Ch3 Cost-Volume-Profit Analysis And Pricing Exam Questions

Chapter 3

Cost-Volume-Profit Analysis and Pricing Decisions

CHAPTER LEARNING OBJECTIVES

1. Calculate the breakeven point in units and sales dollars. (Unit 3.1)

The breakeven point is the level of sales at which sales revenue equals total expense, and profit is $0. This point can be calculated in terms of units or sales revenue using either the profit equation or the contribution margin formula, as follows:

1. Calculate the level of activity required to meet a target income. (Unit 3.2)

To calculate the sales level required to meet a certain level of operating income, use one of the following formulas. If you are working with a target level of net income, divide it by (1 minus the tax rate) to convert it to operating income before using one of the formulas.

1. Determine the effects of changes in sales price, cost, and volume on operating income. (Unit 3.2)

Using the following equations, you should be able to solve for any unknown factors that would help in evaluating the financial impact of certain managerial decisions.

Other relationships that you will find helpful in solving these problems include the contribution margin ratio (contribution margin divided by sales revenue) and the variable cost ratio (variable cost divided by sales revenue). The sum of the contribution margin ratio and the variable cost ratio is 1.

1. Define operating leverage and explain the risks associated with the tradeoff between variable and fixed costs. (Unit 3.2)

Operating leverage indicates the change in operating income that will result from a change in sales; it is directly affected by the ratio of fixed expenses to variable expenses. The degree of operating leverage at a particular level of sales can be calculated as follows:

Companies with relatively high contribution margins (meaning low variable costs) and high fixed expenses generate profits quickly once they pass the breakeven point. However, if their sales fall below the breakeven point, their losses mount quickly. To reduce the risk of covering fixed expenses, some companies prefer to carry high levels of variable costs, so that expenses are incurred only as products are sold.

1. Calculate the multiproduct breakeven point and level of activity required to meet a target income. (Unit 3.3)

Companies that sell more than one product must consider their sales mix in order to solve breakeven and other problems. Holding the sales mix constant for n products, the breakeven point and target operating income can be calculated using the modified profit formula:

CM₁ + CM₂ + …CM_n – Fixed expenses = Operating income

1. Define markup and explain cost-plus pricing. (Unit 3.4)

A markup is the difference between the cost of a product or service and the price a company charges for it. The markup percentage can be calculated as

Cost-plus pricing begins with the cost of a product and adds a markup to determine the price to charge. The flaw in this method is that the resulting price does not reflect the value of the product to the customer. After the price has been calculated, managers must still compare it to the price of a comparable product or service. If the price is too high relative to competitors’ prices, the company is unlikely to be able to sell the product.

1. Explain target costing and calculate a target cost. (Unit 3.4)

Target costing begins with the price a customer is willing to pay for a product or service and works backward to the maximum cost the company can incur to deliver the product or service to market. Assume, for example, that a company is considering a new product that marketing research suggests customers will pay no more than $25 for. If the company needs a 40% gross profit margin to cover its operating expenses and contribute to profit, then managers must be able to acquire or make the product for no more than $15: $25 - ($25 x 40%) = $15. If managers conclude that they can deliver the product for $15, then they should go ahead with the new venture. If they can’t, then they need to halt the project before the company sinks any more funds into it.

TRUE-FALSE STATEMENTS

1. Knowing the breakeven point helps managers evaluate the profitability, but not the desirability of various business opportunities.
2. At the breakeven point, sales revenue is exactly equal to total costs, and there is no profit or loss.
3. To find the breakeven point, set the standard profit equation equal to zero, let x equal the total costs, and then solve for x.
4. At the breakeven point, the total contribution margin equals total fixed expenses.
5. The breakeven graph illustrates the relationship between product and period costs, allowing managers to view a range of results at a single glance.
6. On the breakeven graph, the point at which the total sales revenue line and the total cost line intersect is the breakeven point.
7. On the breakeven graph, any level of sales to the left of the breakeven point represents a profit.
8. One of the activities managers like to engage in is called “what-if” analysis, or sensitivity analysis.
9. A company’s margin of safety is the difference between current sales and breakeven sales.
10. The margin of safety represents the volume of sales that it takes to break even.

LO: 1, Bloom: K, Unit: 3-1, Difficulty: Easy, Min: 1, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

1. Cost-volume-profit analysis, or CVP, helps managers assess the impact of various business decisions on company profits.
2. Units required to meet target operating income is calculated as (Total variable expenses + Target net income) divided Contribution margin per unit.
3. Net income divided by (1 – tax rate) = Operating income
4. When volume changes, total sales revenue, total variable costs, total contribution margin, and total fixed expenses all change.
5. One assumption made when using CVP as a decision tool is that all costs can be easily and accurately separated into fixed and variable categories.
6. Variable and fixed selling expenses are incurred regardless of the level of sales.
7. Companies that carry a high level of fixed costs relative to variable costs are considered to have greater risk than companies with a high level of variable costs relative to fixed costs.
8. Operating leverage is the change in total variable costs relative to sales revenue.
9. A company with high operating leverage will experience a large percentage change in operating income as a result of a small percentage change in sales.
10. The degree of operating leverage is calculated as the contribution margin divided by the sales revenue.
11. Firms can manage their degree of operating leverage by converting variable costs into fixed costs, or vice versa.
12. Changing a company’s cost structure affects its operating leverage and may have behavioral implications for the employees.
13. When a company sells more than one product, its sales mix is the sales of each product relative to operating income.
14. To adhere to the sales mix ratio, a company should split fixed costs between the multiple products and come up with individual product breakeven points or target income points.
15. If the sales mix changes, the breakeven point and target units will change as well.
16. Cost-plus pricing adds an amount to the cost of the product or service to cover the company’s operating costs and contribute to its profit.
17. A drawback of cost-plus pricing is that it is a relatively difficult approach to pricing.

1. Whereas cost-plus pricing starts with the cost, target costing starts with the price customers are willing to pay.
2. Companies must engage in target costing after introducing a new product.
3. Cost-plus pricing implies that the cost of the seller’s operational inefficiencies should be borne by the customer.

Answers to True-False Statements

MULTIPLE-CHOICE QUESTIONS

31. If a product’s variable cost per unit increases while the selling price and fixed costs remain constant, what will happen to the breakeven point?

a. It will increase.

b. It will decrease.

c. It will remain the same.

d. It may increase or decrease, depending on how much the variable cost per unit changes.

32. If a company sells a single product and the selling price per unit and the variable cost per unit both increase by 5% while fixed costs remain the same, then contribution margin

a. per unit increases and breakeven in units increases.

b. per unit increases and breakeven in units decreases.

c. remains the same and breakeven in units increases.

d. decreases and breakeven in units decreases.

33. Knowing the breakeven point helps managers evaluate

• 1. the profitability of various business opportunities.
  2. the desirability of various business opportunities.
  3. the cost behavior various business opportunities.
  4. the operating leverage of various business opportunities.

34. At the breakeven point,

a. sales revenue equals zero.

b. sales revenue equals total costs.

c. operating income equals total sales.

d. operating income equals total costs.

35. At the breakeven point, which of the following is not true?

a. Sales revenue is equal to total costs.

b. Contribution margin is equal to total variable costs.

c. Contribution margin is equal to total fixed costs.

d. Operating income equals zero.

36. At the breakeven point,

a. sales revenue equals zero.

b. contribution margin equals total variable costs.

c. sales revenue equals total costs.

d. operating income equals total costs.

37. Assume a sales price per unit of $20, variable cost per unit $16, and total fixed costs of $168,000. What is the breakeven point in units?

a. 42,000 units

b. 10,500 units

c. 8,400 units

d. 4,666 units

38. Assume a sales price per unit of $25, variable cost per unit $15, and total fixed costs of $18,000. What is the breakeven point in units?

a. 720 units

b. 1,200 units

c. 1,800 units

39. Which of the following is not a step in calculating the breakeven point?

a. Put everything into “constant” form – sales price per unit, variable cost per unit, total fixed cost.

b. Subtract fixed cost from sales revenue.

c. Calculate the contribution margin per unit.

d. Solve by dividing total fixed cost by contribution margin per unit.

40. Which of the following formulas is used to calculate the breakeven point in units?

a. Total fixed costs divided by contribution margin per unit.

b. Total fixed costs divided by total contribution margin.

c. Total fixed costs divided by contribution margin ratio.

d. None of these formulas calculates the breakeven point in units.

41. Which of the following formulas is not used to calculate the breakeven point?

a. Total fixed costs divided by contribution margin per unit.

b. Total fixed costs divided by (sales price per unit less variable cost per unit).

c. Total fixed costs divided by contribution margin ratio.

d. Total fixed cost divided by total contribution margin.

42. Which of the following formulas is used to calculate the breakeven point in sales dollars?

a. Total fixed costs divided by contribution margin per unit.

b. Total fixed costs divided by total contribution margin.

c. Total fixed costs divided by contribution margin ratio.

d. None of these formulas calculates the breakeven point in sales dollars.

43. Assume a sales price per unit of $20, variable cost per unit $16, and total fixed costs of $168,000. What is the breakeven point in dollars?

a. $210,000

b. $420,000

c. $672,000

d. $840,000

44. Assume a sales price per unit of $25, variable cost per unit $15, and total fixed costs of $18,000. What is the breakeven point in dollars?

a. $30,000

b. $45,000

c. $26,999

d. $37,500

45. A breakeven graph illustrates the relationship between

a. volume and sales price.

b. volume and total costs.

c. breakeven and operating income.

d. sales and costs.

