Managerial Accounting

Ninth Edition
Weygandt Kimmel Mitchell

Chapter 6
Cost-Volume-Profit Analysis: Additional
Issues
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Copyright ©2021 John Wiley & Sons, Inc.

Chapter Outline
Learning Objectives
LO 1 Apply basic CVP concepts.
LO 2 Explain the term sales mix and its effects on break-
even sales.
LO 3 Determine sales mix when a company has limited
resources.
LO 4 Indicate how operating leverage affects
profitability.

Copyright ©2017 John Wiley & Son, Inc. 2

 Basic CVP Concepts
CVP Analysis:
 The study of the effects of changes in costs and
volume on a company’s profit.
 Uses a CVP Income Statement format to present
sales and cost data (internal use only)
 With CVP analysis, we can determine
 The break-even point
 The units or sales dollars required to earn a target net income
 Margin of Safety and Margin of Safety Ratio (percentage of Sales)
 How changes in the business environment affect a company’s break-even
point and profit Copyright ©2017 John Wiley & Son, Inc. 3
LO 1
Basic CVP Concepts
Detailed CVP Income Statement

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 4

CVP and Changes in the Business Environment: Case 1
Illustration: Original cell phone sales and cost data for Vargo Electronics is as
shown.

Case I: A competitor is offering a 10% discount on the selling price of its cell phones.
What effect will a 10% discount on selling price ($500 x 10% = $50) have on the
breakeven point?

LO 1 Copyright ©2017 John Wiley & Son, Inc. 5

 CVP and Changes in the Business Environment: Case 1
SOLUTION
Illustration: Original cell phone sales and cost data for Vargo Electronics is as
shown.

Case I: A competitor is offering a 10% discount on the selling price of its cell phones.
What effect will a 10% discount on selling price ($500 x 10% = $50) have on the
breakeven point?
OLD --> $500 SP - $300 VC = $200 UCM
NEW --> $450 SP - $300 VC = $150 UCM

Break-Even
Fixed Costs ÷ Unit Contribution Margin =
Sales
$150 1,334 units
$200,000 ÷ =
($450 - $300) (rounded from 1,333.33)

LO 1 Copyright ©2017 John Wiley & Son, Inc. 6

CVP and Changes in the Business Environment: Case 2
Illustration: Original cell phone sales and cost data for Vargo Electronics is as
shown.

Case II: Management invests in new equipment that will lower the amount of direct
labor required to make cell phones. As a result:
Total fixed costs will increase 30%
Variable cost per unit will decrease 30%
What effect will the new equipment have on the sales volume required to break
even?

LO 1 Copyright ©2017 John Wiley & Son, Inc. 7

 CVP and Changes in the Business Environment: Case 2
SOLUTION
Illustration: Original cell phone sales and cost data for Vargo Electronics is as
shown.

Case II: Management invests in new equipment that will lower the amount of direct
labor required to make cell phones.
Total fixed costs will increase 30% ($200,000 x 1.3 = $260,000)
Variable cost per unit will decrease 30% ($300 x 70% = $210)
What effect will the new equipment have on the sales volume required to break
even?
Break-Even
Fixed Costs ÷ Unit Contribution Margin =
Sales
$260,000 ÷ $290 = 897 units
(rounded from 896.55)
($500 - $210)
LO 1 Copyright ©2017 John Wiley & Son, Inc. 8
CVP and Changes in the Business Environment: Case 3
Illustration: Original cell phone sales and cost data for Vargo Electronics is as
shown.

Case III: Vargo’s principal supplier of raw materials has just announced a price
increase. The higher cost is expected to increase the variable cost of cell phones by
$25 per unit. Management 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 cell phones. What increase in units sold will be needed to maintain the
same level of net income?

LO 1 Copyright ©2017 John Wiley & Son, Inc. 9

 CVP and Changes in the Business Environment: Case 3
SOLUTION
Illustration: Original cell phone sales and cost data for Vargo Electronics is as
shown.
Variable cost per unit increases to $325 ($300 + $25).

Fixed costs are reduced to $182,500 ($200,000 - $17,500).

Contribution margin per unit becomes $175 ($500 - $325).

