Chapter 21 Cost Behavior and Cost-Volume-Profit Analysis 993

Instructions1. Determine the estimated units of sales of the overall product necessary to reach the

break-even point for the current year.2. Based on the break-even sales (units) in part (1), determine the unit sales of both the

18” flat panel TV and 22” flat panel TV for the current year.3. Assume that the sales mix was 25% 18” flat panel TV and 75% 22” flat panel TV.

Compare the break-even point with that in part (1). Why is it so different?

Steamboat Co. expects to maintain the same inventories at the end of 2010 as at the

beginning of the year. The total of all production costs for the year is therefore assumed

to be equal to the cost of goods sold. With this in mind, the various department heads

were asked to submit estimates of the costs for their departments during 2010. A sum-

mary report of these estimates is as follows:

Estimated Estimated Variable CostFixed Cost (per unit sold)

Production costs:Direct materials . . . . . . . . . . . . . . . . . . . . . . . . — $15.00Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 10.00Factory overhead . . . . . . . . . . . . . . . . . . . . . . . $210,000 4.50

Selling expenses:Sales salaries and commissions . . . . . . . . . . . . 42,500 2.20Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,500 —Travel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 —Miscellaneous selling expense . . . . . . . . . . . . . 2,500 1.80

Administrative expenses:Office and officers’ salaries . . . . . . . . . . . . . . . . 70,000 —Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 0.75Miscellaneous administrative expense . . . . . . . 11,000 1.75________ ______

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000 $36.00________ ______________ ______

It is expected that 30,000 units will be sold at a price of $60 a unit. Maximum sales withinthe relevant range are 45,000 units.

Instructions1. Prepare an estimated income statement for 2010.2. What is the expected contribution margin ratio?3. Determine the break-even sales in units.4. Construct a cost-volume-profit chart indicating the break-even sales.5. What is the expected margin of safety in dollars and as a percentage of sales?6. Determine the operating leverage.

PR 21-6BContribution margin,break-even sales,cost-volume-profitchart, margin ofsafety, and operatingleverage

objs. 2, 3, 4, 5

✔ 3. 15,000

Special Activities

Jeff Zengel is a financial consultant to Rae Properties Inc., a real estate syndicate. RaeProperties Inc. finances and develops commercial real estate (office buildings). The com-pleted projects are then sold as limited partnership interests to individual investors. Thesyndicate makes a profit on the sale of these partnership interests. Jeff provides finan-cial information for the offering prospectus, which is a document that provides thefinancial and legal details of the limited partnership offerings. In one of the projects, thebank has financed the construction of a commercial office building at a rate of 8% forthe first four years, after which time the rate jumps to 12% for the remaining 21 years ofthe mortgage. The interest costs are one of the major ongoing costs of a real estate proj-ect. Jeff has reported prominently in the prospectus that the break-even occupancy forthe first four years is 60%. This is the amount of office space that must be leased to coverthe interest and general upkeep costs over the first four years. The 60% break-even isvery low and thus communicates a low risk to potential investors. Jeff uses the 60%break-even rate as a major marketing tool in selling the limited partnership interests.

SA 21-1Ethics andprofessional conductin business

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994 Chapter 21 Cost Behavior and Cost-Volume-Profit Analysis

Buried in the fine print of the prospectus is additional information that would allow anastute investor to determine that the break-even occupancy will jump to 90% after thefourth year because of the contracted increase in the mortgage interest rate. Jeff believesprospective investors are adequately informed as to the risk of the investment.

Comment on the ethical considerations of this situation.

“For a student, a grade of 65 percent is nothing to write home about. But for the airline . . .

[industry], filling 65 percent of the seats . . . is the difference between profit and loss.

The [economy] might be just strong enough to sustain all the carriers on a cash

basis, but not strong enough to bring any significant profitability to the industry. . . .

For the airlines . . ., the emphasis will be on trying to consolidate routes and raise ticket

prices. . . .”

The airline industry is notorious for boom and bust cycles. Why is airline prof-

itability very sensitive to these cycles? Do you think that during a down cycle the strat-

egy to consolidate routes and raise ticket prices is reasonable? What would make this

strategy succeed or fail? Why?

Source: Edwin McDowell, “Empty Seats, Empty Beds, Empty Pockets,” The New York Times,

January 6, 1992, p. C3.

SA 21-2Break-even sales,contribution margin

Techno Games Inc. has finished a new video game, Mountain Bike Challenge.