46. Assume a sales price per unit of $25, variable cost per unit $15, and total fixed costs of $18,000. If no units are sold, how much cost would the company incur?

a. Zero.

b. The amount of variable costs at the breakeven point.

c. $18,000.

d. $27,000.

47. On the breakeven graph, any level of sales to the left of the breakeven point represents

a. a fixed cost.

b. a variable cost.

c. operating income.

d. an operating loss.

48. On the breakeven graph, any level of sales to the right of the breakeven point represents

a. a fixed cost.

b a variable cost.

c. operating income.

d. an operating loss.

49. On the breakeven graph, the fixed cost line

a. increases with sales volume.

b. decreases with sales volume.

c. remains the same regardless of sales volume.

d. moves to the right as fixed cost increase.

50. On the breakeven graph, if sales price and the unit variable cost remain constant and fixed costs decrease, the fixed cost line will shift

a. to the right.

b. to the left.

c. upward.

d. downward.

51. On the breakeven graph, if sales price and the unit variable cost remain constant and fixed costs decrease, the total cost line will shift

a. upward.

b. downward.

c. to the right.

d. to the left.

52. On the breakeven graph, if sales price and the unit variable cost remain constant and fixed costs decrease, the breakeven point will

a. shift upward.

b. not change.

c. shift to the right.

d. shift to the left.

53. If sales price and the unit variable cost remain constant and fixed costs decrease, contribution margin will

a. increase.

b. decrease.

c. remain the same.

d. vary, depending on the circumstances.

54. When both fixed and variable costs go down,

a. operating income goes down.

b. operating income goes up.

c. contribution margin goes down.

d. revenue goes up.

55. The formula for margin of safety in units is

a. current unit sales minus breakeven unit sales.

b. actual net income minus budgeted net income.

c. actual sales minus budgeted sales.

d. breakeven sales minus budgeted sales.

56. The formula for margin of safety in sales dollars is

a. current unit sales minus breakeven unit sales.

b. actual sales minus budgeted sales.

c. current sales revenue minus breakeven sales revenue.

d. breakeven sales revenue minus budgeted sales revenue.

57. Assume a sales volume of 6,000 units, unit selling price of $20, unit variable cost of $12, and total fixed costs of $20,000. What is the margin of safety in units?

a. 2,500

b. 3,500

c. 6,000

d. 8,000

58. Assume a sales volume of 6,000 units, unit selling price of $20, unit variable cost of $12, and total fixed costs of $20,000. What is the margin of safety in sales dollars?

a. $25,000

b. $50,000

c. $70,000

d. $120,000

59. Martin Company has a current breakeven point of 47,000 units. To reduce the breakeven point, Martin should

a. reduce the contribution margin per unit.

b. increase the contribution margin per unit.

c. reduce the sales price per unit.

d. increase variable costs.

60. Benny Books sells first edition books. Benny purchases the books from his supplier for $100 a book and sells them through his website for $225 a book. Benny’s fixed costs are $87,000. What is Benny’s breakeven point in books?

a. 268

b. 387

c. 696

d. 870

61. Benny Books sells first edition books. Benny purchases the books from his supplier for $100 a book and sells them through his website for $225 a book. Benny’s fixed costs are $87,000. Benny’s breakeven point in sales dollars is nearest to

a. $195,750.

b. $156,600.

c. $87,075.

d. $60,300.

62. Nomad Company sells camera bags. The company purchases the bags from its supplier for $12 a bag and sells them to electronics stores for $25 a bag. Nomad’s fixed costs are $39,000. What is Nomad’s breakeven point in sales dollars?

a. $30,000

b. $75,000

c. $81,250

d. $97,500

63. A company has total fixed costs of $200,000 and a contribution margin ratio of 20%. The total sales necessary to break even are

a. $800,000.

b. $1,000,000.

c. $250,000.

d. $240,000.

64. Fixed costs are $600,000 and the variable costs are 75% of the unit selling price. What is the break-even point in dollars?

a. $1,400,000

b. $1,800,000

c. $2,400,000

d. $800,000

65. Saira, Inc. is planning to sell 800,000 units for $1.50 per unit. The contribution margin ratio is 20%. If Saira will break even at this level of sales, what are the fixed costs?

a. $240,000

b. $560,000

c. $800,000

d. $960,000

66. At the break-even point of 2,000 units, variable costs are $55,000, and fixed costs are $32,000. How much is the selling price per unit?

a. $43.50

b. $11.50

c. $16.00

d. $27.50

67. Cross Creek Company sells concrete culverts. Currently, the company’s sales revenue is $900,000, variable costs total $450,000, and fixed costs total $300,000. If Cross Creek’s controller has calculated the company’s breakeven point to be $597,000, what is the company’s margin of safety?

a. $15,000

b. $153,000

c. $303,000

d. $447,000

68. Bonita Corporation produces only one product. Monthly data includes: selling price per unit, $42; unit variable expenses, $14; total fixed expenses, $84,000; actual sales for the month of June, 4,000 units. What is the margin of safety?

a. $84,000

b. $42,000

c. $126,000

d. $1,000

69. The formula for operating income is

a. sales revenue – variable costs – fixed costs.

b. sales revenue – variable costs – fixed costs – profit.

c. sales revenue – contribution margin – variable costs.

d. sales revenue – gross margin – fixed costs.

70. At the breakeven point, the total contribution margin equals

a. gross margin.

b. variable costs.

c. fixed costs.

d. total costs.

71. Contribution margin is the amount

a. that is available to cover fixed costs and provide a profit.

b. of total variable costs and total fixed costs.

c. of sales less cost of goods sold.

d. that is available to cover period costs and provide a profit.

72. Breakeven point can be expressed in terms of

a. units.

b. unit sales price.

c. unit contribution margin.

d. unit fixed costs.

73. On the breakeven graph, the point at which the total sales revenue line and the total cost line intersect is called

a. contribution margin.

b. the breakeven point.

c. net income.

d. operating income.

74. Barbara’s Boutique wants to know what it takes to have $20,000 in operating income. If her selling price is $20, variable cost is $8, and fixed costs total $40,000, how many units must she sell to reach her goal?

a. 1,667 units

b. 2,500 units

c. 5,000 units

d. 7,500 units

75. A company requires $1,360,000 in sales to meet its operating income target. Its contribution margin is 30%, and fixed costs are $240,000. What is the target operating income?

a. $408,000

b. $312,000

c. $560,000

d. $168,000

76. Miguel Manufacturing has fixed costs of $2,500,000 and variable costs are 40% of sales. What are the required sales if Montoya desires an operating income of $250,000?

a. $4,583,333

b. $4,166,667

c. $6,875,000

d. $6,250,000

77. Barbara’s Boutique wants to know what it takes to have $20,000 in operating income. If her selling price is $20, variable cost is $8 and fixed costs total $40,000, what must her sales revenue be in order to reach her goal?

a. $33,340

b. $50,000

c. $100,000

d. $150,000

78. The formula for calculating units required to meet target operating income is

a. (total fixed costs plus target operating income) divided by contribution margin per unit.

b. total fixed costs divided by (contribution margin plus target operating income).

c. contribution margin per unit divided by (total fixed costs plus target operating income).

d. (contribution margin plus target operating income) divided by total fixed costs.

79. Assume total fixed costs of $160,000, variable costs per unit of $6, and contribution margin per unit of $4. How many units must be sold to meet a target operating income of $50,000?

a. 5,000 units

b. 25,000 units

c. 40,000 units

d. 52,500 units

80. Assume total fixed costs of $160,000, variable costs per unit of $6, and contribution margin per unit of $4. How many units must be sold to meet a target net income of $50,000, assuming a tax rate of 20%?

a. 55,625

b. 52,500

c. 50,000

d, 35,000

81. The formula for calculating the sales dollars required to meet target operating income is

a. (total fixed costs plus target operating income) divided by contribution margin per unit.

b. (total fixed costs plus target operating income) divided by contribution margin ratio.

c. (total fixed costs plus target operating income) divided by total variable costs.

d. (contribution margin plus target operating income) divided by total fixed costs.

82. Assume total fixed costs of $160,000, variable costs per unit of $6, and contribution margin per unit of $4. What are the sales dollars required to meet a target operating income of $50,000?

a. $525,000

b. $315,000

c. $210,000

d. $160,000

83. Assume total fixed costs of $160,000, variable costs per unit of $6, and contribution margin per unit of $4. What are the sales dollars required to earn a target net income of $50,000 assuming a tax rate of 20%?

a. $350,000

b. $556,250

c. $525,000

d. $500,000

84. Assume Buddy’s Farm Supply wants to make $45,000 in net income. If the tax rate is 25%, how much operating income must Buddy have?

a. $56,250

b. $60,000

c. $180,000

d. $360,000

85. The formula for converting desired net income into operating income is

a. desired net income times the income tax rate.

b. the income tax rate divided by the desired net income.

c. desired net income divided by (1 − tax rate).

d. desired net income divided by (1 + tax rate).