Case III: Vargo’s principal supplier of raw materials has just announced a price
increase. The higher cost is expected to increase the variable cost of cell phones by
$25 per unit. Management 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 cell phones. What increase in units sold will be needed to maintain the
same level of net income?
(Fixed Cost + Target Net Unit Contribution
÷ = Sales in Units
Income) Margin

($182,500 + $80,000) ÷ $175 = 1,500

(increase of 100 units)

LO 1 Copyright ©2017 John Wiley & Son, Inc. 10

 Sales Mix and Break-Even Sales
a. Sales mix is the relative percentage in which a
company sells its products.
b. Example  Printers = 80,000 units, Computers =
20,000 units, Total Sales = 100,000 units
c. The company’s unit sales are 80% printers and 20%
computers. Its sales mix is 80% to 20% for 100% of
sales.
d. Sales mix is important because different products
often have very different contribution margins.

LO 2 Copyright ©2017 John Wiley & Son, Inc. 11

 Sales Mix & Break-Even Sales in Units (1 of 5)
Companies can compute break-even sales for a mix of
two or more products by determining the weighted-
average unit contribution margin of all the products.
Illustration: Vargo Electronics sells not only cell
phones but high-definition TVs. Vargo sells its
products in the following amounts: 1,500 cell phones
and 500 TVs, total of 2,000 units. Sales Mix is 75%
Cell Phones
Cell Phones, 25% TVs. TVs
1,500 units ÷ 2,000 units = 500 units ÷ 2,000 units =
75% 25%

LO 2 Copyright ©2017 John Wiley & Son, Inc. 12

 Sales Mix & Break-Even Sales in Units (2 of 5)
Additional information related to Vargo Electronics:
Cell Phones TVs
1,500 units ÷ 2,000 units = 500 units ÷ 2,000 units =
75% 25%

Unit Data Cell Phones TVs

Selling price $500 $1,000
Variable costs (300) (500)
Contribution margin $200 $500
Sales mix percentage 75% 25%
Fixed costs = $275,000

LO 2 Copyright ©2017 John Wiley & Son, Inc. 13

 Sales Mix & Break-Even Sales in Units (3 of 5)
First, determine weighted-average contribution
margin.
Unit Data Cell Phones TVs
Selling price $500 $1,000
Variable costs (300) (500)
Contribution margin $200 $500
Sales mix percentage 75% 25%
Fixed costs = $275,000

LO 2 Copyright ©2017 John Wiley & Son, Inc. 14

 Sales Mix & Break-Even Sales in Units (4 of 5)
Second, divide total fixed costs (given as $275,000) by
the weighted-average unit contribution margin.

Weighted-Average Unit Break-Even

Fixed Cost ÷ Contribution Margin = Point in Units
$275,000 ÷ $275 = 1,000 units

LO 2 Copyright ©2017 John Wiley & Son, Inc. 15

 Sales Mix & Break-Even Sales in Units (5 of 5)
(Must do this last step of calculating break-even by product)
With break-even point of 1,000 units, Vargo must sell:
 750 cell phones (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, Net Income = 0.

LO 2 Copyright ©2017 John Wiley & Son, Inc. 16

 Sales Mix & Break-Even Sales in Dollars
Works well if company has many products.
Calculates break-even point in terms of sales dollars for
 divisions or
 product lines,
 not individual products.
 Need to calculate the weighted-average contribution
margin ratio to solve for break-even in sales dollars.

LO 2 Copyright ©2017 John Wiley & Son, Inc. 17

Sales Mix & Break-Even Sales in Dollars (1 of 3)
Kale Garden Supply Company has two divisions. The company’s total
fixed costs are $300,000. [WA CMR shortcut if given total company information]

LO 2 Copyright ©2017 John Wiley & Son, Inc. 18

Sales Mix & Break-Even Sales in Dollars (2 of 3)
1. Determine weighted-average contribution margin ratio.

