CHAPTER 2 PROFIT PLANNING

2-1

Assumptions and Misconceptions about CVP Analysis

General Note to the Instructor: This question can prove difficult because it requires not only considerable understanding of the concepts introduced in Chapter 2 but also some anticipation of concepts introduced in Chapter 3. The purposes of the questions are to stimulate discussion of the uses and limitations of CVP analysis and to counter the natural student skepticism regarding the applicability of basic concepts in light of the factors that make it impossible to portray the practicalities of business operations in the simple forms offered by theoretical analysis. The points to be made are that, the uncertainties of the real world notwithstanding, managers must plan and take actions and that any actions managers take implicitly reflect some assumptions about the future. For example, a store owner must set some prices, and the action of setting a price reflects some expectations about volume and costs. Similarly, a manager must decide not only whether or not to advertise but also, if some advertising is to be done, how much is reasonable. A manager must also decide how many employees to have as well as a host of other matters. CVP analysis, though far from a cure-all, provides a reasonable basis for planning. 1. CVP analysis answers "what if" and "what must we do to achieve" questions. It is a planning tool and helps managers see what should occur given certain estimates of the values of important variables. All of the classmate's statements are true; but they relate to facts that can only be known after the manager is required to decide what to do. A manager must decide what to do on the basis of estimates because the future is not known. The emphasis in CVP analysis is not on past costs nor on current costs, but rather on the costs that can be expected in the future. A manager must make some estimates of the expected pattern of increases of costs and prices, and it is those estimates of expected patterns that form the basis for successful use of CVP analysis. Plans can be made by month, or for the entire year, or for some period of time in between those two extremes. The point is that planning relates to the future. It is probably impossible to overemphasize this point. 2. Note to the Instructor: The depth of the answer to be expected on this question depends on the depth of the students' knowledge and understanding of microeconomics. In any case it is important to emphasize that basic study in microeconomic theory assumes that managers of a firm have information that is not, in fact, automatically available to them. The typical demand curve for a particular product has a negative slope. 2-1

But CVP analysis is not concerned so much with the relationship between price and quantity demanded as it is with the likely results of a particular price and, implicitly, a set of other variables such as advertising expenditures. CVP analysis does not purport to answer the question, "How many will we sell at this price?" Rather it answers questions about profits at given levels of volume and price. CVP analysis is a planning tool. Note also that the idea of relevant range is important here. A cost structure (mix of variable and fixed costs) holds over a range of volume levels for a single firm regardless of the sales price of the product. (To emphasize the points of difference between microeconomic theory and breakeven analysis, note also that the long-run cost curves used for the former do not assume the same cost structures at each level of volume.) 3. Again, CVP analysis is a planning tool and utilizes the best information available at a given point in time when planning must take place. If a manager knows (or considers it probable) that certain costs will change, his CVP analysis should take such knowledge into consideration, for that analysis is, by virtue of its being a planning tool, future oriented. 4. The possibility of reduced prices does not reduce the usefulness of CVP analysis but only changes the manner in which the analysis is carried out. There are several ways to handle the problem proposed by some sales at reduced prices. One way is to integrate into the calculation of contribution margin percentage the effects of sales at reduced prices. Another is to estimate separately the contribution margins from sales at regular prices and sales at reduced prices. In either case, the critical concern is the quantity of merchandise that the manager believes will have to be sold at reduced prices. 2-2 1. Effects of Events The slope of the revenue line will increase.

2. The slope of the total cost line will increase, but the intercept will remain the same. 3. 2-3 The graph will not change, but the expected volume will be higher. Effects of Keeping Up With Technology

The statement describes a typical situation in a retailing company dependant upon technology. Amazon.com will face large and continued fixed costs expenditures to support its marketing and promotion, product development and technology, and operating infrastructure development. Amazon.coms variable costs are primarily the cost of the merchandise (books, audio, and video) sold. To achieve profitability, Amazon.com must emphasize revenue growth.

2-2

2-4 Income Statement and CVP Analysis 1. Sales Variable costs Contribution margin Fixed costs Income 2. (a) (b) $480,000 360,000 120,000 80,000 $ 40,000

(10-15 minutes)

40,000 units $80,000/($8 - $6) $320,000, $8 x 40,000, or $80,000/[($8 - $6)/$8]

Note to the Instructor: We can calculate required volumes incrementally, either in units or dollars, by dividing the existing income or loss by the contribution margin (per unit or percentage) and subtracting that from existing sales. For break-even units, the calculations are as follows: Income Divided by contribution margin per unit ($8 - $6) Equals decrease in unit sales to reach break-even point Subtracted from current unit volume Equals break-even unit sales 3. (a) (b) 100,000 units $ 40,000 $2 20,000 60,000 40,000

$80,000/[($8 - $6) - (15% x $8)] = $80,000/($2 - $1.20) $800,000 100,000 x $8, or $80,000/(25% - 15%). The contribution margin percentage of 25% is ($8 - $6)/$8.

An income statement shows, Sales Variable costs Contribution margin Fixed costs Income 4. $8.67 rounded Desired profit ($40,000 x 2) Plus fixed costs Equals required contribution margin Divided by volume Equals required per-unit contribution margin Plus per-unit variable cost Equals required selling price 2-5 Income Statement and CVP Analysis 1. Sales Variable costs at 40% Contribution margin Fixed costs Income $750,000 $ 80,000 80,000 $160,000 60,000 units $ 2.67 6.00 $ 8.67 $800,000 600,000 200,000 80,000 $120,000

15% x $800,000

(10-15 minutes)

$800,000 320,000 480,000 450,000 $ 30,000

2.

$450,000/(100% - 40%)

2-3

3.

$850,000

[$450,000 + (2 x $30,000)]/(100% - 40%) = $510,000/60%

You might wish to show that this part can also be solved by finding the increase in sales required to increase profit by $30,000. That is $50,000 ($30,000/60%). Adding $50,000 to existing sales of $800,000 gives $850,000. 2-6 1. Income Statement and CVP Analysis with Taxes Sales Variable costs Contribution margin Fixed costs Income before taxes Income taxes at 30% Income (15-20 minutes) $480,000 360,000 120,000 80,000 40,000 12,000 $ 28,000 $ 56,000 $ 80,000 80,000 $160,000 $2 80,000 $8 $640,000

2. Desired income (2 x $28,000) Divided by 70% = required pretax income Plus fixed costs Equals required contribution margin Divided by unit contribution margin (a) Equals unit sales required Times unit price (b) Equals sales dollars required

Note to the Instructor: An alternative calculation is to divide the required contribution margin by the contribution margin percentage. Required contribution margin $160,000 Divided by contribution margin percentage 25% Equals sales dollars required $640,000 3. $8.67 rounded This is the same question and answer as requirement 4 of 2-4. Income taxes do not affect pretax profit calculations or breakeven calculations. Desired pretax profit ($40,000 x 2) $ 80,000 Plus fixed costs 80,000 Equals required contribution margin $160,000 Divided by volume 60,000 Equals required per-unit contribution margin $ 2.67 Plus variable cost 6.00 Equals required price $ 8.67 Note to the Instructor: The $8.67 price also doubles the after-tax profit. We asked the assignment in this way to highlight that doubling pretax profit is equivalent to doubling after-tax profit.

2-4

2-7 1.