86. Donnie’s Donut Shop sells cream-filled muffins for $1 each. Donnie’s variable cost per muffin is $0.30 and total fixed costs are $2,000 per month. If Donnie wants to earn a monthly operating income of $5,000, how many muffins must he sell during the month?

a. 2,857

b. 7,000

c. 10,000

d. 23,333

87. Tammy’s Totes sells hand-made tote bags for $10 each. Tammy’s variable costs are $6 per bag and her fixed costs total $4,000 per month. If Tammy’s tax rate is 20%, how many totes must Tammy sell each month if she wants to earn $5,000 in net income?

a. 1,000

b. 1,250

c. 2,563

d. 2,813

88. Brandi’s Bakery sells strawberry cakes for $15 each. Brandi’s variable costs are $5 and her fixed costs total $3,000 per month. If Brandi’s tax rate is 25%, how many cakes must Brandi sell each month if she wants to earn $6,000 in net income?

a. 1,200

b. 1,100

c. 900

d. 600

89. Cost-volume-profit analysis helps managers assess the impact of

a. a change in variable costs on profit.

b. a change in sales price on profit.

c. a change in fixed costs on profit.

d. changes in sales price, variable costs and fixed costs on profit.

90. Which of the following is not included in the profit equation?

a. Sales revenue

b. Variable costs

c. Cost of goods sold

d. Fixed costs

91. The selling price of a unit is $20 and the variable product cost per unit is $14. In addition, a sales commission of 5% is paid on each sale. If the variable cost per unit (excluding sales commission)) increases by 1%, what is the new total cost per unit?

a. $14.84

b. $14.85

c. $14.90

d. $15.14

92. The selling price of a unit is $20 and the variable product cost per unit is $14. In addition, a sales commission of 5% is paid on each sale. If the variable product cost per unit increases by 1%, what will be the new contribution margin per unit?

a. $4.86

b. $5.10

c. $5.16

d. $6.00

93. Kydell Corporation reported the following results from the sale of 6,000 units in March: sales $300,000, variable costs $180,000, fixed costs $90,000, and operating income $30,000. Assume that Kydell increases the selling price by 10% on April 1. How many units will have to be sold in April to maintain the same level of operating income?

a. 4,800.

b. 5,160.

c. 5,400.

d. 6,000.

94. As volume changes, which of the following items also change?

a. Total sales revenue

b. Variable cost per unit, total contribution margin

c. Total fixed costs, contribution margin per unit

d. Total sales revenue, total variable costs, and total contribution margin

95. As volume changes, which of the following items do not change?

a. Total sales revenue

b. Total variable costs

c. Total fixed costs

d. Total contribution margin

96. Which of the following is not an assumption about the data when using CVP analysis?

a. All costs can be easily and accurately separated into fixed and variable components.

b. Total fixed costs remain at a constant level and variable costs per unit remain unchanged at all sales levels.

c. More inventory is purchased than sold.

d. A linear relationship exists between variable costs and sales activity over the relevant range of interest.

97. Which of the following is not an assumption about the data when using CVP analysis?

a. All costs can be easily and accurately separated into fixed and variable components.

b. Total fixed costs remain at a constant level and variable costs per unit remain unchanged at all sales levels.

c. A linear relationship exists between variable costs and sales activity over the relevant range of interest.

d. Inventory is sold in the period following purchase or manufacture.

98. All other things equal, an increase in the number of units sold will

a. increase unit variable cost.

b. increase fixed cost per unit.

c. increase total contribution margin.

d. decrease the unit sales price.

99. All other things equal, an increase in the number of units sold will increase

a. unit contribution margin.

b. unit variable costs.

c. total fixed costs.

d. operating income.

100. Brandi’s Bakery sells strawberry cakes for $15 each. Last month Brandi sold 1,200 cakes. Variable costs were $5 per cake and fixed costs totaled $3,000. This month, Brandi has decided to spend $1,000 to sponsor a team for a Relay for Life golf tournament. She believes that the additional advertising from the sponsorship will generate 10% more sales than last month. What will be this month’s operating income?

a. $8,000

b. $9,000

c. $9,200

d. $10,200

101. If sales increase by 10%, then total contribution margin will

a. increase more than 10%.

b. increase less than 10%.

c. increase by 10%.

d. decrease by more than 10%.

102. Companies that carry a high level of fixed costs relative to variable costs are considered to have

a. a greater risk than companies with a high level of variable costs relative to fixed costs.

b. a lesser risk than companies with a high level of variable costs relative to fixed costs.

c. a greater amount of period costs than product costs.

d. either a greater amount of product costs than period costs.

103. The change in operating income relative to a change in sales is referred to as

a. CVP.

b. operating leverage.

c. margin of safety.

d. sales mix.

104. A company with a high operating leverage will experience

a. a large percentage change in operating income as a result of a small percentage change in sales.

b. a small percentage change in operating income as a result of a small percentage change in sales.

c. the same percentage change in operating income as a result of a percentage change in sales.

d. a small percentage change in operating income as a result of a large percentage change in sales.

105. The degree of operating leverage is calculated as

a. net operating income divided by contribution margin.

b. contribution margin divided by sales.

c. net operating income divided by sales.

d. contribution margin divided by net operating income.

106. Assume total sales of $800,000, total variable costs of $400,000, and total fixed costs of $300,000. Of these amounts, $200,000 of the variable costs are product costs, and $100,000 of the fixed costs are period costs. What is the degree of operating leverage?

a. 0.25

b. 8.00

c. 2.00

d. 4.00

107. Mercantile Corporation has sales of $2,000,000, variable costs of $1,100,000, and fixed costs of $750,000. Mercantile’s degree of operating leverage is

a. 1.22.

b. 1.47.

c. 1.20.

d. 6.00.

108. Which of the following measures would not help managers manage their degree of operating leverage?

a. Convert a welder who is paid by the hour to a welding machine.

b. Put all sales staff on salary Instead of paying a sales commission.

c. Convert some indirect material to direct material.

d. Change the unit sales price.

109. Brandi’s Bakery’s current degree of operating leverage is 15. Additional advertising is expected to increase her sales by 8%. What is the expected impact on operating income?

a. 12%

b. 53%

c. 120%

d. 187%

110. Brandi’s Bakery’s income statement for last month is given below. What is Brandi’s degree of operating leverage?

a. 0.2

b. 1.4

c. 3.5

d. 5.0

111. Mandy’s Candies’ income statement for last month is given below. What is Mandy’s degree of operating leverage?

a. 1.0

b. 2.0

c. 3.5

d. 7.0

112. One way to compute the expected change in operating income due to a change in sales volume at a given level of sales is to

a. compute the degree of operating leverage.

b. perform high-low analysis.

c. perform scattergraph analysis.

d. perform horizontal analysis.

113. Changing a company’s cost structure may affect

a. the sales mix.

b. operating leverage.

c. total sales revenue.

d. the sales volume in units.

114. All other things equal, a company can increase its operating leverage by converting

a. fixed costs to variable costs.

b. variable costs to fixed costs.

c. period costs to product costs.

d. product costs to period costs.

115. All other things equal, a company can increase its operating leverage by

a. converting commission-based salespeople to salaried.

b. decreasing the amount of depreciation charges.

c. converting indirect costs to direct costs.

d. converting manufacturing overhead to general and administrative expenses.

116. Bumper earned net income of $72,000 and has fixed costs of $36,000. Bumper sold 11,000 units for $30 each and has a 40% contribution margin ratio. What were Bumper’s operating income and tax rate?

a. $96,000; 25%

b. $120,000; 40%

c. $270,000; 27%

d. $162,000; 45%

$96,000 ÷ (1 – Tax rate) = $72,000; Tax rate = 25%

a. $106,912; 25%

b. $147,832; 46%

c. $286,968; 28%

d. $168,912; 75%

$106,912 = $80,184 ÷ (1 – Tax rate); Tax rate = 25%

a. $64,800; $108,000

b. $120,344; $167,656

c. $172,800; $52,456

d. $214,920; $94,576

$460,800 × (1 – .625) = CM; CM = $172,800

Target operating income × (1 – tax rate) = Net income; Target operating income = $42,120 ÷ 0.65 = $64,800;

CM – Fixed costs = Target operating income; $172,800 – FC = $64,800; FC = $108,000

a. $51,840; $86,400

b. $96,275; $134,125

c. $138,240; $41,965

d. $171,936; $75,661

$368,640 × (1 – 0.625) = CM; CM = $138,240

Target operating income × (1 – tax rate) = Net income; Target operating income = $33,696 ÷ 0.65 = $51,840;

CM – Fixed costs = Target operating income; $138,240 – FC = $51,840; FC = $86,400

120. When volume changes,

a. total variable expenses change.

b. total fixed expenses change.

c. contribution margin per unit changes.

d. unit variable costs change.

121. If a company increases the price of its product by 10% with no change in sales volume,

a. the total contribution margin will not change.

b. fixed cost per unit will change.

c. contribution margin per unit will change.

d. total fixed costs will decline.

122. The contribution margin per unit will change when

a. fixed costs increase by 5%.

b. a company increases the price of its product by 5%.

c. the company’s sales volume increases by 5%.

d. fixed costs per unit decline.

123. If a company increases its sales price by $5 and its variable costs per unit also increase $5, then

a. total contribution margin will decrease.

b. the contribution margin per unit will decrease.

c. the contribution margin per unit will increase.

d. the contribution margin per unit will not change

124. The sale of each product relative to total sales is referred to as

a. operating leverage.

b. sales mix.

c. managed ratio.

d. product line sales.

125. If the __________ changes, so does the _______________.

a. horizontal mix; contribution margin ratio

b. sales mix; breakeven point

c. sales mix; contribution margin per unit.

d. horizontal mix; breakeven point.

126. Pelican Co. sells two products, A and Z. Product A’s contribution margin per unit is lower than Product Z’s contribution margin per unit. However, Product A’s contribution margin ratio is higher than Product Z’s contribution margin ratio. If Pelican begins to sell more units of Product A and fewer units of Product Z, its

a. sales mix will remain unchanged.

b. breakeven point will be higher than it was previously

c. breakeven point will be lower than it was previously.

d. the selling price will increase. .

