Solutions Guide: This is meant as a solutions guide



Solutions Guide:   This is meant as a solutions guide. Please try reworking the questions and reword the answers to essay type parts so as to guarantee that your answer is an original. Do not submit as your own.

2-48 2-48 CVP and Financial Statements for a Mega-Brand Company

Procter & Gamble Company is a Cincinnati-based company that produces household products under

brand names such as Gillette, Bounty, Crest, Folgers, and Tide. The company’s 2006 income statement

showed the following (in millions):

Net sales $68,222

Costs of products sold 33,125

Selling, general, and administrative expense 21,848

Operating income $13,249

Suppose that the cost of products sold is the only variable cost; selling, general, and administrative

expenses are fixed with respect to sales.

Assume that Procter & Gamble had a 10% increase in sales in 2007 and that there was no change

in costs except for increases associated with the higher volume of sales. Compute the predicted 2007

operating income for Procter & Gamble and its percentage increase. Explain why the percentage

increase in income differs from the percentage increase in sales.

Amounts are in millions (rounded with slight rounding errors).

Net sales (1.10 x $68,222) $75,044

Variable costs:

Cost of goods sold (1.10 x $33,125) 36,438

Contribution margin 38,606

Fixed costs:

Selling, administrative, and general expenses 21,848

Operating income $16,758

The percentage increase in operating income would be ($16,758 ( $13,249) - 1 = .26 or 26%, compared with a 10% increase in sales. The contribution margin would increase by 10% or .10 x ($68,222 - $33,125) = $3,510 million. Because fixed costs would not change (assuming the new volume is within the relevant range), operating income would also increase by $3,510 million, from $13,249 million to $16,759 million. If all costs had been variable, costs would have increased by an additional .10 x $21,848 = $2,185 million, making operating income $16,758 - $2,185 = $14,573 million, a 10% increase over the 2006 operating income of $13,249 million. Because of the existence of fixed costs, the percentage increase in operating income will exceed the percentage increase in sales.

2-61 CVP in a Modern Manufacturing Environment

A division of Hewlett-Packard Company changed its production operations from one where a

large labor force assembled electronic components to an automated production facility dominated

by computer-controlled robots. The change was necessary because of fierce competitive pressures.

Improvements in quality, reliability, and flexibility of production schedules were necessary just to

match the competition. As a result of the change, variable costs fell and fixed costs increased, as

shown in the following assumed budgets:

Old Production Operation New Production Operation

Unit variable cost

Material $ .88 $ .88

Labor 1.22 .22

Total per unit $ 2.10 $ 1.10

Monthly fixed costs

Rent and depreciation $450,000 $ 875,000

Supervisory labor 80,000 175,000

Other 50,000 90,000

Total per month $580,000 $1,140,000

Expected volume is 600,000 units per month, with each unit selling for $3.10. Capacity is 800,000

units.

1. Compute the budgeted profit at the expected volume of 600,000 units under both the old and the new production environments.

Old: (Contribution margin x 600,000) - $580,000 = Budgeted profit

[($3.10 - $2.10) x 600,000] - $580,000 = $20,000

New: (Contribution margin x 600,000) - $1,140,000 = Budgeted profit

[($3.10 - 1.10) x 600,000] - $1,140,000 = $60,000

2. Compute the budgeted break-even point under both the old and the new production environments.

Old: $580,000 ÷ $1.00 = 580,000 units

New: $1,140,000 ÷ $2.00 = 570,000 units

3. Discuss the effect on profits if volume falls to 500,000 units under both the old and the new production environments.

A fall in volume will be more devastating under the new system because the high

fixed costs will not be affected by the fall in volume:

Old: ($1.00 x 500,000) - $580,000 = -$80,000 (a $80,000 loss)

New: ($2.00 x 500,000) - $1,140,000 = -$140,000 (a $140,000 loss)

The 100,000 unit fall in volume caused a $20,000 - (- $80,000) = $100,000 decrease in

profits in the old environment and a $60,000 - ( - $140,000) = $200,000 decrease in the new

environment.

4. Discuss the effect on profits if volume increases to 700,000 units under both the old and the new production environments.

