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Chapter 4 - Answer - Cost Accounting

BS Accountancy (Mindanao State University)

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COST ACCOUNTING AND CONTROL – Solutions Manual

CHAPTER 4
COST-VOLUME-PROFIT RELATIONSHIP

I. Answers to Questions
1. The total “contribution margin” is the excess of total revenue over total variable costs. The unit
contribution margin is the excess of the unit price over the unit variable costs.
2. Total contribution margin:
Selling price - manufacturing variable costs expensed - nonmanufacturing variable costs expensed = Total
contribution margin.
Gross margin:
Selling price - variable manufacturing costs expensed - fixed manufacturing costs expensed = Gross
margin.
3. A company operating at “break-even” is probably not covering costs which are not recorded in the
accounting records. An example of such a cost is the opportunity cost of owner-invested capital. In some
small businesses, owner-managers may not take a salary as large as the opportunity cost of forgone
alternative employment. Hence, the opportunity cost of owner labor may be excluded.
4. In the short-run, without considering asset replacement, net operating cash flows would be expected to
exceed net income, because the latter includes depreciation expense, while the former does not. Thus,
the cash basis break-even would be lower than the accrual break-even if asset replacement is ignored.
However, if asset replacement costs are taken into account, (i.e., on a “cradle to grave” basis), the long-
run net cash flows equal long-run accrual net income, and the long-run break-even points are the same.
5. Both unit price and unit variable costs are expressed on a per product basis, as:
 = (P1 - V1) X1 + (P2 - V2) X2 +  + (Pn - Vn) Xn - F,
for all products 1 to n where:
 = operating profit,
P = average unit selling price,
V = average unit variable cost,
X = quantity of units,
F = total fixed costs for the period.
6. If the relative proportions of products (i.e., the product “mix”) is not held constant, products may be
substituted for each other. Thus, there may be almost an infinite number of ways to achieve a target
operating profit. As shown from the multiple product profit equation, there are several unknowns for one
equation:
 = (P1 - V1) X1 + (P2 - V2) X2 +  + (Pn - Vn) Xn - F,
for all products 1 to n.
7. A constant product mix is assumed to simplify the analysis. Otherwise, there may be no unique solution.
8. Operating leverage measures the impact on net operating income of a given percentage change in sales.
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.
9. Three approaches to break-even analysis are (a) the equation method, (b) the contribution margin
method, and (c) the graphical method. In the equation method, the equation is: Sales = Variable expenses
+ Fixed expenses + Profits, where profits are zero at the break-even point. The equation is solved to
determine the break-even point in units or peso sales.
10. The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. It
states the amount by which sales can drop before losses begin to be incurred.

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11. The sales mix is the relative proportions in which a company’s products are sold. The usual assumption
in cost-volume-profit analysis is that the sales mix will not change.
12. 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 since it would require more sales to cover the same
amount of fixed costs.
13. The contribution margin (CM) ratio is the ratio of the total contribution margin to total sales revenue. It
can be used in a variety of ways. For example, the change in total contribution margin from a given
change in total sales revenue can be estimated by multiplying the change in total sales revenue by the
CM ratio. If fixed costs do not change, then a peso increase in contribution margin will result in a peso
increase in net operating income. The CM ratio can also be used in break-even analysis. Therefore,
knowledge of a product’s CM ratio is extremely helpful in forecasting contribution margin and net
operating income.
14. Incremental analysis focuses on the changes in revenues and costs that will result from a particular
action.
15. All other things equal, Company B, with its higher fixed costs and lower variable costs, will have a
higher contribution margin ratio than Company A. Therefore, it will tend to realize a larger increase in
contribution margin and in profits when sales increase.
16. (a) If the selling price decreased, then the total revenue line would rise less steeply, and the break-even
point would occur at a higher unit volume. (b) If the fixed cost increased, then both the fixed cost line
and the total cost line would shift upward and the break-even point would occur at a higher unit volume.
(c) If the variable cost increased, then the total cost line would rise more steeply and the break-even point
would occur at a higher unit volume.

