Cost-Volume-Profit Relationships (Exercises with Answers)

Cost-Volume-Profit Relationships Candice Corporation has decided to introduce a new product. The product can be manufactured using either a capital-intensive or labor-intensive method. The manufacturing method will not affect the quality or sales of the product. The estimated manufacturing costs of the two methods are as follows:   Capital-Intensive Labor-Intensive Variable manufacturing cost per unit....... $14.00 $17.60 Fixed manufacturing cost per year........ $2,440,000 $1,320,000 The company's market research department has recommended an introductory selling price of $30 per unit for the new product. The annual fixed selling and administrative expenses of the new product are $500,000. The variable selling and administrative expenses are $2 per unit regardless of how the new product is manufactured.   Required: a. Calculate the break-even point in units if Candice Corporation uses the: 1. capital-intensive manufacturing method. 2. labor-intensive manufacturing method. b. Determine the unit sales volume at which the net operating income is the same for the two manufacturing methods. c. Assuming sales of 250,000 units, what is the degree of operating leverage if the company uses the: 1. capital-intensive manufacturing method. 2. labor-intensive manufacturing method. d. What is your recommendation to management concerning which manufacturing method should be used?   Cost-Volume-Profit Relationships Capital Labor S 30 VC 14+2=16 CM 14 FC 2,440,000 + 500,000 = 2,940,000 NI a) BE Units: FC / CM/unit 2,940,000 / 14 = 210,000 BE units 1,820,000 / 10.40 = 175,000 BE units b) Indifference point: Q = Unit sales volume (quantity) (14 * Q - 2,940,000) = (10.40 * Q - 1,820,000) 360 Q = 1,120,000 Q = 311,111 unit sales c) DOL @ 250,000 unit sales: CM / NI 250,000 units * 14 = $3,500,000 250,000 units * 10.40 = $2,600,000 ($3,500,000 - $2,940,000) / $560,000 = 16.25 DOL (Capital-Intensive) ($2,600,000 - $1,820,000) / $780,000 = 3.33 DOL (Labor-Intensive) d) Recommendation: Capital-intensive is preferred with higher DOL assuming at least 311,111 unit sales can be achieved. a. Capital-intensive: Unit sales to break even = Fixed expenses / Unit CM = ($2,440,000 + $500,000) / ($30 per unit - $14 per unit - $2 per unit) = $2,940,000 / $14 per unit = 210,000 units   2. Labor-intensive: Unit sales to break even = Fixed expenses / Unit CM = ($1,320,000 + $500,000) / ($30 per unit - $17.60 per unit - $2 per unit) = $1,820,000 / $10.40 per unit = 175,000 units   b. Profit = Sales - Variable expenses - Fixed expenses Capital-intensive: Profit = $30Q - $16Q - $2,940,000 = $14Q - $2,940,000 Labor-intensive: Profit = $30Q - $19.60Q - $1,820,000 = $10.40Q - $1,820,000 The profits are equal when: $14Q - $2,940,000 = $10.40Q - $1,820,000 $3.60Q = $1,120,000 Q = $1,120,000 / $3.60   Q = 311,111 units c. 1. Capital-intensive: Sales (250,000 units * $30 per unit) = $7,500,000 Variable expenses (250,000 units * $16 per unit) = 4,000,000 Contribution margin = 3,500,000 Fixed expenses = 2,940,000 Net operating income = $560,000 Degree of operating leverage = Contribution margin / Net operating income = $3,500,000 / $560,000 = 6.25 2. Labor-intensive: Sales (250,000 units * $30 per unit) = $7,500,000 Variable expenses (250,000 units * $19.60 per unit) = 4,900,000 Contribution margin = 2,600,000 Fixed expenses = 1,820,000 Net operating income = $780,000 Degree of operating leverage = Contribution margin / Net operating income = $2,600,000 / $780,000 = 3.33 d. The decision hinges upon the expected sales of the new product. If management is confident that sales will be in excess of 311,111 units, then the capital-intensive method should be used. If sales are likely to fall below this number, then the labor-intensive method should be used. Management should also be aware that net operating income will be more volatile with the capital-intensive method since it has higher operating leverage.   Learning Objectives:   03-01 Explain how changes in activity affect contribution margin and net operating income. 03-04 Show the effects on net operating income of changes in variable costs, fixed costs, selling price, and volume. 03-06 Determine the break-even point. 03-08 Compute the degree of operating leverage at a particular level of sales and explain how it can be used to predict changes in net operating income.   206. In September, Pino Corporation sold 2,100 units of its only product. Its total sales were $195,300, its total variable expenses were $84,000, and its total fixed expenses were $98,700. Required: a. Construct the company's contribution format income statement for September in good form.   b. Redo the company's contribution format income statement assuming that the company sells 2,300 units.   Contribution Format Income Statement