PART 2

PART 2 UNIT 3

3
2C. Decision Analysis

Module

1 C.1. Cost-Volume-Profit Analysis 3

2 C.2. Marginal Analysis 27

3 C.2. Marginal Analysis

C.3. Pricing 43
 NOTES

3–2 © Becker Professional Education Corporation. All rights reserved.

1
MODULE
PART 2 UNIT 3

C.1. Cost-Volume-Profit
Analysis
Part 2
Unit 3

This module covers the following content from the IMA Learning Outcome Statements.

CMA LOS Reference: Part 2—Section C.1. Cost-Volume-Profit Analysis

The candidate should be able to:

a. demonstrate an understanding of how cost/volume/profit (CVP) analysis (breakeven
analysis) is used to examine the behavior of total revenues, total costs, and operating
income as changes occur in output levels, selling prices, variable costs per unit, or
fixed costs
b. calculate operating income at different operating levels
c. differentiate between costs that are fixed and costs that are variable with respect to
levels of output
d. explain why the classification of fixed vs. variable costs is affected by the time frame
being considered
e. calculate contribution margin per unit and total contribution margin
f. calculate the breakeven point in units and dollar sales to achieve targeted operating
income or targeted net income
g. demonstrate an understanding of how changes in unit sales mix affect operating
income in multiple-product situations
h. calculate multiple-product breakeven points given percentage share of sales and
explain why there is no unique breakeven point in multiple-product situations
i. define, calculate, and interpret the margin of safety and the margin of safety ratio
j. explain how sensitivity analysis can be used in CVP analysis when there is uncertainty
about sales
k. analyze and recommend a course of action using CVP analysis
l. demonstrate an understanding of the impact of income taxes on CVP analysis

1 Introduction to Cost‑Volume‑Profit (CVP) Analysis LOS 2C1a

Cost-volume-profit (CVP) analysis is used by managers to forecast profits at different levels

of sales and production volume. The point at which revenues equal total costs is called the
breakeven point. Cost-volume profit analysis is synonymous with breakeven analysis. CVP
analysis is based on the primary assumption that cost behaviors remain consistent over the
relevant range. Changes in volume result in incremental changes in total costs associated solely
with variable costs.

© Becker Professional Education Corporation. All rights reserved. Module 1 3–3 C.

 1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

1.1 Assumptions
To use the CVP analysis model, several assumptions are made.
y Cost Behaviors and Classifications
yy All costs are separated into either variable or fixed costs, depending on the behavior of
the cost.
yy Volume is the only relevant factor affecting cost.
yy All costs behave in a linear fashion in relation to production.
yy Variable costs remain constant per unit but vary in total in direct proportion to a change
in sales or production volume.
yy Fixed costs remain constant in total but vary inversely on a per-unit basis with a change
in the level of activity.
yy Mixed (semi-variable) costs can be separated into the fixed component and the variable
component.
yy Cost behaviors are anticipated to remain constant over the relevant range of production
volume because there is an assumption that the efficiency of production does
not change.
yy Costs show greater variability over time. The longer the time period, the greater the
percentage of variable costs and the shorter the time period, the greater the percentage
of fixed-costs.
y Use of Single Product
Although cost-volume-profit analysis can be performed for more than one product, in its
simplest form, it assumes that the product mix remains constant.
y Contribution Approach (Direct Costing) is Used Rather Than Absorption Approach
The contribution approach to the income statement is used for breakeven analysis.
Identifying each element of cost as fixed or variable defines its relationship to volume and to
the computation of breakeven.
y Selling Prices Remain Unchanged
The volume of transactions produces a uniform contribution margin per unit and a
predictable, projected contribution margin based on volume.

LOS 2C1c 1.2 Fixed vs. Variable Costs

LOS 2C1d Variable costs increase in total as output increases but are fixed per unit within a relevant range.
Direct materials, direct labor, and variable overhead costs all change in total as volume changes
and are examples of variable costs.
Fixed costs do not change in total within the relevant range regardless of the change in
the production level. Examples include fixed overhead costs, including insurance premium
payments and the salary for a manufacturing supervisor who is paid a fixed amount per month
rather than being paid an hourly wage.
Semi-variable costs contain both fixed and variable components.

3–4 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
PART 2 UNIT
1 3 C.1. Cost-Volume-Profit Analysis

Illustration 1 Cost Behaviors

Mixed
Variable Fixed (semi‑variable)
Sales 
Less: returns and allowances 
Cost of sales
Direct material 
Direct labor 
Indirect labor 
Fringe benefits (15% of labor)  
Royalties (1% of product sales) 
Maintenance and repairs of building 
Factory production supplies 
Depreciation: straight-line 
Electricity: used in the mfg. process  
Scrap and spoilage (normal) 
Selling, general, and administrative expense
Sales commissions 
Officers' salaries 
Fringe benefits (relate to labor)  
Delivery expenses 
Advertising expenses (annual contract expenses) 

Whether a cost is variable or fixed depends on the time horizon. The longer the time horizon,
the more likely a cost will be variable. The salaries paid to manufacturing supervisors are fixed
in the current year, but over the long term as production levels increase and as the factory
expands, additional supervisors are needed.

1.3 Contribution Margin

The contribution approach to the income statement uses variable costing (also called direct
costing). Although it does not represent generally accepted accounting principles, the
contribution approach is extremely useful for internal decision making because it identifies each
sale's contribution toward covering fixed costs.

© Becker Professional Education Corporation. All rights reserved. Module 1 3–5 C.

 1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

LOS 2C1e 1.3.1 Contribution Approach to Calculating Operating Income

The contribution margin is the excess of sales revenues over variable costs (both variable
manufacturing costs and variable selling, general, and administrative costs). Once the
contribution margin is sufficient to cover all of the fixed costs (both fixed manufacturing
costs and fixed selling, general, and administrative costs), the remaining portion of the total
contribution margin adds to (contributes to) operating income.

Sales revenue

Less: all variable costs

Contribution margin

Less: all fixed costs

Operating income

Pass Key

Variable costs include direct labor; direct materials; variable overhead; and variable selling,
general, and administrative expenses.
Fixed costs include fixed overhead and fixed selling, general, and administrative expenses.

1.3.2 Contribution Margin per Unit and Total Contribution Margin

Revenue, variable costs, and contribution margin may be expressed in total, on a per-unit
basis, as percentages or as decimals. The contribution margin per unit is the unit sales price
minus the unit variable cost. Contribution margin per unit can be used to calculate total
contribution margin.

Contribution margin per unit = Selling price per unit – Variable costs per unit
Total contribution margin (method 1) = Total sales revenue – Total variable costs
Total contribution margin (method 2) = Contribution margin per unit × Number of units sold

3–6 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
PART 2 UNIT
1 3 C.1. Cost-Volume-Profit Analysis

1.3.3 Contribution Margin Ratio

Variable costs and contribution margin may be expressed as a percentage of revenue. This
percentage is called the contribution margin ratio:

Total contribution margin

Contribution margin ratio =
Total revenues
Contribution margin per unit
=
Selling price per unit

Example 1 Contribution Margin and Contribution Margin Ratio

Facts: Alpha Co. sells 20,000 units per year of its single product at a sales price of $100 per
unit. The variable manufacturing costs are $45 per unit and the variable selling costs are
$15 per unit. The annual fixed costs are $600,000.
Required:
1. Calculate the contribution margin per unit.
2. Calculate the total contribution margin.
3. Calculate the contribution margin ratio.
4. Calculate operating income.
Solution:

1.
Contribution
 Selling price per unit  Total variable costs per unit
margin per unit

 $100  ($45 + $15)

 $100  $60

 $40 per unit

2.
Total
 Contribution margin per unit  Number of units
contribution margin

 $40 per unit  20,000 units

 $800, 000

Or:

Total  $100 sales   $60 total variable 

   20,000 units     20,000 units 
contribution margin  price per unit   costs per unit 
 $2,000,000  $1, 200, 000

 $800, 000

(continued)

© Becker Professional Education Corporation. All rights reserved. Module 1 3–7 C.

 1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

(continued)

3.
Total contribution margin
Contribution margin ratio =
Total sales
$800,000
=
$2,000,000
= 40%
Or:
Contribution margin per unit
Contribution margin ratio =
Sales price per unit
$40
=
$100
= 40%

4.
Operating income = Total contribution margin – Total fixed costs
= $800,000 – $600,000
= $200,000

LOS 2C1b 1.3.4 Effects of Output Level on Profits

Contribution margin analysis can be used to assess the effect of various levels of production on
operating income.

Example 2 Calculating Operating Income at Different Operating Levels

Facts: Production for Falcon Co. is currently 4,000 units. The sales price per unit and
the variable costs per unit are $120 and $50, respectively. Total annual fixed costs are
$140,000. These relationships are constant for production levels up to 10,000 units.
Required: Determine operating income for sales of 2,000, 4,000, 6,000, 8,000, and 10,000 units.
Solution:
Units sold 2,000 4,000 6,000 8,000 10,000
Sales @ $120/unit $240,000 $480,000 $720,000 $960,000 $1,200,000
Less: variable cost
@ $50/unit (100,000) (200,000) (300,000) (400,000) (500,000)
CM @ $70 $140,000 $280,000 $420,000 $560,000 $ 700,000
Less: total fixed costs (140,000) (140,000) (140,000) (140,000) (140,000)
Operating income $ 0 $140,000 $280,000 $420,000 $ 560,000

3–8 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
PART 2 UNIT
1 3 C.1. Cost-Volume-Profit Analysis

2 Breakeven Analysis and Target Profit Computation LOS 2C1f

Breakeven analysis determines the sales required (in dollars or units) to achieve zero profit
or loss from operations. After breakeven is achieved, each additional unit sold will increase
pretax income by the amount of the contribution margin per unit. Note that pretax income is
not taxable income for federal income tax purposes. In determining the amount in revenues
required to break even, management must estimate both fixed costs overall and variable costs
on a per-unit basis.

Example 3 Breakeven Analysis

Facts: The following information is applicable to Green Grass Industries and will be used
for all of the examples in the next several sections:
yySales price per unit of $125 and variable costs per unit of $50. The contribution margin
per unit is $75 ($125 – $50) and the contribution margin ratio is 60% ($75—/—$125).
yyFixed costs of $150,000.
yyDesired pretax profit of $60,000, a tax rate of 40%, and desired after-tax profit
of $36,000.
yyPotential unit sales of 2,500 at the current sales price, and a maximum of 3,000 in unit
sales to reach market saturation.