II. Answers to Exercises

Exercise 1 (Contribution Format Income Statement)

Requirement 1
Total Per Unit
Sales (30,000 units × 1.15 = 34,500 units) P172,500 P5.00
Less variable expenses 103,500 3.00
Contribution margin 69,000 P2.00
Less fixed expenses 50,000
Net operating income P 19,000

Requirement 2
Sales (30,000 units × 1.20 = 36,000 units) P162,000 P4.50
Less variable expenses 108,000 3.00
Contribution margin 54,000 P1.50
Less fixed expenses 50,000
Net operating income P 4,000

Requirement 3
Sales (30,000 units × 0.95 = 28,500 units) P156,750 P5.50
Less variable expenses 85,500 3.00
Contribution margin 71,250 P2.50
Less fixed expenses (P50,000 + P10,000) 60,000
Net operating income P 11,250

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Requirement 4
Sales (30,000 units × 0.90 = 27,000 units) P151,200 P5.60
Less variable expenses 86,400 3.20
Contribution margin 64,800 P2.40
Less fixed expenses 50,000
Net operating income P 14,800

Exercise 2 (Break-even Analysis and CVP Graphing)

Requirement 1

The contribution margin per person would be:

Price per ticket.......................................................................................................................
P30
Less variable expenses:
Dinner................................................................................................................................
P7
Favors and program...........................................................................................................
3 10
Contribution margin per person............................................................................................ P20

The fixed expenses of the Extravaganza total P8,000; therefore, the break-even point would be computed as
follows:
Sales = Variable expenses + Fixed expense + Profits

P30Q = P10Q + P8,000 + P0

P20Q = P8,000
Q = P8,000 ÷ P20 per person
Q = 400 persons; or, at P30 per person, P12,000

Alternative solution:
Break-even point Fixed expenses
in unit sales = Unit contribution margin
P8,000
= P20 per person

= 400 persons
or, at P30 per person, P12,000.

Requirement 2
Variable cost per person (P7 + P3)........................................................................................
P10
Fixed cost per person (P8,000 ÷ 250 persons)......................................................................
32
Ticket price per person to break even...................................................................................
P42
Requirement 3

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Cost-volume-profit graph:

P22,000

P20,000

P18,000

Total Sales
P16,000

Break-even point: 400 persons,

P14,000
or P12,000 in sales

P12,000
Pesos

P10,000 Total Expenses

Fixed Expenses
P8,000

P6,000

P4,000

P2,000

P0
0 100 200 300 400 500 600
Number of Persons

Exercise 3 (Break-
even and Target Profit Analysis)

Requirement 1
Sales = Variable expenses + Fixed expenses + Profits
P900Q = P630Q + P1,350,000 + P0
P270Q = P1,350,000
Q = P1,350,000 ÷ P270 per lantern
Q = 5,000 lanterns, or at P900 per lantern, P4,500,000 in sales

Alternative solution:
Break-even point
in unit sales
Fixed expenses
= Unit contribution margin
P1,350,000
= P270 per lantern

= 5,000 lanterns
or at P900 per lantern, P4,500,000 in sales

Requirement 2

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An increase in the variable expenses as a percentage of the selling price would result in a higher break-even
point. The reason is that if variable expenses increase as a percentage of sales, then the contribution margin
will decrease as a percentage of sales. A lower CM ratio would mean that more lanterns would have to be
sold to generate enough contribution margin to cover the fixed costs.

Requirement 3
Present: Proposed:
8,000 Lanterns 10,000 Lanterns*
Total Per Unit Total Per Unit
Sales P7,200,000 P900 P8,100,000 P810 **
Less variable expenses 5,040,000 630 6,300,000 630
Contribution margin 2,160,000 P270 1,800,000 P180
Less fixed expenses 1,350,000 1,350,000
Net operating income P 810,000 P 450,000

* 8,000 lanterns × 1.25 = 10,000 lanterns

** P900 per lantern × 0.9 = P810 per lantern

As shown above, a 25% increase in volume is not enough to offset a 10% reduction in the selling price; thus,
net operating income decreases.

