ReadingsHealth Care Reform and Future PossibilitiesIntroduct.docx

Readings
Health Care Reform and Future Possibilities
Introduction
Health care has undergone episodes of major change since the
introduction of Medicare in the 1960s. All of these have
resulted in fundamental changes in how health care providers
were paid for services to Medicare patients and were swiftly
followed by matching changes from independent insurance
companies. The latest, and some might say the biggest, change
since diagnosis-related groups (DRGs) were introduced in 1983
is the signing into law of the Patient Protection and Affordable
Care Act (PPACA), on March 23, 2010. This law proposes to
change the delivery of health care services by changing how
providers are paid and what they are paid for. This module
explores some of the key elements of PPACA and how health
care providers are planning their changes in delivery processes
and systems in response.
Major Elements of PPACA
The most significant elements of the PPACA legislation are
scheduled to take place over several years. Congress still has
the ability to modify some of these elements, so we will
examine them with that in mind.
June 2010
Adults with pre-existing conditions were eligible to join a
temporary high-risk insurance pool run by the federal
government. This will be replaced by a health care exchange in
2014, which will provide access to insurance at affordable rates.
Applicants must have a pre-existing health care condition and
have been uninsured in the six months prior to application.
Premiums will be set at rates for the general population rather
than the high-risk premiums charged by insurance companies.
Out-of-pocket costs will be limited to $5,950 for individuals
and $11,900 for families.

July 2010
The government established the National Prevention, Health
Promotion, and Public Health Council, with the Surgeon
General to act as chair of the council. This council will oversee
the implementation of many of the PPACA elements and will
disseminate recommendations to the health care community at
large in regard to best practices in prevention and health
promotion. As of fall 2010, little had yet been heard from this
entity. However, the National Committee on Quality Assurance,
which is a private entity dedicated to improving the quality of
health care services, is providing best practices and quality
measures for health care providers, especially hospitals.
September 2010
Insurance companies can no longer apply lifetime dollar limits
on essential benefits for patients. In addition, children may be
covered under their parents' insurance plan until they turn 26
years of age. This includes children not living at home, not
listed as dependents on their parents' tax returns, not students,
and children who are married. Further, no patients under 19
years of age with pre-existing conditions can be excluded from
health care benefits based on the pre-existing conditions, and
there can be no deductibles or copayments required for
provision of preventive care measures and medical screening
activities for new health insurance plans. However, these may
still apply to existing or grandfathered plans. There was a one-
time payment of $250 to seniors on Medicare Part D to cover
part of the pharmacologic payment gap in 2010. Insurance
companies can no longer drop people from coverage if they
become ill, and Medicare patients with chronic illnesses are to
be monitored and evaluated every three months for coverage of
medications prescribed to treat those illnesses.
January 2011
Insurance companies were be required to spend 85% of the
premiums taken in for large groups and 80% of premiums for
small groups and individuals on health care services or
improvement of quality, not administrative services.

January 2012
Employers must disclose the value of the benefits they provide
for each employee's health coverage on Form W-2.
January 2013
People who are self-employed and individuals making more
than $200,000 per year are subject to an additional tax of 0.5%
to assist in reducing the overall costs of health care reform.
January 2014
Insurers cannot discriminate or charge higher rates for patients
based on pre-existing conditions, and Medicaid eligibility will
be expanded to include people with incomes up to 133% of the
federal poverty level. There will be two years of tax credits
provided to small businesses that provide health insurance to
employees, in order to partially offset those costs. Financial
penalties will be applied to employers with more than 750
employees if they do not provide health insurance as a benefit.
Annual deductible costs will be capped at $2,000 for individuals
and $4,000 for other plans, while individuals who do not obtain
health insurance will be required to pay an annual penalty of
$95 or 1% of their income. Health insurance exchanges will be
set up to enable individuals to shop for insurance.
There are other components in the legislation, but these are the
key ones. The implications for the legislation have several
points for consideration:
What is the cost to operate this new system? Medicare
is still proposing a fee-for-service payment methodology, with a
shared savings bonus for health care providers who meet certain
requirements. Will this be successful in reducing overall health
care costs in the system? Medicare is already exploring other
payment options, including the possibility of capitated
payments in some areas. The current model will continue to
provide payments for procedures and activities rather than the
total shift to care management that capitation would require.
With more people obtaining insurance, what will
happen to demand for access to care? In Massachusetts, a model
similar to the federal model of PPACA has been in place for

several years. Massachusetts experienced a significant increase
in demand for care, resulting in longer waiting times to get
appointments with physicians and increased demand for hospital
services. With primary care physicians graduating in lower
numbers, the access to these physicians may become more
difficult as more people obtain insurance and increase their
demand for services.
As components of the system switch to payments for
keeping people healthy, the demand for procedures may lessen.
However, healthy lifestyles require significant changes in
behavior, as anyone who has tried to lose weight or stop
smoking can attest, and it is still questionable whether the
population as a whole is ready to make those changes.
A highly controversial part of the PPACA legislation
is the requirement to have insurance or pay a penalty. Younger,
healthy adults have made the argument that they do not see a
need to have health insurance or to pay for it. However,
insurance companies need a large number of the people they
insure to have a basis of good health in order to offset the
higher costs to provide care for less healthy individuals. The
requirement to force all citizens to obtain health insurance is
very contentious and may not survive in legislation to 2014.
However, failure to enforce this will result in continued higher
costs for hospitals, which are mandated to provide care
regardless of ability to pay.
Responses of Health Care Providers
What are the health care providers in the system doing to
respond to and prepare for the changes the new legislation is
imposing?
New models of care are emerging. The concept of the
Accountable Care Organization (ACO) is being tested at various
sites across the country. ACOs are systems of health care
delivery that include participants across the continuum of care,
including primary care physicians, hospitals, specialists, post-
acute care facilities, home health, and disease management
clinics, among others. These providers are linked into a system

of care that is tied together by an electronic health record,
standardized protocols of care, a focus on management of care,
case/disease management standards, reduced costs, and
measurement and monitoring of quality outcomes and
indicators. The formation of these ACOs is a huge undertaking,
requiring major changes in current operations and systems
between existing entities. Hospitals and physicians will be
required to align in their approaches to care, their management
of system costs, and their share of revenue. ACOs are likely to
see global or bundled payments from payors for an episode of
care. In this payment method, a total payment for all services is
made to the ACO for a patient's episode of care (which can be
defined in several ways), and the ACO will determine which
provider gets what amount of the total payment for the services
they rendered. The complexity of this can be appreciated when
one understands that this requires the hospital, post-acute care
facility, and all physicians to agree on the distribution of
payment.
Another new model of care that may operate under the
ACO or as a stand-alone is the medical home concept. In this,
patients select a primary care physician who assesses their
health needs, coordinates the care needed by the patient among
a range of providers, and monitors their outcomes and the
quality of the care. The role of the primary care physician takes
on a greater importance than in the existing system. This is
different than a gatekeeper model, where the permission of the
primary care provider was required before patients could access
other services. The role in this model is more collaborative and
coordinative, ensuring that patients get the care they need in
order to achieve the outcomes desired and to maintain health.
Physicians are moving toward being employed by
hospitals and health systems. Many physicians are looking at
the reductions in reimbursement being imposed by Medicare on
Part B payments and the impacts on their ability to maintain
their income. The outcome of this is, in many cases, compelling
physicians to approach their local hospitals and explore

