Module 7 Cost Volume Profit

Q2. Explain why the contribution margin produces profit when an entity sells goods above the break-even point.

The contribution margin is sales revenue (or selling price per unit) less total variable costs
(or variable cost per unit). Therefore, once sales are above break-even point, all fixed costs
are covered and each unit sold beyond this point produces profit equal to the contribution
margin, as by definition the variable costs are also covered.

Q4. If the fixed associated with a product increase while the variable costs and the selling price per unit remain constant,
briefly explain what will happen to:
a. Contribution margin
b. break-even point

As the selling price and variable cost per unit do not change, the contribution margin per
unit will also remain unchanged. However, with an increase in total fixed costs, the break-
even point in sales units (or sales dollars) will increase. For example, if the firm has a
contribution margin of $5.00 per unit and total fixed costs of $100 000, the break- even
point will be 20 000 units (i.e. 20 000 units = $100 000 ÷ $5.00). If total fixed costs increase
to $150 000, the break-even point will increase to 30 000 units (i.e. 30 000 units = $150 000
÷ $5.00).

Q5. In undertaking CVP analysis, several important assumptions must be made. Identify and briefly explain two such
assumptions.

1 Cost-volume-profit (CVP) analysis is based on a number of simplifying assumptions:

• Selling prices per unit do not change (i.e., total revenue is linear). For example, if
a firm’s sales volume increases by 10 per cent, total sales revenue will also
increase by 10 per cent.
• Total fixed costs and variable costs per unit are constant. The combined effect of this cost
behaviour assumption is that total costs are assumed to be linear over the relevant range
where total fixed costs do not change but total variable costs change in direct proportion with
changes in sales volumes.
• Production activity matches sales demand (i.e. there is no inventory used to absorb and
balance out period to period differences in production and sales volumes).
• Uncertainty in costs estimates and the categorisation of a particular cost as being fixed
and/or variable are immaterial and are viewed as not having a significant impact on CVP
analysis.

Problem 3 With a sales figure of $500,000, Fidget Ltd achieves the budgeted break-even point for widget sales. Fixed
costs are $200,000 per annum.

a) A. What is the contribution margin in total and as a ratio?

b) B. If variable costs are $6 per widget, what is the selling price?

c) If 55,000 widgets are sold, calculate the profit/loss.

1 Fidget Ltd.
a If break-even sales are $500 000 for Fidget Ltd and total fixed costs are $200 000,
then the total contribution margin at the break-even point must be $200 000 (i.e. at
breakeven, the total contribution margin = total fixed costs).
If the sales revenue and contribution margin at the break-even points are $500
000 and $200 000 respectively, then total variable costs at the break-even point
= Sales revenue – contribution margin.
= $500 000 – $200 000.
= $300 000.
b If variable costs are $6 per widget and total variable costs are $300 000 at the
break-even point, then the number of widgets sold at break-even
= $300 000 ÷ $6.00.
= 50 000 widgets.
If the total sales revenue at the break-even point of 50 000 widgets is $500
000, then selling price must be
= $500 000 ÷ 50 000 widgets.
= $10.00 per widget.
If the total contribution margin at the break-even point of 50 000 widgets is
$200 000, then then the contribution margin per widget must be
= $200 000 ÷ 50 000 widgets.
= $4.00 per unit.
c If 55 000 units are sold, Fidget Ltd will be selling 5000 widgets above the break-
even point of 50 000 widgets. Thus, Fidget Ltd will generate a profit margin
calculated as follows:
= (Actual sales – Break-even sales) x contribution margin per unit
= (55 000 widgets – 50 000 widgets) x $4.00
= 5000 widgets x $4.00 per widget.
= $20,000.
Proof: Profit at sales of 55 000 widgets.
Per widget Sales of 55 000
widgets
Selling revenue $10 $550 000
Variable costs ($6) ($330 000)
Contribution margin $4 $220 000
Total fixed costs ($200 000)
Net profit $20 000
Problem 6 Cleaner Homes 4U offers cleaning services for households. The company has budgeted fixed costs of $3000
per month for office rent, advertising and a receptionist. Variable expenses for the cleaner’s wages and cleaning supplies
are $100 per average job. Cleaner Homes charges $150 for the average job.

• A. How many jobs must Cleaner Homes average each month to break even?