2.1 Breakeven Point in Units

The breakeven point in units is determined by dividing breakeven sales revenue by the unit
selling price:

Revenues to breakeven
Units to breakeven =
Unit selling price

The breakeven point in units can also be calculated by dividing the unit contribution margin into
total fixed costs.

Total fixed costs

Breakeven point in units =
Contribution margin per unit

© Becker Professional Education Corporation. All rights reserved. Module 1 3–9 C.

1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

Illustration 2 Calculating the Formula for Breakeven in Units

This formula for breakeven point in units can be derived by starting with the fact that at the
breakeven point, sales revenue is equal to total costs:

Breakeven point sales = Total costs at the breakeven point

It is given that:

Sales price
Breakeven point sales   Breakeven units
per unit

Total costs at the  Variable cost Breakeven

    Fixed costs
breakeven point  per unit units 

Using substitution:

Sales price  Variable cost Breakeven

 Breakeven units     Fixed costs
per unit  per unit units 

Therefore:

 Breakeven Sales price   Variable cost Breakeven

 units      Fixed costs
 per unit   per unit units 

 Sales price Variable cost 

Breakeven units     Fixed costs
 per unit per unit 

Total fixed costs

Breakeven units 
Sales price per unit  Variable cost per unit
Total fixed costs

Contribution margin per unit

Example 3 Breakeven Analysis (continued)

Facts: The same as the first part of Example 3.

Required: Calculate Green Grass' breakeven point in units.
Solution: Breakeven point in units = $150,000 / $75 = 2,000 units
The company will need to sell 2,000 units in order to recover its variable costs of $50 per
unit and its total fixed costs of $150,000.

3–10 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
PART 2 UNIT
1 3 C.1. Cost-Volume-Profit Analysis

2.2 Breakeven Point in Dollars

There are two approaches to computing breakeven in sales dollars.
1. Contribution Margin per Unit: Compute the breakeven point in units using the contribution
margin per unit, and then multiply those breakeven units by the selling price per unit:

Breakeven point in dollars = Unit price × Breakeven point (in units)

Example 3 Breakeven Analysis (continued)

Facts: The same as the first part of Example 3.

Required: Calculate Green Grass' breakeven point in dollars, using breakeven units.
Solution: Breakeven point in dollars = $125 × 2,000 units = $250,000
The company will need sales of $250,000 in order to cover total variable costs of
$100,000 (2,000 units × $50 per unit) and total fixed costs of $150,000.

2. Contribution Margin Ratio: Divide total fixed costs by the contribution margin ratio
(i.e., the contribution margin as a percentage of revenue per unit or unit price):

Total fixed costs

Breakeven point in dollars =
Contribution margin ratio

Example 3 Breakeven Analysis (continued)

Facts: The same as the first part of Example 3.

Required: Calculate Green Grass' breakeven point in dollars, using the contribution
margin ratio.
Solution: Breakeven point in dollars = $150,000 / 60% = $250,000

2.3 Required Sales Volume for Target Profit LOS 2C1l

Breakeven analysis can be extended to calculate the unit sales or sales dollars required to
produce a targeted profit. Although profit figures are most relevant on an after-tax basis, the
amount that must be added to the breakeven computation in order to calculate the required
sales dollars/units must be a before-tax profit amount. This is done for the purposes of
maintaining consistency with the pretax sales and pretax cost figures used in the calculation.

© Becker Professional Education Corporation. All rights reserved. Module 1 3–11 C.

1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

Pass Key

Pretax profit can be calculated from after-tax profit using the following formula:

After-tax income
Pretax profit =
1 – Tax rate

2.3.1 Sales Units Needed to Obtain a Desired Profit

The formula is modified to treat the desired net income before taxes as another fixed cost.

Sales (units) = (Fixed cost + Pretax profit) / Contribution margin per unit

Example 3 Breakeven Analysis (continued)

Facts: The same as the first part of Example 3.

Required: Calculate Green Grass' unit sales needed in order to achieve its desired pretax
profit of $60,000.
Solution: Sales (units) = ($150,000 + $60,000) / $75 = 2,800 units
Green Grass must sell 2,800 units in order to cover its fixed and variable costs and
to achieve its desired pretax profit of $60,000.

2.3.2 Sales Dollars Needed to Obtain a Desired Profit

There are two approaches to computing the sales dollars needed to achieve a desired profit.

1. Summation of Total Costs and Profits

Sales dollars = Variable costs + Fixed costs + Pretax profit

Example 3 Breakeven Analysis (continued)

Facts: The same as the first part of Example 3.

Required: Calculate Green Grass' sales (in dollars) needed in order to achieve its desired
pretax profit.
Solution: Total variable costs = 2,800 units × $50 per unit = $140,000
Sales (dollars) = $140,000 + $150,000 + $60,000 = $350,000
Green Grass must have sales of $350,000 in order to cover its variable and fixed costs and
achieve its desired $60,000 pretax profit.

3–12 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
PART 2 UNIT
1 3 C.1. Cost-Volume-Profit Analysis

2. Contribution Margin Ratio

Fixed cost + Pretax profit

Sales =
Contribution margin ratio

Example 3 Breakeven Analysis (continued)

Facts: The same as the first part of Example 3.

Required: Calculate Green Grass' sales (in dollars) needed in order to achieve its desired
pretax profit.
Solution: Sales (dollars) = ($150,000 + $60,000)—/60% = $350,000

2.4 Predicting Profits Based on Volume

After breakeven has been achieved, each additional unit sold will increase net income by the
amount of the contribution margin per unit.

Example 3 Breakeven Analysis (continued)

Facts: The same as the first part of Example 3.

Required: Calculate Green Grass' profit if the company sells 2,500 units.
Solution: Profit = Units above the breakeven point × Contribution margin per unit
= 500 × $75 = $37,500.
The breakeven point calculated earlier was 2,000 units. For every unit sold above 2,000,
the company will book a $75 profit. If it sells 2,500 units, that is 500 additional units above
breakeven; those 500 units will provide a total profit of $37,500.

2.5 Setting Selling Prices Based on Assumed Volume

This analysis also may be used to derive a per-unit selling price necessary to cover all costs and
the desired pretax profit given a specific volume limit.

Sale price per unit = (Fixed costs + Variable costs + Pretax profit) / Number of units sold

© Becker Professional Education Corporation. All rights reserved. Module 1 3–13 C.

 1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

Example 3 Breakeven Analysis (continued)

Facts: The same as the first part of Example 3.

Required: Calculate Green Grass' per-unit sales price needed to produce its desired pretax
profit given the market saturation level of 3,000 units.
Solution: Per-unit sales price = [$150,000 + (3,000 units × $50 per unit) + $60,000]—/—3,000
= $120 per unit.
If the company can sell 3,000 units at $120 per unit, it will cover all fixed costs, variable
costs, and the desired pretax profit.

LOS 2C1h 3 Breakeven Analysis With Sales of Multiple Products

When breakeven analysis is used with multiple products, the units sold to achieve breakeven
depends on the sales mix (also called revenue mix) because each product in the mix likely has a
different contribution margin per unit.

Pass Key

There is no unique, single breakeven point for a company selling multiple products. Each
time the sales mix changes, a new breakeven point results because each product has
a different contribution margin. Selling more of relatively higher contribution margin
products results in a lower breakeven point.

3.1 Calculation of Breakeven Point Using Multiple Products

The calculation of the breakeven point for a given sales mix is a two-step procedure. If the
company sells a small number of products, the use of weighted averages for all products is
appropriate. If there is a wide range of products, the firm should segregate products into
product lines or product groups.

3.1.1 Multiproduct Breakeven Point in Units

y Step 1: Calculate the weighted average contribution margin in dollars. To do so, calculate
each product's contribution margin per unit, multiply that contribution margin by the ratio
of each product's units sold relative to total units sold, and add the results.
y Step 2: Calculate the breakeven point (in units), as follows:

Total fixed costs

Breakeven point in units =
Weighted contribution margin (dollars) per unit

3–14 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
PART 2 UNIT
1 3 C.1. Cost-Volume-Profit Analysis

3.1.2 Multiproduct Breakeven Point in Dollars

y Step 1: Calculate the weighted average contribution margin ratio by adding the weighted
contribution margin in dollars and dividing it by the total sales dollars.
y Step 2: Calculate the breakeven point (in dollars), as follows:

Total fixed costs

Breakeven point in sales dollars =
Weighted contribution margin ratio

3.2 Breakeven Point and Effects of Changes in Sales Mix

A change in the sales mix will result in a change in the breakeven point. When competitive,
economic, or other market conditions are expected to change during the period, managers
may wish to change sales mix assumptions to examine how changes in mix affect breakeven
and profit. Changes to the company's use of variable costs versus fixed costs will change the
contribution margin, contribution margin ratio, breakeven point, and profit forecasts.

Example 4 Breakeven Point Effects of Changes in Sales Mix LOS 2C1g

Facts: A company sells two products, Fix and Brix. Following are the revenues and costs
budgets for the coming year:

Fix Brix
Budgeted sales in units 50,000 150,000
Unit selling price $20 $10
Direct materials per unit $ 2 $ 1
Direct labor per unit $ 3 $ 2
Variable overhead per unit $ 2 $ 2

Fixed overhead is budgeted for the year at $600,000.

Required:
1. Calculate breakeven in dollars and units. Assume that the company will maintain the
sales mix as budgeted.
2. Calculate breakeven in dollars and units. Assume that the direct materials cost per unit
of Fix increases from $2 to $3.
3. Calculate breakeven in dollars and units. Assume that the quantity sold of Brix is
200,000 units instead of 150,000 units.

(continued)

© Becker Professional Education Corporation. All rights reserved. Module 1 3–15 C.