Requirement 4
Sales = Variable expenses + Fixed expenses + Profits
P810Q = P630Q + P1,350,000 + P720,000
P180Q = P2,070,000
Q = P2,070,000 ÷ P180 per lantern
Q = 11,500 lanterns

Alternative solution:
Unit sales to attain Fixed expenses + Target profit
target profit = Unit contribution margin
P1,350,000 + P720,000
= P180 per lantern

= 11,500 lanterns

Exercise 4 (Operating Leverage)

Requirement 1
Sales (30,000 doors) P18,000,000 P600
Less variable expenses 12,600,000 420
Contribution margin 5,400,000 P180
Less fixed expenses 4,500,000
Net operating income P 900,000
Degree of operating Contribution margin
leverage = Net operating income
P5,400,000
= P900,000

= 6

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Requirement 2
a. Sales of 37,500 doors represents an increase of 7,500 doors, or 25%, over present sales of 30,000 doors.
Since the degree of operating leverage is 6, net operating income should increase by 6 times as much, or
by 150% (6 × 25%).
b. Expected total peso net operating income for the next year is:
Present net operating income................................................................................................
P 900,000
Expected increase in net operating income next year
(150% × P900,000)...........................................................................................................
1,350,000
Total expected net operating income....................................................................................
P2,250,000

Exercise 5 (Break-even Analysis; Target Profit; Margin of Safety)

Requirement 1
Sales = Variable expenses + Fixed expenses + Profits
P40Q = P28Q + P150,000 + P0
P12Q = P150,000
Q = P150,000 ÷ P12 per unit
Q = 12,500 units, or at P40 per unit, P500,000

Alternatively:
Break-even point Fixed expenses
in unit sales = Unit contribution margin
P150,000
= P12 per unit

= 12,500 units
or, at P40 per unit, P500,000.

Requirement 2
The contribution margin at the break-even point is P150,000 since at that point it must equal the fixed
expenses.

Requirement 3
Unit sales to attain Fixed expenses + Target profit
target profit = Unit contribution margin
P150,000 + P18,000
= P12 per unit

= 14,000 units
Total Unit
Sales (14,000 units × P40 per unit) P560,000 P40
Less variable expenses
(14,000 units × P28 per unit) 392,000 28
Contribution margin
(14,000 units × P12 per unit) 168,000 P12
Less fixed expenses 150,000
Net operating income P 18,000

Requirement 4

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Margin of safety in peso terms:

Margin of safety in pesos = Total sales – Break-even sales
= P600,000 – P500,000 = P100,000
Margin of safety in percentage terms:
Margin of safety Margin of safety in pesos
percentage = Total sales
P100,000
= P600,000

Requirement 5 = 16.7% (rounded)

The CM ratio is 30%.
Expected total contribution margin: P680,000 × 30%.........................................................
P204,000
180,000
Present total contribution margin: P600,000 × 30%............................................................
Increased contribution margin..............................................................................................
P 24,000

Alternative solution:
P80,000 incremental sales × 30% CM ratio = P24,000
Since in this case the company’s fixed expenses will not change, monthly net operating income will increase
by the amount of the increased contribution margin, P24,000.

Exercise 6 (Changes in Variable Costs, Fixed Costs, Selling Price, and Volume)

Requirement (1)
The following table shows the effect of the proposed change in monthly advertising budget:
Sales With
Additional
Current Advertising
Sales Budget Difference
Sales P225,000 P240,000 P15,000
Variable expenses............................... 135,000 144,000 9,000
Contribution margin........................... 90,000 96,000 6,000
Fixed expenses................................... 75,000 83,000 8,000
Net operating income......................... P 15,000 P 13,000 P(2,000)
Assuming that there are no other important factors to be considered, the increase in the advertising budget
should not be approved since it would lead to a decrease in net operating income of P2,000.
Alternative Solution 1
Expected total contribution margin:
P240,000 × 40% CM ratio..................................................... P96,000
Present total contribution margin:
P225,000 × 40% CM ratio..................................................... 90,000
Incremental contribution margin............................................... 6,000
Change in fixed expenses:
Less incremental advertising expense................................... 8,000
Change in net operating income................................................ P(2,000)
Alternative Solution 2
Incremental contribution margin: P 6,000

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P15,000 × 40% CM ratio......................................................