• B. What is the net profit for Cleaner Homes in a month with 90 jobs? With 100 jobs?

• C. Suppose that Cleaner Homes decides to increase the price to $175 per average job. What is the new break-
even point in the number of jobs per month?

2 Cleaner Homes 4U.

a If variable costs are $100.00 per job and the price per cleaning job is $150.00,
then the contribution margin would be calculated as follows:
= Cleaning fee per job – variable cost per job
= $150.00 – $100.00.
= $50.00 per cleaning job.
Noting that total fixed costs are $3 000 per month, break-even point for
Cleaner Homes 4U will be calculated as follows:
= Total fixed costs ÷ contribution margin per job.
= $3 000÷ $50.00 per job.
= 60 jobs per month.
b If 90 jobs are performed, Cleaner Homes 4U will be providing 30 jobs above the
break-even point of 60 jobs. Thus, Cleaner Homes 4Uwill generate a profit
calculated as follows:
 = (Actual sales – Break-even sales) x contribution margin per job.
= (90 jobs – 60 jobs) x $50.00 per job.
= 30 jobs x $50.00 per job.
= $1 500.
Proof: Profit at with 90 jobs provided per month.

Per job Provision of 90

jobs
Selling revenue $150 $13 500
Variable costs ($100) $9 000)
Contribution margin $50 $4 500
Total fixed costs ($3 000)
Net profit $1 500

If 100 jobs are performed, Cleaner Homes 4U will be providing 40 jobs more
the break-even point of 60 jobs. Thus, Cleaner Homes 4U will earn a profit
calculated as follows:
= (Actual sales – Break-even sales) x contribution margin per job.
= (100 jobs – 60 jobs) x $50.00 per job.
= 40 jobs x $50.00 per job.
= $2 000

Proof: Profit with 100 jobs provided per month.

Per job Provision of 100

jobs
Selling revenue $150 $15 000
Variable costs ($100) $10 000)
Contribution margin $50 $5 000
Total fixed costs ($3 000)
Net profit $2 000
 c If variable costs remain at $100.00 per job but the price per cleaning job is
increased to $175.00, then the contribution margin would be calculated as
follows:
= Cleaning fee per job – variable cost per job
= $175.00 – $100.00.
= $75.00 per cleaning job.
Noting that total fixed costs are assumed to remain unchanged at $3 000 per
month, the new break-even point for Cleaner Homes 4U will be calculated as
follows:
= Total fixed costs ÷ contribution margin per job.
= $3 000 ÷ $75.00 per job.
= 40 jobs per month.

Problem 10 The threadbare Clothing Company has to decide whether to produce trousers or skirts. The manager knows
that the demand for trousers is 1200 per month at a selling price of $45 each and the demand for skirts is 800 at $45
each. Costs of production are as follows:

1 The Threadbare Clothing Company.

Trousers Skirts
Variable costs per unit
Direct materials $15.00 $21.00
Direct labour
Trousers 0.75 DLH x $30.00 $22.50
Skirts 0.50 DLH x $30.00 $15.00
Selling costs $0.50 $1.00
Total variable costs $38.00 $37.00
Selling price per unit $45.00 $45.00
Contribution margin per unit $7.00 $8.00
Known sales demand in units 1 200 800
Total contribution margin $8 400 $6 400
Total fixed costs
Monthly rent ($550) ($550)
Administration costs ($1,000) ($1,000)
Plant depreciation ($120) ($120)
Total fixed costs ($1,670) ($1,670)
Profit per product line $6 730 $4 730

Noting that total fixed costs for the trousers product line are $1670, the break-even point
for trousers will be calculated as follows:
= Total fixed costs ÷ contribution margin per pair of trousers.
= $1670 ÷ $7.00 per pair of trousers.
= 238.57 (say, 239) pairs of trousers.
 Noting that total fixed costs for the skirts’ product line are $1670, the break-even point
for will be calculated as follows:
= Total fixed costs ÷ contribution margin per skirt.
= $1670 ÷ $8.00 per skirt.
= 208.75 (say, 209) skirts.
Threadbare Clothing Company makes a higher profit of $2 000 (i.e. $2 000 = $6 730 –
$4 730) by selling trousers and, even though trousers have a higher break-even of 30
pairs than skirts, it is recommended the clothing company should produce trousers.