1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

(continued)

Solution:
1. Assume that the company will maintain the sales mix as budgeted:
Breakeven (dollars):
Fix Brix
Contribution margin per unit (CM/unit = SP/unit – VC/unit) $13 $5
CM ratio (CM/unit ÷ SP/unit) 65% 50%
Total sales dollars (Q × SP per unit) $1,000,000 $1,500,000
Product mix ratio based on sales dollars (Each product's
sales dollars ÷ Total sales dollars) 40% 60%
Product mix ratio in units (Each product's Q ÷ Total Q 25% 75%
of both)
Variable overhead per unit $2 $2
Weighted average CM ratio = Sum of each product's contribution margin ratio × That
product's mix ratio (based on sales dollars)
Weighted average CM ratio = (65% × 40%) + (50% × 60%) = 56%

Total fixed costs

Breakeven point (sales dollars) =
Weighted average contribution margin ratio
$600,000
=
56%
= $1,071,429 (rounded)

yyFix = 40% Fix's product mix ratio based on total sales dollars × $1,071,429 BEP in total
sales dollars = $428,572 (rounded) Fix sales to achieve BEP
yyBrix = 60% Brix's product mix ratio based on total sales dollars × $1,071,429 BEP in
total sales dollars = $642,857 (rounded) Brix sales to achieve BEP
Breakeven Point (units):
Weighted average per unit CM (in dollars) = Sum of each product's mix ratio (based on
units sold) x That product's per-unit contribution margin in dollars
Weighted average CM per unit = (25% × $13) + (75% × $5) = $7 weighted average CM
per unit

Total fixed costs

Breakeven point (unit) =
Weighted average contribution margin per unit
$600,000
=
$7
= 85,714 units (rounded)

(continued)

3–16 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
PART 2 UNIT
1 3 C.1. Cost-Volume-Profit Analysis

(continued)

yyFix = 25% product mix ratio based on units sold × 85,714 BE total units = 21,429
(rounded) Fix units to be sold to achieve BE
yyBrix = 75% product mix ratio based on units sold × 85,714 BE total units = 64,286
(rounded) Brix units to be sold to achieve BE
2. Assume that the direct materials cost per unit of Fix increases from $2 to $3:

Breakeven (dollars):
Fix Brix
Budgeted sales in units (Q) 50,000 150,000
Product mix ratio in units (Each product's Q ÷ Total Q 25% 75%
of both)
Unit selling price (SP) $20 $10
Direct materials per unit (DM) $ 3 $ 1
Direct labor per unit (DL) $ 3 $ 2
Variable overhead per unit (VOH) $ 2 $ 2
Total variable cost per unit (VC per unit = DM per unit + DL
per unit + VOH per unit) $ 8 $ 5
Contribution margin per unit (CM per unit = SP per unit –
VC per unit) $12 $ 5
CM ratio (CM per unit ÷ SP per unit) 60% 50%
Total sales dollars (Q × SP per unit) $1,000,000 $1,500,000
Product mix ratio based on sales dollars (Each product's
sales dollars ÷ Total sales dollars) 40% 60%

Weighted average CM ratio = Sum of each product's contribution margin ratio × That
product's mix ratio (based on sales dollars)
Weighted average CM ratio = (60% × 40%) + (50% × 60%) = 54%

Total fixed cost

Breakeven point (dollars) =
Weighted average contribution margin ratio
$600,000
=
54%
= $1,111,111 (rounded)

yyFix = 40% product mix ratio based on total sales dollars × $1,111,111 BEP in total
sales = $444,444 (rounded) Fix sales to achieve BEP
yyBrix = 60% product mix ratio based on total sales dollars × $1,111,111 BEP in total
sales = $666,667 (rounded) Brix sales to achieve BEP

(continued)

© Becker Professional Education Corporation. All rights reserved. Module 1 3–17 C.

1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

(continued)

Breakeven Point (units):

Weighted average CM per unit = Sum of each product's mix ratio (based on units sold)
× That product's unit contribution margin in dollars
Weighted average CM per unit = (25% × $12) + (75% × $5) = $6.75 weighted average CM
per unit

Total fixed costs

Breakeven point (units) =
Weighted average contribution margin per unit
$600,000
=
$6.75
= 88,889 (rounded) units

yyFix = 25% product mix based on units sold × 88,889 BEP total units = 22,223
(rounded) Fix units to be sold to achieve BEP.
yyBrix = 75% product mix based on units sold × 88,889 BEP total units = 66,667
(rounded) Brix units to be sold to achieve BEP.
As the contribution margin per unit of Fix decreases, the number of units needed to
break even increases.
3. Assume that the quantity sold of Brix is 200,000 units instead of 150,000 units:

Breakeven (dollars):
Fix Brix
Budgeted sales in units (Q) 50,000 200,000
Product mix ratio in units (Each product's Q ÷ Total Q of both) 20% 80%
Unit selling price (SP) $20 $10
Direct materials per unit (DM) $2 $1
Direct labor per unit (DL) $3 $2
Variable overhead per unit (VOH) $2 $2
Total variable cost per unit (VC per unit = DM per unit +
DL per unit + VOH per unit) $7 $5
Contribution margin per unit (CM per unit = SP per unit – VC
per unit) $13 $5
CM ratio (CM per unit ÷ SP per unit) 65% 50%
Total sales dollars (Q × SP per unit) $1,000,000 $2,000,000
Product mix ratio based on sales dollars (Each product's sales
dollars ÷ Total sales dollars) ⁄
13 ⁄
23

(continued)

3–18 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
PART 2 UNIT
1 3 C.1. Cost-Volume-Profit Analysis

(continued)

Weighted average CM ratio = Sum of each product's contribution margin ratio × That
product's mix ratio (based on sales dollars)
Weighted average CM ratio = (65% × 1⁄ 3) + (50% × 2⁄ 3) = 55%

Total fixed cost

Breakeven point (dollars) =
Weighted average contribution margin ratio
$600,000
=
55%
= $1,090,909 (rounded)

yyFix = 1⁄ 3 Fix's product mix ratio based on total sales dollars × $1,090,909 BEP in total
sales dollars = $363,636 (rounded) Fix sales to achieve BEP.
yyBrix = 2⁄ 3 Brix's product mix ratio based on total sales dollars × $1,090,909 BEP in
total sales dollars = $727,273 (rounded) Brix sales to achieve BEP.
Breakeven Points (units):
Weighted average CM per unit = Sum of each product mix ratio (based on units sold) ×
That product's unit contribution margin in dollars
The weighted average contribution margin per unit = (20% × $13) + (80% × $5) = $6.60

Total fixed cost

Breakeven (units) =
Weighted average contribution margin per unit
$600,000
=
$6.60
= $90,909 (rounded) units

yyFix = 20% product mix based on units sold × 90,909 BEP total units = 18,182
(rounded) Fix units to be sold to achieve BEP.
yyBrix = 80% product mix based on units sold × 90,909 BEP total units = 72,728
(rounded) Brix units to be sold to achieve BEP. Note: As the product with lower
contribution margin per unit constitutes a larger percentage of the sales mix, all else
equal, the number of units needed to break even has increased.

© Becker Professional Education Corporation. All rights reserved. Module 1 3–19 C.

 1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

4 CVP Analytical Tools

Managers may also use CVP analysis to forecast the effects of many types of operating changes
and to determine whether a firm has an operating cushion that can absorb sudden downturns
in the economy. When managers have this type of information, they are better able to make
operational decisions.

LOS 2C1j 4.1 Sensitivity Analysis

Managers use sensitivity analysis to model uncertainties. When sensitivity analysis is used in CVP
analysis, models test the sensitivity of operating income to changes in underlying assumptions
such as volume changes, sales price changes, or cost structure changes.

Illustration 3 Sensitivity Analysis

A company produces and sells widgets. The sales price per unit is $22 and variable costs
per unit are $9.50. Fixed costs for the year are estimated to be $100,000. The company
currently sells 10,000 units each year. The manager wants to analyze the change in
operating income that will result from changes in volume or an increase in variable cost
per unit.
Total sales revenue (10,000 units × $22/per unit) $220,000
Less: variable costs (10,000 units × $9.50 per unit) (95,000)
Total contribution margin (10,000 units × $12.50 CM per unit; CM per
unit = $22 selling price per unit – $9.50 variable costs per unit) 125,000
Less: fixed costs (100,000)
Operating income $ 25,000

Contribution margin per unit is $12.50 per unit; therefore, for every one-unit change in
sales volume there is a $12.50 change in operating income.
yyIf sales volume increases by 1,000 units: $12.50 contribution margin per unit × 1,000
additional units sold = $12,500 increase in operating income.
yyIf sales volume decreases by 1,000 units: $12.50 contribution margin per unit × 1,000
additional units sold = $12,500 decrease in operating income.
To determine how many units that sales would have to decline before profits fall to
$0 (breakeven):
$25,000 current operating income ÷ $12.50 CM per unit = 2,000 decline in unit sales
If variable costs per unit increase by $1, the contribution margin per unit decreases to
$11.50 and operating income falls by $10,000: 10,000 units × $1/unit decrease in the
contribution margin.
To find by how much sales price per unit would have to decline (or variable costs per unit
increase) before profits fall to $0 (breakeven):
$25,000 operating income ÷ 10,000 units = $2.50 per unit
Therefore, the sales price per unit could fall by $2.50 per unit or variable costs could
increase by $2.50 per unit (or some combination of the two) to breakeven.

3–20 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
PART 2 UNIT
1 3 C.1. Cost-Volume-Profit Analysis

4.2 Margin of Safety LOS 2C1i

The margin of safety is the excess of sales over breakeven sales. A decline in sales will not lead
to losses as long as the decline is within the margin of safety.

4.2.1 Sales Dollars

The margin of safety expressed in dollars is calculated as follows:

Margin of safety (in dollars) = Total sales (in dollars) – Breakeven sales (in dollars)

4.2.2 Percentage
The margin of safety also can be expressed as a percentage of sales, as indicated below:

Margin of safety in dollars

Margin of safety ratio =
Total sales

Illustration 4 Margin of Safety

Draft Co. incurs annual fixed costs of $220,000. The company produces and sells a single
product at a price of $180 per unit with variable cost of $60 per unit. The company expects
to sell 3,000 units in the coming year.
yyCM ratio = CM per unit ÷ Selling price per unit = ($180 – $60) ÷ $180 = 66.67%
yyBreakeven sales (dollars) = Fixed costs / CM ratio = $220,000 / 66.7% = $330,000
yyBreakeven sales in units: $330,000 breakeven (dollars) ÷ $180 sales price per unit = 1,834
units (rounded up)
yyExpected sales = 3,000 units × $180 sales price per unit = $540,000
yyMargin of safety = Expected sales – Breakeven sales = $540,000 – $330,000 = $210,000
yyMargin of safety ratio = Margin of safety / Total sales - $210,000 / $540,000 = 39%

(continued)

© Becker Professional Education Corporation. All rights reserved. Module 1 3–21 C.