Income Statement and CVP Analysis with Taxes

(15-20 minutes)

Sales Variable costs Contribution margin Fixed costs Income before taxes Income taxes at 40% Income

$800,000 320,000 480,000 450,000 30,000 12,000 $ 18,000 $ 36,000 60% 60,000 450,000 $510,000 60% $850,000

2. Desired income (2 x $18,000 above) Divided by (100% - 40%) Equals required pre-tax income Plus fixed costs Equals required contribution margin Divided by contribution margin percentage Equals sales required 2-8 1. 2. 3. 4. Basic CVP Analysis (a) (b) (a) (b) (a) (b) (20-25 minutes)

33,334 units (rounded) $600,000/($30 - $12) = $600,000/$18 $1,000,000 $600,000/($18/$30) = $600,000/60%, or 33,334 x $30 40,000 units $1,200,000 ($600,000 + $120,000)/$18 ($600,000 + $120,000)/60%, or 40,000 x $30

41,667 (rounded) $600,000/($18 - [12% x $30]) = $600,000/$14.40 $1,250,00 $600,000/(60% - 12%) = $600,000/48%, or 41,667 x $30 = profit = $100,000

$35.33 rounded Sales - variable costs - fixed costs S (30,000 x $12) - $600,000 S - $360,000 - $600,000 = $100,000 S = $1,060,000 Price = $1,060,000/30,000 = $35.33

5.

$35.93 rounded Sales variable costs fixed costs S - 30,000 x $9 - 10%S $600,000 S - $270,000 - 10%S - $600,000 = $100,000 90%S = $970,000 S = $1,077,778 Price = $1,077,078/30,000 = $35.93 (rounded)

= profit = $100,000

Note to the Instructor: This basic exercise makes the point that CVP analysis and other techniques can yield impossible answers, here fractions of units or pennies. Some students believe that if their answer is not a whole number, they must have done something wrong. (This feeling is especially prevalent during examinations.) 2-9 Basic CVP Relationships, with Income Taxes (15-20 minutes)

2-5

1. (a) 266,667 units $4,000,000/$15

($3,000,000 + [$600,000/60%])/($40 - $25) =

(b) $10,666,667 Total required contribution margin (part a) $4,000,000 Divided by contribution margin percentage ($40 - $25)/$40 37.5% Or, 266,667 x $40 2. $38.333 Required contribution margin (part 1) Divided by units Required contribution margin per unit Plus variable cost Required price 3. $38.15 Sales S 90%S = S = Price = $4,000,000 300,000 $ 13.333 25.000 $ 38.333

rounded variable costs - fixed costs = pretax profit (300,000 x $21) - 10%S - $3,000,000 = $1,000,000 $10,300,000 $11,444,444 $11,444,444/300,000 = $38.15 rounded (20-30 minutes)

2-10 1.

Relationships Among Variables

To work this part it is necessary to start with the second blank. (d) (c) $78,000, $28,000 + $50,000

2,600 units ($78,000/$30 contribution margin per unit) Contribution margin per unit ($50 x 60%) $30 Contribution margin in total, from part (d) $78,000 75% (100% - contribution margin of 25%) Contribution margin per unit ($60,000/3,000) Contribution margin percentage ($20/$80) $20 25%

2.

(b)

(e) 3.

$80,000, (loss of $20,000 after deducting fixed costs from a contribution margin of $60,000)

Again, it is necessary to start with the second blank. (d) (b) $75,000, $25,000 + $50,000 $5 20%

80% (100% - contribution margin percentage of 20%) Contribution margin per unit ($75,000/15,000) Contribution margin percentage ($5/$25)

2-6

2-11 1. 2. 3.

Relationships Among Variables $8 selling price $800 fixed costs 2,000 units sold $2,500 income $10 selling price $8,000 income CVP Graph $6,000

(15-20 minutes)

$6 + ($2,000/1,000) $2,000 - $1,200 $4,000/($5 - $3) $4,000 - $1,500 $6 + ($16,000/4,000) $16,000 - $8,000

2-12 1. 2.

(10-15 minutes)

$2,000, which is the answer at all levels of sales.

3. $4,000, the difference between $6,000 total costs at the 4,000-unit (break-even) level minus $2,000 fixed costs. You do not need variable cost per unit to solve this part. 4. $1.00, $4,000/4,000 from the previous part. Or, read the value of total cost at any level above zero sales, subtract fixed costs of $2,000, and divide by unit sales. 5. $1.00, same as in part 4. This question emphasizes the point that variable cost per unit remains constant throughout the relevant range. 6. 7. 8. $1.50, $6,000 sales divided by 4,000 units at the break-even point. $1,500, $0.50 contribution margin ($1.50 - $1.00) times 3,000 units. $500 loss, $1,500 contribution margin (part 7) minus $2,000 fixed costs.

9. $500 profit, which is contribution margin of $2,500 (500 x $0.50) less fixed costs of $2,000. 10. 5,000 units. margin per unit. 2-13 1. This is $2,500 fixed costs divided by $0.50 contribution

Basic Sales Mix 34%

(10

minutes) Produce Meat/Dairy 35% 20% 7% Canned Goods 30% 50% 15%

12% + 7% + 15% 40% 30% 12%

Contribution margin percentage Sales mix percentage Weighted-average contribution margin 2. 3. 2-14 $2,000,000 $2,617,647 $680,000/34% ($680,000 + $210,000)/34%

Improving Sales Mix

(15-20 minutes) 2-7

1.

62%

20% + 18% + 24% Termites Lawn Pests 60% 30% 18% Interior Pests 80% 30% 24% 50% 40% 20%

Contribution margin percentage Sales mix percentage * Weighted-average

* $160,000/$400,000; $120,000/$400,000, $120,000/$400,000 Alternatively, some students will solve for total contribution margin by carrying out the multiplication of CM% by budgeted sales, then adding the sales and contribution margins. This part tests to see whether students understand the concept of sales mix by presenting the information in a different form from that in the text. 2. $98,000 Contribution margin, $400,000 x 62% Fixed costs Profit (a) 68% 10% + 18% + 40% Termites Contribution margin percentage Sales mix percentage Weighted-average 50% 20% 10% Lawn pests 60% 30% 18% $272,000 150,000 $122,000 Interior pests 80% 50% 40% $248,000 150,000 $ 98,000

3.

(b) $122,000 Contribution margin ($400,000 x 68%) Fixed costs Profit

Note to the Instructor: This exercise demonstrates that sales mix affects profit (through its effect on the contribution margin percentage). Thus, even though selling prices, the percentages of variable cost to price, total fixed costs, and total sales dollars remained constant, the shift in sales mix resulted in a six percentage point increase in the weighted-average contribution margin percentage and a corresponding six percentage point increase in return on sales, an additional $24,000 profit.

2-15

Margin of Safety

(5-10 minutes)

2,250 units, or $202,500 (2,250 x $90), as computed below. Expected sales, in units Fixed costs Contribution margin, $90 - $52 - (20% x $90) Breakeven point Margin of safety, in units 2-16 Alternative CVP Graph (continuation of 2-15) 16,000 $275,000 $ 20 13,750 2,250 (10-15 minutes)

Per-unit contribution margin under the alternative is $26.50 [$90 - $41 (25% x $90)] and the break-even point is 12,264 units ($325,000 fixed costs/ 2-8

$26.50), which is 1,486 less than before.