2. Divide total Weighted-Average Break-even

Fixed Costs by Fixed Cost ÷ Contribution = Point in
Margin Ratio Dollars
the WA CMR to
determine $300,000 ÷ .32 = $937,500
break-even in
dollars.
LO 2 Copyright ©2017 John Wiley & Son, Inc. 19
Sales Mix & Break-Even Sales in Dollars (3 of 3)
(Must do this last step of calculating break-even by division)

With break-even sales of $937,500 and a sales mix

of 20% to 80%, Kale must sell:
 $187,500 from the Indoor Plant division
($937,500 x 20%)
 $750,000 from the Outdoor Plant division
($937,500 x 80%)

LO 2 Copyright ©2017 John Wiley & Son, Inc. 20

 DO IT! 2 Sales Mix Break Even
Manzeck Bicycles International produces and sells three different types of
mountain bikes. Information regarding the three models is shown below.
Pro Intermediate Standard Total
Units sold 5,000 10,000 25,000 40,000
Selling price $800 $500 $350
Variable costs $500 $300 $250
The company’s total fixed costs are $7,500,000.
(a) Determine the sales mix as a function of units sold for the three products.
(b) Determine the weighted-average unit contribution margin.
(c) Determine the total number of units of each model that the company must
sell to break-even.

LO 2 Copyright ©2017 John Wiley & Son, Inc. 21

 DO IT! 2 Sales Mix Break Even - SOLUTION
Pro Intermediate Standard Total
Units sold 5,000 10,000 25,000 40,000
Selling price $800 $500 $350
Variable costs $500 $300 $250
The company’s total fixed costs are $7,500,000.
(a) Sales Mix:

(b) WA UCM:

(c) Units to B/E:

LO 2 Copyright ©2017 John Wiley & Son, Inc. 22

 DO IT! 2 Sales Mix Break Even - SOLUTION
Pro Intermediate Standard Total
Units sold 5,000 10,000 25,000 40,000
Selling price $800 $500 $350
Variable costs $500 $300 $250
The company’s total fixed costs are $7,500,000.
a) Sales Mix: Pro = 5,000/40,000 = 12.5%
Intermediate = 10,000/40,000 = 25%
Standard = 25,000/40,000 = 62.5%
b) WA UCM:[.125 × ($800 − $500)] = $37.50 +[.25 × ($500 − $300)] = $50 +
[.625 × ($350 − $250)] = $62.50 = WA UCM = $150
c) Units to B/E: $7,500,000 ÷ $150 = 50,000 units
Pro: 50,000 units × 12.5% = 6,250 units
Intermediate: 50,000 units ×25% = 12,500 units
Standard: 50,000 units × 62.5% = 31,250 units
LO 2 Copyright ©2017 John Wiley & Son, Inc. 50,000 units 23
 Sales Mix with Limited Resources (1 of 2)
All companies have limited resources whether it be floor
space, raw materials, direct labor hours, etc.
Management must decide which products to sell to
maximize net income.
Illustration: Vargo manufactures cell phones and TVs.
Machine capacity is limited to 3,600 hours per
month.
Cell Phones TVs
Unit contribution margin $200 $500
Machine hours required per unit .2
LO 3 .625
Copyright ©2017 John Wiley & Son, Inc.
24
 Sales Mix with Limited Resources (2 of 2)
Need to calculate the contribution margin per unit
of limited resource  CM per Machine Hour
Cell Phones TVs
(a) Unit contribution margin $200 $500
(b) Machine hours required per unit .2 .625
Contribution margin per unit of
Limited resource  (a) ÷ (b) $1,000 $800
Management should produce more cell phones if
demand exists or increase machine capacity.
Copyright ©2017 John Wiley & Son, Inc.
LO 3 25
 Sales Mix with Limited Resources
Approach used to identify and manage constraints so as
to achieve company goals.
Company must continually
 identify its constraints and
 find ways to reduce or eliminate them, where
appropriate.
 Understanding the contribution margin per unit of
limited resource helps a company determine which
product to produce if a they obtain additional
capacity.
Copyright ©2017 John Wiley & Son, Inc.
LO 3 26
Sales Mix with Limited Resources
Review Question
If the unit contribution margin is $15 and it takes 3.0
machine hours to produce the unit, the contribution
margin per unit of limited resource is:
a. $25.
b. $5.
c. $4.
d. No correct answer is given.

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 27

 DO IT! 3 Sales Mix with Limited Resources
Carolina Corporation manufactures and sells three different types of high-quality
ball bearings for mountain bike wheels: Fine, Extra-Fine, and Super-Fine.
Machine time is limited. The bearings vary in terms of their quality
specifications; therefore, more machine time is required to manufacture the
Extra-Fine and Super-Fine bearings. Extra Super
Fine Fine Fine
Selling price $6.00 $10.00 $16.00
Variable costs and expenses $4.00 $6.50 $11.00
Contribution margin $2.00 $3.50 $5.00
Machine hours required 0.02 0.04 0.08
What is the contribution margin per unit of limited resource for each type of
bearing?
How much contribution margin would the company earn if it obtained 100
additional machine hours and produced only the most profitable product?