Less incremental advertising expense....................................... 8,000
Change in net operating income................................................ P(2,000)

Requirement (2)
The P3 increase in variable costs will cause the unit contribution margin to decrease from P30 to P27 with the
following impact on net operating income:
Expected total contribution margin with the higher-quality
components:
3,450 units × P27 per unit........................................................................... P93,150
Present total contribution margin:
3,000 units × P30 per unit........................................................................... 90,000
Change in total contribution margin............................................................... P 3,150
Assuming no change in fixed costs and all other factors remain the same, the higher-quality components
should be used.

Exercise 7 (Degree of Operating Leverage)

Requirement (1)
The company’s degree of operating leverage would be computed as follows:

Contribution margin......................................... P36,000

÷ Net operating income.................................... P12,000
Degree of operating leverage........................... 3.0
Requirement (2)
A 10% increase in sales should result in a 30% increase in net operating income, computed as follows:
Degree of operating leverage.....................................................................................
3.0
× Percent increase in sales.........................................................................................
10%
Estimated percent increase in net operating income................................................. 30%

Requirement (3)
The new income statement reflecting the change in sales would be:
Percent of
Amount Sales
Sales P132,000 100%
Variable expenses............................... 92,400 70%
Contribution margin........................... 39,600 30%
Fixed expenses................................... 24,000
Net operating income......................... P 15,600

Net operating income reflecting change in sales................................................... P15,600

Original net operating income................................................................................
P12,000
Percent change in net operating income................................................................30%

Exercise 8 (Break-Even and Target Profit Analysis)

Requirement (1)
Variable expenses: P60 × (100% – 40%) = P36.

Requirement (2)
Selling price...................................................... P60 100%

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Variable expenses.............................................. 36 60%

Contribution margin.......................................... P24 40%
Let Q = Break-even point in units.
Sales = Variable expenses + Fixed expenses + Profits
P60Q = P36Q + P360,000 + P0
P24Q = P360,000
Q = P360,000 ÷ P24 per unit
Q = 15,000 units
In sales pesos: 15,000 units × P60 per unit = P900,000
Alternative solution:
Let X = Break-even point in sales pesos.
X = 0.60X + P360,000 + P0
0.40X = P360,000
X = P360,000 ÷ 0.40
X = P900,000
In units: P900,000 ÷ P60 per unit = 15,000 units
P60Q = P36Q + P360,000 + P90,000
P24Q = P450,000
Q = P450,000 ÷ P24 per unit
Q = 18,750 units
In sales pesos: 18,750 units × P60 per unit = P1,125,000

Alternative solution:
X = 0.60X + P360,000 + P90,000
0.40X = P450,000
X = P450,000 ÷ 0.40
X = P1,125,000
In units: P1,125,000 ÷ P60 per unit = 18,750 units
c. The company’s new cost/revenue relationships will be:
Selling price........................................................................... P60 100%
Variable expenses (P36 – P3)................................................ 33 55%
Contribution margin............................................................... P27 45%
P60Q = P33Q + P360,000 + P0
P27Q = P360,000
Q = P360,000 ÷ P27 per unit
Q = 13,333 units (rounded).
In sales pesos: 13,333 units × P60 per unit = P800,000 (rounded)
Alternative solution:
X = 0.55X + P360,000 + P0
0.45X = P360,000
X = P360,000 ÷ 0.45
X = P800,000
In units: P800,000 ÷ P60 per unit = 13,333 units (rounded)
Requirement (3)
Break-even point in Fixed expenses
unit sales = Unit contribution margin

= P360,000  P24 per unit = 15,000 units

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a.