employment rather than independent practice. The trade-off is
the security of a salary and benefits without the headaches of
billing and collections and the costs of operating the practice.
For the hospitals, the advantage is to have access to that
physician's pool of patients when they need care. The trick is to
find a way to manage employed physicians' practices without
suffering significant financial losses. An interesting concept for
this that is gaining considerable traction is the rise of midlevel
providers in practices, including nurse practitioners and
physician assistants.
Primary care physicians are the key to the future in an
ACO. The foundation of an ACO will be the pool of patients it
manages, and the key to that is a large, competent, high-quality
base of primary care physicians to establish some variety of the
medical home and attract large groups of patients to it. The
Centers for Medicare and Medicaid Services (CMS) is already
pushing this by reducing the payments going to specialists while
increasing the percentages of payments going to primary care
physicians. CMS is also beginning to compensate primary care
physicians for managing care outside the hospital and promoting
health assessments and preventive activities, such as cholesterol
screens, diabetes monitoring through hemoglobin A1C testing,
and regular blood pressure monitoring, among others. ACOs are
experimenting with chronic disease management clinics and
protocols as a method of keeping patients healthier and out of
the hospital. These may be based in primary care practices.
The role of the hospital will change in this model.
Hospitals have traditionally been a revenue generator for a
health care system in the world of payment for procedures. High
occupancy rates by patients needing surgery or other procedures
have long been an effective strategy for making money. In the
new system, however, as the payment methodologies begin to
shift to payment for prevention and maintaining health and to
capitated methods, the hospital will become a cost center and a
location of last resource. Efforts will be made to do more
procedures on an outpatient basis, such as minimally invasive

surgeries and outpatient imaging studies, rather than do them
during a hospital admission. Hospitals will be pushed to reduce
costs of care, by standardizing care protocols with groups of
physicians, negotiating supply cost reductions on a large scale,
and actively case managing inpatients to reduce length of stay.
Elective surgeries may begin their process weeks in advance, as
discharge planning and postoperative care issues are planned
prior to hospitalization. The use of post-acute care facilities to
provide post-procedure care may well be expanded, and patients
formerly staying four days in a hospital may find themselves
transferred to a lower level of care within two days. The
insurance companies are beginning to refer to this reduction in
hospital usage as "demand destruction," or the attempt to
destroy/reduce demand for high-acuity/high-cost services. The
implications for specialists whose practices are built around
hospitalized patients are obvious and frightening for those
looking ahead.
Conclusion
The advent of change of this magnitude to the health care
delivery system is both frightening and intriguing. No one with
knowledge of the current system would deny that it is
fundamentally broken in many ways, with costs growing
exponentially and care outcomes frequently less than desired.
Access to care is limited or absent for a large number of the
population, and the focus on pay for procedures assures that
costs will continue to climb. The question is whether the new
legislation will actually reduce costs in meaningful ways while
maintaining or improving quality of outcomes and higher
maintenance of people's health. One thing is for certain: the
changes over the next decade will be challenging, and the final
outcome is yet to be determined.
Assignment
1) Use your critical thinking skills to write a paper of 1,000
words that responds to the question, "Is the PPACA legislation
an improvement or a liability to our health care delivery

system?" Use examples to illustrate your points and include
pros and cons of the changes.
2) Refer to the assigned readings to incorporate specific
examples and details into your paper
PPACA: Patient Protection and Affordable Care Act
120 C h a p t e r 6 : C o s t – V o l u m e – P r o f i t A n a l y
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Introduction
Some of the more important decisions managers make involve
analyzing the relationships among the cost, volume, and profit-
ability of products produced and services provided by a
company.
Cost– volume–profit (CVP) analysis focuses on the
relationships among
the following five factors and the overall profitability of a
company:
1. The prices of products or services
2. The volume of products or services produced and sold
3. The per-unit variable costs
4. The total fixed costs
5. The mix of products or services produced
As in any form of analysis involving projections of the future,
certain
assumptions must be considered. The major assumptions are as
follows:
1. The selling price is constant throughout the entire relevant

range. In other words, we
assume that the sales price of the product will not change as the
volume changes.
2. Costs are linear throughout the relevant range. As discussed
in Chapter 5, although
costs may behave in a curvilinear fashion, they can often be
approximated by a linear
relationship between cost and volume within the relevant range.
3. The sales mix used to calculate the weighted-average
contribution margin is constant.
4. The amount of inventory is constant. In other words, the
number of units produced is equal to the number of units sold.
Although some of these assumptions are often vio-
lated in real business settings, the violations are usually
minor and have little or no impact on management deci-
sions. CVP analysis can still be considered valid and very
useful in decision making.
Cost–Volume–Profit
Analysis
Learning Objectives
After studying the material in this chapter,
you should be able to:
LO1 Use the contribution margin in its
various forms to determine the impact of
changes in sales on income.
LO2 Analyze what-if decisions by using
CVP analysis.

LO3 Compute a company’s break-
even point in single- and multiproduct
environments.
LO4 Analyze target profit before and
after the impact of income tax.
LO5 Compute a company’s operating
leverage and understand the relationship
of leverage to cost structure.
Cost–volume–profit
(CVP) analysis A tool that
focuses on the relationships among
a company’s profits and (1) the prices
of products or services, (2) the volume of
products or services, (3) the per-unit variable
costs, (4) the total fixed costs, and (5) the mix
of products or services produced.
ACCT
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9781305323339, Managerial ACCT2, Second Edition,
Sawyers/Jackson/Jenkins - © Cengage Learning. All rights
reserved. No distribution allowed without express authorization.
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LO1 The Contribution Margin and Its Uses
A s mentioned in Chapter 5, the traditional income statement
required for external financial reporting focuses on function
(product costs versus period costs) in calculat-
ing the cost of goods sold and a company’s gross profit. Gross
profit is the difference between
sales and cost of goods sold. However, because cost of goods
sold includes both fixed costs
(facility-level costs, such as rent) and variable costs
(unit-level costs, such as direct materials), the behavior
of cost of goods sold and gross profit is difficult to pre-
dict when production increases or decreases.
Gross profit The difference
between sales and cost of goods sold.
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The contribution margin
income statement is
structured to emphasize
cost behavior as opposed
to cost function.
Blizzard Entertainment and Bioware Corp., is a start-up
company and produces just one game but plans to in-
crease its product line to include more games in the
near future.
A contribution margin income statement for Happy
Daze Game Company follows.
Total Per Unit
Sales (8,000 units) $100,000 $12.50

Less: Variable costs 72,000 9.00
Contribution margin $ 28,000 $ 3.50
Less: Fixed costs 35,000
Net operating income (loss) $ (7,000)
Note that, in addition to the total sales, variable
costs, and contribution margin, per-unit cost information
is also shown in the statement. Happy Daze sells each
game for $12.50, and the variable cost of manufactur-
ing each game is $9.00. As you can see, the contribution
margin per unit is $3.50 and can be found by subtracting
the per-unit variable costs of $9.00 from the per-unit
In contrast, the contribution margin income state-
ment is structured by behavior rather than by function.
In Exhibit 6-1, a traditional income statement and a
contribution margin income statement are shown side
by side so that you can see the difference.
As you can see, although the net income is the same
for both statements, the traditional statement focuses
on the function of the costs, whereas the contribution
margin income statement focuses on the behavior of
the costs. In the traditional income statement, the cost
of goods sold and selling, general, and administrative
(S, G, & A) costs include both variable and fixed costs.
In the contribution margin income statement, costs are
separated by behavior (variable versus fixed) rather
than by function. Note, however, that the contribution
margin income statement combines product and period
costs. Variable costs include both variable product costs
(direct materials) and variable selling, general, and ad-