 1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

(continued)

$990,000

$880,000
es
e nu
Rev
$770,000

$660,000
Margin of safety

$550,000
ts
l cos
Tota
$440,000

$330,000
s
cost
able
Vari
$220,000
Fixed costs

$110,000

Quantity
0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000

Quantity to BE

The graph illustrates the breakeven sales point, relative to the production costs and total
2C_Margin
revenues. The margin of safety is the area on the of Safetythat is to the right of the BEP point
graph
and that is between the Revenues line and the Total Costs line.

LOS 2C1k 4.3 Decision Making Using CVP

Managers can use CVP to compare how revenues, costs, and contribution margins change and
select the alternatives that maximize operating income.

Example 5 Decision Analysis Using CVP

Facts: A college operates a print shop that offers copying services to students for $0.15 per
copy. The machines are leased from a supplier. Labor and paper cost $0.07 per copy.
The supplier who provides the copying machines makes two offers to the college:
yyOffer No. 1: Pay a fixed monthly lease of $1,400.
yyOffer No. 2: Pay a fixed monthly fee of $200 plus an additional $20 for every 500
copies made.

(continued)

3–22 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
PART 2 UNIT
1 3 C.1. Cost-Volume-Profit Analysis

(continued)

Required:
1. Calculate the breakeven point in units if offer No. 1 is accepted.
2. Calculate the breakeven point in units if offer No. 2 is accepted.
3. Calculate the level of sales volume at which the college will be indifferent between the
two offers.
4. Which option should the college select if estimated sales volume is 40,000 copies
per month?
Solution:
1. Sales price per copy $0.15
Variable cost per copy (0.07)
Contribution margin per copy $0.08

Fixed costs
Breakeven point =
Contribution margin per copy
$1,400
=
$0.08
= 17,500 copies

2. Sales price per copy $0.15

Variable cost per copy (0.11) (0.07) paper and labor + $20 / 500 copies
additional variable (costs in lease)
Contribution margin per copy $0.04

Fixed costs
Breakeven point =
Contribution margin per copy
$200
=
$0.04
= 5,000 copies

(continued)

© Becker Professional Education Corporation. All rights reserved. Module 1 3–23 C.

1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

(continued)
3. The indifference point occurs when the numbers of copies sold generate the same cost
under either option.
Total cost of offer No. 1 = Total cost of offer No. 2
$1,400 fixed costs + $0.07 variable costs × Number of copies = $200 fixed costs +
$0.11 variable costs × the number of copies
$1,400 + $0.07N = $200 + $0.11N
$1,200 = $0.04N
N = 30,000 copies
At sales volume of 30,000 copies, the cost under either option is identical.
4. If the print shop expects to sell 40,000 copies, offer No. 1 will be the better option.
yy Offer No. 1: (40,000 copies × $0.07 VC per copy) + $1,400 fixed costs = $4,200
yy Offer No. 2: (40,000 copies × $0.11 VC per copy) + $200 fixed costs = $4,600

Question 1 MCQ-12494

A retailer sells a product throughout its stores for $30 per unit. Fixed costs include rent of
$60,000, salaries of $200,000, and other fixed costs of $100,000. Each unit's wholesale cost
is $16.50. A salesperson is paid a 5 percent sales commission in addition to the fixed salary
that the salesperson receives and that is included in the total annual salaries listed above.
What is the annual breakeven point in units?
a. 12,000 units
b. 20,000 units
c. 21,819 units
d. 30,000 units

Question 2 MCQ-12495

A retailer sells a product throughout its stores for $30 for each unit. Fixed costs include
rent of $60,000, salaries of $200,000, and other fixed costs of $100,000. Each unit's whole
cost is $16.50. The salesperson receives a 5 percent sales commission in addition to the
fixed salary that the salesperson receives and that is included in the total annual salaries
listed above. If the company expects to sell 35,000 units next year, what is the estimated
operating income?
a. $112,500
b. $60,000
c. $0
d. $(60,000)

3–24 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
PART 2 UNIT
1 3 C.1. Cost-Volume-Profit Analysis

Question 3 MCQ-12496

A company produces three products, X, Y, and Z, with a contribution margin of $6, $4, and
$3, respectively. Management estimates sales of 300,000 units next year: 100,000 units
of X; 150,000 units of Y; and 50,000 units of Z. How many units of Y must be sold to break
even if the sales mix is maintained and if fixed costs for the year are $112,500?
a. 25,000 units
b. 12,500 units
c. 8,334 units
d. 4,167 units

Question 4 MCQ-12497

A retailer sells a product throughout its stores for $30 for each unit. Fixed costs include rent
of $60,000, salaries of $200,000, and other fixed costs of $100,000. Each unit's wholesale
cost is $16.50. A salesperson receives a 5 percent sales commission in addition to a fixed
salary, and that is included in the total annual salaries listed above. If the company expects
to sell 35,000 units next year, what is the margin of safety?
a. $1,050,000
b. $900,000
c. $150,000
d. $0

© Becker Professional Education Corporation. All rights reserved. Module 1 3–25 C.

1 C.1. Cost-Volume-Profit Analysis PART 2 UNIT 3

NOTES

3–26 Module 1 C.1. Cost-Volume-Profit

© Becker Professional Education Corporation. Analysis
All rights reserved.
2
MODULE
PART 2 UNIT 3

C.2. Marginal Analysis

Part 2
Unit 3

This module covers the following content from the IMA Learning Outcome Statements.

CMA LOS Reference: Part 2—Section C.2. Marginal Analysis

The candidate should be able to:

a. identify and define relevant costs (incremental, marginal, or differential costs), sunk
costs, avoidable costs, explicit and implicit costs, split-off point, joint production costs,
separable processing costs, and relevant revenues
b. explain why sunk costs are not relevant in the decision-making process
c. demonstrate an understanding of and calculate opportunity costs
d. calculate relevant costs given a numerical scenario
g. demonstrate proficiency in the use of marginal analysis for decisions such as (a)
introducing a new product or changing output levels of existing products, (b) accepting
or rejecting special orders, (c) making or buying a product or service, (d) selling a
product or performing additional processes and selling a more value-added product,
and (e) adding or dropping a segment
h. calculate the effect on operating income of a decision to accept or reject a special order
when there is idle capacity and the order has no long-run implications
i. identify and describe qualitative factors in make-or-buy decisions, such as product
quality and dependability of suppliers
j. calculate the effect on operating income of a make-or-buy decision
k. calculate the effects on operating income of a decision to sell or process further or to
drop or add a segment
l. identify the effects of changes in capacity on production decisions
m. demonstrate an understanding of the impact of income taxes on marginal analysis
n. recommend a course of action using marginal analysis

1 Terms Related to Marginal Analysis

The operational decision method, referred to as marginal analysis, is used when analyzing
business decisions such as the introduction of a new product or changes in output levels of
existing products, acceptance or rejection of special orders, making or buying a product or
service, selling or processing further, and adding or dropping a segment. Marginal analysis
focuses on the relevant revenues and costs that are associated with a decision.

© Becker Professional Education Corporation. All rights reserved. Module 2 3–27

 2 C.2. Marginal Analysis PART 2 UNIT 3

LOS 2C2a 1.1 Relevant Revenues and Costs

LOS 2C2b When making business decisions that will affect future periods, revenues and costs related to
those decisions are deemed to be relevant only if they change as a result of selecting different
LOS 2C2c alternatives. Although variable costs are more likely to be relevant because they change with
production volume and output, relevant costs can be either fixed or variable.
Relevant revenues and costs often share similar characteristics, including their specific
traceability to cost objects that may change as a result of selecting different alternatives.
Ultimately, a cost's relevance pertains to its potential to affect the decision.
y Relevant Revenue: Revenues are relevant if the amount of revenue will change based on
the decision made. If no additional (incremental) revenue is gained or lost as a result of the
decision, that revenue is not relevant to the decision made.
y Direct Costs: Costs that can be identified with or traced to a given cost object. Direct costs
are usually relevant (variable costs are generally direct costs).
y Prime Costs: Direct material and direct labor costs, which are generally relevant.
y Discretionary Costs: Costs arising from periodic (usually annual) budgeting decisions
by management to spend in areas not directly related to manufacturing or selling.
Discretionary costs are generally relevant.

Illustration 1 Discretionary Costs

Costs to maintain landscaping at a corporation's headquarters are generally viewed

as discretionary.

y Incremental Costs: Also known as marginal costs, differential costs, or out-of-pocket costs,
the additional costs incurred to produce an additional amount of the unit over the present
output. Incremental costs are relevant costs and include all variable costs and any avoidable
fixed costs associated with a decision.
y Explicit Costs: Identifiable expenses are explicit costs. Explicit costs are generally direct
costs and are relevant to a decision if they change among the different alternatives.
y Implicit Costs: Also called imputed costs or opportunity costs, implicit costs are not
recorded in the accounting records of a company.

Illustration 2 Implicit Costs

A company that invests $1,000,000 on average in inventory loses the opportunity to invest
that money in a savings account that earns 5 percent annual interest. The forgone interest
income of $50,000 ($1,000,000 × 5%) is considered an implicit cost. This $50,000 amount is
not recorded in the company's accounting records.

y Opportunity Costs: The cost of forgoing the next best alternative when making a decision.
Opportunity costs are relevant costs.

3–28 Module 2 C.2.

© Becker Professional Education Corporation. All Marginal
rights Analysis
reserved.
PART 2 UNIT
2 3 C.2. Marginal Analysis

Illustration 3 Opportunity Costs

Relevant opportunity costs for decision making may include the following:
1. The contribution margin lost from not producing and selling at capacity because
production resources are needed for other items.
2. Costs associated with alternative uses of facility space.

Example 1 Opportunity Cost Calculation

Facts: A company produces ovens and refrigerators. Each oven sells for $500 with variable
costs of $230. Each refrigerator sells for $1,000 with variable costs of $600.
To expand the capacity to produce 300 additional refrigerators in the current month, the
company reduced oven production by 400 units.
Required: Calculate the opportunity cost and total incremental cost per new refrigerator.
Solution: To increase the production volume of refrigerators, the company ceased
producing and selling 400 ovens. The opportunity cost of not producing the ovens is equal
to the lost contribution margin:
Lost contribution margin =
 400 ovens × ($500 sales price per oven – $230 variable cost per oven)
= $108,000
The opportunity cost per additional refrigerator to be produced and sold is:
$108,000 ÷ 300 additional refrigerators = $360
The per-unit incremental cost to produce and sell 400 additional refrigerators by forgoing
the production and sale of 300 ovens is:
$360 opportunity costs + $600 variable costs = $960

Irrelevant Costs: Costs that do not differ among alternatives are irrelevant and should be
ignored in a marginal cost analysis.
Sunk Costs: Costs that are unavoidable because they were incurred in the past and cannot
be recovered or changed as a result of a new decision. Sunk costs, also known as historical
costs, are not relevant costs. Sunk costs are generally relevant with respect to computing
the after-tax cash flow arising from the sale or other disposition of an asset.