LO 3 Copyright ©2017 John Wiley & Son, Inc. 28

 DO IT! 3 Sales Mix with Limited Resources
- SOLUTION
Extra Super
Fine Fine Fine
Selling price $6.00 $10.00 $16.00
Variable costs and expenses $4.00 $6.50 $11.00
Contribution margin $2.00 $3.50 $5.00
Machine hours required 0.02 0.04 0.08

What is the contribution margin per unit of limited resource for each type of
bearing?

How much contribution margin would the company earn if it obtained 100
additional machine hours and produced only the most profitable product?

LO 3 Copyright ©2017 John Wiley & Son, Inc. 29

 DO IT! 3 Sales Mix with Limited Resources
- SOLUTION
Extra Super
Fine Fine Fine
Selling price $6.00 $10.00 $16.00
Variable costs and expenses $4.00 $6.50 $11.00
Contribution margin $2.00 $3.50 $5.00
Machine hours required 0.02 0.04 0.08
What is the contribution margin per unit of limited resource for each type of
bearing?

How much contribution margin would the company earn if it obtained 100
additional machine hours and produced only the most profitable product?
Fine is the most profitable product based on CM per machine hour.
$100 CM per limited resource (MH) x 100 machine hours = $10,000 in extra CM.

LO 3 Copyright ©2017 John Wiley & Son, Inc. 30

 Cost Structure and Profitability
Cost Structure is the relative proportion of fixed
versus variable costs that a company incurs.
May have a significant effect on profitability
Company must carefully choose its cost structure -- may
be able to choose between automation (more FC)
versus more direct labor (more VC)

LO 4 Copyright ©2017 John Wiley & Son, Inc. 31

 Cost Structure and Profitability
Vargo Electronics and one of its competitors, New Wave
Company, both make cell phones. Vargo uses a traditional,
labor-intensive manufacturing process. New Wave has
invested in a completely automated system. The factory
employees are involved only in setting up, adjusting, and
maintaining the machinery.
Vargo New Wave
Sales $800,000 $800,000
Variable costs (480,000) (160,000)
Contribution margin $320,000 $640,000
Fixed costs (200,000) (520,000)
Net income $120,000 $120,000
LO 4 Copyright ©2017 John Wiley & Son, Inc. 32
 Cost Structure’s Effect on CM Ratio
Vargo New Wave
Sales $800,000 $800,000
Variable costs (480,000) (160,000)
Contribution margin $320,000 $640,000
Fixed costs (200,000) (520,000)
Net income $120,000 $120,000
Contribution Contribution
÷ Sales Margin Ratio
Margin

Vargo $320,000 ÷ $800,000 = 40%

New Wave $640,000 ÷ $800,000 = 80%

New Wave contributes _________to net income for each dollar of increased sales while
Vargo only contributes _________.
New Wave’s cost structure which relies on fixed costs is more _____________ to changes
in sales.
LO 4 Copyright ©2017 John Wiley & Son, Inc. 33
 Cost Structure’s Effect on Break-Even Point

Fixed Contribution
÷ = Break-even Point
Costs Margin Ratio in Dollars

Vargo $200,000 ÷ .40 = $500,000

New Wave $520,000 ÷ .80 = $650,000

New Wave needs to generate ___________ more in sales than Vargo to break-
even.
Because of the greater break-even sales required, New Wave is a ___________
company than Vargo.
However, once New Wave reaches break-even sales, they will earn profits
___________ than Vargo.

LO 4 Copyright ©2017 John Wiley & Son, Inc. 34

 Cost Structure’s Effect on Margin of Safety

The difference in ratios reflects the difference in ______ between

New Wave and Vargo.
Vargo can sustain a _____ decline in sales before operating at a
loss versus only a _____ decline for New Wave.