300,000 200,000 100,000 0 -100,000 -200,000 -300,000 -400,000 5,000 10,000 15,000 20,000

The graph highlights the desirability of the change. Profit is higher under the alternative once volume reaches 7,692 units ($50,000 difference in fixed costs divided by $6.50 difference in contribution margin). Because the company expects sales of 16,000 units, unless the new production/marketing strategies will reduce volume, the alternative dominates the existing case. 2-17 CVP Graph, Analysis of Changes Revenue Line 1. 2. 3. Decrease slope (shallower revenue line) No effect No effect (5-10 minutes) Break-even Point Increase Lower (decrease) Not determinable (the answer depends on the specific numbers) No effect Not determinable (depends on relationship between price and cost changes)

Total Cost Line No effect Decrease slope (shallower angle on cost line) Higher intercept of cost line, but reduction of slope of that line No effect Increase slope

4. 5.

No effect Increase slope

Note to the Instructor: This exercise should help students understand how changes in the basic facts of a situation will change its graphical analysis. To emphasize that both the graphic and the contribution-margin approaches allow conceptual analysis of break-even situations, you might wish 2-9

to review each of the above changes using the contribution-margin approach, as follows: 1. 2. 3. A price decrease decreases per-unit contribution margin, which raises the break-even point. A decrease in per-unit variable cost increases per-unit contribution margin, which lowers the break-even point.

A decrease in per-unit variable cost increases per-unit contribution margin and therefore reduces the break-even point. An increase in fixed costs increases the break-even point, so the effect of the two events cannot be determined without knowing the numerical amounts. 4. Since price, per-unit variable costs, and total fixed costs do not change, the break-even point remains the same. The company's profit will be lower than expected, but break-even remains the same. 5. point. The ultimate effect on the break-even point depends on the relative magnitudes of the changes in the two factors. 2-18 1. Converting an Income Statement Sales Variable costs: Cost of goods sold Commissions ($400,000 x 10%) Total variable costs Contribution margin Fixed costs: Salaries ($71,000 - $40,000) Utilities Rent Other Total fixed costs Income (20 minutes) $400,000 $240,000 40,000 280,000 120,000 31,000 10,000 15,000 25,000 81,000 $ 39,000 An increase in selling price increases contribution margin, thus lowering the break-even point; but an increase in per-unit variable cost decreases contribution margin, thus raising the break-even

2. (a) (b)

10,800 units $81,000/$7.50 Volume is $400,000/$25 = 16,000, so contribution margin is $120,000/16,000 = $7.50 $270,000 10,800 x $25 or $81,000/30% (30% = $120,000/$400,000)

2-10

3.

$26 Cost of goods sold is $15 per unit ($240,000/16,000). commission of 10% of price gives sales variable costs - fixed costs = profit S - (15,000 x $15) - 10%S - $81,000 = $45,000 90%S = $351,000 S = $390,000 Price = $390,000/15,000 = $26 Target Costing $14,000,000 Revenue (200,000 x $100) Target profit Total allowable cost $20,000,000 6,000,000 $14,000,000 (10 minutes)

Adding the

2-19 1.

2.

$25,

$5,000,000 allowable variable cost divided by 200,000 units $14,000,000 9,000,000 $ 5,000,000

Total allowable cost Estimated fixed cost Allowable total variable cost 2-20 Profit Planning

(20-25 minutes)

The following preliminary calculations will be helpful. Selling price Cost of goods sold: Cost of sales Divided by number of units sold Equals unit cost of sales Plus increase expected Equals new unit cost of sales in Selling costs: Selling costs, per unit Plus expected increase Equals new unit selling cost Total variable cost per unit Contribution margin per unit 1. Zaldec Company Income Statement $1,680,000 $1,032,000 100,800 $310,000 220,000 1,132,800 547,200 530,000 $ 17,200 $35.00 $800,000 40,000 $20.00 1.50 21.50 $2.00 0.10 2.10 23.60 $11.40

Sales, 48,000 (40,000 units x 120%) x $35 Variable costs: Cost of goods sold (48,000 x $21.50) Selling costs (48,000 x $2.10) Contribution margin (48,000 x $11.40) Fixed costs: Selling* Administrative ($190,000 + $30,000) Income *Fixed costs Expected increase $350,000 - (40,000 x $2)

$270,000 40,000

2-11

Fixed costs, new 2. 3.

$310,000

51,754 units rounded ($60,000 + $530,000)/$11.40 = $590,000/$11.40 $35.89 rounded, $1,722,800 total revenue divided by 48,000 units sales = variable costs + fixed costs + profit S = (48,000 x $23.60) + $530,000 + $60,000 S = $1,722,800 Basic Income Taxes (15-20 minutes) $1,440,000 $864,000 144,000 1,008,000 432,000 250,000 182,000 72,800 $ 109,200 $120,000 .60 200,000 250,000 450,000

2-21 1.

$109,200 Sales (12,000 x $120) Variable costs: Manufacturing (12,000 x $72) Commission ($1,440,000 x 10%) Contribution margin Fixed costs Income before taxes Income taxes (40%) Net income

2.

12,500 units Desired after-tax profit Divided by (1 - tax rate of 40%) Required pre-tax profit Plus, fixed costs Equals required contribution margin for target profit Divided by contribution margin per unit: Selling price $120 Variable manufacturing cost ( 72) Commission (10% of selling price) (12) Equals volume required for target profit About Sales S 90%S S Price $123.43 variable costs - fixed costs = profit - [(11,000 x $72) - 10%S] $250,000 = $180,000 = $1,222,000 = $1,357,778 = $1,357,778/11,000 = $123.43 (rounded)

$36 12,500

units 3.

2-12

2-22 1.

Basic Sales Mix

(20 minutes)

60% weighted-average contribution margin, $400,000 monthly sales. Selling price Variable cost Contribution margin Contribution margin percentage Sales mix, in dollars Weighted contribution margin Allergy-free $18 9 $ 9 50% 60% 30% + Cleansaway $24 6 $18 75% 40% 30% = 60%

Required sales = ($180,000 + $60,000)/60%

= $400,000 Cleansaway $160,000 $24 6,667

Allergy-free Sales, 60%, 40% Divided by selling price Units sold (rounded) $240,000 $18 13,333

20,000

Thus, the company could also express the mix percentage in units as 2/3 Allergy-free, 1/3 Cleansaway. Again, we have a fractional answer, indicating that the company cannot really earn $60,000 under the stated conditions. 2. $13.50 weighted-average unit contribution margin, 17,778 units Contribution margin Sales mix, in units Weighted-average contribution margin Allergy-free $9 50% $4.50 + Cleansaway $ 18 50% $9.00 =

$13.50

Required sales = $240,000/$13.50 = 17,778,

8,889 of each

Dollar sales = 8,889 x $18, 8,889 x $24 = $160,002 + $213,336 = $373,338 The reason that unit sales here are much lower than the unit sales required in requirement 1, where the mix was expressed in dollars is that the implied unit mix of 2/3, 1/3 in requirement 1 is leaner than the 50/50 given here. Therefore, the company needs to sell less total product to earn the same profit. The same reasoning applies to the dollar sales differences. Some students do not understand that the way you express mix, units or dollars, depends on circumstances. A department store manager would never try to express mix in units because units range from handkerchiefs to refrigerators. An auto dealer would be very comfortable using units to express mix.

2-13

3.