127. A company produces Product 11 and Product 22. Product 11 sells for $20 and has a contribution margin ratio of 60%. Product 22 sells for $30 and has a contribution margin ratio of 60%. This year the company sold 1,500 units of Product 11 and 2,500 units of Product 22. At the breakeven point, the company needs to sell 1,275 units of Product 11. What are the company’s fixed costs?

a. $48,450

b. $32,130

c. $52,020

d. $53,550

1,500 ÷ (1,500 + 2,500) = 37.5%; 2,500 ÷ (1,500 + 2,500) = 62.5%

At breakeven 0.375x = 1,275 units of Product 11, so “x” = 3,400

0.625 × 3,400 = 2,125 units of Product 22

(1,275 × $12) + (2,125 × $18) – FC = $0; FC = $53,550

128. Using the following unit data for a company that produces Product A and B, what is the breakeven point (round properly) when fixed costs total $175,000?

a. 659 Product A; 556 Product B

b. 792 Product A; 352 Product B

c. 849 Product A; 849 Product B

d. 2,574 Product A; 1,144 Product B

1,144 × 1 = 1,144 of B

129. Using the following unit data for a company that produces Product X and Y, what is the breakeven point when fixed costs total $280,000?

a. 1,120 Product A; 1,120 Product B

b. 0 Product A; 2,000 Product B

c. 1,000 Product A; 1,000 Product B

d. 2,000 Product A; 2,000 Product B

130. Which of the following is an assumption made in a multiproduct environment?

a. The sales mix can be determined and will remain constant.

b. The sales mix must be broken into variable, fixed, and mixed costs.

c. The relevant range will vary with a change in activity.

d. Fixed costs are no longer static.

131. Which of the following is not an assumption of multiproduct CVP analysis?

a. All variable costs relationships are linear with respect to activity.

b. The sales mix can be determined and will remain constant.

c. Cost can be separated into fixed and variable components.

d. The relevant range will vary with a change in activity.

132. Computer Basics offers three types of on-line basic computer training: Office, Web Design, and Programming. In the past, for every 20 students who sign up for training, 10 take the Office, 6 take Web Design, and 4 take Programming. Compute Basics has calculated a breakeven point of 1,200 courses. How many of the 1,200 courses will be Office?

a. 30

b. 60

c. 300

d. 600

133. Computer Basics offers three types of basic computer training: Office, Web Design, and Programming. In the past, for every 20 students who sign up for training, 10 take the Office, 6 take Web Design, and 4 take Programming. Compute Basics has calculated a breakeven point of 1,200 courses. How many of the 1,200 courses will be Web Design?

a. 30

b. 60

c. 360

d. 600

134. EverGreen Company sells two types of air filters, Standard and Deluxe. The Standard filter has a contribution margin of $10 while the Deluxe has a contribution margin of $24. EverGreen sells 5 Standard filters to every 1 Deluxe filter. If fixed costs total $148,000, how many Standard and Deluxe filters must be sold to breakeven?

a. 10,000 Standard; 2,000 Deluxe

b. 9,280 Standard; 2,300 Deluxe

c. 4,353 Standard; 6,167 Deluxe

d. 14,800 Standard; 6,167 Deluxe

135. Harding Corporation sells two products, Standard and Supreme. Expected sales are 40,000 Standard and 60,000 Supreme. Standard’s unit contribution margin is $30 and Supreme’s is $60. Fixed expenses are $1,800,000. How many Standard units would Harding sell at the break-even point?

a. 15,000

b. 20,000

c. 22,500

d. 40,000

136. Mats for Life produces yoga mats. Mat A sells for $60 and has a contribution margin ratio of 40%. Mat B sells for $100 and has a contribution margin ratio of 60%. This year the company sold a total of 80,000 mats, of which 30,000 were units of Mat A. At the breakeven point, the company needs to sell 25,500 units of Mat A. How many units of Mat B were sold and what are the company’s fixed costs?

a. 45,000; $3,540,000

b. 50,000; $3,162,000

c. 48,000; $3,648,000

d. 50,000; $3,180,000

30,000 ÷ 80,000 = 37.5% so Mat B = 62.5%

62.5% × 80,000 = 50,000 units of Mat B

At breakeven 0.375x = 25,500 units of Mat A, so “x” = 68,000

.625 × 68,000 = 42,500 units of Mat B

(25,500 × $24) + (42,500 × $60) – FC = $0; FC = $3,162,000

a. $28.62

b. $39.60

c. $65.21

d. $46.80

(3,510 × CM Complex) = $183,978 – $44,892

(3,510 × CM Complex) = $138,996

CM Complex = $39.60

a. $100.02

b. $77.99

c. $22.48

d. $26.78

(1,755 × CM Expert) = $91,989 – $44,892

(1,755 × CM Expert) = $47,007

CM Expert = $26.78

139. Which of the following statements is not true?

a. The higher the price, the lower the demand for a product.

b. At lower prices, customers will demand a higher quantity than they will at a higher price.

c. The lower the price, the fewer units of product a company is willing to supply.

d. The price paid for a product should not reflect its value.

140. While customers and cost influence prices, so does

a. contribution margin.

b. fixed versus variable costs.

c. competition.

d. desired profit.

141. Lingh Suit Co. has received a shipment of suits that cost $200 each. If the company uses cost-plus pricing and applies a markup percentage of 60%, what is the sales price per suit?

a. $333

b. $320

c. $280

d. $500

142. Lochte Inc. has collected the following data concerning one of its products:

Unit sales price $145

Total sales 15,000 units

Unit cost $115

Total investment $1,800,000

The markup percentage is

a. 20.69%.

b. 22.59%.

c. 25%.

d. 26.09%.

143. Grassi Company produces high definition television sets. The following information is available for this product:

Fixed cost per unit $250

Variable cost per unit 750

Markup per unit 300

Grassi Company's markup percentage is

a. 30%.

b. 40%.

c. 60%.

d. 120%.

144. Which of the following does not influence prices?

a. Competition

b. Contribution margin

c. Costs

d. Customers

145. To reduce the cost to deliver a product or service to consumers, a company must focus on

a. operational efficiency.

b. location.

c. sales mix.

d. competition.

146. Cost-plus pricing adds an amount to

a. the cost of the product or service to cover operating costs and contribute to its profit.

b. variable and fixed costs to cover overhead.

c. the sales price to cover unexpected costs.

d. contribution margin to cover fixed costs.

147. The “plus” in cost-plus pricing is often referred to as

a. Extra profit.

b. Margin of Safety.

c. Markup.

d. Gross profit.

148. Assume a company has a selling price of $20 and a unit cost of $15. What is the company’s markup percentage?

a. 33.3%

b. 1.33%

c. 25%

d. 1.25%

149. Assume a company wishes to maintain a markup of 35% on a product with a unit cost of $25 ($14 variable and $11 fixed). What amount will the company set as the selling price?

a. $30.00

b. $33.75

c. $38.46

d. $43.90

150. Which of the following is not a flaw of cost-plus pricing?

a. Cost-plus pricing is complex to calculate.

b. Cost-plus pricing implies that the cost of the seller’s operational inefficiencies should be borne by the customer.

c. A markup based on cost does not represent the value to the customer.

d. The price customers are willing to pay represents the value of the product or service.

151. Which of the following does not affect the price a company charges under cost-plus pricing?

a. Desired gross margin percentage

b. The cost of the product

c. The historical price of the product or service

152. Mounts CPA firm prepares approximately 1,200 individual tax returns each year. Since a majority of the cost of preparing tax returns results from the salary of the tax preparers and reviewers, Mounts charges customers a markup on labor rates. The highest paid preparers earn $30 per hour and are CPAs with several years’ experience. Mounts charges its customers $45 per hour. If Mounts charges the same markup percentage to all clients, what price will Mounts charge for a less-experienced preparer who earns only $20 per hour?

a. $25

b. $30

c. $35

d. $45

153. Which of the following formulas represents the calculation for markup percentage?

a. (Sales price – Cost) ÷ Cost

b. (Sales price – Cost) ÷ Sales price

c. Sales price ÷ Cost

d. Sales price ÷ Contribution margin

154. A difference in cost-plus pricing and target costing is that target costing

a. is generally determined after introducing a product and cost-plus pricing is determined before introducing a product.

b. is a simple approach while cost-plus pricing is relatively complex.

c. starts with the price customers are willing to pay whereas cost-plus pricing starts with the cost.

d. computes the desired markup while cost-plus pricing computes the maximum cost the company is willing to incur.

155. Companies need to engage in target costing

a. at the beginning of an accounting period.

b. before introducing a new product.

c. at the end of a product’s lifecycle.

d. only if costs are primarily variable.

156. If a company sells its product for $30 and has a unit cost of $12, what is the company’s markup percentage?

a. 35%

b. 40%

c. 25%

d. 150%

157. Given that the selling price is $200, the variable unit cost is $120, and there’s operating income of $50, what is the company’s markup percentage?

a. 50%

b. 66.7%

c. 33.3%

d. 250%

158. Blond Co. is using the target cost approach on a new product. Information gathered so far reveals:

Expected annual sales 400,000 units

Desired profit per unit $0.35

Target cost $168,000

What is the target selling price per unit?

a. $0.42

b. $0.70

c. $0.35

d. $0.77

159. Mountain Spring Inc. wants to produce and sell a new brand of bottled water. In order to penetrate the market, the product will have to sell at $2.00 per 12 oz. bottle. The following data has been collected:

Annual sales 50,000 bottles

Projected selling and administrative costs $8,000

Desired profit $70,000

The target cost per bottle is

a. $0.44.

b. $0.60.

c. $0.16.

d. $0.40.