In sales pesos: 15,000 units × P60 per unit = P900,000

Alternative solution:
Break-even point in Fixed expenses
sales pesos = CM ratio

= P360,000  0.40 = P900,000

In units: P900,000 ÷ P60 per unit = 15,000 units

Unit sales to attain Fixed expenses + Target profit

b. =
target profit Unit contribution margin
= (P360,000 + P90,000)  P24 per unit
= 18,750 units
In sales pesos: 18,750 units × P60 per unit = P1,125,000

Alternative solution:
Peso sales to attain Fixed expenses + Target profit
target profit = CM ratio

= (P360,000 + P90,000)  0.40

= P1,125,000
In units: P1,125,000 ÷ P60 per unit = 18,750 units

c. Break-even point in Fixed expenses

unit sales = Unit contribution margin

= P360,000  P27 per unit

= 13,333 units (rounded)
In sales pesos: 13,333 units × P60 per unit = P800,000 (rounded)

Alternative solution:
Break-even point in Fixed expenses
sales pesos = CM ratio

= P360,000  0.45
= P800,000
In units: P800,000 ÷ P60 per unit = 13,333 (rounded)

III. Answers to Multiple Choice Questions

1. B 6. B 11. B 16. D 21. A 26. A

2. B 7. D 12. A 17. D 22. D 27. B
3. B 8. B 13. A 18. D 23. C 28. C
4. C 9. A 14. A 19. C 24. B 29. B

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5. C 10. D 15. D 20. D 25. C 30. A

IV. Answers to Problems

Problem 1
Requirement 1: Break-even chart

600,000 TR

500,000
TC
400,000
(P)
Break-even
300,000 point

200,000

FC
100,000

5,000 10,000 15,000 20,000 25,000 30,000

Requirement 2: Profit-volume graph (units)

250,000

P 200,000
R
O
F 150,000
I
T
100,000

50,000 Break-even
point

0
5,000 10,000 15,000 20,000 25,000 30,000
50,000

100,000
L
O 150,000
S
S
200,000

250,000
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Problem 2 (CVP Relationships)

Requirement 1
Contribution margin P15
CM ratio = Selling price = P60 =
25%
Variable expense P45
Requirement
Variable 2 ratio
expense = Selling price = P60 =
Sales = Variable expenses + Fixed expenses + Profits 75%
P60Q = P45Q + P240,000 + P0
P15Q = P240,000
Q = P240,000 ÷ P15 per unit
Q = 16,000 units, or at P60 per unit, P960,000

Alternative solution:
X = 0.75X + P240,000 + P0
0.25X = P240,000
X = P240,000 ÷ 0.25
X = P960,000; or at P60 per unit, 16,000 units

Requirement 3
Increase in sales........................................................... P400,000
Multiply by the CM ratio............................................. x 25%
Expected increase in contribution margin................... P100,000
Since the fixed expenses are not expected to change, net operating income will increase by the entire
P100,000 increase in contribution margin computed above.

Requirement 4
Sales = Variable expenses + Fixed expenses + Profits
P60Q = P45Q + P240,000 + P90,000
P15Q = P330,000
Q = P330,000 ÷ P15 per unit
Q = 22,000 units

Contribution margin method:

Fixed expenses + Target profit P240,000 + P90,000
Contribution margin per unit = P15 per unit = 22,000 units

Requirement 5
Margin of safety in pesos = Total sales – Break-even sales
= P1,200,000 – P960,000 = P240,000
Margin of safety Margin of safety in pesos P240,000
percentage = Total sales = P1,200,000 = 20%

Requirement 6
Contribution margin P300,000
a. Degree of operating leverage = Net operating income = = 5
P60,000

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b. Expected increase in sales.................................................. 8%

Degree of operating leverage.............................................. x 5
Expected increase in net operating income........................ 40%

c. If sales increase by 8%, then 21,600 units (20,000 x 1.08 = 21,600) will be sold next year. The new
income statement will be as follows:
Percent of
Total Per Unit Sales
Sales (21,600 units)............... P1,296,000 P60 100%
Less variable expenses........... 972,000 45 75%
Contribution margin.............. 324,000 P15 25%
Less fixed expenses............... 240,000
Net operating income............ P 84,000
Thus, the P84,000 expected net operating income for next year represents a 40% increase over the
P60,000 net operating income earned during the current year:
P84,000 – P60,000 P24,000
P60,000 = P60,000 = 40% increase

Note from the income statement above that the increase in sales from 20,000 to 21,600 units has resulted
in increases in both total sales and total variable expenses. It is a common error to overlook the increase
in variable expense when preparing a projected income statement.