Profit rises by $12,000, to $72,000. Contribution margin percentage Sales mix, in dollars Weighted contribution margin Contribution margin, $400,000 x Fixed costs, $180,000 + $8,000 Profit Allergy-free Cleansaway 50% 75% 40% 60% 20% + 45% = 65% $260,000 188,000 $ 72,000

65%

An alternative calculation that emphasizes the change in total contribution margin accompanying a change in the weighted-average contribution margin percentage is: Monthly volume times increase in weighted average contribution margin (65% - 60%) Increase in total contribution margin Less increased fixed costs Increase in profit 2-23 1. 2. Weighted-Average Contribution Margin (20 minutes) $400,000 5% 20,000 8,000 $ 12,000

Luxury, because its per-unit contribution margin is highest. Necessary, because its contribution margin percentage is highest. Selling price Variable cost Contribution margin Contribution margin percentage Necessary $10.00 4.00 $ 6.00 60% 60% 40% 24% Frill $20.00 12.00 $ 8.00 40% 40% 20% 8% Luxury $25.00 12.50 $12.50 50% 50% 40% 20%

3. (a) 52% 24% + 8% + 20% Contribution margin percentage Sales mix, in dollars Weighted contribution margin (b) (c) $550,000 $286,000/52%

8,800 units Sales at the break-even point, part 3b $550,000 Times sales mix % for Luxury 40% Sales of Luxury $220,000 Divided by selling price per unit of Luxury $25 Equals sales of Luxury at break-even 8,800 $9 $2.40 + $1.60 + $5.00 Necessary $6.00 40% $2.40 $286,000/$9 Frill $8.00 20% $1.60 Luxury $12.50 40% $ 5.00 Total $9.00

4. (a)

Contribution margin per unit Sales mix, in units Weighted contribution margin (b) 31,778 units, rounded

2-14

(c) 2-24 1.

12,711 units, rounded Indifference Point

31,778 x 40%

(10-15 minutes) Alternative #1 Alternative #2 $104,000 $60 28 $26 2,308 rounded $32 3,250

Fixed costs Divided by contribution margin: Selling price Variable cost Contribution margin Equals break-even point, in units

$60,000 $60 34

2. 7,333 units We can solve this using either total costs or total profit. Let Q = volume. Using total costs, Alternative #1, Total Costs Fixed costs + variable costs $60,000 + $34Q $ 6Q Q Using profit, ($60 - $34)Q $26Q $60,000 $60,000 $6Q Q = = = = = = = = = Alternative #2, Total Costs Fixed costs + variable costs $104,000 + $28Q $44,000 7,333 ($60 - $28)Q - $104,000 $32Q - $104,000 $44,000 7,333

Thus, if managers expect volume to exceed 7,333 units, they should prefer alternative 2 because it will give higher profits than alternative 1 above that volume. The reverse is true for volumes below 7,333 units. Note to the Instructor: It is necessary to work with profit if total costs are not the same at the volume where profits are the same. This occurs if the selling price differs between the alternatives. Here, the selling price is the same, but we show the technique for completeness. 2-25 1. Cost Structure $300,000 and $308,000 Hand-Fed Machine Total annual fixed costs Total annual variable costs: 4,000 x $44 4,000 x $35 Total annual cost $124,000 176,000 ________ $300,000 Automatic Machine $168,000 140,000 $308,000 (15 minutes)

2-15

2.

4,889 tables, Let Q = volume Total cost with hand-fed machine $44Q + $124,000 $9Q Q Changes in Contribution Margin

= total cost with automatic machine = $35Q + $168,000 = $44,000 = 4,889 (20 minutes)

2-26

General Note to the Instructor: This assignment looks at relationships of contribution margin per unit and contribution margin percentage. It highlights some important points about volume, in units and in dollars, required to achieve target profits. 1. 2. 25,000 units ($50,000 + $50,000)/($10 - $6) $50,000 50,000 100,000 20,000 $5 6 $11

(a) $11 Profit Fixed costs Required contribution margin Divided by volume Required unit contribution margin Plus variable cost Required price (b) $220,000 20,000 units x $11 (a) $12 Unit variable cost Divided by variable cost percentage Selling price $200,000 ($50,000 + $50,000)/50% 16,667 units, $200,000/$12

3.

$ 6 50% $12

$5/$10 from last year

(b) (c)

Note to the Instructor: This part could be troublesome. The key is that the variable cost ratio is one minus the contribution margin ratio, so that you must divide the per unit variable cost by the variable cost ratio. The point of (b) and (c) is that maintaining the contribution margin ratio results in needing the same dollar volume but a lower unit volume, to earn the same profit. 2-27 Pricing and Return on Sales (25-30 minutes)

1. (a) $25,000,000 $5,000,000/20% The 20% is ($30 - $18)/$30 - 20% = (40% - 20%) (b) 833,333 square feet $5,000,000/[$30 - $18 - (20% x $30)] = $5,000,000/$6, or $25,000,000 (part a)/$30 2. $27 Required contribution margin ($5,000,000 + $400,000) Divided by expected volume Required contribution margin/sq. ft Plus variable cost Required price $21.20 2-16 $5,400,000 600,000 $ 9 18 $27

3.

Selling price $30.00 Required contribution margin ($5,000,000 + $280,000) Divided by volume Required contribution margin/sq. ft. 8.80 Allowable variable cost $21.20 4. $32.56 Required contribution margin Divided by volume Required contribution margin/sq. ft Plus variable cost Required price

$5,280,000 600,000

$5,280,000 500,000 $10.56 22.00 $32.56

Note to the Instructor: This assignment uses square feet as the measure of volume, allowing you to remind students that volume can be expressed in different ways. It also can be used to discuss the assumption of a constant sales mix, which the chapter describes. The appendix covers the use of weighted-average contribution margin in multiproduct cases. Here, the point is that so long as the mix remains reasonably constant, it is possible to use CVP analysis. 2-28 1. 2. CVP Analysis for a Service Firm 1,838 (5-10 minutes)

hours ($97,000 + $50,000)/$80 $2,400 3,000 $5,400 270 $20

$20 per hour, as follows Salary, 300 x $8 Profit Total revenue required divided by chargeable hours Required hourly rate

(300 - 30)

2-29 1.

Pricing DecisionNursery School $108 per child per month.

(25-30 minutes)

Fixed costs ($34,000 + $1,200 + $800) Divided by number of children Contribution margin per child per year Divided by nine months Contribution margin per child per month Variable cost per child per month ($3 + $5) Required monthly price

$36,000 40 $900 9 $100 8 $108

An alternative calculation, where P = price Revenue variable costs fixed costs = profit (40 x 9 x P) - [40 x 9 x ($3 + $5)] - ($34,000 + $1,200 + $800) = $0 360P - $2,880 - $36,000 = $0 360P = $38,880 P = $108 2. Approximately 43 children. (Exactly 43 children will actually yield a 2-17

small loss if all estimates are correct.) One way to make the calculation is to determine the total annual contribution margin per child at a fee of $100 per month. Contribution margin per month per child ($100 - variable cost of $8) Number of months Annual contribution margin per child Break-even point ($36,000/$828) 2-30 Sensitivity of Variables (25-35 minutes) $92 9 $828 43.48 children

1. Item (a) reduces profit the most (yielding a loss, in fact). Profits are computed below using two approaches. The first shows an answer resulting from the simple equation sales - variable costs - fixed costs = profit. The second approach uses contribution margin and compares total contribution margin with fixed costs. (a) (b) (c) (d) 2. (a) (b) (c) (d) ($75,000) (50,000 x $25 x 90%) - ($18 x 50,000) - $300,000 or [50,000 x ($22.50 - $18)] - $300,000 ($40,000) (50,000 x $25) - (50,000 x $18 x 110%) - $300,000 or [50,000 x ($25 - $19.80)] - $300,000 $20,000 (50,000 x $25) - (50,000 x $18) - ($300,000 x 110%) or [50,000 x ($25 - $18)] - $330,000 $15,000 (50,000 x 90% x $25) - (50,000 x 90% x $18) - $300,000 or [45,000 x ($25 - $18)] - $300,000 Item (a) produces the largest profit. $175,000 (50,000 x $25 x 110%) - (50,000 x $18) 50,000 x ($27.50 - $18) - $300,000 - $300,000 or

$140,000 (50,000 x $25) - (50,000 x $18 x 90%) - $300,000 or [50,000 x ($25 - $16.20)] - $300,000 $85,000 (50,000 x 110% x $25) - (50,000 x 110% x $18) - $300,000 or [55,000 x ($25 - $18)] - $300,000 $80,000 (50,000 x $25) - (50,000 x $18) - ($300,000 x 90%) or [50,000 x ($25 - $18)] - $270,000

3. 77,778 units, rounded, an increase of 55.6% Profit at planned volume and original price [50,000 x ($25 - $18)] - $300,000 Required volume at reduced price: ($300,000 + $50,000)/($22.50 - $18) 4.

