ACCOUNTING

Problem 3-28 Teri Hall has recently opened Sheer Elegance, Inc., a store specializing in

fashionable stockings. Ms. Hall has just completed a course in managerial accounting, and she

believes that she can apply certain aspects of the course to her business. She is particularly

interested in adopting the cost- volume profit (CVP) approach to decision making. Thus, she has

prepared the following analysis:

Sales price per pair of stockings . . . . . . . . . . . . . . . . . $2.00

Variable expense per pair of stockings . . . . . . . . . . . . 0.80

Contribution margin per pair of stockings . . . . . . . . . . $1.20

Fixed expense per year:

Building rental . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000

Equipment depreciation . . . . . . . . . . . . . . . . . . . . . . 3,000

Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Total fixed expense . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000

Required:

1. How many pairs of stockings must be sold to break even? What does this represent in total

dollar sales?

2. Prepare a CVP graph for the store from zero pairs up to 70,000 pairs of stockings sold each

year. Indicate the break-even point on the graph.

3. How many pairs of stockings must be sold to earn a $9,000 target profit for the first year?

4. Ms. Hall now has one full-time and one part-time salesperson working in the store. It will cost

her an additional $8,000 per year to convert the part-time position to a full-time position. Ms.

Hall believes that the change would bring in an additional $20,000 in sales each year. Should she

convert the position? Use the incremental approach. (Do not prepare an income statement.)

5. Refer to the original data. Actual operating results for the first year are as follows:

Sales . . . . . . . . . . . . . . . . . . . . . . $125,000

Variable expenses . . . . . . . . . . . . 50,000

Contribution margin . . . . . . . . . . . 75,000

Fixed expenses . . . . . . . . . . . . . . 60,000

Net operating income . . . . . . . . . . $ 15,000

a. What is the store’s degree of operating leverage?

b. Ms. Hall is confident that with some effort she can increase sales by 20% next year. What

would be the expected percentage increase in net operating income? Use the degree of

operating leverage concept to compute your answer.

SOLUTION 3-28

1. Sales = Variable expenses + Fixed expenses + Profits

$2.00Q = $0.80Q + $60,000 + $0

$1.20Q = $60,000

Q = $60,000 ÷ $1.20 per pair

Q = 50,000 pairs

50,000 pairs × $2 per pair = $100,000 in sales.

Alternative solution:

Fixed expenses $60,000Break-even point= = =50,000 pairs in unit sales CM per unit $1.20 per pair

Fixed expenses $60,000Break-even point= = =$100,000 in sales in dollar sales CM ratio 0.60

2. See the graph on the following page.

3. Sales = Variable expenses + Fixed expenses + Profits

$2.00Q = $0.80Q + $60,000 + $9,000

$1.20Q = $69,000

Q = $69,000 ÷ $1.20 per pair

Q = 57,500 pairs

Alternative solution:

Fixed expenses + Target profitUnit sales to attain = target profit CM per unit

$60,000 + $9,000 =

$1.20 per pair

= 57,500 pairs

2. Cost-volume-profit graph:

4. Incremental contribution margin:

$20,000 increased sales × 60% CM ratio ……………………………… $12,000

Less incremental fixed salary cost ………………………………………….. 8,000

Increased net operating income ……………………………………………. $ 4,000

Yes, the position should be converted to a full-time basis.

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

0 10,000 20,000 30,000 40,000 50,000 60,000 70,000

D o

ll a

rs

Number of Pairs

Break-even point: 50,000 pairs, or

$100,000 in sales

Fixed Expenses

Total Expenses

Total Sales

5. a. Degree of operating leverage:

Contribution margin $75,000 = = 5

Net operating income $15,000

b. 5 × 20% sales increase = 100% increase in net operating income. Thus, net operating

income would double next year, going from $15,000 to $30,000.

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