REVIEW PROBLEM: CVP RELATIONSHIPS

Voltar Company manufactures and sells a specialized cordless telephone for high electromagnetic radiation
environments. The company's contribution format income statement for the most recent year is given below:

Management is anxious to increase the company's profit and has asked for an analysis of a number of items.
Required:
1. Compute the company's CM ratio and variable expense ratio.
2. Compute the company's break-even point in both units and sales dollars. Use the equation method.
3. Assume that sales increase by $400,000 next year. If cost behavior patterns remain unchanged, by how
much will the company's net operating income increase? Use the CM ratio to compute your answer.
4. Refer to the original data. Assume that next year management wants the company to earn a profit of at least
$90,000. How many units will have to be sold to meet this target profit?
5. Refer to the original data. Compute the company's margin of safety in both dollar and percentage form.
6.
a. Compute the company's degree of operating leverage at the present level of sales.
b. Assume that through a more intense effort by the sales staff, the company's sales increase by 8% next
year. By what percentage would you expect net operating income to increase? Use the degree of
operating leverage to obtain your answer.
c. Verify your answer to (b) by preparing a new contribution format income statement showing an 8%
increase in sales.
7. In an effort to increase sales and profits, management is considering the use of a higher-quality speaker.
The higher-quality speaker would increase variable costs by $3 per unit, but management could eliminate
one quality inspector who is paid a salary of $30,000 per year. The sales manager estimates that the higher-
quality speaker would increase annual sales by at least 20%.
Page 216
a. Assuming that changes are made as described above, prepare a projected contribution format income
statement for next year. Show data on a total, per unit, and percentage basis.
b. Compute the company's new break-even point in both units and dollars of sales. Use the formula method.
c. Would you recommend that the changes be made?

Solution to Review Problem 1.

2.

3.
 Because the fixed expenses are not expected to change, net operating income will increase by the entire
$100,000 increase in contribution margin computed above.
4. Equation method:

Formula method:

5.

6.
a.

b.

c. If sales increase by 8%, then 21,600 units (20,000 × 1.08 = 21,600) will be sold next year. The new
contribution format income statement would be as follows:

Thus, the $84,000 expected net operating income for next year represents a 40% increase over the
$60,000 net operating income earned during the current year:
 Note from the income statement above that the increase in sales from 20,000 to 21,600 units has
increased both total sales and total variable expenses.
7.
a. A 20% increase in sales would result in 24,000 units being sold next year: 20,000 units × 1.20 =
24,000 units.

Note that the change in per unit variable expenses results in a change in both the per unit
contribution margin and the CM ratio.

b.

c. Yes, based on these data the changes should be made. The changes increase the company's net
operating income from the present $60,000 to $78,000 per year. Although the changes also result
in a higher break-even point (17,500 units as compared to the present 16,000 units), the company's
margin of safety actually becomes greater than before:
Margin of safety in dollars = Total sales – Break–even sales
= $ 1,440,000 – $ 1,050,000 = $ 390,000
As shown in (5) on the prior page, the company's present margin of safety is only $240,000. Thus,
several benefits will result from the proposed changes.

THE FOUNDATIONAL 15
Oslo Company prepared the following contribution format income statement based on a sales volume of 1,000 units
(the relevant range of production is 500 units to 1,500 units):

Required:

(Answer each question independently and always refer to the original data unless instructed otherwise.)
 1. What is the contribution margin per unit?
2. What is the contribution margin ratio?
3. What is the variable expense ratio?
4. If sales increase to 1,001 units, what would be the increase in net operating income?
5. If sales decline to 900 units, what would be the net operating income?/li>
6. If the selling price increases by $2 per unit and the sales volume decreases by 100 units, what would be the
net operating income?
7. If the variable cost per unit increases by $1, spending on advertising increases by $1,500, and unit sales
increase by 250 units, what would be the net operating income?
8. What is the break-even point in unit sales?
9. What is the break-even point in sales dollars?
10. How many units must be sold to achieve a target profit of $5,000?
11. What is the margin of safety in dollars? What is the margin of safety percentage?
12. What is the degree of operating leverage?
13. Using the degree of operating leverage, what is the estimated percent increase in net operating income of a
5% increase in sales?
14. Assume that the amounts of the company's total variable expenses and total fixed expenses were reversed.
In other words, assume that the total variable expenses are $6,000 and the total fixed expenses are
$12,000. Under this scenario and assuming that total sales remain the same, what is the degree of
operating leverage?
15. Using the degree of operating leverage that you computed in the previous question, what is the estimated
percent increase in net operating income of a 5% increase in sales?