$50,000 77,778

$5, the same as the increase in selling price ($25 x 20% = $5).

2-18

Note to the Instructor: This problem illustrates the sequence and degree of sensitivity in a particular case. However, some of the relationships will usually hold in other cases. So long as price exceeds variable cost, profit will be more sensitive to changes in price than to equal percentage changes in variable cost. Also, changes in price will have greater effects on income than will equal percentage changes in volume. (In both cases revenue increases by the given percentage, but with the price change total variable costs remain the same, unless all variable costs are a constant percentage of sales.) The effects of changes in fixed costs are probably less than those of the others. Only if fixed costs are extremely high will changes in them have greater effects on profit than will equal percentage changes in other variables. 2-31 CVP Analysis--Changes in Variables (20 minutes) March Sales Total variable costs Less commission at 10% of sales Purchase cost of goods sold Divided by purchase cost per unit Equals unit sales Divided into sales (above) equals price per unit Total variable cost, from above Divided by units of sales, as above Equals variable cost per unit $200,000 $130,000 20,000 $110,000 $11 10,000 $20 $130,000 10,000 $13 April $222,000 $154,200 22,200 $132,000 $11 12,000 $18.50 $154,200 12,000 $12.85

Note to the Instructor: This rather difficult problem makes an important point. The key is to recognize that the two components of variable cost (purchase price and sales commission) do not both vary with the same factor. It is necessary to separate the two components of variable cost. Some instructors might prefer to assign this problem with Chapter 3, rather than attack it as a complication of Chapter 2. Note also that the company sold 20% more units in April than in March, but earned less profit because of the reduced selling price. Some students believe that increasing sales automatically increases income, failing to realize that variable costs increase as sales increase. 2-32 1. 2. Changes in Cost Structure 40,000 units $48,000/$1.20 $72,000 48,000 $24,000 If (20 minutes)

$24,000 increase Reduced variable costs ($1.20 x 60,000) Increase in fixed costs Increase in income

3. More likely, because the cost would then be avoidable at any time. volume fell, the machine could be returned and production performed as before, assuming no changeover cost in returning to the old method.

2-19

2-33 1. 2.

CVP Analysis on New Business 208,333 $12.25

(15 minutes)

($650,000 + $450,000 + $150,000)/($12 - $6), or $1,250,000/$6 $1,250,000/200,000 + $6, or $6.25 + $6

3. $0.25 reduction to $5.75. The $6.25 from requirement 2 is still the required contribution margin. The $6.25 is $0.25 over the original $6 ($12 $6) so variable cost must be reduced by $0.25. This reasoning illustrates the point that contribution margin is the critical figure, not price or variable cost alone. The assignment also shows the use of CVP analysis for a single product, rather than for an entire oneproduct company. Alternatively, $150,000 $1,250,000 200,000V V 2-34 1. = = = = [($12 - V) x 200,000] - $1,100,000 $2,400,000 - 200,000V $1,150,000 $5.75 (15-20 minutes)

CVP Analysis for a Hospital

An increase of $5,200 per month. Sales (200 per month x $65) Variable costs (200 x $10) Contribution margin Fixed costs ($2,200 + $3,600) Additional income $13,000 2,000 11,000 5,800 $ 5,200

2.

$39 Sales - variable costs - fixed costs = profit S - $2,000 - $5,800 = $0 S = $7,800 Price = $7,800/200

As proof: Sales (200 x $39) Variable costs (200 x $10) Contribution margin Fixed costs Additional income $7,800 2,000 5,800 5,800 $ 0

2-20

2-35 1.

CVP in a Service Business $200,000

(10-15 minutes)

Hours generated internally, 15 x 2,000 Hours from freelancers, 80,000 - 30,000 Total hours Revenues at $40 per hour Variable cost, 50,000 x $25 Contribution margin Fixed costs Profit 2. 56,667

30,000 50,000 80,000 $3,200,000 1,250,000 1,950,000 1,750,000 $ 200,000

Fixed costs plus desired profit ($1,750,000 + $300,000) $2,050,000 Revenue from internal billing, 30,000 x $40 (no variable cost) 1,200,000 Contribution needed from free-lancers 850,000 Required hours, $850,000/($40 - $25) 56,667 Or, to increase profit by $100,000 from $200,000 to $300,000 requires 6,667 additional hours, which is $100,000/$15 contribution per hour. 2-36 Developing CVP Information (25-30 minutes) April Sales $100,000 Variable costs: Cost of sales (40% of sales) $40,000 Commissions (20% of sales) 20,000 Supplies (2% of sales) 2,000 Total variable costs (62% of sales) 62,000 Contribution margin (38% of sales) 38,000 Fixed costs: Rent $ 1,200 Salaries* 14,500 Insurance 1,100 Utilities 1,500 Miscellaneous 6,000 Total fixed costs 24,300 Income $13,700 *Calculation of fixed cost of salaries: Salaries, wages commissions for April Less variable cost of commissions: April sales $100,000 Commission percentage 20% Commissions for April Fixed portion of payroll $34,500 May $80,000 $32,000 16,000 1,600 49,600 30,400 $ 1,200 14,500 1,100 1,500 6,000 24,300 $ 6,100

20,000 $14,500

Note to the Instructor: This assignment offers the opportunity to illustrate the greater usefulness of contribution margin format income statements, as well as to discuss the notion of fixed and variable costs 2-21

being in the same account (salaries, wages, and commissions). 2-37 1. Margin of Safety (25 minutes) Model 440 Expected sales Sales at break-even point: $59,000/40% $120,000/60% Margins of safety Margins of safety as percentages Model 440, 26.25%, $52,500/$200,000 Model 1200, 20%, $50,000/$250,000 2. With a higher margin of safety on Model 440, most students will conclude that it should be introduced despite its lower expected profitability. There is no correct answer because there are no reasonably objective data regarding the probabilities of the expected sales not materializing. The decision should hinge on whether the expected difference in profits of $9,000 ($30,000 - $21,000) is significant enough to offset the greater risk that attends Model 1200. Some factors that bear on the decision follow. (a). The current state of the company and its expected state without considering the new possibilities. If the company expects high profitability from its other lines, it might be more willing to take the greater risk involved with the Model 1200. A company experiencing low profitability and expecting it to continue, might be more likely to take the apparently surer thing, the Model 440. It could go the other way, as well. A company with relatively low expected profitability might be more willing to take some risks to get back into a more favorable situation. (b). The extent to which the fixed costs are avoidable. If virtually all fixed costs could be avoided if the wallet turned out to be a poor seller, there might be more willingness to bring out the Model 1200. The less the avoidability of fixed costs, the more likely that a conservative management would select the safer product. (c). The confidence in the forecasts. At this point students have not been exposed to expected value calculations and other techniques that could be applied, but some will see that investigation into the reliability of the forecasts would be helpful. $200,000 147,500 $ 52,500 200,000 $ 50,000 Model 1200 $250,000