ministrative costs (commissions on sales), whereas fixed
costs likewise include both product and period costs.
Contribution Margin per Unit
To illustrate the many uses of the contribution margin
income statement in managerial decision making, let’s
look at the income statement of Happy Daze Games.
Happy Daze, unlike large established firms such as
Exhibit 6-1 Comparison of Income Statements
Traditional Contribution Margin
Sales $1,000 Sales $1,000
Less: Cost of goods sold: Less: Variable costs:
Variable costs $350 Manufacturing costs $350
Fixed costs 150 S, G, & A costs 50
Total cost of goods sold 500 Total variable costs 400
Gross profit $ 500 Contribution margin $ 600
Less: S, G, & A costs: Less: Fixed costs:
Variable costs $ 50 Manufacturing costs $150
Fixed costs 250 S, G, & A costs 250
Total S, G, & A costs 300 Total fixed costs 400
Net operating income $ 200 Net operating income $ 200
Contribution margin per unit The sales price
per unit of product, less all variable costs to produce
and sell the unit of product; used to calculate the change in
contribution margin resulting from a change in unit sales.
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123C h a p t e r 6 : C o s t – V o l u m e – P r o f i t A n a l y
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The contribution margin per
unit and the contribution
margin ratio will remain
constant as long as sales
vary in direct proportion to
volume.
Contribution Margin Ratio
The contribution margin income statement can also be
presented in terms of percentages, as shown in the follow-
ing income statement:
Total Percentage
Sales (8,000 units) $100,000 100
Less: Variable costs 72,000 72
Contribution margin $ 28,000 28 ($28,000/$100,000)
Net operating income (loss) $ ( 7,000)

What exactly does this tell us? It tells us that every
game that is sold adds $3.50 to the contribution mar-
gin. Assuming that fixed costs don’t change, net operat-
ing income increases by the same $3.50.
What happens if sales increase by 100 games? Be-
cause we know that the contribution margin is $3.50 per
game, if sales increase by 100 games, net operating income
will increase by $350 ($3.50 × 100). In a similar fashion,
if sales were to decrease by 200 games, then net operating
income would decrease by $700 ($3.50 × −200).
As summarized in Exhibit 6-2, the use of contribu-
tion margin per unit makes it very easy to predict how
both increases and decreases in sales volume affect con-
tribution margin and net income.
Contribution margin (per unit) =
Contribution margin (in $)
Units sold
=
28,000
= $3.50
8,000
Contribution margin ratio =
Contribution margin (in $)
Sales (in $)
Exhibit 6-2 The Impact of Changes in Sales on Contribution
Margin and Net Income

Decreased by Original Increased by
200 units Total 100 units
7,800 units 8,000 units 8,100 units
Sales (sales price, $12.50/unit) $97,500 $100,000 $101,250
Less: Variable costs ($9/unit) 70,200 72,000 72,900
Contribution margin ($3.50/unit) $27,300 $ 28,000 $ 28,350
Less: Fixed costs 35,000 35,000 35,000
Net operating income (loss) $ (7,700) $ (7,000) $ (6,650)
Change in income Decreased by $700 Increased by $350
(200-unit decrease × $3.50) (100-unit increase × $3.50)
The contribution margin ratio can be viewed as
the amount of each sales dollar contributing to the
payment of fixed costs and increasing net operating
profit; that is, 28 cents of each sales dollar contributes
to the payment of fixed costs or increases net income.
sales price of $12.50. The contribution margin per unit
can also be calculated by dividing the contribution mar-
gin (in dollars) by the number of units sold:
The contribution margin ratio is calculated by dividing the
contribution margin in dollars by sales in dollars:
Contribution margin ratio The contribution
margin divided by sales; used to calculate the change in
contribution margin resulting from a dollar change in sales.

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Like the contribution margin per unit, the contribution
margin ratio will remain constant as long as sales vary
in direct proportion to volume.
Like contribution margin per unit, the contribution
margin ratio allows us to very quickly see the impact of
a change in sales on contribution margin and net operat-
ing income. As you saw in Exhibit 6-2, a $1,250 increase
in sales (100 units) will increase contribution margin by
$350 ($1,250 × 28%). Assuming that fixed costs don’t
change, this $350 increase in contribution margin in-
creases net operating income by the same amount. Like-
wise, in Exhibit 6-2, we decreased sales by 200 units
($2,500), resulting in a decrease in contribution margin
and net operating income of $700 ($2,500 × 28%).
LO2 What-If Decisions Using CVP
Continuing with our example, we note that Happy Daze had a
net loss of $7,000 when 8,000 units
were sold. At that level of sales, the total contribution
margin of $28,000 is not sufficient to cover fixed costs

of $35,000. The CEO of the company would like to
consider options to increase net income while main-
taining the high quality of the company’s products.
After consultation with marketing, operations, and
accounting managers, the CEO identifies three options
that she would like to consider in more depth:
1. Reducing the variable costs of manufacturing the
product
2. Increasing sales through a change in the sales
incentive structure or commissions (which would
also increase variable costs)
3. Increasing sales through improved features and
increased advertising
Option 1—Reduce Variable Costs
When variable costs are reduced, the contribution mar-
gin will increase. So the question becomes, What can
be done to reduce the variable costs of manufacturing?
Happy Daze could find a less expensive supplier of raw
materials. The company could also investigate the pos-
sibility of reducing the amount of labor used in the pro-
duction process or of using lower wage employees in
the production process.
In either case, qualitative factors must be consid-
ered. If Happy Daze finds a less expensive supplier of
raw materials, the reliability of the supplier (shipments
may be late, causing downtime) and the quality of the
material (paper products are not as good, adhesive is
not bonding) must be considered. Reducing labor costs
also has both quantitative and qualitative implications.
If less labor is involved in the production process, more
machine time may be needed. Although this option cer-

tainly lowers variable costs, it may also raise fixed costs.
Using lower skilled workers to save money could result
in more defective products, owing to mistakes made by
inexperienced workers. Another possible result of using
fewer workers is that it can adversely affect employee
morale. Being short staffed can cause stress on workers,
owing to the likelihood that they will be overworked.
Happy Daze decides to decrease variable costs by
reducing the costs of direct labor. The operations man-
ager assures the CEO that the change can be made by
outsourcing some of the current production activities.
This change reduces variable costs by 10 percent and,
as shown in the following analysis, results in an overall
increase in net operating income of $7,200:
Impact of Reducing Variable Costs By 10 Percent
Current Option 1
Sales $100,000 $100,000
Less: Variable costs 72,000 64,800
Contribution margin $ 28,000 $ 35,200
Less: Fixed costs 35,000 35,000
Net operating income (loss) $ (7,000) $ 200
Option 2—Increase Sales Incentives
(Commissions)
The CEO of Happy Daze would also like to consider
providing additional sales incentives to motivate the
sales staff in an effort to increase sales volume. The ©

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marketing manager estimates that if Happy Daze raises
the sales commission by 10 percent on all sales above
the present level, sales will increase by $40,000, or
3,200 games. (The additional sales commission will be
$4,000.)
Happy Daze can increase net operating income by
$7,200 by increasing the sales commission by 10 percent
on all sales of more than $100,000. The new variable
costs are calculated by using a variable-cost percentage
of 72 percent on sales up to $100,000 and 82 percent
on all sales of more than $100,000. As you can see in
the following income statement, if sales increase by
$40,000, operating income will increase by $7,200, and
Happy Daze will report net operating income of $200:
Impact of Increasing Sales Incentives
(Sales Increase to $140,000)