Requirement 7
a. A 20% increase in sales would result in 24,000 units being sold next year: 20,000 units x 1.20 = 24,000
units.
Percent of
Total Per Unit Sales
Sales (24,000 units)............... P1,440,000 P60 100%
Less variable expenses........... 1,152,000 48* 80%
Contribution margin.............. 288,000 P12 20%
Less fixed expenses............... 210,000†
Net operating income............ P 78,000

* P45 + P3 = P48; P48  P60 = 80%.

†
P240,000 – P30,000 = P210,000.
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. Break-even point Fixed expenses

in unit sales = Contribution margin per unit
P210,000
= P12 per unit
= 17,500 units
Break-even point Fixed expenses
in peso sales = CM ratio
P210,000
= 0.20
P1,050,000
=
c. Yes, based on these data the changes should be made. The changes will increase the company’s net
operating income from the present P60,000 to P78,000 per year. Although the changes will 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 will actually be wider than before:

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Margin of safety in pesos = Total sales – Break-even sales

= P1,440,000 – P1,050,000 = P390,000
As shown in requirement (5) above, the company’s present margin of safety is only P240,000. Thus,
several benefits will result from the proposed changes.

Problem 3 (Basics of CVP Analysis; Cost Structure)

Requirement 1

The CM ratio is 30%.

Total Per Unit Percentage
Sales (13,500 units) P270,000 P20 100 %
Less variable expenses 189,000 14 70
Contribution margin P 81,000 P 6 30 %

The break-even point is:

Sales = Variable expenses + Fixed expenses + Profits
P20Q = P14Q + P90,000 + P0
P 6Q = P90,000
Q = P90,000 ÷ P6 per unit
Q = 15,000 units
15,000 units × P20 per unit = P300,000 in sales
Alternative solution:
Break-even point Fixed expenses
in unit sales = Contribution margin per unit
P90,000
= P6 per unit

= 15,000 units
Break-even point Fixed expenses
in sales pesos = CM ratio
P90,000
= 0.30

= P300,000 in sales
Requirement 2
Incremental contribution margin:
P70,000 increased sales × 30% CM ratio.........................................................................
P21,000
Less increased fixed costs:
Increased advertising cost.................................................................................................
8,000
Increase in monthly net operating income............................................................................
P13,000
Since the company presently has a loss of P9,000 per month, if the changes are adopted, the loss will turn into
a profit of P4,000 per month.

Requirement 3
Sales (27,000 units × P18 per unit*).....................................................................................
P486,000
Less variable expenses
(27,000 units × P14 per unit)............................................................................................
378,000
Contribution margin..............................................................................................................
108,000
Less fixed expenses (P90,000 + P35,000)............................................................................
125,000
Net operating loss..................................................................................................................
P(17,000)

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*P20 – (P20 × 0.10) = P18

Requirement 4
Sales = Variable expenses + Fixed expenses + Profits
P 20Q = P14.60Q* + P90,000 + P4,500
P5.40Q = P94,500
Q = P94,500 ÷ P5.40 per unit
Q = 17,500 units
* P14.00 + P0.60 = P14.60.
Alternative solution:
Unit sales to attain Fixed expenses + Target profit
target profit = CM per unit
P90,000 + P4,500
= P5.40 per unit**

= 17,500 units
** P6.00 – P0.60 = P5.40.

Requirement 5
a. The new CM ratio would be:
Per Unit Percentage
Sales P20 100 %
Less variable expenses 7 35
Contribution margin P13 65 %

The new break-even point would be:

Break-even point Fixed expenses
in unit sales = Contribution margin per unit
P208,000
= P13 per unit

= 16,000 units
Break-even point Fixed expenses
in sales pesos = CM ratio
P208,000
= 0.65

= P320,000 in sales
b. Comparative income statements follow:
Not Automated Automated
Total Per Unit % Total Per Unit %
Sales (20,000 units) P400,000 P20 100 P400,000 P20 100
Less variable expenses 280,000 14 70 140,000 7 35
Contribution margin 120,000 P 6 30 260,000 P13 65
Less fixed expenses 90,000 208,000
Net operating income P 30,000 P 52,000

c. Whether or not one would recommend that the company automate its operations depends on how much