160. Ron White Inc. plans to introduce a new product and is using the target cost approach. Projected sales revenue is $810,000 ($4.05 per unit) and target costs are $730,000. What is the desired profit per unit?

a. $0.40

b. $2.03

c. $3.65

d. $1.63

161. Evergreen’s most popular product sells for $33.00 and has a variable cost of $26.40. On Evergreen’s income statement the cost of goods sold per unit is $24.42. What is Evergreen’s markup percentage based on cost of goods and based on variable cost per unit?

a. 35%; 35%

b. 35%; 25%

c. 26%; 20%

d. 20%; 26%

162. Monty’s has one product with a variable cost of $19.80 and a cost of goods sold per unit of $18.32. If Monty sells this product for $24.75, what is Monty’s markup percentage based on variable cost per unit and based on cost of goods sold?

a. 25%; 35%

b. 35%; 25%

c. 26%; 20%

d. 20%; 26%

163. Bluegreen’s most popular product has a variable cost of $43.56. On Bluegreen’s income statement, the cost of goods sold per unit is $40.29. If Bluegreen’s markup percentage on variable cost is 25% and its gross margin is 26%, what is the selling price of this product?

a. $54.45

b. $58.08

c. $58.86

d. $53.72

164. Patch Work’s product, Patch Supreme, sells for $62.00 and its variable cost is $44.60 while the cost of goods sold per unit is $42.80. What is Patch Work’s markup percentage on variable cost and what is its gross margin percentage?

a. 39%; 45%

b. 28%; 45%

c. 39%; 31%

d. 28%; 31%

a. $5.40

b. $27.00

c. $8.44

d. $9.00

a. $31.42

b. $56.10

c. $37.40

d. $35.90

167. Wasson Whatsit Company is contemplating the production and sale of a new product. Projected sales are $300,000 (or 75,000 units) and desired profit is $36,000. What is the target cost per unit?

a. $4.00

b. $3.52

c. $4.48

d. $4.80

Answers to Multiple Choice Questions

MATCHING

168. Match the following terms to the appropriate statement by placing the letter to the left of each statement.

1. B – Breakeven point
2. G – Margin of safety
3. D – Cost-volume-profit analysis
4. H – Operating leverage
5. I – Sales mix
6. C – Cost-plus pricing
7. J – Target costing
8. A – Breakeven graph
9. F – Markup
10. E – Degree of operating leverage

BRIEF EXERCISES

169. Cindy’s Chocolates sells its cream filled donuts for $1.50 each. The variable cost per unit for the donuts is $1.05 and total fixed costs are $9,000.

• 1. What is the contribution margin per unit for the donuts?
  2. What is the breakeven point in sales dollars?

1. $1.50 ̶ $1.05 = $0.45
2. $0.45 ÷ $1.50 = .30; $9,000 ÷ .30 = $30,000

170. The New Age Pet Store sells butterfly garden kits which includes a free-standing pop-up habitat and three varieties of butterfly larvae. New Age sells the kits for $30. The store pays $12 for the habitat and $8 for the butterfly larvae. Fixed costs are $5,000.

1. What is the contribution margin ratio for the butterfly garden kits?
2. What is the breakeven point in units?
3. ($30 ̶ $20) ÷ $30 = 33.33%
4. $5,000 ÷ ($30 ̶ $20) = 500 kits

171. Kid’s Corner sells lamp systems for $25. These systems use LEDs to create a light display across walls or ceilings. Kid’s Corner pays $13 for the systems. Fixed costs incurred by the company are $18,000.

1. What is the breakeven point in units?
2. If Kid’s Corner wishes to earn $10,000 in operating income, how many systems will it have to sell?
3. $18,000 ÷ ($25 ̶ $13) = 1,500
4. ($18,000 + $10,000) ÷ ($25 ̶ $13) = 2,334

172. The contribution margin ratio for Stanley Company is 25%. The breakeven point is $200,000. If Stanley wishes to have operating income of $60,000, how much must the company have in sales?

$200,000 × .25 = $50,000 ; ($50,000 + $60,000) ÷ 0.25 = $440,000

173. Colorado Furniture Company manufactures naturally weathered reclaimed wood furniture. A queen-size bed sells for $1,800 and variable costs total $1,080. Colorado incurs $300,000 in fixed costs during the year. The company’s tax rate is 20%.

Required:

How many queen-size beds must Colorado sell to generate net income of $300,000?

$300,000 ÷ (1 ̶ .2) = $375,000 operating income; ($375,000 + $300,000) ÷ ($1,800 ̶ $1,080)= 938 beds

174. Morgan Creations sells monogrammed baby blankets. The blankets sell for $36 each. Variable costs are $12 per blanket and fixed costs total $45,000. Morgan wishes to have operating income of $9,000.

Required:

1. How many blankets must Morgan sell to meet her target operating income?
2. If Morgan can cut her fixed costs by 20%, to reach her target income, how many blankets will she need to sell?
3. ($45,000 + $9,000) ÷ ($36 ̶ $12) = 2,250 blankets
4. ($36,000 + $9,000) ÷ ($36 ̶ $12) = 1,875 blankets

175. Patton Company’s selling price is $100, variable costs are 60% of sales, and fixed costs total $60,000.

Required:

1. At a $400,000 sales level, what is Patton’s degree of operating leverage?
2. If sales volume increases by 10%, what will be the amount of increase in operating income?
3. $400,000 × (1 ̶ 0.60) = $160,000 CM ̶ $60,000 = $100,000 operating income

$160,000 ÷ $100,000 = 1.6 operating leverage

1. 0.10 × 1.6 = 0.16 increase; $100,000 × 0.16 = $16,000 increase

176. Colorado Furniture Company manufactures natural weathered reclaimed wood furniture. The company produces two sizes of beds. Data for the company’s activity during a typical period are presented below:

The company incurs $300,000 in fixed costs during the year. Assuming the sales mix is constant, what will Colorado's operating income be if sales volume increases by 10%?

[(100 × 1.10) × ($1,800 ̶ $1,080)] + [(300 × 1.10) × ($2,000 ̶ $1,100)] = $376,200;

$376,200 ̶ $300,000 = $76,200

177. Morgan’s Creations sells monogrammed baby blankets. The blankets cost Morgan $15 each. Morgan sells her blankets at a 60% markup. What is her sales price?

$15 × 1.60 = $24

178. Assume Wilkerson’s Shoe Store has decided to add hiking boots to its inventory to be more competitive with another shoe store in the same mall where Wilkerson is located. If Wilkerson can purchase the boots at $45, what price should the store charge to maintain a 60% markup on the boots?

$45 × 1.60 = $72

EXERCISES

179. Bart’s Bike Shop has the following income statement.

Required:

1. Calculate the contribution margin per unit.
2. Calculate the contribution margin ratio.
3. Calculate the breakeven point in units. In sales dollars.
4. Calculate the margin of safety in units. In dollars.
5. $150 – ($96 + $6) = $48
6. $48 ÷ $150 = 32%
7. ($24,000 + $12,000) ÷ $48 = 750 units; 750 × $150 = $112,500 or ($24,000 + $12,000) ÷ 32% = $112,500
8. 1,000 – 750 = 250 units; $150 × 250 = $37,500

180. Bivouac Camping Supply sells harsh weather tents. The company has the following income statement.

Required:

1. What is the contribution margin per unit?
2. What is the contribution margin ratio?
3. What is the breakeven point in units? In sales dollars?
4. What is the margin of safety in units? In dollars?
5. $1,000 – ($475 + $5 + $20) = $500
6. $500 ÷ $1,000 = 50%
7. ($40,000 + $10,000) ÷ $500 = 100 units; 100 × $1,000 = $100,000 or ($40,000 + $10,000) ÷ 50% = $100,000
8. 200 – 100 = 100 units; $200,000 ̶ $100,000 = $100,000

181. Bivouac Camping Supply sells marine-grade hatches. The hatches sell for $20 each. The cost of each hatch is $12. The only other costs are fixed costs of $15,000. During the current period, Bivouac sold 2,400 units.

Required:

1. What is the contribution margin per unit?
2. What is the contribution margin ratio?
3. What is the breakeven point in units? In dollars?
4. What is the margin of safety in units? In dollars?
5. ($20 ̶ $12) = $8
6. $8 ÷ $20 = 40%
7. $15,000 ÷ $8 = 1,875 units; 1,875 × $20 = $37,500 or $15,000 ÷ 40% = $37,500
8. 2,400 – 1875 = 525 units; $48,000 ̶ $37,500 = $10,500

182. The New Age Pet Store sells Diva Doggie pet waste disposal systems for $50 each. The systems include the unit and a one-year supply of enzyme digester waste terminator. The cost of the unit and enzyme is $35. The only other costs are fixed costs of $3,000. During the current period, New Age sold 600 of the units through the store’s new on-line catalog division.

Required:

1. What is the contribution margin per unit?
2. What is the contribution margin ratio?
3. What is the breakeven point in units? In dollars?
4. What is the margin of safety in units? In dollars?
5. $50 ̶ $35 = $15
6. $15 ÷ $50 = 30%
7. $3,000 ÷ $15 = 200 units; $3,000 ÷ .30 = $10,000
8. 600 – 200 = 400; $30,000 ̶ $10,000 = $20,000

183. Buttermilk Bakery has provided the following cost data for the last year when 5,000 Danish pastries were produced and sold.