EXERCISE 5–3 Prepare a Profit Graph [LO2]

Capricio Enterprises distributes a single product whose selling price is $19 and whose variable expense is $15 per
unit. The company's fixed expense is $12,000 per month.
Required:
1. Prepare a profit graph for the company up to a sales level of 4,000 units.
2. Estimate the company's break-even point in unit sales using your profit graph.

EXERCISE 5–4 Computing and Using the CM Ratio [LO3]

Last month when Harrison Creations, Inc., sold 40,000 units, total sales were $300,000, total variable expenses were
$240,000, and fixed expenses were $45,000.
Required:
1. What is the company's contribution margin (CM) ratio?
2. Estimate the change in the company's net operating income if it were to increase its total sales by $1,500.

EXERCISE 5–5 Changes in Variable Costs, Fixed Costs, Selling Price, and Sales Volume [LO4]
Data for Herron Corporation are shown below:

Fixed expenses are $75,000 per month and the company is selling 3,000 units per month.
Required:

1. The marketing manager believes that an $8,000 increase in the monthly advertising budget would
increase monthly sales by $15,000. Should the advertising budget be increased?
2. Refer to the original data. Management is considering using higher-quality components that would
increase the variable cost by $3 per unit. The marketing manager believes that the higher-quality
product would increase sales by 15% per month. Should the higher-quality components be used?
Review of chapters 2 and 5
Case 1 Case 2
Direct materials used $H $ 48 000 Costs of goods manufactured and sold
Direct manufacturing labor $ 36 000 $ 18 000
Variable marketing,
distribution,customer service and K T Direct materials Case 1
administrative costs
Fixed manufacturing overhead I $ 24 000 Beg. RM $ 14 400
Fixed marketing, distribution,
customer service,a and J $ 12 000
administrative costs + Purchases $ 18 000
Gross margin $ 30 000 $ 24 000 = Avaible raw material 32400
Finished goods inventory, Jan 1,
$ - $ 6 000
2015 - Ending RM -$ 6 000
Finished goods inventory,
$ - $ 6 000
December 31, 2015 = RM used (Variable) 26400 H
Contribution margin (dollars) $ 36 000 V Labor (Variable) $ 36 000
Revenues $ 120 000 $ 120 000 Mfg OH
Direct materials inventory,
$ 14 400 $ 24 000
January 1, 2015 Fixed 21600 I
Direct materials inventory,
$ 6 000 W
December 31,2015 Variable $ 6 000
Variable manufacturing overhead $ 6 000 X Total costs 90000
Work in process, Janvuary 1, 2015 $ - $ 10 800 + Beg. WIP $ -
Work in process, December 31,
$ - $ 10 800
2015 - Ending WIP $ -
Purchases of direct materials $ 18 000 $ 60 000 = Cost of goods mfg 90000 G
Break-even point (in dollars) $ 80 000 Y
Cost of goods manufactured G U + Beg. FG $ -
Operation income (loss) L (6 000,00) - End. FG $ -
= Costs of goods sold 90000

Income statement Income statement contribution margin format

Sales $ 120 000 Sales $ 120 000
COGS Variables DM, DL, OH $ 68 400
Fix OH $ 21 600 Operating $ 15 600 K
Var DM, DL, OH $ 68 400 = CM $ 36 000 30%
= Gross margin $ 30 000 - Fixed OH 21600
Operating Costs Operating $ 2 400 J
Fixed $ 2 400 $ 24 000
Var $ 15 600
Net operating income L $ 12 000 = Net operating income $ 12 000

Calculate Fixed expenses = CM% * BE ($) $ 24 000