© Becker Professional Education Corporation. All rights reserved. Module 2 3–29

2 C.2. Marginal Analysis PART 2 UNIT 3

Illustration 4 Sunk Costs and Irrelevant Costs

Electramag Corporation is evaluating whether to replace a piece of equipment. The cost of

the old equipment is a sunk cost and not relevant to the replacement decision. Additionally,
under either alternative (keep the old equipment or replace it), the anticipated cost of
electricity needed to operate the equipment remains the same. The cost of electricity is
a variable cost. Even so, the cost of electricity is not relevant because it does not change
regardless of the selected alternative.

Controllable Costs: Costs that are authorized by the business unit manager or the decision
maker. The ability to control cost is evaluated when analyzing business decisions. By
classifying a cost as either controllable or uncontrollable, the specific level of management
responsible for the cost is identified. Controllable costs are relevant if they will change as a
result of selecting different alternatives.
Uncontrollable Costs: Costs that were authorized at a different level in the organization.
Uncontrollable costs are not relevant costs because they cannot be changed by the manager
making the decision.

Illustration 5 Controllable vs. Uncontrollable Costs

A manufacturing department manager has control over the materials and supplies used in
the manufacturing department (i.e., controllable costs), but that manager has no control
over the fixed asset depreciation allocated to the department (i.e., uncontrollable costs).

Avoidable Costs: Costs that are avoided as a result of not choosing an alternative. As a
result, the firm avoids the cost associated with the course of action not selected. They are
relevant to the decision.
Unavoidable Costs: Costs that are the same regardless of the chosen course of action
are unavoidable costs that are not relevant to future decisions. These costs will continue
regardless of the course of action taken. They have no effect on the decision.
Joint Costs: Joint costs are the costs from a single process that yields multiple products
(e.g., processing raw milk to produce butter, cream, buttermilk, and whole, or full fat, milk).
Joint costs cannot be traced to an individual product. Joint costs are sunk costs that are not
relevant to the decision to sell a product after one process or to process the product further
and then sell it.
The Split-off Point: The split-off point is the point in a joint production process at which two
or more products become separately identifiable.
Separable Costs: Separable costs are all costs incurred beyond the split-off point and are
traceable to each specific product identified at the split-off point. Separable costs occur
during manufacturing, marketing, and/or distribution.

3–30 Module 2 C.2.

© Becker Professional Education Corporation. All Marginal
rights Analysis
reserved.
PART 2 UNIT
2 3 C.2. Marginal Analysis

Illustration 6 Relevant Costs and Relevant Revenues LOS 2C2d

The following data are taken from a manufacturer's records for the current period:

Sales in units 30,000

Selling price per unit $ 400
Direct materials (DM) cost per unit $70
Direct labor (DL) cost per hour $20
Hours worked per worker, per year 2,000
Number of workers currently employed 30
Total other fixed costs (manufacturing OH, marketing and
selling, general and administrative costs) $850,000

An analysis of production identified opportunities to improve the production process

by reorganizing the machine setup process. This reorganization will cost approximately
$100,000 and will reduce the number of workers employed by seven. All other revenues
and costs remain unchanged due to the reorganization.
To decide whether to reorganize, management performs an analysis using available
information to compare operating income under the two alternatives.

Using All Information Using Relevant Information Only

Process Unchanged Reorganize Process Unchanged Reorganize
Revenues (30,000 units × $400
sales price per unit) $12,000,000 $12,000,000 Same under both alternatives → irrelevant
DM (30,000 units × $70 per unit) $ (2,100,000) $ (2,100,000) Same under both alternatives → irrelevant
DL $ (1,200,000) $ (920,000) $(1,200,000) $ (920,000)
[30 employees [23 employees
× $20 per hour × $20 per hour
per employee × per employee ×
2,000 hours] 2,000 hours]
Total other costs $ (850,000) $ (850,000) Same under both alternatives → irrelevant
Reorganization costs – $ (100,000) – $ (100,000)
Operating income (OI) $ 7,850,000 $ 8,030,000 $(1,200,000) $(1,020,000)
Difference in OI Difference in OI
Increase in operating income
$180,000 $180,000
if management reorganizes

If only relevant information is used, all costs and revenues that do not change among the
different alternatives are ignored in evaluating the alternatives. Ignoring irrelevant costs
and irrelevant revenues results in the same decision and reduces the time and resources
needed to make the decision.

© Becker Professional Education Corporation. All rights reserved. Module 2 3–31

 2 C.2. Marginal Analysis PART 2 UNIT 3

LOS 2C2m 1.2 Impact of Income Taxes on Decision Making

In addition to relevant revenues and relevant costs, income taxes are an important component
of marginal analysis. Incremental revenues, also known as differential revenues, result in taxable
income, and incremental costs are usually deductible for income tax purposes. The following
formulas are relevant when considering the impact of income taxes on decision making:

After-tax cost = Pretax cost × (1 – Tax rate)

After-tax benefit (revenue) = Pretax benefit (revenue) × (1 – Tax rate)

After-tax income = Pretax income × (1 – Tax rate)

Illustration 7 Computing After-Tax Cost

Company X embarks on a new advertising campaign at a pretax cost of $40,000. What is

Company X's after-tax cost for the new advertising campaign?
The after-tax cost of advertising = Pretax cost × (1 – Tax rate) = $40,000 × (1 – 21%) = $31,600.
This $31,600 amount represents the true cost of Company X's new advertising campaign.

LOS 2C2g 2 Special Order Decisions

LOS 2C2h
Special order decisions are defined as opportunities that require a firm to decide whether a
LOS 2C2n specially priced order should be accepted or rejected. Decisions of this character involve a
comparison of the special order price to the relevant costs of the decision and an analysis of the
strategic issues that relate to the acceptance or rejection of the order.

LOS 2C2l 2.1 Determining Relevant Costs

Special orders are short-term decisions that often assume excess capacity. Fixed costs are
generally not relevant to these decisions unless the special order will change total fixed costs.

2.1.1 Presumed Excess Capacity

If there is excess capacity, a comparison should be made of the incremental costs of the order
to the incremental revenue generated by the order. The special order should be accepted if the
selling price per unit is greater than the variable cost per unit.

2.1.2 Presumed Full Capacity

If the company is operating at full capacity, the opportunity cost of producing the special
order should be included in the analysis.
y The production that is forfeited to produce the special order is the next best alternative use
of the facility.
y The opportunity cost is the contribution margin that would have been produced if the
special order were not accepted.

3–32 Module 2 C.2.

© Becker Professional Education Corporation. All Marginal
rights Analysis
reserved.
PART 2 UNIT
2 3 C.2. Marginal Analysis

Pass Key

Decision Rule for Special Orders:

1. Presumed excess capacity → Accept if price offered per unit ≥ Variable cost per unit.
2. Presumed full capacity → Accept if price offered per unit ≥ Variable cost per unit +
Opportunity cost per unit

Example 2 Special Order With Excess Capacity

Facts: Kator Company is a manufacturer of industrial components. Product KB-96 is

normally sold for $150 per unit and has the following costs per unit:
Direct materials $20
Direct labor 15
Variable manufacturing overhead 12
Fixed manufacturing overhead 30
Shipping and handling costs 3
Fixed selling costs 10
Total cost $90

Kator has received a special, one-time order for 1,000 units of KB-96.
Required: Assuming that Kator has excess capacity, calculate the minimum acceptable
price for this one-time special order.
Solution: The fixed manufacturing overhead and the fixed selling costs are not relevant
to the decision. The incremental per-unit production cost is the total variable cost per unit
of $50. Kator should accept the special order only if the selling price per unit is greater
than $50.

Example 3 Special Order With No Excess Capacity

Facts: Assume the same costs as in the previous example. Kator has received a special,
one-time order for 1,000 units of KB-96. Assume that Kator is operating at full capacity. Also
assume that the next best alternative use of the capacity is the production of LB-64, which
would produce a contribution margin of $10,000.
Required: Calculate the minimum acceptable price for this one-time special order.
Solution: Kator's next best alternative use of its capacity would produce a contribution
margin of $10,000. If Kator produces 1,000 units of KB-96, this $10-per-unit ($10,000 / 1,000
units) opportunity cost would be added to the variable cost of $50 to determine the
minimum justifiable price for the special order. Kator should accept the special order only if
the selling price per unit is greater than $60.

© Becker Professional Education Corporation. All rights reserved. Module 2 3–33

 2 C.2. Marginal Analysis PART 2 UNIT 3

2.2 Qualitative Factors

The acceptance of a special order also requires consideration of a number of strategic and
qualitative factors, including:
y The effect on regular-priced sales and other long-term pricing issues.
y The possibility of future sales to this customer.
y The possibility of exceeding plant capacity or the complexities of the order itself.
y The pricing of the special order.
y The impact of income taxes.
y The effect on machinery and/or the scheduled machine maintenance program.

LOS 2C2g 3 Make vs. Buy

LOS 2C2j
The decision to make or buy a component (also referred to as insourcing versus outsourcing) is
LOS 2C2n similar to the special order decision. Managers should select the lowest-cost alternative.

3.1 Determining Relevant Costs and Other Make-or-Buy Issues

3.1.1 Capacity Issues
y Excess Capacity: If there is excess capacity, the cost of making the product internally is the
cost that will be avoided (or saved) if the product is not made. This will be the maximum
outside purchase price.
y No Excess Capacity: If there is no excess capacity, the cost of making the product internally
is the cost that will be avoided (saved) if the product is not made plus the opportunity cost
associated with the decision.

Example 4 Make vs. Buy Decisions

Facts: Offset Manufacturing produces 20,000 units of part No. 125. The production costs are:

Total Cost Cost per Unit

Direct materials $ 10,000 $0.50
Direct labor 40,000 2.00
Variable manufacturing overhead 20,000 1.00
Fixed factory overhead 40,000 2.00
Total cost $110,000 $5.50

An outside manufacturer approaches Offset Manufacturing and offers to sell it the same
part for $5 per unit. Offset has excess capacity. The $10,000 factory floor supervisor's salary
is the only fixed cost that will be eliminated if Offset purchases the part.
Required: Determine whether Offset Manufacturing should make or buy the part.

