• Example
▫ Vargo makes camcorders and TVs. Machine capacity is limited to 3,600
hours per month.

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Determine Sales Mix with Limited Resources (cont’d)
• The TVs may appear more profitable because they have a higher
unit contribution margin (UCM).
• However, the camcorders take fewer machine hours to produce the
TVs.

• Necessary to find the contribution margin per unit of limited

resource.
▫ In the example of Vargo Company, it is the contribution margin per
machine hour.

Camcorders TVs
Unit contribution margin (a) $200 $500
Machine hours required (b) 0.2 0.625
Contribution margin per machine
hour (a) ÷ (b) $1,000 $800

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Determine Sales Mix with Limited Resources (cont’d)
• If Vargo is able to increase machine capacity from 3,600 hours to
4,200 hours, the additional 600 hours could be used to produce
either the camcorders or TVs.

To maximize net income, all 600 hours should be used to produce and sell
camcorders.

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Exercise 4
• Carolina Corporation manufactures and sells three different types of high-
quality sealed ball bearings for mountain bike wheels. The bearings vary in
terms of their quality specifications—primarily with respect to their
smoothness and roundness. Machine time is limited. Additional information
is provided below.

a) Ignoring the machine time constraint, which product should Carolina Corp.
focus on?
b) What is the contribution margin per unit of limited resource for each type of
bearing?
c) If additional machine time could be obtained, how should the additional capacity
be used?
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Operating Leverage
• Cost structure
▫ is the relative proportion of fixed versus variable costs that a company
incurs.

• Example
▫ Vargo Electronics and one of its competitors, New Wave Company, both
make camcorders. Vargo Electronics uses a traditional, labor-intensive
manufacturing process. New Wave Company has invested in a completely
automated system. The factory employees are involved only in setting up,
adjusting, and maintaining the machinery.

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Operating Leverage (cont’d)
• Effect on contribution margin ratio:

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Operating Leverage (cont’d)

• New Wave contributes 80 cents to net income for each dollar of

increased sales while Vargo only contributes 40 cents.
• New Wave’s cost structure which relies on fixed costs is more
sensitive to changes in sales.

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Operating Leverage
• Effect on break-even sales:

• New Wave needs to generate $150,000 more in sales than Vargo to

break-even.
• Because of the greater break-even sales required, New Wave is a
riskier company than Vargo.

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Operating Leverage (cont’d)
• Operating leverage is a measure of how sensitive net operating
income is to percentage changes in sales. It is a measure, at any
given level of sales, of how a percentage change in sales volume
will affect profits.

Degree of Contribution margin

operating leverage = Net operating income

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Operating Leverage (cont’d)
• When sales revenues are increasing, high operating leverage
means that profits will increase rapidly.
• When sales revenues are declining, too much operating leverage
can have devastating consequences.

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Operating Leverage (cont’d)
• Example
▫ Vargo Electronics and one of its competitors, New Wave Company, both
make camcorders. Vargo Electronics uses a traditional, labor-intensive
manufacturing process. New Wave Company has invested in a completely
automated system. The factory employees are involved only in setting up,
adjusting, and maintaining the machinery.

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Operating Leverage (cont’d)
• The degree of operating leverage of Vargo Electronics:

• New Wave’s earnings would go up (or down) by about two times

(5.33 ÷ 2.67 = 1.99) as much as Vargo’s with an equal increase in
sales.

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 33

Absorption Costing versus Variable Costing

Under variable costing, product costs consist of:

• Direct Materials
• Direct Labor
• Variable Manufacturing Overhead

Difference between absorption and variable costing is:

 34

Absorption Costing versus Variable Costing (cont’d)

Illustration: Premium Products Corporation manufactures a sealant, called

Fix-It, for car windshields. Relevant data for Fix-It in January 2020, the
first month of production is shown.
Selling price $20 per unit.
Units Produced 30,000; sold 20,000; beginning inventory zero.

Variable unit costs Manufacturing $9 (direct materials $5, direct

labor $3, and variable overhead $1).
Selling and administrative expenses $2.
Fixed costs Manufacturing overhead $120,000. Selling and
administrative expenses $15,000.
 35

Absorption Costing versus Variable Costing (cont’d)

Per unit manufacturing cost under each approach.

Type of Cost Absorption Variable
Direct materials $5 $5
Direct labor 3 3
Variable manufacturing overhead 1 1
Fixed manufacturing overhead
($120,000 ÷ 30,000 units produced) 4 single underline
0 single
underline

Manufacturing cost per unit $13 double

underline
$9 double
underline

Manufacturing cost per unit is $4 ($13 − $9) higher for absorption

costing because fixed manufacturing costs are treated as product costs.
 Type of Cost Absorption Variable
36
Direct materials $5 $5
Direct labor 3 3
Absorption Costing
Variableversus Variable
manufacturing overhead Costing (cont’d)
1 1
Fixed manufacturing overhead
($120,000 ÷ 30,000 units produced) 4 single underline
0 single
underline

Manufacturing cost per unit $13 double

underline
$9 double
underline
 Type of Cost Absorption Variable
37
Direct materials $5 $5
Direct labor 3 3
Absorption Costing
Variableversus Variable
manufacturing overhead Costing (cont’d)
1 1
Fixed manufacturing overhead
($120,000 ÷ 30,000 units produced) 4 single underline
0 single
underline

Manufacturing cost per unit $13 double

underline
$9 double
underline
 38

Absorption Costing versus Variable Costing (cont’d)

 39

Absorption Costing versus Variable Costing (cont’d)

Advantages of Variable Costing

1. Net income computed under variable costing is unaffected by
changes in production levels.
2. Variable costing readily supports cost-volume-profit analysis.
3. Net income computed under variable costing is closely tied to
changes in sales levels and therefore provides a more realistic
assessment of a company’s success or failure.
4. The presentation of fixed and variable cost components on the
variable costing income statement makes it easier to identify
these costs.