Required:

1. How many units would the company need to sell to earn $3,000 in operating income?
2. How many units would the company need to sell to earn $1,000 in net income if the tax rate is 20%?
3. ($1,060 + $3,000) ÷ ($1.00 ̶ $.30) = 5,800
4. $1,000 ÷ (1 ̶ .20) = $1,250 operating income; ($1,060 + $1,250) ÷ $0.70 = 3,300

184. Buttermilk Bakery has provided the following cost data for the last year when 100,000 loaves of bread were produced and sold.

All costs are variable except for $125,000 of the overhead and $75,000 of the selling and administrative. The sales price was $10 per loaf.

Required:

1. How many units must be sold to meet a target operating income of $405,000?
2. If Buttermilk desires a target operating income of $150,000, what is the amount of sales dollars needed to reach this target?
3. What will be the operating income from producing 90,000 loaves?
4. ($225,000 + $75,000 + $200,000 + $150,000 ̶ $125,000 ̶ $75,000) ÷ 100,000 = $4.50 Unit V.C.; $10.00 ̶ $4.50 = $5.50 Unit CM; ($200,000 + $405,000) ÷ 5.50 = 110,000 loaves
5. $5.50 ÷ $10 = .55 CM ratio; ($200,000 + $150,000) ÷ .55 - $636,364
6. (90,000 × $10) – (90,000 × $4.50) ̶ $200,000 = $295,000

185. Marling Machine Works produces soft serve ice cream freezers. The freezers sell for $12,000, and variable costs total $8,200 per unit. Marling incurs $6,840,000 in fixed costs during the year. The company’s tax rate is 25%.

Required:

How many freezers must Marling sell to generate net income of $3,450,000?

LO: 2, Bloom: AP, Unit: 3-2, Difficulty: Moderate, Min: 3, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

$12,000x – $8,200x – $6,840,000 = 3,450,000 ÷ (1 – 0.25)

X = 3,011 freezers (rounded)

Required:

1. How many units would the company need to sell to earn $4,000 in operating income?
2. How many units would the company need to sell to earn $4,000 in net income if the tax rate is 20%?
3. By how much would operating income change from part (b) with a 10% increase in units sold?
4. $10,000 ÷ $50 = 200 units; ($10,000 ̶ $6,000) ÷ 200 = $20 Unit CM; ($2,800 + $4,000) ÷ $20 = 340
5. $4,000 ÷ (1 ̶ .20) = $5,000 operating income; ($2,800 + $5,000) ÷ $20 = 390
6. ($390 × ($50 ̶ $30)) ÷ ($390 × ($50 ̶ $30) ̶ $2,800) = 1.56 degree of operating leverage; 1.56 × .10 = 15.6%; $5,000 × 0.156 = $780

187. Clarkson Computer Company distributes a specialized wrist support that sells for $30. The company’s variable costs are $12 per unit; fixed costs total $360,000 a year.

Required:

1. If sales increase by $41,000 per year, by how much should operating income increase?
2. Last year, Clarkson sold 32,000 wrist supports. The company’s marketing manager is convinced that a 6% reduction in the sales price, combined with a $50,000 increase in advertising, will result in a 30% increase in sales volume over last year. Should Clarkson implement the price reduction? Why or why not?

LO: 3, Bloom: E, Unit: 3-2, Difficulty: Difficult, Min: 6-8, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Reporting

1. Operating income would increase by the change in contribution margin:

Contribution margin ratio = ($30 − $12) ÷ $30 = 0.60

Change in operating income = $41,000 × 0.60 = $24,600

b. Operating income last year = (32,000 × $18.00) ̶ $360,000 = $216,000

New price = $30.00 × 0.94 = $28.20

New fixed expenses = $360,000 + $50,000 = $410,000

New unit sales = 32,000 × 1.3 = 41,600 units

Projected income = [($28.20 – $12.00) × 41,600] – $410,000 = $263,920

Clarkson should implement the price reduction because the estimated operating income is larger than the current operating income.

188. Manson Monograms sells stadium blankets that have been monogrammed with high school and university emblems. The blankets retail for $40 throughout the country to loyal alumni of over 1,000 schools. ­Manson’s variable costs are 40% of sales; fixed costs are $120,000 per month.

Required:

1. Manson currently sells 100,000 blankets per year. If sales volume were to increase by 12%, by how much would operating income increase?
2. Assume that variable costs increase to 45% of the current sales price and fixed costs increase by $10,000 per month. If Manson were to raise its sales price 10% to cover these new costs, but the number of blankets sold were to drop by 5%, what would be the new annual operating income?
3. If variable costs and fixed costs were to change as in part (c), would Manson be better off raising its selling price and losing volume or keeping the selling price at $40 and selling 100,000 blankets? Why?

LO: 3, Bloom: E, Unit: 3-2, Difficulty: Difficult, Min: 10-12, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Reporting

1. Operating income will increase by the increase in contribution margin.

Additional units sold = 100,000 × .12 = 12,000 additional units

12,000 additional units × ($40 × .60) = $288,000

b. New variable cost: 0.45 × $40 = $18 per unit

New fixed expenses: ($120,000 × 12) + ($10,000 × 12 months) = $1,560,000

New sales price: $40 × 1.1 = $44 per unit

New contribution margin: $44 – $18 = $26 per blanket

New sales volume: 100,000 × .95 = 95,000 blankets

c. From part d, operating income = $910,000

With a sales price of $40 per blanket and sales volume of 100,000 blankets, operating income is:

[($40 – $18) × 100,000] – $1,560,000 = $640,000

Manson is better off to raise the sales price to $44 and sell fewer blankets.

189. A manufacturer of potting soil has the following financial data:

Required:

1. What is the company’s unit contribution margin?
2. What is the company’s degree of operating leverage?
3. ($200,000 ̶ $125,000 ̶ $30,000) ÷ 25,000 = $1.80
4. ($200,000 ̶ $125,000 ̶ $30,000) ÷ $20,000 = 2.25

190. Donnie’s Donuts sells three types of donuts: sugar-glazed, cream-filled and giant-sized. The following table shows the sales price and variable cost for each type. Donnie’s incurs $216,000 a year in fixed costs. Assume that the store has a sales mix of three sugar-glazed, two cream-filled, and one giant-sized.

Required:

• 1. How many donuts of each type will be sold at the breakeven point?
  2. What amount of revenue would need to be generated by each type of donut for the company to earn $36,000 in operating income?

1. $216,000 ÷ [($.20 × 3) + ($.35 × 2) + ($.50 × 1)] = 120,000

Sugar-glazed: (120,000 × 3) = 360,000

Cream-filled: (120,000 × 2) = 240,000

Giant-sized: (120,000 × 1) = 120,000

1. ($216,000 + $36,000) ÷ [($.20 × 3) + ($.35 × 2) + ($.50 × 1)] = 140,000

Sugar-glazed: (140,000 × 3) × $.35 = $147,000

Cream-filled: (140,000 × 2) × $.55 = $154,000

Giant-sized: (140,000 × 1) × $.75 = $105,000

191. Sports Nation sells two types of soccer jerseys: Deluxe and Superior. The following table shows the sales price and unit variable costs for each jersey. Sports Nation incurs $200,000 a year in fixed costs. Assume the store has a sales mix of three Deluxe jerseys for every Superior jersey sold.

Required:

1. How many jerseys of each type will be sold at the breakeven point?
2. What amount of revenue would need to be generated by each type of jersey for the company to earn $25,000 in operating income?
3. $200,000 ÷ [($5 × 3) + $10] = 8,000

Deluxe: (8,000 × 3) = 24,000

Superior: (8,000 × 1) = 8,000

1. ($200,000 + $25,000) ÷ (($5 × 3) + $10) = 9,000

Deluxe: (9,000 × 3) × $15.00 = $405,000

Superior: (9,000 × 1) × $25.00 = $225,000

192. Back Yard Leisure sells two types of hammocks: Sundance and Shady Lady. The following table shows the sales price and variable cost for each hammock. Back Yard Leisure incurs $600,000 a year in fixed costs. Assume the store has a sales mix of four Sundance for each Shady Lady hammock sold.

Required:

1. How many hammocks of each type must be sold for Back Yard Leisure to break even?
2. What amount of revenue would be generated by each type of hammock for the company to earn $75,200 in operating income?
3. $600,000 ÷ [($75 × 4) + $100] = 1,500

Sundance: (1,500 × 4) = 6,000

Shady Lady: (1,500 × 1) = 1,500

1. ($600,000 + $75,200) ÷ [($75 × 4) + $100] = 1,688

Sundance: (1,688 × 4) × $125 = $844,000

Shady Lady: (1,688 × 1) × $175 = $295,400

193. Debbie’s Kitchen sells three types of soups: tomato basil, cheddar dill, and loaded potato. The following table shows the sales price and variable cost for each type. Debbie incurs $200,000 a year in fixed costs. Assume that the restaurant has a sales mix of two tomato basil servings, two cheddar dill servings and one loaded potato serving.