(continued)

3–34 Module 2 C.2.

© Becker Professional Education Corporation. All Marginal
rights Analysis
reserved.
PART 2 UNIT
2 3 C.2. Marginal Analysis

(continued)

Solution:
Make Buy
Total Per Unit Total Per Unit
Purchase cost $100,000 $5.00
Direct materials $10,000 $0.50
Direct labor 40,000 2.00
Variable factory overhead 20,000 1.00
Fixed factory overhead (avoidable) 10,000 0.50
Total relevant costs $80,000 $4.00 $100,000 $5.00
Difference $20,000 $1.00
Offset will choose to make the part because it is the lowest-cost alternative when relevant
costs are considered.

3.2 Qualitative Factors LOS 2C2i

The following strategic and qualitative factors should be considered when analyzing a make-or-
buy decision:
y The quality of the product purchased compared with the quality of the product manufactured.
y The reliability of the purchased product.
y The value of service contracts or other warranties.
y The risks associated with outsourcing or buying outside the organization, including
inflexibility, loss of control, and less confidentiality.
y The most efficient use of the entity's resources.

4 Sell or Process Further LOS 2C2g

LOS 2C2k
The decision regarding additional processing is made based on profitability.
LOS 2C2n
4.1 Deciding Factors to Sell or Process Further
The decision on whether to sell at the split-off point is made by comparing the incremental
cost and the incremental revenue generated after the split-off point.
If the incremental revenue exceeds the incremental cost, the organization should
process further.
If the incremental cost exceeds the incremental revenue, the organization should sell at the
split-off point.

© Becker Professional Education Corporation. All rights reserved. Module 2 3–35

2 C.2. Marginal Analysis PART 2 UNIT 3

Example 5 Joint Processing in Decision Making

Facts: Lola Co. produces two products in a joint process. Joint costs for the month of
April amount to $40,000. The two products, X and Y, can be sold for $10 and $24 per
unit, respectively, at the split-off point. In April, 10,000 units of X and 4,000 units of
Y were produced.
Lola can further process both X and Y into higher-quality refined products that can be sold
for $12 and $25 per unit, respectively. The separable costs for further processing of X and
Y are $9,000 and $6,000, respectively.
Required: Recommend the best decision for the manager of Lola to make to improve the
company's operating income.
Solution:

Incremental revenues = $20,000

X = 10,000 × $10 = $100,000 X = 10,000 × $12 = $120,000

Separable costs = $9,000

Joint costs = $40,000 (Relevant, incremental costs)
(Irrelevant sunk cost)

Split-off Separable costs = $6,000

point (Relevent, incremental costs)

Y = 4,000 × $24 = $96,000 Y = 4,000 × $25 = $100,000

Incremental revenues = $4,000

The joint costs of $40,00 are irrelevant since they will not
2C_Joint change
Processing basedMaking
in Decision on the
sell‑or‑process-further decision.
For product X, the incremental revenues of $20,000 exceed the incremental costs of $9,000,
resulting in incremental operating income of $11,000. Therefore, X should be processed
further to maximize operating income.
For product Y, the incremental revenues of $4,000 are less than the incremental costs of
$6,000, which would decrease operating income by $2,000. Product Y should be sold at
split-off and not processed further.

3–36 Module 2 C.2.

© Becker Professional Education Corporation. All Marginal
rights Analysis
reserved.
PART 2 UNIT
2 3 C.2. Marginal Analysis

5 Keep or Drop a Segment LOS 2C2g

LOS 2C2k
The decision to drop or add a business segment relates to the segment's contribution to overall
company profitability and management's ability to trace accurately the segment's relevant costs. LOS 2C2n
y Classification of Costs
The fixed costs associated with the segment must be identified as either avoidable (relevant)
or unavoidable (irrelevant) if the segment is discontinued.
y Decision Factors
A firm should compare the fixed costs that are avoided if the segment is dropped (i.e., the
cost of operating the segment regardless of the level of production) to the total contribution
margin that is forgone if the segment is dropped.
yy Keep the segment if the lost contribution margin exceeds avoided fixed costs.
yy Drop the segment if the lost contribution margin is less than avoided fixed costs.

Example 6 Fixed Costs are Unavoidable

Facts: The executives at Chowderhead Industries are evaluating each of its product lines.
A variable costing analysis by product shows that the company's clam and corn chowder
products are profitable but its conch chowder product is not.
Description Clam Conch Corn Total
Sales $125,000 $75,000 $50,000 $250,000
Variable costs 90,000 60,000 25,000 175,000
Contribution margin 35,000 15,000 25,000 75,000
Fixed costs 20,000 20,000 20,000 60,000
Operating income $ 15,000 $ (5,000) $ 5,000 $ 15,000
The conch chowder fixed costs are unavoidable.
Required:
Determine whether Chowderhead should eliminate its conch chowder product line.
Solution:
If the conch chowder fixed costs are unavoidable, they are incurred even if conch chowder
is eliminated.
Description Clam Conch Corn Total
Sales $125,000 – $50,000 $175,000
Variable costs 90,000 – 25,000 115,000
Contribution margin 35,000 – 25,000 60,000
Fixed costs 20,000 20,000 20,000 60,000
Net operating income $ 15,000 $(20,000) $ 5,000 –

The conch chowder product line should not be eliminated. Elimination of the product
will eliminate company-wide profits because the product makes a positive contribution
towards covering the entity's fixed costs.

© Becker Professional Education Corporation. All rights reserved. Module 2 3–37

2 C.2. Marginal Analysis PART 2 UNIT 3

Example 7 Avoidable Fixed Costs

Facts: Assume that $16,000 of the Conch Chowder fixed costs are avoidable advertising
costs that will not be incurred if the product is eliminated.
Required: Given these new facts, determine whether Chowderhead Industries should
eliminate its conch chowder product line.
Solution: If $16,000 of the fixed costs are avoidable, then only $4,000 are unavoidable and
will be incurred even if conch chowder is eliminated.

Description Clam Conch Corn Total

Sales $125,000 – $50,000 $175,000
Variable costs 90,000 – 25,000 115,000
Contribution margin 35,000 – 25,000 60,000
Unavoidable fixed costs 15,000 4,000 16,000 35,000
Avoidable fixed costs* 5,000 – 4,000 9,000
Operating income $ 15,000 $ (4,000) $ 5,000 $ 16,000

The Chowderhead executives should eliminate the conch chowder product line because
the avoidable fixed costs exceed the contribution margin that is lost when the product is
eliminated. In this case, elimination of the conch chowder product line improves overall
productivity from $15,000 to $16,000.
* Although this table showed the splits of unavoidable and avoidable fixed costs for Clam
and Corn, those product lines are continuing on and so the splits are irrelevant for this
particular decision regarding the Conch line.

5.1 Qualitative Factors

Important strategic and qualitative factors to consider include:
The complementary character of products and their relationship to the sales of other
products. Manufacturers might produce and price certain products as loss leaders to
promote sales of more profitable products.
The impact of product addition or deletion on employee morale.
The growth potential of each product regardless of individual profitability.
Opportunity costs associated with available capacity.

3–38 Module 2 C.2.

© Becker Professional Education Corporation. All Marginal
rights Analysis
reserved.
PART 2 UNIT
2 3 C.2. Marginal Analysis

Question 1 MCQ-12498

A company producing home appliances uses parts that it currently manufactures internally.
A supplier offered to sell the parts to the company at the same quality for $7 per unit.
The cost accounting department accumulated the following information related to the
production of these parts:
Parts need in a year 20,000 units
Direct materials (DM) per unit $ 4
Direct labor (DL) per unit $ 2
Variable overhead cost (VOH) per unit $ 1
Supervisor's salary $60,000
If the company decides to purchase the parts from the external vendor, $40,000 of the
supervisor's salary will continue to be paid because the supervisor will continue to work as
a part-time employee. The space that is currently used for the production of the parts can
be rented to others at $20,000 per year.
Which of the following statements is correct?
a. The company should accept the offer because operating income would increase
by $40,000.
b. The supervisor's salary is irrelevant to the decision and therefore should be
ignored in the analysis.
c. The company should reject the offer because only $20,000 of the supervisor's
salary is saved.
d. The company should reject the offer because the purchase price ($7 per unit) is
higher than the variable costs of producing the unit internally.

© Becker Professional Education Corporation. All rights reserved. Module 2 3–39

2 C.2. Marginal Analysis PART 2 UNIT 3

Question 2 MCQ-12499

A company producing home appliances uses parts that it currently manufactures internally.
A supplier offered to sell the parts to the company at the same quality for $7 per unit.
The cost accounting department accumulated the following information related to the
production of these parts:
Parts need in a year 20,000 units
Direct materials per unit $ 4
Direct labor per unit $ 2
Other variable costs per unit $ 1
Supervisor's salary $60,000
If the company decides to purchase the parts from the external vendor, $40,000 of the
supervisor's salary will continue to be paid because the supervisor will continue to work
as a part-time employee. The space that is currently used for the production of the parts
can be rented to others at $20,000 per year. What is the maximum price per unit that
the company can pay to the external vendor without reducing the company's operating
income? Assume that everything else is equal.
a. $6
b. $7
c. $8
d. $9

Question 3 MCQ-12500

A company produces T-shirts that it sells to its regular customers at $10 per shirt. Based on
a budget of 100,000 T-shirts, the cost of producing one T-shirt is presented below:
Direct materials per T-shirt $2.00
Direct labor per T-shirt $1.00
Variable overhead $1.00
Fixed overhead $1.50
Total unit cost $5.50
A one-time order is received from a new customer who is willing to pay $4.50 per T-shirt for
10,000 shirts. If the company has excess capacity, what would the effect be on operating
income if the company accepts the order?
a. Decrease by $10,000.
b. Increase by $5,000.
c. Decrease by $5,000.
d. Increase by $10,000.

3–40 Module 2 C.2.