Current Option 2
Sales $100,000 $140,000
Contribution margin $ 28,000 $ 35,200
Net operating income (loss) $ (7,000) $ 200
In Option 1 and Option 2, the ultimate change in net
income can be determined by focusing solely on the change
in contribution margin. Fixed costs are not relevant in ei-
ther analysis because they do not vary. However, as you
will see in Option 3, that is not always the case.
Option 3—Change Game Features and
Increase Advertising
Changes can be made to more than one variable at a
time. In fact, changes in cost, price, and volume are never
made in a vacuum and almost always affect one or both
of the other variables. Happy Daze has decided to change
some key features of its game. Although this change will
add $0.25 to the variable cost per game, the market-
ing manager estimates that with additional advertising
of $5,000, sales volume will increase by 40 percent, or
3,200 units. In order to offset some of these costs, the
accounting manager proposes an increase of $0.75 per
unit in the sales price. As shown next, this option in-
creases the contribution margin per unit to $4.00 per
unit. The new sales price per unit is $13.25, and variable
costs increase from $9.00 to $9.25 per unit. The increase
in contribution margin of $16,800 is more than enough

to offset the $5,000 increase in fixed costs and results in
an overall increase of $11,800 in net operating income.
MAKING IT REAL
As consumer spend-ing slowed during the recent recession,
managers and owners of both
large and small companies
employed CVP analysis in an
effort to bolster income. For
example, Drue Sanders, foun-
der of Drue Sanders Custom
Jewelers, created a new line
of jewelry using silver rather
than more costly gold and platinum as the main compo-
nent. This approach allowed the company to sell items for
$150 to $200 rather than the normal $500 and up prices
she normally charged. The result was increased volume
as consumers reacted to the
lower pricing.
In a similar fashion, in
order to lure cost-conscious
customers, PC makers such
as Hewlett-Packard Co. and
Dell shifted their product
lines toward cheaper laptops
and notebooks that sold for
as little as $399. With con-
sumers balking at spending
thousands of dollars on a new computer, offering lower
priced computers with fewer (and less expensive) fea-
tures allowed the companies to continue making sales in
a difficult economy.

Source: “Smart Ways to Cut Prices,” by Diana Ransom, and
“Leaner Laptops, Lower Prices,” by Justin Scheck and Loretta
Chao, The Wall Street Journal, April 22, 2009.
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which volume is increased or decreased in an effort to
find the point at which income is equal to zero.
Break-even analysis is facilitated through the use
of a mathematical equation derived directly from the
contribution margin income statement. Another way to
look at these relationships is to put the income state-
ment into equation form:
Sales − Variable Costs − Fixed Costs = Income
SP(x) − VC(x) − FC = I
where

SP = Sales price per unit
VC = Variable costs per unit
FC = Total fixed costs
I = Income
x = Number of units sold
At the break-even point, income is equal to zero, so
SP(x) − VC(x) − FC = 0
Rearranging and dividing each side by SP − VC, we
find that the number of units (x) that must be sold to
reach the break-even point is
(SP − VC)(x) = FC
and x =
FC
CM
Because the selling price per unit (SP) less variable
costs per unit (VC) is equal to the contribution margin
per unit, by dividing the contribution margin of each
product into the fixed cost, we are calculating the num-
ber of units that must be sold to cover the fixed costs—
the break-even point:
Break-even (units) =
Fixed costs
Contribution margin per unit
At that point, the total contribution margin will be

equal to the fixed cost and net income will be zero.
For example, if Happy Daze has fixed costs of
$35,000 and the contribution margin per unit is $3.50,
the break-even point is computed as follows:
Fixed costs
Contribution margin per unit
= $35,000 ÷ $3.50
= 10,000 units
We can use a similar formula to compute the amount of
sales dollars needed to break even:
Break-even ($) =
Fixed costs
Contribution margin ratio
How well does each option meet the stated objectives
of increasing net operating income while maintaining a
high-quality product? The CEO of Happy Daze should
analyze each alternative solution in the same manner
and choose the best course of action on the basis of
both quantitative and qualitative factors.
From a quantitative perspective, Option 1 results
in an increase in net operating income of $7,200, Option 2
increases net operating income by the same $7,200, and
Option 3 increases net operating income by $11,800. The
CEO must also assess the risk inherent in each option,
including the sensitivity of a decision to make changes
in key assumptions. For example, although Option 1 ap-

pears to have little quantitative risk because the decrease
in costs is known with certainty and no increase in sales is
projected, Happy Daze should consider whether reducing
labor costs in Option 1 will have a negative impact on
the quality of its product. If the reduction in labor costs
results from using lower paid but inadequately skilled
workers, quality may be adversely affected.
LO3 Break-Even Analysis
In addition to considering what-if analysis, it is useful for man
agers to know the number of units sold or
the dollar amount of sales that is necessary for a com-
pany to break even. The break-even point is the level of
sales at which the contribution margin just covers fixed
costs and, consequently, income is equal to zero. Break-
even analysis is really just a variation of CVP analysis in
Break-even point The level of sales at which the
contribution margin just covers fixed costs and income is
equal to zero.
Impact of Changes to Cost, Price, and Volume
Current (8,000 units) Option 3 (11,200 units)
Sales $100,000 ($8,000 × $12.50) $148,400 (11,200 × $13.25)
Less:
Variable costs 72,000 (8,000 × $9.00) 103,600 (11,200 ×
$9.25)
Contribution
margin $ 28,000 (8,000 × $3.50) $ 44,800 (11,200 × $4.00)
Less:

Fixed costs 35,000 40,000
Net operating
income (loss) $ (7,000) $ 4,800
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Using the amounts from the previous example gives
$35,000
Break-even ($) =
28% (see page 123)
= $125,000
Graphically, the break-even point can be found by
comparing a company’s total revenue with its total costs
(both fixed and variable). As shown in Exhibit 6-3, the
break-even point is the volume at which total revenue is
equal to total cost.
Now, assume that Happy Daze adds another game
to its product line. The company estimates that the new
game will achieve sales of approximately 4,500 units.
The expected sales product mix (in units) is therefore
64 percent (8,000 ÷ 12,500) old game and 36 per-
cent (4,500 ÷ 12,500) new game. The new game will
be priced at $15 per unit and requires $11 of variable
production, selling, and administrative costs, so the
contribution margin per unit is $4. The game will also
require an investment of $15,000 in additional fixed
costs. A summary of the price and cost of the old and
new games follows:
Exhibit 6-3 Break-Even Graph
Volume
Loss Area
Break-Even Point

Total Cost
RevenueProfit Area$
A thorough understanding
of fixed and variable costs is
necessary before a manager
can calculate and understand
a break-even analysis.
Break-Even Calculations with
Multiple Products
Break-even calculations become more difficult when
more than one product is produced and sold. In a
multiproduct environment, a manager calculating the
break-even point is concerned not so much with the
unit sales or the dollar sales of a single product but
with the amount of total sales necessary to break even.
This requires the calculation of an “average” contribu-
tion margin for all the products produced and sold.
This calculation in turn requires an estimate of the
sales mix: the relative percentage of total units or total
sales dollars expected from each product.1 However,
customers (and sales volume) will not always behave
in the manner that we predict. For example, although
the expected sales product mix may be 600 units of
Product A and 400 units of Product B, we can estimate
our customers’ buying habits only from past experi-
ence. If the sales product mix ends up being 700 units
of A and 300 units of B, the break-even analysis will
change accordingly.
Happy Daze Game Company
Old Game New Game