Required:

1. How many servings of each type will be sold at the breakeven point?
2. What amount of revenue would need to be generated by each type of soup for the company to earn $25,000 in operating income?
3. $200,000 ÷ [($1.50 × 2) + ($2.50 × 2) + ($2.00 × 1)] = 20,000

Tomato basil: (20,000 × 2) = 40,000

Cheddar dill: (20,000 × 2) = 40,000

Loaded potato: (20,000 × 1) = 20,000

1. ($200,000 + $25,000) ÷ [($1.50 × 2) + ($2.50 × 2) + ($2.00 × 1)] = 22,500

Tomato basil: (22,500 × 2) × $3.00 = $135,000

Cheddar dill: (22,500 × 2) × $4.50 = $202,500

Loaded potato: (22,500 × 1) × $4.50 = $101,250

194. Judy’s Jewelry sells necklaces to retailers across the country. Her gross margin can run as high as 35%.

Required:

1. If the sales price for a pearl necklace is $249, what is the cost to make it, assuming a 35% gross margin?
2. If Judy were to increase the cost of producing the pearl necklace to $166, what would be the markup percentage at the $249 sales price?
3. If Judy were to increase the cost of producing the pearl necklace to $166, what would be the sales price at a 35% gross margin?

LO: 6, Bloom: AP, Unit: 3-4, Difficulty: Moderate, Min: 4-5, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

a. Cost = $249 × .65 = $161.85

b. Markup = ($249 − $166) ÷ $166 = 50%

c. 0.65(sales price) = $166

Sales price = $255.39

195. Due to a recent increase in demand, Office Electronics has been able to sell its most expensive document shredder for a profit of 25%.

Required:

1. If Office Electronics sells the shredder for $250, what is the cost of the shredder assuming a 25% markup?
2. If Office Electronics were to reduce the cost of the shredder to $175, what would be the markup percentage at the $250 sales price?
3. If Office Electronics were to reduce the cost of the shredder to $175, what would be the sales price at a 25% gross margin?
4. $250 ̶ 0.25X = X; $250 ÷ 1.25 = $200
5. ($250 ̶ $175) ÷ $175 = 42.86%
6. SP ̶ $175 = 0.25SP; $175 ÷ .75 = $233.33

196. Clear Blue Pools builds custom in-ground pools ranging in price from $18,000 to $36,000. Dr. Jim Hardin, a local plastic surgeon has asked Clear Blue Pools to show him a portfolio of pools. Dr. Hardin has selected a model that calls for materials of $18,000, and labor and overhead of $13,000, but Dr. Hardin wants some handicap features not included in the model that would add another $4,000 to the cost but does not want to pay more than $32,000. Clear Blue Pools typically prices its pools based on the total cost of construction plus 15%.

Required:

1. What price would Clear Blue Pools normally quote for this pool?
2. What is the target cost Clear Blue Pools would need to meet to sell the pool for $32,000 at a 15% markup? (Round to the nearest dollar)
3. What could Clear Blue Pools do to meet the target cost in part b?
4. $35,000 ($18,000 + $13,000 + $4,000) × 1.15 = $40,250
5. $32,000 ̶ 0.15X = X; $32,000 ÷ 1.15 = $27,826
6. Clear Blue Pools will need to reduce its cost of material or labor, or both. Perhaps Dr. Hardin might be willing to substitute some items for less expensive ones. Clear Blue Pools might try to reduce its labor costs by avoiding overtime or putting its lowest paid employees on the job. Clear Blue Pools could encourage Dr. Hardin to recycle some items. In addition, Clear Blue Pools should point out to Dr. Hardin that the handicap features might possibly qualify as a tax-deductible cost.

197. Silver Moon Boutique sells a line of sterling silver jewelry. On average, Silver Moon earns a 60% gross profit on its jewelry. The owner, Pat Harring, wants to add some pewter jewelry to the boutique’s offerings. Pat has found a supplier who sells pewter necklaces for $35 each. However, she believes that her customers won’t pay more than $50 for pewter jewelry.

Required:

1. What price would Silver Moon normally charge for a pewter necklace?
2. What is the target cost Silver Moon would need to meet to sell the pewter necklaces for $50?
3. What could Silver Moon do to meet the target cost in part b?
4. $35 ÷ 0.40 = $87.50
5. $50 × (1.0 ̶ 0.6) = $20
6. Pat should find a way to reduce variable costs. She might find another supplier who has a similar line of jewelry at a cheaper cost. Pat could also negotiate with the vendor to purchase the jewelry for less than the regular cost of $35. If the pewter proves to be a good seller, she might purchase at a large enough quantity to receive a volume discount. Since fixed costs generally cannot be changed over the short run, it is not likely that fixed costs could be reduced.

198. Metro Boat Company produces custom-built houseboats. Metro’s house boats generally sell for prices between $85,000 and $125,000. Bob Smith, the football coach at State University, has presented Metro with the amenities he wishes to have on his boat. Metro has calculated that to build this boat to Bob’s specifications, materials, labor and overhead would total $95,652. Bob does not want to pay more than $100,000. Metro normally prices their house boats based on the total cost of construction plus 15%.

Required (round to the nearest dollar):

1. What price would Metro normally quote for the houseboat Bob is requesting?
2. What is the target cost Metro would need to meet to sell the houseboat for $100,000 at a 15% markup?
3. What could Metro do to meet the target cost in part b?
4. $95,652 × (1 + 0.15) = $110,000
5. $100,000 ̶ 0.15X = X; $100,000 ÷ 1.15 = $86,957
6. Metro would probably have to find a way to reduce variable costs. The company might find material at a lower cost or move their lower-paid employees to produce this houseboat, thereby lowering labor cost. Since fixed costs generally cannot be changed over the short run, it is not likely that fixed costs could be reduced.

PROBLEMS

199. The Rouge Company sells sports decals that can be personalized with a player’s name, a team name, and a jersey number for $5 each. Rouge buys the licensed decals from a supplier for $1.25 each and spends an additional $0.75 in variable operating costs per decal. The results of last month’s operations are as follows:

Required:

1. What is Rouge’s monthly breakeven point in units? In dollars?
2. What is Rouge’s margin of safety (both units and dollars)?

LO: 1, Bloom: AP, Unit: 3-1, Difficulty: Moderate, Min: 6-8, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

1. Using the sales revenue of $10,000 and sales price of $5.00 per unit, determine that The Rouge Units sold = ($10,000 ÷ $5.00) = 2,000 units

Contribution margin per unit = $6,000 ÷ 2,000 units = $3.00 per unit

Breakeven points - $1,500 ÷ $3.00 = 500 units

Sales = 500 units × $5.00 = $2,500

b. Margin of safety =2,000 units – 500 units = 1,500 units

Margin of safety = 1,500 units × $5.00 = $7,500

200. Skipmar Company produces a molded briefcase that is distributed to luggage stores. The following operating data for the current year has been accumulated for planning purposes.

Skipmar can produce 1.5 million cases a year. The projected net income for the coming year is expected to be $1.8 million. Skipmar is subject to a 40% income tax rate.

During the planning sessions, Skipmar’s managers have been reviewing costs and ­expenses. They estimate that the company’s variable cost of goods sold will increase 15% in the coming year and that fixed administrative expenses will increase by $150,000. All other costs and expenses are expected to remain the same.

Required:

1. What amount of sales revenue will Skipmar need to achieve in the coming year to earn the projected net income of $1.8 million?
2. What price would Skipmar need to charge for the briefcase in the coming year to maintain the current year’s contribution margin ratio?

LO: 2, 3, 6, Bloom: AP, Unit: 3-2,3-4 Difficulty: Moderate, Min: 7-9, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

a. New variable cost of goods sold: $12.00 × 1.15 = $13.80 per unit

New total variable costs: $13.80 + $10.60 + $3.00 = $27.40 per unit

New contribution margin per unit: $40.00 ̶ $27.40 = $12.60 per unit

New fixed expenses: $7,800,000 + $1,650,000 + $3,150,000 + $150,000 = $12,750,000

Operating income = $1,800,000 ÷ 0.60 = $3,000,000

Or: ($12,750,000 + $3,000,000) ÷ ($40.00 − $27.40) = 1,250,000 units

Sales revenue required = 1,250,000 cases × $40.00 = $50,000,000

1. Current contribution margin ratio = $14.40 ÷ $40.00 = 36%

New contribution margin ratio = (SP − $27.40) ÷ SP;

SP = 36%

SP ̶ $27.40 = 0.36 SP

SP = $42.8125, rounded to $42.82

201. Braque’s Pantry is a chain of arts and crafts stores. Results for the most recent year are as follows:

Required:

1. What is Braque’s Pantry’s degree of operating leverage?
2. If sales increase by 7%, what will the new operating income be?
3. Managers are considering changing Braque’s cost structure by offering employees a commission on sales rather than a fixed salary. What effect would such a change have on the firm’s operating leverage?

LO: 4, Bloom: E, Unit: 3-2, Difficulty: Difficult, Min: 3-4, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Reporting

1. Degree of operating leverage = Contribution margin ÷ Operating income =

= ($9,000,000 − $5,000,000) ÷ $2,000,000 = 2.0

b. 7% sales increase × 2 degree of operating leverage = 14% increase

New operating income = $2,000,000 × 1.14 = $2,280,000

c. Moving employees from a fixed salary to a commission based on sales will increase variable costs, decrease fixed costs, and decrease contribution margin. This will cause the degree of operating leverage to decrease.

202. Herzig Industries sells two electrical components with the following characteristics. Fixed costs for the company are $200,000 per year.

Required:

1. How many units of each product must Herzig Industries sell in order to break even?
2. Herzig’s vice president of sales has determined that due to market changes, the sales price of component XL-709 can be increased to $14.00 with no impact on sales volume. What will be Herzig’s new breakeven point in units?
3. Returning to the original information, Herzig’s vice president of marketing believes that spending $80,000 on a new advertising campaign will increase sales of component CD-918 to 80,000 units, without affecting the sales of product XL-709. How many units of each product must Herzig sell to break even under this new scenario?