Increases in volume create larger increases in profit in the new environment:

Old: ($1.00 x 700,000) - $580,000 = $120,000

New: ($2.00 x 700,000) - $1,140,000 = $260,000

The 100,000 unit increase in volume caused a $120,000 - $20,000 = $100,000 increase

in profit under the old environment and a $260,000 - $60,000 = $200,000 increase

under the new environment.

5. Comment on the riskiness of the new operation versus the old operation.

Changes in volume affect profits in the new environment (a high fixed cost, low

variable cost environment) more than they affect profits in the old environment.

Therefore, profits in the old environment are more stable and less risky. The higher

risk new environment promises greater rewards when conditions are favorable, but

also leads to greater losses when conditions are unfavorable, a more risky situation.

2-62 Goal: Create an Excel spreadsheet to perform CVP analysis and show the relationship

between price, costs, and break-even points in terms of units and dollars. Use the results

to answer questions about your findings.

Scenario: Phonetronix is a small manufacturer of telephone and communications devices.

Recently, company management decided to investigate the profitability of cellular phone

production. They have three different proposals to evaluate. Under all the proposals, the

fixed costs for the new phone would be $110,000. Under proposal A, the selling price of the

new phone would be $99 and the variable cost per unit would be $55. Under proposal B, the

selling price of the phone would be $129 and the variable cost would remain the same.

Under proposal C, the selling price would be $99 and the variable cost would be $49.

When you have completed your spreadsheet, answer the following questions:

1. What are the break-even points in units and dollars under proposal A?

2. How did the increased selling price under proposal B impact the break-even points in

units and dollars compared to the break-even points calculated under proposal A?

3. Why did the change in variable cost under proposal C not impact the break-even points

in units and dollars as significantly as proposal B did?

1. Daily break-even volume is 85 dinners and 170 lunches:

First compute contribution margins on lunches and dinners:

Variable cost percentage = ($1,246,500 + $222,380) ÷ $2,098,400

= 70%

Contribution margin percentage = 1 - variable cost percentage

= 1 - 70% = 30%

Lunch contribution margin = .30 x $20 = $6

Dinner contribution margin = .30 x $40 = $12

Annual fixed cost is $170,940 + $451,500 = $622,440

Let X = number of dinners and 2X = number of lunches

12(X) + 6(2X) - $622,440 = 0

24(X) = 622,440

X = 25,935 dinners annually to break even

2X = 51,870 lunches annually to break even

On a daily basis:

Dinners to break even = 25,935 ÷ 305 = 85 dinners daily

Lunches to break even = 85 x 2 = 170 lunches daily or 51,870 ÷ 305 = 170 lunches daily.

To determine the actual volume, let Y be a combination of 1 dinner and 2 lunches. The price of Y is $40 + (2 x $20) = $80, and total volume in units of Y is $2,098,400 ÷ $80 = 26,230 and daily volume is 26,230 ÷ 305 = 86. Therefore, 86 dinners and 2 x 86 = 172 lunches were served on an average day. This is 1 dinner and 2 lunches above the break-even volume.

2. The extra annual contribution margin from the 3 dinners and 6 lunches is:

3 x $40 x .30 x 305 = $10,980

+ 6 x $20 x .30 x 305 = 10,980

Total $21,960

The added contribution margin is greater than the $15,000 advertising expenditure. Therefore, the advertising expenditure would be warranted. It would increase operating income by $21,960 - $15,000 = $6,960.

3. Let Y again be a combination of 1 dinner and 2 lunches, priced at $80. Variable costs are .70 x $80 = $56, of which $56 x .25 = $14 is food cost. Cutting food costs by 20% reduces variable costs by .20 x $14 = $2.80, making the variable cost of Y $56 - $2.80 = $53.20 and the contribution margin $80 - $53.20 = $26.80. (This could also be determined by adding the $2.80 saving in food cost directly to the old contribution margin of $24.) The required annual volume in Y needed to keep operating income at $7,080 is:

$26.80 (Y) - $622,440 = $7,080

$26.80 (Y) = $629,520

Y = 23,490

Therefore, daily volume = 23,490 ÷ 305 = 77 (rounded)

If volume drops no more than 86 - 77 = 9 dinners and 172 - 154 = 18 lunches, using the less costly food is more profitable. However, there are many subjective factors to be considered. Volume may not fall in the short run, but the decline in quality may eventually affect repeat business and cause a long-run decline. Much may depend on the skill of the chef. If the quality difference is not readily noticeable, so that volume falls less than, say, 10%, saving money on the purchases of food may be desirable.