Problem 10 – Extension;

By how much would the selling price per skirt have to increase to for The Threadbare
Clothing Company would be indifferent to whether it sold trousers or skirts? Assume
that the demand for skirts remains unchanged at 800 units.
As the difference in profits is $2 000 in favour of trousers, the price per skirt with a
demand of 800 units would need to increase by $2.50 (i.e. $2.50 = $2 000 ÷ 800 units).
Thus, if 800 skirts could be made and sold for $47.50 (i.e. $47.50 = $45.00 + $2.50),
then The Threadbare Clothing Company would be indifferent as to whether it sold
trousers or skirts.

Problem 13 DEF Ltd produces digital radios and sells these for $250 each. The company can produce a maximum of 5000
units per year. Variable costs are $185 per unit and fixed costs are $243 750 per year, regardless of production.

A. Calculate the break-even point

B. what is the profit for the company if it sells 5000 units?

C. The company believes it can sell more units if it leases additional equipment. The lease costs are $195,000 a year and
the company has to give one year’s notice t cancel the lease. Because of the increase production capacity, variable costs
are reduced to $175 per unit. If the maximum number of units the company can produce and sell with the new
equipment is $8100, should the company lease the new equipment?

D. If there is a recession in the audio industry and the company can now sell only 4000 units at $240, should the
company cease producing digital radios? Give reasons for your answer (assume it did not lease additional equipment).

DEF Ltd.
a Break-even point in units and sales dollars.
Details Amounts per unit Percentage
Selling price $250.00 100.00%
Variable costs ($185.00) (74.00%)
Contribution margin $65.00 26.00%

The break-even point in units:

= Total fixed costs ÷ contribution margin per unit.
= $243 750 ÷ $65.00 per unit.
 = 3 750 units.

The break-even point in sales dollars:

= Total fixed costs ÷ contribution margin ratio.
= $243 750 ÷ 0.26.
= $937 500.

Proof: Break-even sales revenue

= $250 x 3 750 units.
= $937 500.

b Profit at sales level = 5000 units.

If 5000 units sold, it will be 1 250 units above the break-even point of 3 750
units (i.e. 1 250 = 5 000 – 3 750). Thus, DEF will generate a profit calculated as
follows:
= (Units sold – Break-even units) x contribution margin per unit.
= (5 000 units – 3 750 units) x $65 per unit.
= 1 250 units x $65.00 per unit.
= $81 250.

Proof: Profit with 5000 units sold

Per unit 5000 units sold

Sales revenue $250.00 $1 250 000
Variable costs ($185.00) ($925 000)
Contribution margin $65.00 $325 000
Total fixed costs ($243 750)
Net profit $81 250

c Lease additional equipment.

Fixed costs increased by $195 000 to $438 750 (i.e. $438 750 = $243 750+
$195 000). With the new equipment, variable costs will be reduced by $10.00 to
$175.00 per unit and the contribution margin will increase to $75.00 per unit (i.e.
$85.00 = $250.00 – $175.00). Thus, the break-even point with the lease of the
new equipment would be calculated as follows:
= Total fixed costs ÷ contribution margin per unit.
= $438 750 ÷ $75.00 per unit.
= 5 850 units.
 If monthly sales are estimated to rise to 8 100 units with the lease of the new
equipment, the annual profit would be calculated as follows:
= (Annual sales – Break-even sales) x contribution margin per unit.
= (8100 units – 5 850 units) x $75.00 per unit.
= 2 250 units x $75.00 per unit.
= $168 750.

Proof: Profit for 8100 units sold.

Per unit 8 100 units sold

Sales revenue $250.00 $2 025 000
Variable costs ($175.00) ($1 417 500)
Contribution margin $75.00 $607 500
Total fixed costs ($438 750)
Net profit $168 750

This is a significant increase in profit and provided the predicted sales and cost
estimates are achievable, then DEF Ltd should proceed to lease the new
equipment.

d With the recession in the audio industry, despite reducing prices by $10.00 to
$240.00 per unit, DEF Ltd can only generate annual sales of 4 000 units. Noting
that the new equipment has not been leased, total fixed costs remain at $243 750 .
Furthermore, as variable costs per unit remain at $175.00 per unit, the
contribution margin declines by $10.00 to $55.00 per unit (i.e. $55.00 = $240.00 –
$175.00).