Management is now considering its marketing strategies. The following information is

available:

Anticipated sales price per unit . . . . . . . . . $40Variable cost per unit* . . . . . . . . . . . . . . . $20Anticipated volume . . . . . . . . . . . . . . . . . . 400,000Production costs . . . . . . . . . . . . . . . . . . . . $6,000,000Anticipated advertising . . . . . . . . . . . . . . . $2,000,000*The cost of the video game, packaging, and copying costs.

Two managers, David Hunter and Jamie Berry, had the following discussion of ways toincrease the profitability of this new offering:

David: I think we need to think of some way to increase our profitability. Do you have any ideas?

Jamie: Well, I think the best strategy would be to become aggressive on price.

David: How aggressive?

Jamie: If we drop the price to $28 per unit and maintain our advertising budget at $2,000,000, I think we willgenerate sales of 1,500,000 units.

David: I think that’s the wrong way to go. You’re giving too much up on price. Instead, I think we need to fol-low an aggressive advertising strategy.

Jamie: How aggressive?

David: If we increase our advertising to a total of $6,000,000, we should be able to increase sales volume to1,300,000 units without any change in price.

Jamie: I don’t think that’s reasonable. We’ll never cover the increased advertising costs.

Which strategy is best: Do nothing? Follow the advice of Jamie Berry? Or fol-

low David Hunter’s strategy?

SA 21-3Break-even analysis

The owner of Banner-Tech, a printing company, is planning direct labor needs for the

upcoming year. The owner has provided you with the following information for next

year’s plans:

One Two Three Four Color Color Color Color Total

Number of banners 99 125 176 200 600

Each color on the banner must be printed one at a time. Thus, for example, a four-color banner will need to be run through the printing operation four separate times. Thetotal production volume last year was 300 banners, as shown on the next page.

SA 21-4Variable costs andactivity bases indecision making

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Chapter 21 Cost Behavior and Cost-Volume-Profit Analysis 995

One Two Three Color Color Color Total

Number of banners 76 103 121 300

As you can see, the four-color banner is a new product offering for the upcomingyear. The owner believes that the expected 300-unit increase in volume from last yearmeans that direct labor expenses should increase by 100% (300/300). What do you think?

Sales volume has been dropping at La Cross Publishing Company. During this time,

however, the Shipping Department manager has been under severe financial con-

straints. The manager knows that most of the Shipping Department’s effort is related to

pulling inventory from the warehouse for each order and performing the paperwork.

The paperwork involves preparing shipping documents for each order. Thus, the

pulling and paperwork effort associated with each sales order is essentially the same,

regardless of the size of the order. The Shipping Department manager has discussed the

financial situation with senior management. Senior management has responded by

pointing out that sales volume has been dropping, so that the amount of work in the

Shipping Department should be dropping. Thus, senior management told the Shipping

Department manager that costs should be decreasing in the department.

The Shipping Department manager prepared the following information:

Sales Number of Sales Volume Month Volume Customer Orders per Order

January $168,000 700 240February 165,600 720 230March 160,600 730 220April 150,000 750 200May 149,150 785 190June 148,000 800 185July 147,600 820 180August 147,000 840 175

Given this information, how would you respond to senior management?

SA 21-5Variable costs andactivity bases indecision making

Break-even analysis is one of the most fundamental tools for managing any kind of

business unit. Consider the management of your school. In a group, brainstorm some

applications of break-even analysis at your school. Identify three areas where break-

even analysis might be used. For each area, identify the revenues, variable costs, and

fixed costs that would be used in the calculation.

SA 21-6Break-even analysis

Group Project

Answers to Self-Examination Questions

1. B Variable costs vary in total in direct proportionto changes in the level of activity (answer B). Coststhat vary on a per-unit basis as the level of activi-ty changes (answer A) or remain constant in totaldollar amount as the level of activity changes(answer C), or both (answer D), are fixed costs.

2. D The contribution margin ratio indicates thepercentage of each sales dollar available to coverthe fixed costs and provide income from opera-tions and is determined as follows:

3. D The break-even sales of 40,000 units (answer D)is computed as follows:

= 60%

Contribution Margin Ratio =$500,000 - $200,000

$500,000

Contribution Margin Ratio =Sales - Variable Costs

Sales

4. D Sales of 45,000 units are required to realizeincome from operations of $20,000, computed asfollows:

5. C The operating leverage is 1.8, computed asfollows:

Operating Leverage =$360,000$200,000

= 1.8

Operating Leverage =Contribution Margin

Income from Operations

Sales (units) =$160,000 + $20,000

$4= 45,000 units

Sales (units) =Fixed Costs + Target Profit

Unit Contribution Margin

Break-Even Sales 1units2 =$160,000

$4= 40,000 units

Break-Even Sales 1units2 =Fixed Costs

Unit Contribution Margin

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