Margins of safety in dollars

2-22

2-38

Changes in Operations

(25-30 minutes)

1. Extending the hours of operations appears wise. Packard can expect an additional profit of $460 per week, computed as follows: Revenues (2,000 x $.80 per hour) Costs to achieve additional revenue: Variable costs: Additional rent on lease (10% of additional revenue) Additional city tax (5% of additional revenue) Total additional variable cost (15%) Fixed costs: Additional salaries for attendants Additional utilities and insurance Total additional fixed cost Total additional costs Increase in profit 2. About 1,324 hours $ 900 $0.68 1,323.5 $1,600

$160 80 $ 240 $800 100 900 $ 1,140 460

Fixed costs to be covered, from requirement 1 Contribution margin from additional revenue $0.80 - 15% of $0.80 (from requirement 1) Hours required to offset additional costs ($900/$0.68)

Note to the Instructor: The $12,000 paid to the owner of the lot is, of course, irrelevant because it will not change regardless of the number of hours the parking lot remains open. Even at this early stage in the course, most students are likely to recognize this fact and deal only with incremental costs in their solutions, but it may be worthwhile to point out this fact specifically in reviewing the solution. 2-39 1. CVP Analysis--Product Mix (35 minutes)

About 319,000 cases (rounded) ($600,000 + $375,000)/$3.057 Premium Regular $7.40 4.25 0.74 4.99 $2.41 2/3 $1.607 Total

Selling price Variable brewing costs Commissions, 10% of price Total variable costs Unit contribution margin Percentage in mix Weighted-average contribution margin 2.

$10.50 5.10 1.05 6.15 $4.35 1/3 $1.45

$3.057

106,333 premium and 212,667 regular (1/3 and 2/3 of 319,000)

2-23

3. Monthly profit decreases about $7,000, so the campaign is not worthwhile. The totals below are rounded. Profit without campaign Contribution margin 350,000 x $3.057 Fixed costs Profit Profit with campaign Premium Cases, 350,000/3 x 120%; 350,000 x 2/3 x 95% Per case contribution margin Total contribution margin Fixed costs $975,000 + $80,000 Profit 140,000 221,700 361,700 $ 4.35 $609,000 $ 2.41 $534,300 $1,143,300 1,055,000 $ 88,300 Regular Total $1,069,950 975,000 $ 94,950

4. $3.161 (rounded) $1,143,300/361,700 It is possible to redo the analysis from requirement 1, but unnecessary if the students understand the weightedaverage contribution margin. 5. 333,755 $1,055,000/$3.161

You might want to note that the increase in the breakeven point indicates that the increase in fixed costs overwhelmed the increase in WACM per case. Of course, the opposite could have happened. Moreover, we have no assurance that the new mix would prevail at different levels of total volume. For example, the increased advertising might get nearly all of the new and existing customers who would to switch to premium to do so. So the company might have to rely on increases in regular sales beyond the 361,700 case level. 2-40 Unit Costs (20-25 minutes) Anderson Shoe Store Income Statement for Month Sales (5,000 x $25) Cost of sales (50% of sales) Gross profit Commissions (15% of sales) Contribution margin Fixed costs: Salaries and wages Utilities, insurance, rent Profit $125,000 62,500 62,500 18,750 43,750 $30,000 3,500 33,500 $ 10,250

An alternative way to determine what would happen to income if sales increase by 1,000 pairs is to use contribution margin of $8.75 per pair ($25 - $12.50 - $3.75 commission). Profit should rise by $8,750 if volume rises by 1,000 pairs, and the income statement shows that. The fallacy in Anderson's reasoning is the unit cost problem. He assumed that the unit costs would be constant, not decline as sales 2-24

increased. Despite the great deal of attention paid to this point, it remains a serious difficulty for many students. 2-41 CVP Analysis and Break-even Pricing-Municipal Operation minutes) 1. A loss of $8,000 $25,000 $25,000 3,000 5,000 (15-20

Revenues, (200 x $50) + (1,000 x $15) Costs: Fixed Variable, businesses, 200 x 12 x $1.25 residences, 1,000 x 4 x $1.25 Loss 2.

33,000 $( 8,000)

$61.87 for businesses, $20.63 for residences, both rounded $33,000 6,400 $5.156 $61.87 $20.63

Total revenue required, equals total cost, above Total pickups (200 x 12) + (1,000 x 4) Price per pickup Business charge = per-pickup price x 12 Residence charge = per-pickup price x 4

Alternatively, solving for the monthly prices, let R = residence price, then 3R = business price 1,000R + (3 x 200 x R) = $33,000 1,600R = $33,000 R = $20.63 2-42 Product Profitability (35 minutes)

1. Gold is the most profitable per unit sold, because its contribution margin per unit is highest. 2. Silver is the most profitable per dollar of sales because its contribution margin percentage is highest. Regular Silver Gold Contribution margin $ 4 $12 $15 Divided by selling price $10 $20 $30 Contribution margin percentage 40% 60% 50% 3. (a) 48% Regular 40% 40% 16% Silver 60% 20% + 12% Gold 50% 40% + 20% = 48%

Contribution margin percentages Sales mix percentage, in dollars Weighted-average contribution margin (b) (c) 4. (a)

The break-even point is $416,667

($200,000/48%)

Volume required for a profit of $30,000 is $479,167 ($200,000 + $30,000)/48% $400,000 ($200,000/50%) 2-25

Contribution margin percentages Sales mix percentage Weighted contribution margin (b) 5. (a) $460,000 $10

Regular 40% 30% 12%

Silver 60% 30% + 18%

Gold 50% 40% + 20% = 50%

(($200,000 + $30,000)/50%) Regular Silver $ 4 $12 40% 20% $1.60 + $2.40 Gold $15 40% + $6.00 = $10.00

Contribution margin per unit Sales mix percentage Weighted-average contribution margin (b) (c) 2-43 20,000 23,000 ($200,000/$10)

($200,000 + $30,000)/$10 = $230,000/$10 (20 minutes)

Alternative Cost Behavior--A Movie Company

1. $68,421,052 under the normal arrangement, $62,500,000 under the special arrangement Normal (N) Fixed costs: Drift's salary Other Total Divided by contribution margin percentage: Price Variable cost, 5% of the receipts-to-producer Equals contribution margin percentage Equals break-even sales in receipts-to-producer

$20,000,000 45,000,000 $65,000,000 100% 5% 95% $68,421,052

Special (S) Fixed costs: Drift's salary ($20,000,000 x .25) Other Total Divided by contribution margin percentage (100% - 20%) Equals break-even sales in receipts-to-the-producer 2. Total admissions Receipts to the producer at 40% Total costs: Fixed costs, requirement 1 Variable cost-Drift's salary 5% 20% Total costs Income to the producer N $200,000,000 $ 80,000,000 65,000,000 4,000,000 _ 69,000,000 $11,000,000

$ 5,000,000 45,000,000 $50,000,000 80% $62,500,000 S . $200,000,000 $ 80,000,000 50,000,000 16,000,000 66,000,000 $14,000,000 Let X

3. $100,000,000 Equate the returns to Drift under the two schemes. = receipts to the producer.

