Topic 5 Cost-Volume-Profit analysis Tut and WS solutions PDF

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Week 10 tutorial power point for topic 5 cost volume analysis and workshop solutions...

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Topic 5: Cost-VolumeProfit analysis • • •

Tutorial Ruby Hanlu Fan [email protected]

Tutorial Questions Chapter 5: Question 5-1 Q:What is the meaning of contribution margin ratio? How is this ratio useful in planning business operations? The contribution margin (CM) ratio is the ratio of the total contribution margin to total sales revenue.

It can also be expressed as the ratio of the contribution margin per unit to the selling price per unit. It is used in target profit and break-even analysis and can be used to quickly estimate the effect on profits of a change in sales revenue.

Tutorial Questions Chapter 5: Question 5-4 Q: What is the meaning of operating leverage? Operating leverage is a measure of how sensitive net operating income is to a given percentage change in unit sales. If operating leverage is high, a small percentage increase in unit sales can produce a much larger percentage increase in net operating income. The degree of operating leverage at a given level of sales is computed by dividing the contribution margin at that level of sales by the net operating income at that level of sales.

Q:Explain how a shift in the sales mix could result in both a higher break-even point and a lower net operating income.

Tutorial Questions Chapter 5: Question 5-9

The term sales mix refers to the relative proportions in which a company’s products are sold. A higher break-even point and a lower net operating income could result if the sales mix shifted from high contribution margin products to low contribution margin products. Such a shift would cause the average contribution margin ratio in the company to decline, resulting in less total contribution margin for a given amount of sales. Thus, net operating income would decline. With a lower contribution margin ratio, the break-even point would be higher because more sales would be required to cover the same amount of fixed costs.

Tutorial Questions Chapter 5: EXERCISE 5–8 Compute the Margin of Safety Q: Molander Corporation is a distributor of a sun umbrella used at resort hotels. Data concerning the next month’s budget appear below:

• 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?

• The margin of safety is the excess of budgeted or actual sales dollars over the break-even sales dollars.

• The margin of safety also can be expressed in percentage form by dividing the margin of safety in dollars by total dollar sales:

1. What is the company’s margin of safety? 2. What is the company’s margin of safety as a percentage of its sales?

Tutorial Questions Chapter 5: EXERCISE 5–9 Compute and Use the Degree of Operating Leverage Q: Engberg Company installs lawn sod in home yards. The company’s most recent monthly contribution format income statement follows:

. • 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 unit sales. Verify your estimate from part (2) above by constructing a new contribution format income statement for the company assuming a 5% increase in unit 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 unit sales.

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 unit sales.

Tutorial Questions Chapter 5: PROBLEM 5–22 CVP Applications; Contribution Margin Ratio; Break-Even Analysis; Cost Structure Q: 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:

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 increase unit sales and the total sales by $80,000 per month. 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? 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 contribution 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.

2. The president believes that a $16,000 increase in the monthly advertising budget, combined with an intensified effort by the sales staff, will increase unit sales and the total sales by $80,000 per month. If the president is right, what will be the increase (decrease) in the company’s monthly net operating income?

1. Compute the company’s CM ratio and its break-even point in unit sales and dollar sales.

Since the company is now showing a loss of $4,500 per month, if the changes are adopted, the loss will turn into a profit of $3,500 each month ($8,000 – $4,500 = $3,500).

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)?

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 contribution format income statements, one assuming that operations are not automated 4. Refer to the original data. The Marketing Department thinks that a fancy new package and one assuming that they are. (Show data on a per unit and percentage basis, as well for the laptop computer battery would grow sales. The new package would increase as in total, for each alternative.) 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?

c. Would you recommend that the company automate its operations? Explain. • Whether or not the company should automate its operations depends on how much risk the company is willing to take and on prospects for future sales. The proposed changes would increase the company’s fixed costs and its break-even point. However, the changes would also increase the company’s CM ratio (from 0.30 to 0.40). The higher CM ratio means that once the break-even point is reached, profits will increase more rapidly than at present. If 26,000 units are sold next month, for example, the higher CM ratio will generate $6,000 (= $60,000 – $54,000) more in profits than if no changes are made. • The greatest risk of automating is that future sales may drop back down to present levels (only 19,500 units per month), and as a result, losses will be even larger than at present due to the company’s greater fixed costs. (Note the problem states that sales are erratic from month to month.) In sum, the proposed changes will help the company if sales continue to trend upward in future months; the changes will hurt the company if sales drop back down to or near present levels.

Tutorial Questions Chapter 5: PROBLEM 5–27 Sales Mix; Break-Even Analysis; Margin of Safety Q: 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:

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 columns 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.

Fixed expenses total $475,800 per year. 1. Assuming the sales mix given above, do the following: a. Prepare a contribution format income statement showing both dollar and percent columns 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.

• The reason for the increase in the break-even point can be traced to the decrease in the company’s overall contribution margin ratio when the third product is added. Note from the income statements above that this ratio drops from 65% to 48.8% with the addition of the third product. This product (the Samoan Delight) has a CM ratio of only 20%, which causes the average contribution margin per dollar of sales to shift downward. • This problem shows the somewhat tenuous nature of break-even analysis when the company has more than one product. The analyst must be very careful of his or her assumptions regarding sales mix, including the addition (or deletion) of new products. • It should be pointed out to the president that even though the break-even point is higher with the addition of the third product, the company’s margin of safety is also greater. Notice that the margin of safety increases from $68,000 to $275,000 or from 8.5% to 22%. Thus, the addition of the new product shifts the company much further from its break-even point, even though the break-even point is higher.

Workshop Question EXERCISE 5–17 Break-Even and Target Profit Analysis Q: Outback Outfitters sells recreational equipment. One of the company’s products, a small camp stove, sells for $ 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 conditions, and one as operations would appear after the proposed changes. Show both total and per unit data on your statements. 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?

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

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 conditions, and one as operations would appear after the proposed changes. Show both total and per unit data on your statements.

1. What is the break-even point in unit sales and in dollar sales?

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?

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.) An increase in variable expenses as a percentage of the selling price would result in a higher break-even point. If variable expenses increase as a percentage of sales, then the contribution margin will decrease as a percentage of sales. With a lower CM ratio, more stoves would have to be sold to generate enough contribution margin to cover the fixed costs.

Workshop Question PROBLEM 5–23 CVP Applications; Contribution Margin Ratio: Degree of Operating Leverage Q: Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for $20 per unit. Variable expenses are $8 per unit, and fixed expenses total $180,000 per year. Its operating results for last year were as follows:

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. Assume this year’s unit sales and total sales increase by 3,750 units and $75,000, respectively. If the 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 unit 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?

Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for $20 per unit. Variable expenses are $8 per unit, and fixed expenses total $180,000 per year. Its operating results for last year were as follows:

3. Assume this year’s unit sales and total sales increase by 3,750 units and $75,000, respectively. If the fixed expenses do not change, how much will net operating income increase?

$75,000 increased sales × 0.60 CM ratio = $45,000 increased contribution margin. Because the fixed costs will not change, net operating income should also increase by $45,000.

1. What is the product’s CM ratio? 4. a. What is the degree of operating leverage based on last year’s sales? b. Assume the president expects this year’s unit 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?

2. Use the CM ratio to determine the break-even point in dollar sales....