(8,000 units) Per Unit (4,500 units) Per Unit
Sales $100,000 $12.50 $67,500 $15.00
Less: Variable costs 72,000 9.00 49,500 11.00
Contribution margin $ 28,000 $ 3.50 $18,000 $ 4.00
Net operating income (loss) $ (7,000) $ 3,000
1Calculating the optimum mix of products to produce given
limited resources and demand
constraints is addressed in Chapter 7. The optimum mix will
result in the highest overall
contribution margin and also the highest overall profit for a
company.
The average contribution margin can be found by
weighting the contribution margins per unit for the
old game and the new game by the relative sales mix
and then summing the products. The weighting is as
follows:
Old game = 0.64 × $3.50 = $2.24
New game = 0.36 × $4.00 = $1.44
The weighted-average contribution margin for
Happy Daze Game Company is therefore $3.68 per game
($2.24 + $1.44). The amount can also be calculated by
dividing the total contribution margin earned by sell-
ing both games ($46,000) by the total number of units
sold (12,500 games) ($46,000 ÷ 12,500 games = $3.68
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per game). The break-even formula for a company with
multiple products is as follows:
Fixed costs
Weighted-average contribution
margin per unit
Happy Daze’s break-even point is therefore 13,587
units ($50,000 ÷ $3.68). How is this number inter-
preted? Remember that the weighted-average contribu-
tion margin is dependent on the sales mix. Likewise, the
break-even point is dependent on the sales mix. Assum-
ing a sales mix of 64 percent old games and 36 percent
new games, Happy Daze must sell 8,696 old games and
4,891 new games to break even:
Old game = 13,587 × 0.64 = 8,696
New game = 13,587 × 0.36 = 4,891
If the sales mix changes to 50 percent old games
and 50 percent new games, what will be the impact on

the break-even point? What if the sales mix changes to
40 percent old games and 60 percent new games? With
the sales mix at 50 percent old and 50 percent new,
the weighted-average contribution margin becomes
$3.75 [(0.50 × $3.50) + (0.50 × $4.00)]. When the
mix changes to 40 percent old and 60 percent new, the
weighted-average contribution margin changes to $3.80
[(0.40 × $3.50) + (0.60 × $4.00)]. Notice that when
the volume shifts toward selling more of the product
with the highest contribution margin, the weighted-
average contribution margin increases. As the weighted-
average contribution margin increases, the break-even
point will decrease.
The break-even point calculated with a weighted-
average contribution margin for multiple products is
valid only for the sales mix used in the calculation. If
the sales mix changes, the break-even point will also
change. The more products involved in the sales mix,
the more sensitive the calculation becomes to changes
in sales mix.
LO4 Target Profit Analysis
(Before and After Tax)
T he goal of most businesses is not to break even but to earn a
profit. Luckily, we can easily modify
the break-even formula to compute the amount of sales
needed to earn a target profit (before tax). Instead of
solving for the sales necessary to earn a net income of
zero, we simply solve for the sales necessary to reach a
target profit:
Sales − Variable costs − Fixed costs = Target profit (before tax)
SP(x) − VC(x) − FC = TP,

where
SP = Sales price per unit
VC = Variable costs per unit
FC = Total fixed costs
TP = Target profit (before tax)
x = Number of units sold
Rearranging and dividing each side by SP − VC, we
find the number of units (x) that must be sold to earn a
before-tax target profit by dividing the sum of the fixed
costs and the target profit by the contribution margin
(CM) per unit:
(SP − VC) (x) = (FC + TP )
x =
[FC + TP (before tax)]
CM
Consequently,
Sales volume (to reach a = [FC + TP (before tax)]
target profit before tax) CM
Happy Daze has decided that it must earn a target
profit of $100,000 on sales of the old game or the
owners will not want to continue their investment in
the business. The question is how many old games
does the company have to sell to earn that amount of
profit?
Sales volume (to reach a

=
($35,000 + $100,000)
target profit before tax) $3.50
= 38,571 units (rounded)
Although Happy Daze must sell only 10,000 old
games to break even, the company must sell 38,571 old
games to reach a before-tax target profit of $100,000.
In fact, once we know that Happy Daze’s break-even
point is 10,000 units, we can directly calculate the
sales necessary to reach a target profit of $100,000
by using the CM per unit. Because each additional
unit sold (above the break-even point) will contribute
$3.50 toward net income, Happy Daze must sell an
additional 28,572 units ($100,000 ÷ $3.50) to earn a
profit of $100,000.
The multiple-product break-even formula can
be modified in a similar fashion to solve for the sales
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necessary to reach a target profit. In a multiple-product
environment,
Sales volume (to reach
=
(Fixed costs + Target profit)
target profit) Weighted-average contribution
margin per unit
The Impact of Taxes
The payment of income taxes also needs to be consid-
ered in the target profit formula. If Happy Daze sells
38,572 games and earns the projected $100,000 in tar-
get profit, the company still won’t have $100,000 in
cash flow to distribute to the owners as dividends, be-
cause it must pay income tax on the profit. If we assume
that the income tax rate for Happy Daze is 35 percent,

the company will have to pay $35,000 in income tax
($100,000 × 35%) and will be left with after-tax profit
of $65,000. The after-tax profit can be found by mul-
tiplying the before-tax profit by (1 − tax rate). Cor-
respondingly, the before-tax profit equals the after-tax
profit divided by (1 − tax rate):
Before-tax profit =
After-tax profit
(1 − tax rate)
If Happy Daze desires to earn an after-tax profit of
$100,000, the company must earn a before-tax profit of
$153,846 (rounded):
Before-tax profit =
$100,000
(1 − 0.35)
= $153,846
Consequently, Happy Daze must sell 53,956 units
of the old game in order to reach a before-tax profit of
$153,846 and an after-tax profit of $100,000:
Sales volume (to reach an
=
($35,000 + $153,846)
after-tax target profit) $3.50
=

53,956 units
This is confirmed in the following income state-
ment for Happy Daze:
Sales (53,956 units) $674,450
Less: Variable costs 485,604
Contribution margin $188,846
Income before taxes $153,846
Less: Income tax @35% 53,846
Net income after tax $100,000
The payment of income taxes
is an important variable in
target profit and other CVP
decisions if managers are to
understand the bottom-line
effect of their decisions.
LO5 Cost Structure and
Operating Leverage
A s mentioned in Chapter 5, cost structure refers to the relative
proportion of fixed and variable costs
in a company. On the one hand, highly automated manu-
facturing companies with large investments in property,
plant, and equipment are likely to have cost structures
dominated by fixed costs. On the other hand, labor-inten-
sive companies such as home builders are likely to have

cost structures dominated by variable costs. Even compa-
nies in the same industry can have very different cost struc-
tures. A company’s cost structure is important because it
directly affects the sensitivity of that company’s profits to
changes in sales volume. Consider, for example, two com-
panies that make the same product (furniture), with the
same sales and same net income. Company A is highly
automated and uses state-of-the-art machinery to design,
cut, and assemble its products. Company B is highly labor
intensive and uses skilled craftspeople to cut and assemble
its products. Contribution margin income statements for
both companies are provided in Exhibit 6-4.
Which company would you prefer to run? Although
you might opt for Company A, with its high level of
Exhibit 6-4 Contribution Margin Ratio and
Operating Leverage
Company A Company B
Sales $200,000 $200,000
Contribution margin $160,000 $120,000
Net operating income $ 80,000 $ 80,000
Contribution margin ratio 80% 60%
Operating leverage 2.0 1.5
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automation and correspondingly higher contribution
margin ratio relative to Company B, consider the impact
of changes in sales volume on the net income of each
company. Although increasing sales will benefit Com-
pany A more than Company B, what happens when
sales decline? If sales decline by 10 percent ($20,000),
the income of Company A will decline by $16,000
($20,000 × 80%), whereas the income of Company B
will decline by $12,000 ($20,000 × 60%).
A company with a cost structure characterized by a
large proportion of fixed costs relative to variable costs
will experience wider fluctuations in net income as sales
increase and decrease than a company with more vari-
able costs in its cost structure.
Operating Leverage
Operating leverage is a measure of the proportion of
fixed costs in a company’s cost structure and is used
as an indicator of how sensitive profit is to
changes in sales volume. A company with
high fixed costs in relation to variable costs
will have a high level of operating leverage.
In this case, net income will be very sensitive

to changes in sales volume. In other words,
a small percentage increase in sales dollars
will result in a large percentage increase in net income. In
contrast, a company with high variable costs in relation to
fixed costs will have a low level of operating leverage and
income will not be as sensitive to changes in sales volume.
Operating leverage is computed with the following formula:
Operating leverage =
Contribution margin
Net operating income
In Exhibit 6-4, Company A has an operating lever-
age of 2.0 ($160,000 ÷ $80,000) whereas Company B
has an operating leverage of 1.5
($120,000 ÷ $80,000). What does this
mean? When sales increase (de-
crease) by a given percentage,
the operating income of Com-
pany A will increase (decrease)
by 2 times that percentage
increase (decrease), whereas the operating income of
Company B will increase (decrease) by 1.5 times the per-
centage change in sales. When sales increase by 10 per-
cent, the operating income of Company A will increase
by 20 percent, or $16,000 ($80,000 × 20%). In other
words, when sales of Company A increase to $220,000,
operating income will increase to $96,000. The operat-
ing income of Company B will increase by 15 percent, or
$12,000 ($80,000 × 15%), to a new operating income
of $92,000. Likewise, when sales decrease by 10 percent,
the operating income of Company A will decrease by
20 percent whereas the operating income of Company B
will decrease by 15 percent.