The new break-even point would be calculated as follows:

= Total fixed costs ÷ contribution margin per unit.
= $243 750 ÷ $55.00 per unit.
= 4 431.82 (say, 4 432) units.

If only 4 000 units are sold, DEF Ltd will be operating below the break-even
point of 4 432 units. Thus, DEF Ltd will incur a loss calculated as follows:
= (Actual sales – Break-even sales) x contribution margin per unit.
= (4 000 units – 4 432 units) x $55.00 per unit.
= –432 units x $55.00 per unit.
= ($23 750 ) rounded to say, a loss of $23 760.
 If DEF Ltd continues to produce and sell 4 000 units it obtains a $220 000
contribution (i.e. $220 000 = 4 000 units x $55.00 per unit) towards total fixed
costs and it will incur a loss of $30 000. Stopping production is a major decision
and if total fixed costs continue it would not be a wise decision. DEF Ltd would
only consider stopping production if it avoided more than $220 000 of total fixed
costs and it viewed the recession in the audio industry as being a long-term
phenomenon. The issue requiring greater consideration is the role of total fixed
costs in this decision and the DEF Ltd’s position in the market. If DEF Ltd did
stop production it may lose customers to competitors and it may be difficult for
the company to attract them back.

Problem 15 Einstein Medallions manufactures medals made of rare and precious metals…

Details TY-01 TY-02 TY-03 Totals

Budget sales (units) 5000 3000 2000 10000
Budgeted selling price 400 550 600
Manufacturing costs
Budgeted variable cost per unit 200 300 315
Budgeted total
fixed costs 550000
Non-manufacturing costs
Budgeted variable cost per unit 40 50 60
budgeted total fixed costs 190000

Capacity 10000

Part a Calculate the sale mix percentage (%) where the budgeted sales in units are as follows: TY-
01, 5000 units; TY-02, 3000 units; and TY-03, 2000 units.
Part b. Calculate the contribution margin for each unit for each of the three Platinum medal
models: TY-01, TY-02 and TY-03.
Part c. calculate the budgeted weighted average contribution margin per unit for the Platinum
medal product line.
Part d. Calculate the budgeted break-even point in units for the Platinum medal model product
line and for each of the individual product lines.
Part e. Calculate the budgeted margin of safety in total units for the Platinum Medal Production
line.

a Sales mix percentage (%) for TY-01, TY-02 and TY-03.

Sales mix percentages TY-01 TY-02 TY-03 Totals

Budgeted sales in units 5 000 3 000 2 000 10 000
 5 000 3 000 2 000
Sales mix
10 000 10 000 10 000

50.00% 30.00% 20.00% 100.00%

b Contribution margin per unit for TY-01, TY-02 and TY-03.

Contribution margin TY-01 TY-02 TY-03

Budgeted selling price per unit $400 $550 $600
Budgeted variable costs per unit
Manufacturing cost ($200) ($300) ($315)
Non-manufacturing cost ($40) ($50) ($60)
Total variable costs ($240) ($350) ($375)
Contribution margin per unit $160 $200 $225

c Budgeted weighted average contribution margin per unit.

Weighted average
TY-01 TY-02 TY-03
contribution margin (WACM)
Contribution margin per unit $160 $200 $225
Sales mix percentage 50.00% 30.00% 20.00% 100.00%
Weighted average contribution
margin $80 $60 $45 $185
 d Budgeted breakeven point in units for the Platinum medal
model product line and each individual model.

Overall budgeted breakeven point in units Total

Budgeted total fixed costs
Manufacturing cost ($550 000)
Non-manufacturing cost ($190 000)
Total fixed costs ($740 000)
Overall breakeven point in units
$740 000
Total fixed costs ÷ WACM
$185

4 000

TY-01 TY-02 TY-03

Breakeven point all models
Overall breakeven point 4 000 4 000 4 000
Sales mix % 50.00% 30.00% 20.00% 100.00%
2 000 1 200 800 4 000

e Budgeted margin of safety in total units for the Platinum Medal Production line.

Budgeted margin of safety in = Budgeted sales in units – Overall budgeted breakeven

total units point in units
= 10 000 units – 4 000 units
= 6 000 units