LO 4 Copyright ©2017 John Wiley & Son, Inc. 35

 Putting it All Together:
Cost structure impacts a company’s contribution margin ratio,
break-even point and margin of safety.
With a higher amount of ________ costs relative to ________
costs, New Wave has a higher contribution margin ratio and
higher break-even point. With the higher break-even point,
they have a lower margin of safety ratio.
This means that New Wave is more ___________ to changes in
sales and more vulnerable to economic downturns. They will
experience wider swings in Net Income as sales fluctuate,
with greater profits as sales increase, and greater losses as
sales decrease.

LO 4 Copyright ©2017 John Wiley & Son, Inc. 36

 Operating Leverage - Important
Extent that net income reacts to a given change in
sales – measure of earnings volatility
Higher fixed costs relative to variable costs cause a
company to have higher operating leverage.
Operating leverage acts as a multiplier.
a. When sales revenues are increasing, high
operating leverage means that profits will
increase rapidly.
b. When sales revenues are declining, too much
LO 4 operating leverage can
Copyright ©2017 have
John Wiley devastating
& Son, Inc. 37
Degree of Operating Leverage - Important
Provides a measure of a company’s earnings volatility  Higher
FC, Higher DOL
Computed by dividing total contribution margin by net income.

Degree of
Contribution Operating
÷ Net Income =
Margin Leverage
Vargo $320,000 ÷ $120,000 = 2.67
New Wave $640,000 ÷ $120,000 = 5.33

LO 4 Copyright ©2017 John Wiley & Son, Inc. 38

Degree of Operating Leverage - Important
Contribution Net Income Degree of
Margin ÷ = Operating
Leverage
Vargo $320,000 ÷ $120,000 = 2.67
New Wave $640,000 ÷ $120,000 = 5.33

Use DOL as a multiplier to predict profit impacted if change in sales. If Sales

increase by 10%, how much will Net Income increase?
Vargo 2.67 x 10% increase in sales = 26.7 % increase in NI
New Wave 5.33 x 10% increase in sales = 53.33 % increase in NI

LO 4 Copyright ©2017 John Wiley & Son, Inc. 39

Operating Leverage
Review Question
The degree of operating leverage:
a. Can be computed by dividing contribution margin by
net income.
b. Provides a measure of the company’s earnings
volatility.
c. Affects a company’s break-even point.
d. All of the above.

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 40

 DO IT! 4 Operating Leverage
Rexfield Corp., a company specializing in crime scene investigations, is
contemplating an investment in automated mass-spectrometers. Its current
process relies on a high number of lab technicians. The new equipment would
employ a computerized expert system. The company’s CEO has requested a
comparison of the old technology versus the new technology. The accounting
department has prepared the following CVP income statements for use in your
analysis.
Old New
Sales $2,000,000 $2,000,000
Variable costs (1,400,000) (600,000)
Contribution margin $600,000 $1,400,000
Fixed costs (400,000) (1,200,000)
Net income $200,000 $200,000
a) Compute the degree of operating leverage.
b) How much will net income change under each alternative if sales increase
by 10%?
LO 4 Copyright ©2017 John Wiley & Son, Inc. 41
 DO IT! 4 Operating Leverage - SOLUTION
Old New
Sales $2,000,000 $2,000,000
Variable costs (1,400,000) (600,000)
Contribution margin $600,000 $1,400,000
Fixed costs (400,000) (1,200,000)
Net income $200,000 $200,000

a) Compute the degree of operating leverage.

b) How much will net income change under each alternative if sales increase by
10%?

LO 4 Copyright ©2017 John Wiley & Son, Inc. 42

 DO IT! 4 Operating Leverage - SOLUTION
Old New
Sales $2,000,000 $2,000,000
Variable costs (1,400,000) (600,000)
Contribution margin $600,000 $1,400,000
Fixed costs (400,000) (1,200,000)
Net income $200,000 $200,000
a) Compute the degree of operating leverage.
Contribution Degree of
Net Income
Margin Operating Leverage
Old $600,000 ÷ $200,000 = 3.00
New $1,400,000 ÷ $200,000 = 7.00
b) How much will net income change under each alternative if sales increase
by 10%? Use DOL as a multiplier to predict profit impacted if change in
sales. Old: 10% increase in sales x 3 = 30% increase in NI
New: 10% increase in sales x 7 = 70% increase in NI

LO 4 Copyright ©2017 John Wiley & Son, Inc. 43

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Copyright ©2021 John Wiley & Sons, Inc. 44