2-26

N = $20,000,000 + 5%X

S = $5,000,000 + 20%X

$20,000,000 + 5%X = $5,000,000 + 20%X 15%X = $15,000,000 X = $100,000,000 Note to the Instructor: Variations and extensions of this problem appear in 2-44 and 3-26. The extension in 2-44 introduces additional products in the form of TV and foreign distribution rights and the extension in Chapter 3 delves further into the indifference analysis. 2-44 Multiple Products--Movie Company (Continuation of 2-43) minutes) (20-25

Note to the Instructor: It is not easy to see that this is multipleproduct problem. It is also not easy to derive the correct percentages in the sales mix. 1. $64,283,374 rounded, ($45,000,000 + $10,000,000)/85.56% Theater _ TV Mix percentage* Contribution margin percentage Weighted average 8/9ths 85% 75.56% 1/9th 90% 10%

= 85.56%

* TV rights are 1/8 of theater receipts, so theater receipts are 1/1.125 and TV rights are .125/1.125. Some students will set up a formula such as the one below. Receipts - Fixed costs - Variable costs R R 2. = Profit

- $55,000,000 - [(.15 x 8/9 x R) + (.10 x 1/9 x R)] = $0 .1444R = $55,000,000 R = $64,282,374 $68,421,052, ($45,000,000 + $20,000,000)/95%

Note that because only one variable cost percentage applies to both types of business, there is no need to be concerned with product mix. 3. $63,218,390 ($45,000,000 + $10,000,000)/87.0% Theater Mix percentage* Contribution margin percentage Weighted average 75.7% 85.0% 64.2% _ TV 9.4% 90.0% 8.5% Foreign 15.1% 95.0% 14.3%

87.0%

* Foreign receipts are 20% of domestic theater receipts, so theater receipts are 1/1.325, TV rights are .125/1.325, and foreign sales are .20/1.325 Again, some students will set up a formula such as the one below. Receipts - Fixed costs - Variable costs R = Profit

- $55,000,000 - [(.15 x .755R) + (.10 x .094R) + (.05 x .151R )] = $0 2-27

.130R R

= $55,000,000 = $63,218,390

2-45 Conversion of Income Statement to Contribution Margin Basis (20 minutes) 1. Rudolf Company Budgeted Income Statement $300,000 $40,000 20,000 50,000 38,000 148,000 152,000 100,000 70,000 170,000 $( 18,000)

Sales (20,000 units) Variable costs Materials Labor Factory overhead Selling and administrative Total variable costs Contribution margin Fixed costs: Factory overhead Selling and administrative Total fixed costs Expected income (loss) 2. About 22,369 units

Selling price per unit ($300,000/20,000 units) Variable cost per unit of sales ($148,000/20,000 units) Contribution margin per unit Break-even point ($170,000/$7.60)

$15.00 7.40 $ 7.60 22,369 rounded

3. Other things equal, the campaign is wise because the company will go into the black. The additional contribution of $60,800 (8,000 units at $7.60 per unit) exceeds the $30,000 advertising cost by $30,800, bringing the company to a $12,800 profit ($18,000 loss + $30,800 additional profit). 2-46 1. (a) (b) 2. 3. 4. Occupancy Rate as Measure of Volume $6,000,000 60% $4,200,000/70% $6,000,000/$100,000 [($100,000 x 75) x 70%] - $4,200,000 ($4,200,000 + $700,000)/($100,000 x 70%) (25-30 minutes)

$1,050,000 70%

Yes, profit would increase by $40,000. $140,000 100,000 $ 40,000

Increase in contribution margin (2 x $100,000 x 70%) Less increased fixed costs Increase in profit

Note to the Instructor: This assignment uses a different measure of volume. Some students will fail to see that a percentage point is 1.0, not . 01, and therefore make some calculational errors. The assignment allows students to work with a volume measure other than the usual units of product.

2-28

2-47 1.

Changes in Variables Sales (given) Variable costs Contribution margin Fixed costs Income (given)

(20-25 minutes) $442,800 259,200 183,600 114,000 $ 69,600

Expected income was $46,000 on sales of $400,000. Expected contribution margin was $160,000, 40% of sales, expected profit $46,000, so that expected fixed costs were $114,000 ($160,000 - $46,000). Once fixed costs are known, we can calculate contribution margin as income plus fixed costs. Total variable costs are then $259,200, sales of $442,800 less contribution margin of $183,600. 2. 10,800 units. Unit variable costs are $24, so that $259,200/$24 = 10,800. With a 60% variable cost ratio (100% - 40% contribution margin ratio) and volume of $400,000, expected variable costs were $240,000, or $24 per unit (60% x $40). (b) $41 $442,800/10,800 (a)

3. The title of the assignment suggests that changes in variables are the source of the difference. The memo should make the following points. Thompson's actual contribution margin percentage was 41.5% [($41 - $24)/ $41], rather than 40%. The $1 selling price increase increased both the contribution margin per unit and the contribution margin percentage. Had we known of the change in the selling price before the year had begun, we would have prepared the following planned income statement. Sales (10,000 x $41) Variable costs (10,000 x $24) Contribution margin Fixed costs Profit $410,000 240,000 170,000 114,000 $ 56,000

Then, we would have told Ms. Thompson that increases in dollar sales (at the $41 price) would increase income by 41.5% of the sales increase. Accordingly, Increase in sales ($442,800 - $410,000) Increase in profit, 41.5% x $32,800 Planned profit at $41 price and 10,000 units Actual profit $32,800 $13,600 (rounded) 56,000 $69,600

We should tell Ms. Thompson that our analysis depended on the stability of the values of price, variable cost, and fixed costs. Had we known the actual values we could have forecast income correctly. 2-48 Cost Structure (40 minutes)

The first step is to analyze the results at the different levels. Selected Sales Volumes (in thousands) 2-29

Outside representatives: Sales Variable costs at 50% Contribution margin Additional fixed costs Additional profit Inside salespeople: Sales Variable costs at 35% Contribution margin Additional fixed costs Additional profit The indifference point is $800,000. Profit with outside representatives 50%S - $80,000 15%S S

$600 300 300 80 $220 $600 210 390 200 $190

$1,000 500 500 80 $ 420 $1,000 350 650 200 $ 450

$1,200 600 600 80 $ 520 $1,200 420 780 200 $ 580

= Profit with inside salespeople = 65%S - $200,000 = $120,000 = $800,000

If Wink's managers can reasonably expect sales to exceed $800,000 with either type of sales effort, they should employ inside salespeople. However, at least two other factors are important. First, is it likely that sales will be the same either way? The outside representatives must rely on commissions and might therefore be more motivated. However, because they handle other lines, they might ease up on Wink's products if they do not have immediate success. Even if they do push Wink products, outside reps might sell less than Wink's own salespeople because the inside salespeople sell nothing else and are more familiar, and more comfortable, with Wink products. The outside reps might also have already developed customers who could be expected to buy Wink's products, while Wink's salespeople would have to develop customers from scratch. Thus, this problem might not be amenable to indifference analysis because volumes could differ under the two arrangements and indifference analysis applies when the alternatives will not affect the variable being analyzed (volume in this case). 2-49 1. Opening a Law Office $1,146,520 Revenues Variable costs, 18,000 x $4 Contribution margin Fixed costs Income (25-30 minutes) $2,700,000 72,000 2,628,000 1,481,480 $1,146,520 18,000 $30 $ 540,000 2,160,000 $2,700,000

Revenues: Number of clients, 50 x 360 Initial consulting fee Revenue from consulting fees Revenue from judgments, 18,000 x 20% x $2,000 x 30% Total revenue Fixed costs: Advertising Rent, 6,000 x $28 2-30 $

500,000 168,000

Property insurance Utilities Malpractice insurance Depreciation, $60,000/4 Wages, ($25 + $20 + $15 + $10) x 16 x 360 Fringes at 40% of wages Total fixed costs

22,000 32,000 180,000 15,000 403,200 161,280 $1,481,480

2. About 10,150 visits $1,481,480/$146 = 10,147, Expected contribution margin per visit, $2,628,000/18,000 = $146 3. The memo should make the following points.