LO: 13,5, Bloom: AP, Unit: 3-1,3-2, 3-3, Difficulty: Moderate, Min: 10-12, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

a. Sales mix: 4:6 or 1:1.5

Let x = number of XL-709s sold

($10.00 ̶ $6.00)x + (($25.00 ̶ $17.00) × 1.5x) ̶ $200,000 = 0

x = 12,500 XL-709s

1.5x = 18,750 CD-918s

b. New XL-709 contribution margin: $14.00 ̶ $6.00 = $8.00

Let x = number of XL-709s sold

($14.00 ̶ $6.00)x + ($25.00 ̶ $17.00)(1.5x) ̶ $200,000 = 0

$8.00x + $8.00(1.5x) = $200,000

x = 10,000 XL-709s

1.5x = 15,000 CD918s

c. New sales mix: 4:8 or 1:2

New fixed expense = $200,000 + $80,000 = $280,000

Let x = number of XL-709s sold

($10.00 ̶ $6.00)x + ($25.00 ̶ $17.00)(2x) ̶ $280,000 = 0

X = 14,000 XL-709s

2x = 28,000 CD-918s

203. The following is Ralley Company’s income statement.

Required:

a. What is the markup percentage on cost of goods sold?

b. What is the markup percentage on total cost?

c. What is the gross margin percentage?

d. If the company wants to sell a new product that costs $48 wholesale while keeping the same markup structure, what will be the price of the new product?

LO: 6, 7 Bloom: AP, C, Unit: 3-4, 3-7 Difficulty: Moderate, Min: 7-8, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

1. $218,000 ÷ $324,000 = 0.667 or 66.7%
2. Total cost = $324,000 + $126,000 = $450,000

Markup percentage = $90,000 ÷ $450,000 = 20%

1. $216,000 ÷ $540,000 = 40%

d. Use the gross margin percentage:

(x − $48) ÷ x = 0.4

x = $80

204. Jesse Allen, a product engineer for L’Oso Gaming, is designing a new electronic game. Market research indicates that gamers will pay $36 for the game.

Required:

1. If L’Oso desires an 80% markup on production costs, what is the target cost for the new game?
2. Jesse believes it will cost $24 per unit to produce the new game. What actions should he take next?

LO: 7, Bloom: AN, Unit: 3-4, Difficulty: Moderate, Min: 3-4, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Reporting

1. 0.8 = ($36 – x) ÷ x

X = $20.00

b. Jesse should work to find a way to reduce the unit price by $4.00 to reach the target price of $20.00.Jesse would probably have to find a way to reduce variable costs. The company may find material sat a lower cost or some way to reduce labor costs.

205. Define breakeven point. If a product’s variable costs per unit increases while the selling price and fixed costs remains constant, what will happen to the breakeven point?

Breakeven point is the point where revenue is equal to total costs, and there is no profit or loss. If variable costs increase while sales price and fixed costs remain constant, total contribution margin will decrease, resulting in an increase in the breakeven point.

206. What is the formula for calculating breakeven point in units? In sales dollars? What action might a company take if it wishes to reduce breakeven point?

Total fixed costs ÷ contribution margin per unit = breakeven point in units.

Total fixed costs ÷ contribution margin ratio = breakeven point in sales dollars.

If a company wishes to reduce breakeven point, it can increase the selling price per unit or reduce variable or fixed costs, or some combination of these items.

207. What is the meaning of margin of safety and how do managers use the information?

The margin of safety is the difference between current sales and breakeven sales. It represents the volume of sales that can be lost before the company begins to incur a loss. Managers use it in the decision-making process as a way to evaluate and control operations. For example, if a manager sees that the margin of safety drops below a projected level, he or she might take measures to increase sales volume or reduce costs.

208. What basic information is needed in order to calculate the level of sales to reach a target operating income?

You use the same profit equation you use to determine the breakeven point, but set profit equal to the target operating income. Thus, you need the unit sales price, the unit variable cost, the total fixed costs, and the desired operating income.

209. What is the formula for calculating degree of operating leverage? What does operating leverage mean? How can a company manage its degree of operating leverage?

The degree of operating leverage is the change in operating income due to a change in sales. The formula to calculate the degree of operating leverage is contribution margin divided by net operating income. A company can manage its degree of operating leverage by converting variable costs to fixed costs, or vice versa.

210. What is meant by the term “sales mix”? What is the profit formula for a company with multiple products?

Most companies produce or sell more than one type of product. Companies that sell multiple products need to know what results are required for the company, not individual products, to achieve certain targets. Sales mix is the proportional sales of each product relative to total sales of all products.

The CVP formula for a company with multiple products is (Contribution margin × units of 1^st product) + (Contribution margin × units of 2^nd product) – Fixed costs = Operating income. If more than two products exist, the formula continues as (Contribution margin × units of n-th product).

211. What assumptions are made when calculating breakeven point in a multi-product environment?

Unit sales price, unit variable cost and total fixed costs will remain constant within the relevant range, all costs can be easily and accurately separated into fixed and variable categories, and sales mix can be determined and will remain constant.

ESSAY

212. As managers evaluate business opportunities, they examine many factors including profitability. Discuss two profitability factors that managers might evaluate. In addition to the profitability factors discussed, discuss three factors other than profitability that managers might evaluate before engaging in a business opportunity.

Managers should conduct CVP to determine how many items or the sales revenue needed to break even or make a target operating income. “What if” analysis helps managers know what will happen to profit or other measures if costs or volume change. A way to compute the expected change in operating income due to a change in sales volume at a given level of sales is to compute the degree of operating leverage.

Managers will need to evaluate the demand for their products and the competition they will encounter. For example, if there is no demand or competition is too strong, the company will probably not be successful. In addition, manpower supply may be a factor. If the company is located in an area where not enough workers can be hired, it will be difficult to remain in business. Availability of capital is another concern to companies wanting to enter the market. If a company cannot find adequate investors or does not have the ability to borrow start-up funds, the business opportunity may be better left alone. Expertise in the industry is another factor to consider. If managers do not have the expertise to succeed, they should make sure they can hire staff with the expertise needed to operate the business.

213. If a manager desires to increase profit, he or she might attempt to modify sales volume, sales price or fixed or variable costs. Discuss how each of these might affect profit.

Increasing sales volume will increase profit or decrease a loss, assuming that variable cost is less than the sales price. For example, if the sales price is $10, the variable cost is $6, and total fixed cost is $5, if one unit is sold, the company will incur a loss of $1. However, if two units are sold, profit will be $3. If all other factors remain the same, increasing variable cost will decrease contribution margin, thereby reducing profit. Decreasing variable costs will increase contribution margin and increase profit. Generally, fixed costs remain unchanged in total regardless of the sales volume. The more units sold, the greater the profit. If fixed costs are altered, an increase in fixed costs will require a greater sales volume to cover the cost. Inversely, if fixed costs are decreased, fewer units must be sold to cover the fixed cost. Breakeven point is calculated as fixed cost divided by contribution margin per unit. One can see how changing sales price or variable costs changes the contribution margin.

214. Discuss the differences in “margin of safety” and “target operating income.” How do managers use these two items in the decision-making process?

Margin of safety relates to sales while target operating income relates to sales less variable and fixed costs. The margin of safety is the difference between current sales and breakeven sales. It represents the volume of sales that can be lost before the company incurs a loss. Managers use it in the decision-making process as a way to evaluate and control operations. For example, if a manager sees that the margin of safety drops below a projected level, he or she might take measures to increase sales volume or reduce costs. Target operating income is the profit (sales revenue less variable costs less fixed costs) that a company desires. Managers frequently have an income target in mind in the planning stage of decision-making activities. Managers calculate the level of sales required to meet their target operating income.

215. What basic information is needed in order to calculate the level of sales to reach a target operating income? Managers often want to know how many units must be sold to reach target net income, but the profit equation calculates operating income. How can a manager convert net income to operating income?

You use the same profit equation you use to determine the breakeven point, but set profit equal to the target income. In order to calculate a sales level requirement, you need the unit sales price, the unit variable cost, the total fixed costs, and rather than zero for breakeven, the desired operating income.

Net income is operating income less income taxes. The general formula for converting net income to operating income is net income divided by (1 – tax rate).

216. Discuss the terms “cost-plus pricing” and “target costing”. What are some advantages and disadvantages of each?

Cost-plus pricing adds an amount to the cost of the product or service to cover the company’s operating costs and contribute to its profit. The “plus” amount is often referred to as a markup, or the difference between the selling price and the cost of the product. Target costing starts with the price customers are willing to pay. This method computes the desired markup and the maximum cost the company can incur to deliver the product at the market price.

An advantage of cost-plus pricing is that it is a simple approach to pricing. A disadvantage of cost-plus pricing is that profit hinges on the company being able to define cost. Thus, it is important to identify the appropriate cost basis in communicating markups. Cost-plus pricing has several flaws. First, the price a customer is willing to pay for a product should represent the value of that product. A markup based on cost does not represent the value to the customer. Also, cost-plus pricing implies that the cost of the seller’s operational inefficiencies should be borne by the customer.

An advantage of the target costing method is that, in the planning stage, managers may be able to determine whether or not they should produce a product (whether the market price will provide a desired return.) A disadvantage is that, if the company does not engage in target costing before introducing a new product, the company may not be able to reduce cost enough to provide a desired return.