As summarized in Exhibit 6-5, when operating
leverage is high, a change in sales results in large changes
in profit. By contrast, when operating leverage is low, a
change in sales results in small changes in profits.
Operating leverage The
contribution margin divided by
net income; used as an indicator
of how sensitive net income is to a
change in sales.
Operating Leverage
High Low
Percent increase in profit with increase in sales Large Small
Percent increase in loss with decrease in sales Large Small
Exhibit 6-5 Operating Leverage and the Impact on Profit
Exhibit 6-6 Company B—Operating Leverage at Various Levels
of Sales
500 Units 1,000 Units 2,000 Units
Sales $100,000 $200,000 $400,000
Less: Variable costs 40,000 80,000 160,000
Contribution margin $ 60,000 $120,000 $240,000
Less: Fixed costs 40,000 40,000 40,000
Net operating income $ 20,000 $ 80,000 $200,000
Operating leverage $60,000
$20,000

= 3.0 $120,000
$80,000
= 1.5 $240,000
$200,000
= 1.2
Unlike measures of contribution margin, operat-
ing leverage changes as sales change (see Exhibit 6-6).
At a sales level of 1,000 units ($200,000), Company
B’s operating leverage is 1.5. A 10 percent increase in
sales increases net income by 15 percent. At a sales level
of 500 units, operating leverage increases to 3.0 and a
10 percent increase in sales will increase net income by
30 percent (3 × 10%). At a sales level of 2,000 units,
operating leverage is reduced to 1.2 and a 10 percent
increase in sales will increase income by 12 percent.
As a company gets closer and closer to the break-
even point, operating leverage will continue to increase
and income will be very sensitive to changes in sales.
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A company operating
near the break-even
point will have a high
level of operating
leverage, and income
will be very sensitive to
changes in sales volume.
Exhibit 6-7 Company B—Operating
Near the Break-Even Point
Sales (334 units) $66,800

Net operating income $ 80
Operating leverage $40,080
$80
= 501
For example, when Company B sells 334 units (see
Exhibit 6-7), the contribution margin is equal to $40,080,
operating income is equal to $80, and operating leverage
is equal to 501 ($40,080 ÷ $80). A 10 percent increase in
sales at this point will increase net operating income by a
whopping 5,010 percent.
Understanding the concepts of contribution mar-
gin and operating leverage and how they are used in
CVP analysis is very important in managerial decision
making. Using these tools, managers can quickly esti-
mate the impact on net income of changes in cost, sales
volume, and price.
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ST U D Y TO O LS 6
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BRIEF EXERCISES
1. Contribution Margin LO1
Companies that wish to distribute their income
statements to outside parties such as banks must
prepare those statements by using the traditional in-
come statement format. These same companies may
also prepare contribution margin income statements
to more fully understand their costs. The following
terms are commonly used in describing contribution
margin income statements and related topics:
Gross profit Decrease
Contribution margin Fixed costs

Net income Contribution margin ratio
Variable costs Increase
Required
Choose the term from the preceding list that most
appropriately completes the following statements.
a. Once a company has paid all of its fixed costs,
net income increases in an amount equal to
___________ for each unit sold to customers.
b. When production and sales are equal, whether
a company prepares a traditional income state-
ment or a contribution margin income statement,
two numbers do not change. One of these is
sales, and the other is ___________.
c. ___________ , the difference between sales and
cost of goods sold, is not reported on the contri-
bution margin income statement.
d. For every unit sold, contribution margin will
___________ in total.
e. The ___________ is computed by dividing the
contribution margin by sales dollars.
f. Of these two cost categories, only ___________
increases and decreases contribution margin.
g. If a company is unable to increase sales or
___________ variable costs, the company can
increase net income by reducing ___________.
2. What-If Analysis LO2

Mike’s Motorcycles has enjoyed several years of
business success, but recently the company has
seen some indications of a slowdown in sales.
The company’s owner has decided to increase the
advertising budget by 10% and reduce sales prices
by 4%. The following partial income statement
shows the company’s results for the most recent
quarter:
Mike’s Motorcycles
Partial Income Statement
Sales $800,000
Contribution margin 240,000
Net operating income $ 65,000
Required
Assuming that the advertising budget was
$30,000 for the quarter and was included in the
fixed costs, calculate Mike’s Motorcycles’ new
net income or loss if the changes are made.
You should assume that the variable costs will
not change if Mike implements the preceding
changes.
3. Break-Even Analysis LO3
Katie and Holly founded Hokies Plumbing Company
after graduating from college. They wanted to be
competitive, so they set their rate for house calls

at a modest $100. After paying the company’s gas
and other variable costs of $60, the women thought
there would be enough profit. Because they were
ready to live life a bit, they set their salaries at
$100,000 each. There were no other fixed costs
at all.
Required
Calculate the number of house calls that Hokies
Plumbing must make to break even.
4. Target Profit Analysis LO4
Nellie’s Nursery has the following information
related to sales of one popular type of spring flower
that is widely sold to landscapers in a multistate
region of the country:
Sales price per flower $ 0.70
Variable costs per flower 0.20
Total fixed costs for the type of flower $20,000
Required
If Nellie’s Nursery wishes to earn a before-tax profit
of $30,000 on this type of flower, how many flowers
must be sold to landscapers?
5. Operating Leverage LO5
Naru’s has the following information for the most
recent year:
Naru’s
Partial Income Statement

Sales $1,200,000
Contribution margin 500,000
Net operating income $ 250,000
Required
What is Naru’s operating leverage?
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EXERCISES
6. CVP: The Impact on Income LO2
Eric Ziegler started a lawn-mowing service in
high school. He currently prices his lawn-
mowing service at $35 per yard. He estimates
that variable expenses related to gasoline, sup-
plies, and depreciation on his equipment total
$21 per yard.
Required
If Eric wants to increase his price by 40 percent,
how many fewer yards can he mow before his net
income decreases?
7. CVP: What-If Analysis LO2
Last year, Mayes Company had a contribution
margin of 30 percent. This year, fixed expenses
are expected to remain at $120,000 and sales are
expected to be $550,000, which is 10 percent higher
than last year.
Required
What must the contribution margin ratio be if the
company wants to increase net income by $15,000
this year?