© Becker Professional Education Corporation. All Marginal
rights Analysis
reserved.
PART 2 UNIT
2 3 C.2. Marginal Analysis

Question 4 MCQ-12501

A company produces T-shirts that it sells to its regular customers at $10 per T-shirt. Based
on a budget of 100,000 T-shirts, the cost of producing one T-shirt is presented below:
Direct materials per T-shirt $2.00
Direct labor per T-shirt $1.00
Variable overhead $1.00
Fixed overhead $1.50
Total unit cost $5.50
A one-time order is received from a new customer who is willing to pay $4.50 per T-shirt for
10,000 T-shirts. The company does not have excess capacity, and to accept the new order,
the company must stop producing 2,000 elegant shirts, which are usually sold for $20 each
and are produced at a variable cost of $12 each. What should be the minimum acceptable
price per T-shirt for the special order?
a. $4.00
b. $5.50
c. $5.60
d. $10.00

© Becker Professional Education Corporation. All rights reserved. Module 2 3–41

2 C.2. Marginal Analysis PART 2 UNIT 3

NOTES

3–42 Module 2 C.2.

© Becker Professional Education Corporation. All Marginal
rights Analysis
reserved.
3
MODULE
PART 2 UNIT 3

C.2. Marginal Analysis

C.3. Pricing
Part 2
Unit 3

This module covers the following content from the IMA Learning Outcome Statements.

CMA LOS Reference: Part 2—Section C.2. Marginal Analysis

The candidate should be able to:
e. define and calculate marginal cost and marginal revenue
f. identify and calculate total cost, average fixed cost, average variable cost, and average
total cost

CMA LOS Reference: Part 2—Section C.3. Pricing

The candidate should be able to:
a. identify different pricing methodologies, including market comparables, cost-based,
and value-based approaches
b. differentiate between a cost-based approach (cost-plus pricing, markup pricing) and a
market-based approach to setting prices
c. calculate selling price using a cost-based approach
d. demonstrate an understanding of how the pricing of a product or service is affected by
the demand for and supply of the product or service, as well as the market structure
within which it operates
e. demonstrate an understanding of the impact of cartels on pricing
f. demonstrate an understanding of the short-run equilibrium price for the firm in (1)
pure competition; (2) monopolistic competition; (3) oligopoly; and (4) monopoly using
the concepts of marginal revenue and marginal cost
g. identify techniques used to set prices based on understanding customers' perceptions
of value and competitors' technologies, products, and costs
h. define and demonstrate an understanding of target pricing and target costing and
identify the main steps in developing target prices and target costs
i. define value engineering
j. calculate the target operating income per unit and target cost per unit
k. define and distinguish between a value-added cost and a nonvalue-added cost
l. define the pricing technique of cost plus target rate of return
m. calculate the price elasticity of demand using the midpoint formula
n. define and explain elastic and inelastic demand
o. estimate total revenue given changes in prices and demand as well as elasticity
p. discuss how pricing decisions can differ in the short run and in the long run
q. define product life cycle; identify and explain the four stages of the product life cycle;
and explain why pricing decisions might differ over the life of a product
r. evaluate and recommend pricing strategies under specific market conditions

© Becker Professional Education Corporation. All rights reserved. Module 3 3–43 C.2. Mar
 3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

LOS 2C3d 1 The Laws of Demand and Supply

While macroeconomics focuses on how human behavior affects outcomes in highly aggregated
markets (e.g., products, labor), microeconomics focuses on how human behavior affects the
conduct of more narrowly defined units, including a single individual, household, or business
firm. Basic principles of microeconomic theory are very important, but understanding the
fundamentals is also important to the business manager. Managers are more likely to be
successful if they understand how their actions and various governmental policies or collusive
actions (for example, cartels) affect their market and firm. A market is simply a collection of
buyers and sellers meeting or communicating in order to trade goods or services.

1.1 Demand
1.1.1 Definitions
y Demand Curve
The demand curve illustrates the maximum quantity of a good that consumers are willing
and able to purchase at each and every price (at any given price), all else being equal. Note
that this demand curve is similar to the aggregate demand curve, except that the x-axis here
is quantity and not real GDP. It does, however, illustrate the same kind of relationship. This
demand curve is the microeconomics demand curve for a certain good or product and not
the total demand in the economy as a whole.
y Quantity Demanded
Quantity demanded is defined as the quantity of a good (or service) individuals are willing
and able to purchase at each and every (given) price, all else being equal.
y Change in Quantity Demanded (Movement Along the Demand Curve)
A change in quantity demanded is a change in the amount of a good demanded resulting
solely from a change in price. Changes in quantity demanded are shown by movements
along the demand curve (D). When assumptions regarding price or quantity change, the
"demand point" will change along this demand curve. For example, if the price of a product
increases, there will be a move up the demand curve.
y Change in Demand (Movement of the Demand Curve)
A change in demand is a change in the amount of a good demanded resulting from a
change in something other than the price of the good. A change in demand cannot be due
to a change in price. A change in demand causes a shift in the demand curve.

1.1.2 Fundamental Law of Demand

The fundamental law of demand states that the price of a product (or service) and the quantity
demanded of that product (or service) are inversely related. As the price of the product increases
(decreases), the quantity demanded decreases (increases). Quantity demanded is inversely
related to price for two reasons:
y Substitution Effect
The substitution effect refers to the fact consumers tend to purchase more (less) of a good
when its price falls (rises) in relation to the price of other goods. The substitution effect
exists because people tend to substitute one similar good for another when the price of a
good they usually purchase increases. For example, if the price of Pepsi decreases, it will be
used as a substitute for Coca-Cola (a similar good).

3–44 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

Income Effect
The income effect means that as prices are lowered with income remaining constant
(i.e., as purchasing power or real income increases), people will purchase more or all of
the lower‑priced products. For example, a decrease in the price of a good increases a
consumer's real income even when nominal income remains constant. As a result, the
consumer can purchase more of all goods.

1.1.3 Factors That Shift Demand Curves (Factors Other Than Price)
Changes in Wealth
A positive or negative change in wealth for people will result in a shift in the demand curve.
For example, if people become wealthier it may increase (shift) their demand for luxury
items (e.g., high-end sports cars).
Changes in the Price of Related Goods (Substitutes and Complements)
If the price of a similar good (a substitute good) increases, the demand curve will shift to the
right (increase) for the original good, now perceived as a bargain. If the price of a good used
in conjunction with the original good (referred to as a complementary good) decreases, the
demand for the original good will increase (e.g., if personal computer prices fall, demand
increases for peripherals, such as monitors and printers).
Changes in Consumer Income
An increase in consumers' incomes will shift the demand curve to the right (depicted as the
shift from D1 to D2). Assume, for example, that employment in a local community is primarily
retail-based. Because employees' commissions rise during the Christmas season, those
employees will have additional consumer income and will demand more goods (demand
curve shifts to right).
Changes in Consumer Tastes or Preferences for a Product
When consumers' preferences (tastes) for a given product increase or decrease, there is
a shift in the demand curve. For example, if the clothing industry experiences a revival of
the 1960s era, the demand for bell-bottom jeans (retro clothing) will increase. This is also
depicted as the shift from D1 to D2.
Changes in Consumer Expectations
If consumers anticipate that there will be a future price increase, immediate demand will
increase for that product (at the current, lower price). For example, if commuters expect that
the price of a monthly or annual bus pass will increase 10 percent in the near term, there
should be a spike in demand for bus passes.
Changes in the Number of Buyers Served by the Market
An increase in the number of buyers will shift the demand curve to the right. This is evident
in a community in which there has been a steady rise in the population of people 65 and
older. As the number of senior citizens grows, there will be more buyers of prescription
drugs, resulting in a shift in the demand curve to the right.

© Becker Professional Education Corporation. All rights reserved. Module 3 3–45 C.2. Mar
3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

Change in Quantity Demanded vs. Change in Demand

Price Price D3 D1 D2
(in $1) D (in $1)

A increase
PX1 in demand

PX2

A decrease D2
in demand D1
D
D3
X1 X2 Quantity Quantity

Change in quantity demanded: Change in demand:

Changes in price cause movements Shift in demand curve caused by external
along the demand curve. influences (other than the price of the good).

1.2 Supply
1.2.1 Definitions
B5_change in quantity demanded vs change in demand_p33
The fundamental law of supply states that price and quantity supplied are positively related
(i.e., they have a positive correlation). The higher the price received for a good, the more sellers
will produce (higher quantity).
Supply Curve
The supply curve illustrates the maximum quantity of a good that sellers are willing and able
to produce at each and every price (at any given price), all else being equal. Note that this
supply curve is similar to the aggregate supply curve, except that the x-axis here is quantity
and not real GDP. It does, however, illustrate the same kind of relationship. This is the
microeconomics supply curve for a certain good or product and not the total supply in the
economy as a whole.
Quantity Supplied
Quantity supplied is the amount of a good that producers are willing and able to produce at
each and every (given) price, all else being equal.
Change in Quantity Supplied (Movement Along the Supply Curve)
A change in quantity supplied is a change in the amount producers are willing and able
to produce resulting solely from a change in price. A change in quantity supplied is
represented by a movement along the supply curve. When price changes, there will be
movement up or down the supply curve to find the new quantity that will be supplied.
Change in Supply (Movement of the Supply Curve)
A change in supply is a change in the amount of a good supplied resulting from a change in
something other than the price of the good. A change in supply cannot be due to a change
in price. A change in supply causes a shift in the supply curve.

3–46 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

1.2.2 Factors That Shift Supply Curves

Changes in Price Expectations of the Supplying Firm
If prices are expected to decrease, the firm will supply more now at each price level to
take advantage of the currently higher prices. For example, Coffee Products Inc. produces
gourmet coffee (in cans) sold primarily to the restaurant industry. Given expected favorable
crop and market conditions, the company believes that the average price of gourmet coffee
will decline by $1 a can in the next six months. Based on this forecast, the company will
increase the supply of gourmet coffee now to maximize profitability. This is represented by
the shift in the supply curve from S1 to S2.
Changes in Production Costs (Price of Inputs)
When production costs are expected to decline (rise) there will be a shift in the supply curve
to the right (left). A decrease in wages paid to workers would cause a shift to the right in the
supply curve because for a lower amount of production dollars, the firm is willing to supply
more products. This is represented by the shift in the supply curve from S1 to S2.
Changes in the Price or Demand for Other Goods
A decrease (increase) in the demand for another good supplied by a firm would cause the firm
to shift its resources and increase (decrease) the supply of its remaining goods. Assume that a
firm produces two products, butter and margarine. If there is an industry‑wide increase in the
price of butter that also lowers butter demand, the firm will shift its production to make more
margarine, causing a shift in the supply curve for margarine to the right.
Changes in Subsidies or Taxes
A decrease in taxes or an increase in subsidies would increase the amount supplied at each
price level. In contrast, assume that a local company produces cigarettes and that a tax is
levied on the sale of cigarettes in the state. If the company believes that this tax increase will
negatively affect the demand for cigarettes, it will decrease the supply of cigarettes, which
will shift the supply curve to the left.
Changes in Production Technology
An improvement in technology would cause a shift to the right of the supply curve. For
example, a company has introduced a state-of-the art technology that would significantly
increase the finished bottle output for a production day. Under this scenario, the company
would increase supply, resulting in a shift in the supply curve to the right.