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risk he or she is willing to take, and depends heavily 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 30% to 65%). The higher CM ratio means that once the break-
even point is reached, profits will increase more rapidly than at present. If 20,000 units are sold next
month, for example, the higher CM ratio will generate P22,000 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 13,500
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.
Note to the Instructor: Although it is not asked for in the problem, if time permits you may want to
compute the point of indifference between the two alternatives in terms of units sold; i.e., the point where
profits will be the same under either alternative. At this point, total revenue will be the same; hence, we
include only costs in our equation:
Let Q = Point of indifference in units sold
P14Q + P90,000 = P7Q + P208,000
P7Q = P118,000
Q = P118,000 ÷ P7 per unit
Q = 16,857 units (rounded)
If more than 16,857 units are sold, the proposed plan will yield the greatest profit; if less than 16,857 units are
sold, the present plan will yield the greatest profit (or the least loss).

Answer to Test Material 4-1

Requirement 1
The CM ratio is 60%:
Selling price P150 100%
Less variable expenses 60 40
Contribution margin P 90 60%

Requirement 2
Break-even point Fixed expenses
in total sales pesos = CM ratio
P1,800,000
= 0.60

Requirement 3 = P3,000,000 in sales

P450,000 increased sales × 60% CM ratio = P270,000 increased contribution margin. Since fixed costs will
not change, net operating income should also increase by P270,000.

Requirement 4
Contribution margin P2,160,000
a. Degree of operating leverage Net operating income = = 6
P360,000
b. 6 × 15% = 90% increase in net operating income.

Requirement 5
Last Year: Proposed:
28,000 units 42,000 units*

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Total Per Unit Total Per Unit

Sales P4,200,000 P150.00 P5,670,000 P135.00**
Less variable expenses
1,680,000 60.00 2,520,000 60.00
Contribution margin 2,520,000 P 90.00 3,150,000 P 75.00
Less fixed expenses 1,800,000 2,500,000
Net operating income P 720,000 P 650,000
* 28,000 units × 1.5 = 42,000 units
** P150 per unit × 0.90 = P135.00 per unit
No, the changes should not be made.

Requirement 6
Expected total contribution margin:
28,000 units × 200% × P70 per unit*...............................................................................
P3,920,000
Present total contribution margin:
28,000 units × P90 per unit...............................................................................................
2,520,000
Incremental contribution margin, and the amount by which
advertising can be increased with net operating income
remaining unchanged........................................................................................................
P1,400,000
* P150 – (P60 + P20) = P70

Answer to Test Material 4-2

Requirement 1
The contribution margin per patch would be:
Selling price...........................................................................................................................
P30
Less variable expenses:
Purchase cost of the patches.............................................................................................
P15
Commissions to the student salespersons.........................................................................
6 21
Contribution margin..............................................................................................................
P 9
Since there are no fixed costs, the number of unit sales needed to yield the desired P7,200 in profits can be
obtained by dividing the target profit by the unit contribution margin:
Target profit P7,200
Unit contribution margin = P9 per patch = 800 patches

800 patches x P30 per patch = P24,000 in total sales

Requirement 2
Since an order has been placed, there is now a “fixed” cost associated with the purchase price of the patches
(i.e., the patches can’t be returned). For example, an order of 200 patches requires a “fixed” cost (investment)
of P3,000 (200 patches × P15 per patch = P3,000). The variable costs drop to only P6 per patch, and the new
contribution margin per patch becomes:
Selling price...........................................................................................................................
P30
Less variable expenses (commissions only)......................................................................... 6
Contribution margin..............................................................................................................
P24

Since the “fixed” cost of P3,000 must be recovered before Ms. Morales shows any profit, the break-even

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computation would be:

Break-even point Fixed expenses
125 in
patches x P30 per
unit sales = patch
Unit =contribution
P3,750 in total sales
margin
If a quantity other than 200 patches were ordered,
P3,000 the answer would change accordingly.
= P24 per patch = 125 patches

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