8. What-If Decisions with Changing
Fixed Costs LO2
Walker Company has current sales of $600,000 and
variable costs of $360,000. The company’s fixed costs
are equal to $200,000. The marketing manager is
considering a new advertising campaign, which will
increase fixed costs by $10,000. She anticipates that
the campaign will cause sales to increase by 5 per-
cent as a result.
Required
Should the company implement the new advertising
campaign? What will be the impact on Walker’s net
operating income?
9. Operating Leverage LO2, 5
Burger Queen Restaurant had the following infor-
mation available related to its operations from
last year:
Sales (150,000 units) $500,000
Variable costs 200,000
Fixed costs 150,000
Net operating income $150,000
Required
A. What is Burger Queen’s operating leverage?
B. If sales increased by 30 percent, what would

Burger Queen’s net operating income be?
Jimmy’s Seafood Restaurant is a family-owned busi-
ness on the North Carolina coast. In the last several
months, the owner has seen a drop-off in business.
Last month, the restaurant broke even. The owner
looked over the records and saw that the restaurant
served 1,000 meals last month (variable cost is $10
per meal) and incurred fixed costs totaling $25,000.
Required
Calculate Callahan’s average selling price for a meal.
Lincoln Company sells logs for an average of $18
per log. The company’s president, Abraham, esti-
mates that the variable manufacturing and selling
costs total $6 per log. Logging operations require
substantial investments in equipment, so fixed
costs are quite high and total $108,000 per month.
Abraham is considering making an investment in a
new piece of logging equipment that will increase
monthly fixed costs by $12,000.
Required
Assist Abraham by calculating the number of ad-
ditional logs that must be sold to break even after
investing in the new equipment.
12. Break-Even Analysis: Multiproduct
Environment LO3

Kim Johnson’s company produces two well-known
products: Glide Magic and Slide Magic. Glide Magic
accounts for 60 percent of her sales, and Slide Magic
accounts for the rest. Glide currently sells for
$16 per tube and has variable manufacturing and
selling costs of $8. Slide sells for just $12 and has
variable costs of $9 per tube. Kim’s company has
total fixed costs of $36,000.
Required
Calculate the total number of tubes that must be
sold for Kim’s company to break even.
13. Break-Even Analysis: Multiproduct
Environment LO3
Donald Tweedt started a company to produce and
distribute natural fertilizers. Donald’s company sells
two fertilizers that are wildly popular: green fertil-
izer and compost fertilizer. Green fertilizer, the most
popular among environmentally minded consum-
ers, commands the highest price and sells for $16
per 30-pound bag. Green fertilizer also requires
additional processing and includes environmentally
friendly ingredients that increase its variable costs to
$10 per bag. Compost fertilizer sells for $12 and has
easily acquired ingredients that require no special pro-
cessing. It has variable costs of $8 per bag. Tweedt’s
total fixed costs are $35,000. After some aggressive
marketing efforts, Tweedt has been able to drive
consumer demand to be equal for each fertilizer.
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Required
Calculate the number of bags of green fertilizer that
will be sold at break-even.
14. Sales to Reach After-Tax Profit LO4
Lockwood Company currently sells its deadbolt locks

for $30 each. The locks have a variable cost of $10,
and the company’s annual fixed costs are $150,000.
The company’s tax rate is 40 percent.
Required
Calculate the number of locks that must be sold to
earn an after-tax profit of $24,000.
15. Target Profit Analysis LO4
Kingman Corp. has been concerned with maintain-
ing a solid annual profit. The company sells a line
of fire extinguishers that are perfect for homeown-
ers, for an average of $10 each. The company has
perfected its production process and now produces
extinguishers with a variable cost of $4 per extin-
guisher. Kingman’s annual fixed costs are $92,000.
Kingman’s tax rate is 40 percent.
Required
Calculate the number of extinguishers Kingman
must sell to earn an after-tax profit of $60,000.
PROBLEMS
16. Multiproduct Break-Even Analysis LO1, 3
Don Waller and Company sells canisters of three
mosquito-repellant products: Citronella, DEET, and
Mean Green. The company has annual fixed costs of
$260,000. Last year, the company sold 5,000 canisters
of its mosquito repellant in the ratio of 2:4:4. Waller’s
accounting department has compiled the following
data related to the three mosquito repellants:

Citronella DEET Mean Green
Price per canister $11.00 $15.00 $17.00
Variable costs per canister 6.00 12.00 16.00
Required
A. Calculate the total number of canisters that must
be sold for the company to break even.
B. Calculate the number of canisters of Citronella,
DEET, and Mean Green that must be sold to
break even.
C. How might Don Waller and Company reduce its
break-even point?
17. CVP: What-If Analysis LO1, 2, 3
Hacker Aggregates mines and distributes various
types of rocks. Most of the company’s rock is sold to
contractors who use the product in highway con-
struction projects. Treva Hacker, company president,
believes that the company needs to advertise to
increase sales. She has proposed a plan to the other
managers that Hacker Aggregates spend $100,000
on a targeted advertising campaign. The company
currently sells 25,000 tons of aggregate for total
revenue of $5,000,000. Other data related to the
company’s production and operational costs follow:
Direct labor $1,500,000
Variable production overhead 200,000
Fixed production overhead 350,000
Selling and administrative expenses:

Variable 50,000
Fixed 300,000
Required
A. Compute the break-even point in units (i.e., tons)
for Hacker Aggregates.
B. Compute the contribution margin ratio for
Hacker Aggregates.
C. If Treva decides to spend $100,000 on advertis-
ing and the company expects the advertising
to increase sales by $200,000, should the
company increase the advertising? Why
or why not?
18. CVP and Break-Even Analysis LO1, 2, 3
Lauren Tarson and Michele Progransky opened Top
Drawer Optical seven years ago with the goal of pro-
ducing fashionable and affordable eyewear. Tarson
and Progransky have been very pleased with their
revenue growth. One particular design, available in
plastic and metal, has become one of the company’s
best sellers. The following data relate to this design:
Plastic Frames Metal Frames
Sales price $ 60.00 $ 80.00
Direct materials 20.00 18.00
Direct labor 13.50 13.50
Variable overhead 6.50 8.50
Budgeted unit sales 10,000 30,000
Currently, the company produces exactly as many
frames as it can sell. Therefore, it has no opportu-

nity to substitute a more expensive frame for a less
expensive one. Top Drawer Optical’s annual fixed
costs are $1.225 million.
Required
Each of the following is an independent situation.
A. Calculate the total number of frames that Top
Drawer Optical needs to produce and sell to
break even.
B. Calculate the total number of frames that Top
Drawer Optical needs to produce and sell to
break even if budgeted direct material costs for
plastic frames decrease by $10 and annual fixed
costs increase by $12,500 for depreciation of a
new production machine.
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C. Tarson and Progransky have been able to reduce
the company’s fixed costs by eliminating cer-
tain unnecessary expenditures and downsizing
supervisory personnel. Now, the company’s fixed
costs are $1,122,000. Calculate the number of
frames that Top Drawer Optical needs to produce
and sell to break even if the company sales mix
changes to 35 percent plastic frames and 65 per-
cent metal frames.
19. Decision Focus: Basic CVP and Break-Even
Analysis LO1, 2, 3
Gigi LeBlanc founded a company to produce a spe-
cial bicycle suspension system several years ago after
her son, who worked for a bicycle delivery service,
was hurt in a riding accident. The market’s response
has been overwhelmingly favorable to the com-
pany’s new suspension system. Riders report feeling
that they experience fewer “unpredictable” bumps
than with traditional suspension systems. Gigi made
an initial investment of $100,000 and has set a target

of earning a 30 percent return on her investment.
Gigi expects her company to sell approximately
10,000 suspension systems in the coming year. Based
on this level of activity, variable manufacturing costs
will be $5 for each suspension system. Fixed selling
and administrative expenses will be $2 per system,
and other fixed costs will be $1 per system.
Required
A. Calculate the sales price that Gigi LeBlanc’s
company must charge for a suspension system if she
is to earn a 30 percent return on her investment.
B. Calculate the company’s break-even point.
C. Assuming that Gigi’s company maintains the
current activity level, how can she increase her
return on investment to 35 percent?
20. Break-Even and Target Profit LO1, 2, 3, 4
Matthew Hagen started his company, The Sign of
Things to Come, three years ago after graduat-
ing from Upper State University. While earning his
engineering degree, Matthew became intrigued
by all of the neon signs he saw at bars and taverns
around the university. Few of his friends were sur-
prised to see him start a neon sign company after
leaving school. Matthew is currently considering
the introduction of a new custom neon sign that he
believes will sell like hot cakes. In fact, he is estimat-
ing that the company will sell 700 of the signs. The
new signs are expected to sell for $75 and require
variable costs of $25. The new signs will require a
$30,000 investment in new equipment.