3-38 Mixed Cost, Choosing Cost Drivers, and High-Low and Visual-Fit Methods

Cedar Rapids Implements Company produces farm implements. Cedar Rapids is in the process of

measuring its manufacturing costs and is particularly interested in the costs of the manufacturing

maintenance activity, since maintenance is a significant mixed cost. Activity analysis indicates that

maintenance activity consists primarily of maintenance labor setting up machines using certain supplies.

A setup consists of preparing the necessary machines for a particular production run of a product.

During setup, machines must still be running, which consumes energy. Thus, the costs associated

with maintenance include labor, supplies, and energy. Unfortunately, Cedar Rapid's cost accounting

system does not trace these costs to maintenance activity separately. Cedar Rapids employs two fulltime maintenance mechanics to perform maintenance. The annual salary of a maintenance mechanic is $25,000 and is considered a fixed cost. Two plausible cost drivers have been suggested: “units produced” and “number of setups.” Data had been collected for the past 12 months and a plot made for the cost driver—units of production. The maintenance cost figures collected include estimates for labor, supplies, and energy. Cory Fielder, controller at Cedar Rapids, noted that some types of activities are performed each time a batch of goods is processed rather than each time a unit is produced. Based on this concept, he has gathered data on the number of setups performed over the past 12 months. The plots of monthly maintenance costs versus the two potential cost drivers follow on page 122.

1. Find monthly fixed maintenance cost and the variable maintenance cost per driver unit using the visual-fit method based on each potential cost driver. Explain how you treated the April data.

2. Find monthly fixed maintenance cost and the variable maintenance cost per driver unit using the high-low method based on each potential cost driver.

3. Which cost driver best meets the criteria for choosing cost functions? Explain.

A master of the scatter-diagrams with least-square regression lines and high-low lines below:

1)

Maintenance costs = $13,108 + $2.17 x Units produced (000s)

Maintenance costs = $5,162 + $751 x Number of setups

The April observation should be ignored since it does not represent a typical month -- it is an example of an outlier. Other examples would be strikes, abnormal downtime, or scheduled plant closings.

2. The high-low method uses only the highest and lowest activity levels. Note that using a scatter diagram, the high-low method can be used without knowing the exact figures. Fixed cost can be easily estimated using a straight edge and should be about $11,500 based on Units Produced and $7,500 based on Number of Setups. Variable costs are estimated using the following computations:

Variable maintenance costs = ($21,000 - $15,000)/(3,900 - 1,200)

= $2.22 per unit

Variable maintenance costs = ($25,500 - $15,000)/(27 - 11)

= $656 per setup

3. Both cost drivers appear, on the surface, to be plausible. However, if maintenance activity is primarily associated with a “batch-level” activity such as setups, the setup driver is preferred. Of the three costs associated with maintenance activity, supplies and energy are probably variable, so salaries are the primary fixed costs. The monthly salary of two mechanics is $4,167 [(2 x $25,000)/12]. The cost function based on setups estimates fixed costs of about $5,200 (visual-fit method). This is much more plausible than the $15,200 estimate based on units of production. Students may inquire as to the use of “setup time” as an alternative to number of setups. Setup time is an acceptable alternative that is often used when setup times differ among different products. Another consideration is data availability. Setup times by product may not be easily obtained or maintained.

Just looking at the two graphs, a linear cost function seems to fit the second graph much better than the first. Reliability of cost drivers is measured by the coefficient of determination, R-Squared. In the regressions used in requirement 1, only 21% of the past year’s variability in maintenance costs can be explained by changes in the volume of units produced, whereas 85% of past fluctuations in maintenance costs can be explained by the number of setups performed. This confirms the visual observation.

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Regression Line

High-Low

Outlier

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