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Ch.09 Kinney 9e SM Final.doc-CHAPTER 9 BREAK-EVEN ...
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Page 11
Chapter 9
Racine Tire Co.
Income Statement
For the Month XXX
Sales $60 (20,000; 23,000)
Less variable expense
$30 (20,000; 23,000)
Contribution margin
Less fixed costs
Net income
Sales ($7.20 × 125,000)
$ 900,000
Variable costs ($4.32 × 125,000)
Contribution margin
$ 360,000
Fixed costs
Net income
Break-even point = $316,600 ÷ 0.40
= $791,500 or 109,931 packages
Margin of safety, dollars: $900,000
$791,500 = $108,500
Margin of safety in units: $108,500 ÷ $7.20 = 15,069 packages (rounded)
$4.32) ÷ $7.20 = Contribution margin ratio
$360,000 ÷ $43,400 = 8.295
c.Income will increase by: 8.295 × 30% = 249%
Sales ($7.20 × 125,000 × 1.30)
Variable costs ($4.32 × 125,000 × 1.30)
Contribution margin
Fixed costs
Net income
$43,400) ÷ $43,400 = 249%
Break-even point = ($316,600 + $41,200) ÷ 0.40 = $894,500
Sales ($7.20 × 125,000 × 1.15)
Variable costs ($4.32 × 125,000 × 1.15)
Contribution margin
Fixed costs ($316,600 + $41,200)
Net income
Operating leverage = $414,000 ÷ $56,200 = 7.37
Substantial cost structure implications must be considered in selecting from
the alternative production technologies. Machine-based technologies will tend to
have much higher levels of fixed costs and lower levels of variable costs than
labor-intense technologies. Accordingly, the machine-based technologies will
have higher operating leverage. Having higher operating leverage means that the
firm’s income will be much more sensitive to changes in the level of sales.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.

Page 12
Chapter 9
Because higher operating leverage is associated with higher income sensitivity to
volume changes, high operating leverage is desired if future sales are expected to
be increasing. Higher leverage allows net income to grow at a higher rate as sales
increase. Alternatively, if sales will be decreasing, firms will prefer to have low
operating leverage because costs will tend to fall more rapidly as sales diminish.
With high operating leverage, costs will remain more constant as sales drop
causing net income to drop very rapidly.
In an ideal world, one would desire to have a very low level of fixed costs below
the break-even point and only fixed costs above the break-even point. If the cost
structure contained only fixed costs, then each dollar of revenue above the break-
even point would generate a dollar of income before profit. CVP analysis is useful
to determine when a firm should consider trading variable costs for fixed costs in
order to shift the cost structure from more variable to more fixed, or vice versa.
For a given level of sales, a company with mostly variable costs will have a higher
margin of safety than a similar firm with mostly fixed costs. If a firm had only
variable costs, its sales could fall to zero without causing the firm to incur a loss.
Consequently, its break-even point is zero. The firm with a high level of fixed
costs would have a much higher break-even point.
An issue in the use of CVP analysis is that CVP analysis requires costs to be
classified as either variable or fixed. The outcome of CVP analysis is sensitive to
variations in this classification. In making decisions that rely on CVP analyses, it
is important to be mindful of the requirement to dichotomize costs between these
two categories (fixed and variable). Further, it is important to recognize that in the
long term, all costs are variable. A problem arises when short-term decisions have
long-term consequences. In this circumstance, costs will have been incorrectly
considered in the CVP analysis because too many of the costs would have been
classified as fixed. Accordingly, the greatest potential for problems arises in
situations in which a long-term decision is made on the basis of a short-term
classification of costs. A final observation is that CVP decisions are made in an
incremental fashion. This means that each decision is made independently of all
other decisions. The reality is that past decisions affect future decisions and short-
term decisions can affect long-term decisions.
CVP analysis can be used in long-, medium-, and short-term decision making. The
key is to use a classification of costs that is appropriate for the time horizon. For
longer-term decisions, newer cost control technologies such as activity-based
costing can be used to determine which costs are likely to vary with decision
alternatives being considered. By relating the cost drivers to the decision at hand,
managers can determine which costs are likely to be affected, and by how much,
by the decision being made.
Each “bag” contains one unit of liquid and two units of spray. Thus, each bag
generates contribution margin of: (1 × $10) + (2 × $5) = $20.
The break-even point would be: $100,000 ÷ $20 = 5,000 bags. Since each bag
contains two units of spray, at the break-even point 5,000 × 2 or 10,000 units of
spray must be sold.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.

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