Required
A. How many new signs must be sold to break even?
B. How many new signs must be sold to earn a
profit of $15,000?
C. If 700 new signs are sold, how much profit will
they generate?
D. What would be the break-even point if the sales
price decreased by 20 percent? Round your an-
swer to the next-highest number.
E. What would be the break-even point if variable
costs per sign decreased by 40 percent?
F. What would be the break-even point if the
additional fixed costs were $50,000 rather
than $30,000?
21. Decision Focus: Break-Even and Target
Profit LO1, 2, 3, 4
ZIA Motors is a small automobile manufacturer.
Chris Rickard, the company’s president, is currently
evaluating the company’s performance and is con-
sidering options that might be effective at increas-
ing ZIA’s profitability. The company’s controller,
Holly Smith, has prepared the following cost and
expense estimates for next year, on the basis of a
sales forecast of $3,000,000:
Direct materials $ 800,000
Direct labor 700,000
Factory overhead 750,000

Selling expenses 300,000
Other administrative expenses 100,000
$2,650,000
After Chris received and reviewed the cost and
expense estimates, he realized that Holly had
given him all the data without breaking it out
into fixed and variable components. He called her,
and she told him the following: “Factory over-
head and selling expenses are 40 percent variable,
but other administrative expenses are 30 percent
variable.”
Required
A. How much revenue must ZIA generate to break
even?
B. Chris Rickard has set a target profit of $700,000
for next year. How much revenue must ZIA gener-
ate to achieve Chris’s goal?
22. Decision Focus: Multiproduct Break-Even
Analysis LO4
Clean Skin Company sells bottles of three face-
wash products: Daily Wash, Mud Mask, and Face
Cleanser. The company has annual fixed costs of
$300,000. Last year, the company sold 7,500 bottles
of its face-wash products in the ratio of 4:2:4.
Clean Skin’s accounting department has compiled
the following data related to the three face-wash
products:
Daily Mud Face

Wash Mask Cleanser
Price per bottle $12.00 $20.00 $14.00
Variable costs per bottle 2.00 8.00 6.00
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A. Calculate the total number of bottles that must
be sold for the company to break even.
B. Calculate the number of bottles of Daily Wash,
Mud Mask, and Face Cleanser that must be sold
to break even.
C. How might Clean Skin Company reduce its break-
even point?
CASES
23. CVP Analysis: Target Profit with Constraints
LO1, 2, 4
Moore, Inc., invented a secret process to double the
growth rate of hatchery trout. The company manu-
factures a variety of products related to this pro-
cess. Each product is independent of the others and
is treated as a separate division. Product managers
have a great deal of freedom to manage their divi-
sions as they think best. Failure to produce target
division income is dealt with severely; however,
rewards for exceeding one’s profit objective are, as
one division manager described them, lavish.
The Morey Division sells an additive that is
added to pond water. Morey has had a new man-
ager in each of the three previous years because
each manager failed to reach Moore’s target profit.
Bryan Endreson has just been promoted to manager
and is studying ways to meet the current target
profit for Morey.
The target profit for Morey for the coming year
is $800,000 (20 percent return on the investment in

the annual fixed costs of the division). Other con-
straints on division operations are as follows:
• Production cannot exceed sales, because Moore’s
corporate advertising stresses completely new
additives each year, even though the “newness”
of the models may be only cosmetic.
• The Morey selling price may not vary above the
current selling price of $200 per gallon, but it may
vary as much as 10 percent below $200 (i.e., $180).
Endreson is now examining data gathered by
his staff to determine whether Morey can achieve its
target profit of $800,000. The data are as follows:
• Last year’s sales were 30,000 units at $200 per
gallon.
• The present capacity of Morey’s manufacturing
facility is 40,000 gallons per year, but capacity can
be increased to 80,000 gallons per year with an
additional investment of $1 million per year in
fixed costs.
• Present variable costs amount to $80 per unit,
but if commitments are made for more than
60,000 gallons, Morey’s vendors are willing to
offer raw material discounts amounting to $20
per gallon, beginning with gallon 60,001.
Endreson believes that these projections are reliable,
and he is now trying to determine what Morey must
do to meet the profit objectives assigned by Moore’s
board of directors.

Required
A. Calculate the dollar value of Morey’s current an-
nual fixed costs.
B. Determine the number of gallons that Morey
must sell at $200 per gallon to achieve the profit
objective. Be sure to consider any relevant con-
straints. What if the selling price is $180?
C. Without prejudice to your previous answers,
assume that Bryan Endreson decides to sell
40,000 gallons at $200 per gallon and 24,000
gallons at $180 per gallon. Prepare a pro forma
income statement for Morey, showing whether
Endreson’s decision will achieve Morey’s profit
objectives.
24. Break-Even and Target Profit Analysis
LO1, 2, 3, 4
Boeing Corporation (formerly McDonnell Douglas
Corporation) manufactures the C-17, the most flexi-
ble jet transport used by the U.S. Air Force. The com-
pany originally sold the C-17 for a “flyaway cost” of
$175 million per jet. The variable production cost of
each C-17 was estimated to be approximately $165
million. When the C-17 was first proposed in 1981,
the Air Force expected to eventually purchase 400
jets. However, as of June 2011, only 232 C-17s have
been produced and sold.
Production began, and at one point the com-
pany was faced with the following situation: With
20 jets finished, a block of 20 more in production,
and funding approved for the purchase of a third

block of 20 jets, the U.S. Congress began indicating
that it would approve funding for the order and
purchase of only 20 more jets (for a total of 80). This
was a problem for the company because company
officials had indicated previously that the break-
even point for the C-17 project was around 100
aircraft.
Required
A. Given the previous facts concerning the sales
price, variable cost, and break-even point, what
were McDonnell Douglas’s fixed costs associated
with the development of the C-17?
B. What would the income or loss be if the company
sold only 80 C-17s?
C. Assume that McDonnell Douglas had been told
up front that the Air Force would buy only 80
jets. Calculate the selling price per jet that the
company would have to charge to achieve a tar-
get profit (before tax) of $10 million per jet.
D. Assuming that the costs and sales price of the
jet have remained the same over the years, how
much income have McDonnell Douglas and Boe-
ing made from the sale of the C-17?
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Condensed_ManagerialACCT2_Sawyers_ch06aCh 6: Cost-
Volume-Profit AnalysisLearning ObjectivesIntroductionLO1:
The Contribution Margin and Its
UsesCondensed_ManagerialACCT2_Sawyers_ch06bCh 6: Cost-
Volume-Profit AnalysisLO2: What-If Decisions Using
CVPLO3: Break-Even
AnalysisCondensed_ManagerialACCT2_Sawyers_ch06cCh 6:
Cost-Volume-Profit AnalysisLO4: Target Profit Analysis
(Before and after Tax)LO5: Cost Structure and Operating
LeverageCondensed_ManagerialACCT2_Sawyers_ch06dCh 6:
Cost-Volume-Profit AnalysisBrief
ExercisesExercisesProblemsCases

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