To: Don Masters From: Student Date: Today The venture appears to be profitable, with an expected income of $1,146,250 in the first year. The breakeven point expressed as visits to the office is 10,150, which is well below the 18,000 expected visits, giving a good margin of safety. The principal risk is that the fixed costs are high, so that any unfavorable deviation from the expectations will have serious effects on the expected profit. The estimate of the percentage of clients whose cases will result in favorable judgments is an example. 2-50 A Concessionaire (35 minutes)

1. The royalty that Newkirk can pay, as a percentage of sales, and still make a profit of $180,000 is no greater than 14.9%. A reasonable analysis follows. Hot Soft Dogs Drinks Total Selling price Variable costs: Hot dog and roll Condiments Soft drink and ice Commission (20% of sales) Total variable cost Contribution margin $1.50 0.46 0.02 0.30 0.78 $0.72 0.22 0.20 0.42 $0.58 $1.00 $2.50 0.46 0.02 0.22 0.50 1.20 $1.30

2-31

Sales expected for the season: College games, (30,000/2) x 7 Professional games, (60,000/2) x 7 Total expected sales (1 hot dog and 1 drink) Times CM per unit Total expected contribution margin Fixed costs: Cost per game Number of games

105,000 210,000 315,000 $1.30 $409,500 $ 8,000 14 112,000 297,500 180,000 $117,500 $787,500 14.9%

Expected profits before royalty Desired profit Available to pay royalty Sales at this level of profit (315,000 x $2.50) Percentage of royalty to sales ($117,500/$787,500)

An income statement at the expected rate of sales proves the above answer. Sales (315,000 units at $2.50) Variable costs: Materials and sales commissions (315,000 units at $1.20 per unit) Royalty ($787,500 x 14.9%, rounded) Total variable costs Contribution margin Fixed costs ($8,000 x 14 games) Income (difference due to rounding) 2. $787,500 $378,000 117,338 495,338 292,162 112,000 $180,162

With a bid of 12% royalty, expected income is $203,000. $787,500 $378,000 94,500 472,500 315,000 112,000 $203,000

Sales (315,000 units at $2.50) Variable costs: Materials and commissions, as above Royalty ($787,500 x 12%) Contribution margin Fixed costs Income

The expected profit is larger than the $180,000 stated in requirement 1, which is consistent with the 12% royalty being smaller than the 14.9% rate previously determined to produce a $180,000 profit. 3. (a) Selling price per unit, hot dog and drink Variable costs: Originally stated Royalty at 12% Total variable costs Contribution margin Breakeven units Required attendance ($112,000/$1.00) (112,000 x 2) $2.50 $1.20 0.30 1.50 $1.00 112,000 224,000

Attendance must be only 36% (224,000/630,000) of expected for Newkirk to break even, which gives a considerable margin of safety of 64%. (b) 2-32

Breakeven as percentage of expected attendance: Expected attendance (30,000 x 7) + (60,000 x 7) Percentage of people who must buy a unit (112,000/630,000)

630,000 17.8%

4. At a minimum, Newkirk wants the same kind of information available for his bid for football games: the number of scheduled games, the average attendance per game, and some idea of the estimated number of sales in terms of average attendance. In addition, because baseball games are more dependent upon the weather (attendance may be hurt, or the game not played at all or cut short), he would probably want some idea of the number of games normally canceled and the probabilities associated with that number. Sales of soft drinks may be influenced by the weather as well as the attendance; hence, it may not be possible to come up with an average sales per game in the simple form available for the football season. Note to the Instructor: We believe that the interrelationships among the various disciplines in the business curriculum should be identified and emphasized early and often. You might want to take this opportunity to convey to students some indication of the ways in which statistics courses will help them in dealing with problems such as the one proposed in requirement 4. In fact, you can point out that some of the information already given (average attendance, relationship between attendance and sales) must have come from past analyses, perhaps through the use of statistical methods or through judgment based on experience. It is characteristic of most problems in managerial accounting to assume that a good deal of analysis has already been done so that the major problem remaining is determining the expected results. This is generally appropriate because the course is not intended to cover such other matters, but we believe it is helpful to point to the relationships with other courses wherever possible. 5. The absence of the star quarterback might well cut into attendance at professional games. The effect of this drop in attendance on forecast profits is obvious (a drop) but the extent of the drop in sales, and hence profits, is debatable. This very possible contingency must be considered in developing a bid for royalties. Thus, the answer in requirement 1 might be an absolute maximum assuming no variation whatever from forecast conditions. The specified royalty percentage in requirement 2 allows for some contingencies. (This problem is an excellent example of the difficulties of relying on forecasts, the need to allow for contingencies, and the general problem of the business manager in having to deal with the future.)

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2-51 1.

Hockey Camp

(30-40 minutes)

$2,755, calculated as follows. $20,250 $7,470 2,025 $3,300 1,000 3,700 9,495 10,755

Revenue, 90 x $225 Variable costs: Per-camper costs, 90 x $83* Payment to college, $20,250 x 10% Contribution margin Fixed costs: Coaches, (90/15) x $550 Ice arena charge Brochures, etc. Profit *

8,000 $ 2,755

Food, insurance and T-shirts, room ($50 + $15 + $18)

Note to the Instructor: We classified coaches' salaries as fixed even though they are variable provided that campers come in multiples of 15 and Oldcraft can predict the number of campers so that there will not be an excess of coaches hired before the camp starts. This, of course, is one of Oldcraft's concerns. 2. $231.67, calculated as follows. $ 4,000 3,850 1,000 3,700 8,300 $20,850 $23,167 $231.67

Profit Coaches, 7 x $550 * Ice arena charge Brochures, etc. Variable costs per camper, 100 x $83 Required revenue net of 10% to college divided by 90% equals total revenue required divided by 100 campers equals price per camper

* 100/15 = 6.67, rounded up to 7. The number of coaches is deliberately not an integer amount. 3. About 28.3%. One approach is to use the basic formula of revenue - cost = profit and proceed as follows. Revenue - Per-camper cost - Coaches - Ice charge - Fee $20,250 $7,470 - $3,300 $20,250X = $5,725 X = 28.3% $1,000 = Profit $2,755

- $20,250X =

Another approach is to determine the percentage that $3,700 (the costs to be assumed by the college) bears to $20,250 and add it to the 10%. Thus, $3,700/ $20,250 = 18.3%. 4. The advantage to the college is the disadvantage to Oldcraft. If the camp is more successful than anticipated, the college will earn more than it otherwise would have, while Oldcraft will earn less. Of course, Oldcraft will earn more than she would have if the camp goes as planned. She will earn less than she would have with the $3,700 flat fee. The disadvantage to the college is also the advantage to Oldcraft. If the camp is less successful than anticipated, the college will have a lower fee while Oldcraft 2-34

will earn more than she otherwise would have. Essentially, the proposed arrangement simply converts a fixed cost (revenue) for Oldcraft (college) to a variable cost (revenue). Oldcraft reduces her risk and gives up some potential profit, while the college does the reverse.

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