Change in Quantity Supplied vs. Change in Supply

S3
S S1
Price Price A decrease S2
(in $) (in $) in supply

P2

P1 An increase
in supply

X1 X2 Quantity Quantity

Change in quantity supplied: Change in supply:

Changes in price cause movements Shift in supply curve caused by external factors
along the supply curve. (other than price).

© Becker Professional Education Corporation. All rights reserved. Module 3 3–47 C.2. Mar

B5_change in quantity supplied vs change in supply_p34

3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

1.3 Market Equilibrium

A market is in equilibrium when there are no forces acting to change the current price/quantity
combination. The market supplies just as much as is demanded, and there is no pressure to
change prices.
The market's equilibrium price and output (quantity) is the point at which the supply and
demand curves intersect. This is sometimes called the market clearing price.
The interaction of demand and supply determines equilibrium price.

Market Equilibrium
Price (P)
D
Surplus S

$12 Price floor

10 Equilibrium price

9 Price ceiling

Shortage
S D

QS QE QD Quantity

• Price (P) is $10 at equilibrium, and the quantity supplied (Q) is QE.
• If the price is set below the equilibrium price, the quantity demanded
will exceed the quantity supplied, and a shortage will result.
• If the price is set above the equilibrium price, the quantity demanded
will be less than the quantity supplied, and a surplus will result.

1.3.1 Changes in Equilibrium

B5_market equilibrium_p35
If supply and/or demand curves shift, the equilibrium price and quantity will change.
Effects of a Change in Demand on Equilibrium
A rightward shift (increase) in demand from curve D to curve D1 (below, left) will result in an
increase in price (from P to P1) and an increase in market clearing quantity (from Q to Q1).
Conversely, a leftward shift (decrease) in demand from curve D to curve D1 (below, right) will
result in a decrease in price (from P to P1) and a decrease in market clearing quantity (from
Q to Q1).

Effects of a Change in Demand on Equilibrium

S
Price S Price

P1 P

P P1
D1
D

D D1
Q Q1 Quantity Q1 Q Quantity

3–48 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.

B5_effects of a change in demand on equilibrium_p35

PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

Effects of a Change in Supply on Equilibrium

A rightward shift (increase) in supply from curve S to curve S1 (below, left) will result in a
decrease in price (from P to P1) and an increase in market clearing quantity (from Q to Q1).
Conversely, a leftward shift (decrease) in supply from curve S to curve S1 (below, right) will
result in an increase in price (from P to P1) and a decrease in market clearing quantity (from
Q to Q1). Market clearing quantity is the equilibrium quantity. Market clearing is the idea that
the market will "eventually" be cleared of all excess supply and demand (all surpluses and
shortages), assuming that prices are free to change.

Effects of a Change in Supply on Equilibrium

S1
S
S
Price S1 Price

P1
P
P
P1
D
D

Q Q1 Quantity Q1 Q Quantity

Illustration 1 Effects of Changes in Demand and Supply on Equilibrium

B5_effects of a change in supply on equilibrium_p36

Consider the situation in the northeastern U.S. seaboard states during a recent hurricane.
Prior to the hurricane, the market for generators was most likely in a state of equilibrium.
However, as a result of the hurricane, residents began to demand more generators,
causing a shortage. Suppliers of generators were motivated to increase the price of
generators so fewer people wanted to purchase them. The price increase could potentially
"clear" the market (both demand and supply), resulting in a state of equilibrium at the
higher price.

General Effects of Changes in Demand and Supply on Equilibrium

yy An increase in demand and supply results in an increase in equilibrium quantity, but the
effect on price is indeterminate.
It is certain that the effect is an increase of equilibrium quantity (because both an
increase in demand and an increase in supply cause quantity to increase); however, the
effect on equilibrium price is indeterminate because an increase in demand and supply
could cause an increase, decrease, or no change (if equal changes) in equilibrium price.
—If
— the increase in demand is larger than the increase in supply, the equilibrium price
will rise.
—Conversely,
— if the increase in supply is larger than the increase in demand, the
equilibrium price will fall.

© Becker Professional Education Corporation. All rights reserved. Module 3 3–49 C.2. Mar
 3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

yy The effect of other complex scenarios such as 1) a decrease in demand and an increase
in supply, 2) an increase in demand and a decrease in supply, or 3) a decrease in
demand and a decrease in supply can be analyzed in a similar manner. The table
below summarizes the effect of all four scenarios discussed above on equilibrium price
and quantity. To understand them more fully, you should draw supply and demand
diagrams for each case to verify the effects listed.

Change Change Effect on Effect on

in Demand in Supply Equilibrium Quantity Equilibrium Price
Increase Increase Increase Indeterminate
Increase Decrease Indeterminate Increase
Decrease Decrease Decrease Indeterminate
Decrease Increase Indeterminate Decrease

2 Elasticity of Demand

Elasticity is a measure of how sensitive the demand for a product is as the price for that
product changes.

LOS 2C3m 2.1 Price Elasticity of Demand

LOS 2C3n The price elasticity of demand is the percentage change in quantity demanded divided by the
percentage change in price.

% Change in quantity demanded

Ep = Price elasticity of demand =
% Change in price
New quantity – Old quantity
% Change in quantity demanded =
(New quantity + Old quantity) / 2
New price – Old price
% Change in price =
(New price + Old price) / 2

y In a normal demand curve, the price elasticity of demand is usually negative. This negative
price elasticity reflects the downward sloping demand curve; as price goes up (positive
percentage change), the quantity demanded goes down (negative percentage change).
A negative price elasticity coefficient results if the demand curve is normal.

3–50 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

Example 1 Price Elasticity of Demand

Facts: When the price of a product increases from $100 per unit to $120 per unit, quantity
demanded decreases from 1,000 units to 900 units.
Required: Using the mid-point method, calculate the price elasticity of demand.
Solution:

% Change in New quantity – Old quantity 900 – 1,000

quantity demanded = (New quantity + Old quantity) / 2 = (900 – 1,000) / 2
–100
=
950
= –10.53%

New price – Old price 120 – 100

% Change in price = =
(New price + Old price) / 2 (120 – 100) / 2
20
=
110
= 18.18%

Ep = Price elasticity = % Change in quantity demanded = –10.53% = –0.58

of demand % Change in price 18.18%

The negative result represents the negative relationship between quantity demanded and
price. The law of demand that states that as prices go up, quantity demanded of normal
goods and services goes down.
Because the absolute value of elasticity is less than 1.00, demand is price inelastic; the
percentage decrease in quantity demanded is less than the percentage increase in prices.
Increasing the price of the product results in an increase in revenue since the revenues lost
due to decrease in quantity demanded are less than the gains in revenues resulting from
increased prices.

2.1.1 Price Inelasticity (Absolute Price Elasticity of Demand < 1.0)

Demand for a good is price inelastic if the absolute price elasticity of demand is less than 1.0.
The smaller the number the more inelastic the demand for the good.
If price inelasticity is zero, demand is perfectly inelastic. Note also that perfectly inelastic
demand curves are vertical, depicting that the quantity demanded stays the same no
matter how the price changes (e.g., in the pharmaceutical industry, the demand for insulin
by diabetics).
The calculation above with a 0.58 absolute value is an example of inelastic demand.

© Becker Professional Education Corporation. All rights reserved. Module 3 3–51 C.2. Mar
3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

2.1.2 Price Elasticity (Absolute Price Elasticity of Demand > 1.0)

Demand is price elastic if the absolute price elasticity of demand is greater than 1.0. When the
value is greater than 1.0 (defined as elastic), the greater the number, the more elastic the demand.

2.1.3 Unit Elasticity (Absolute Price Elasticity of Demand = 1.0)

Demand is unit elastic if the absolute price elasticity of demand is equal to exactly 1.0. Demand
is unit elastic if the percentage change in the quantity demanded caused by a price change
equals the percentage change in price.

2.1.4 Factors Affecting Price Elasticity of Demand

Product demand is more elastic with more substitutes available but is inelastic if few
substitutes are available. (Demand for soft drinks and fast-food restaurant meals are price
elastic. Purveyors of those products must be careful in raising their prices.)
The longer the time period, the more product demand becomes elastic because more
choices are available.

2.1.5 Price Elasticity Effects on Total Revenue

If we know the price elasticity of demand for a good, we can determine how a change in price
will affect a firm's total revenue. Total revenue is simply the price of a good multiplied by the
quantity of the good sold.
Effects of Price Inelasticity on Total Revenue (Positive Relationship)
When demand is price inelastic, an increase in price results in a decrease in quantity
demanded that is proportionally smaller than the increase in price. As a result, total revenue
(equal to price times quantity) will increase.
Effects of Price Elasticity on Total Revenue (Negative Relationship)
When demand is price elastic, an increase in price results in a decrease in quantity
demanded that is proportionally larger than the increase in price. As a result, total revenue
(equal to price times quantity) will decrease.
Effects of Unit Elasticity on Revenue (No Effect)
If demand is unit elastic, a change in price will have no effect on total revenue.
Summary
The table below summarizes the relationship between the price elasticity of demand and
total revenue.

Price Impact of Impact of

Elasticity Implied a Price Increase a Price Decrease
of Demand Elasticity on Total Revenue on Total Revenue
Elastic Greater than 1 Total revenue decreases Total revenue increases
Inelastic Less than 1 Total revenue increases Total revenue decreases
Unit Elastic Equal to 1 Total revenue is unchanged Total revenue is unchanged

3–52 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

Example 2 Price Elasticity of Demand: Effect on Revenue LOS 2C3o

Facts: The price of a product increased from $1.50 per unit to $1.75 per unit, and the
quantity demanded declined from 210 units to 195 units.
Required: Calculate the total revenue if the price increases to $1.85 per unit. Assume that
the relationship described in the facts remains constant.
Solution:
Step 1: Calculate price elasticity of demand.
%∆ in quantity demanded
Price elasticity of demand =
%∆ in price

New quantity – Old quantity 195 – 210

% Change in quantity = =
(Old quantity + New quantity) / 2 (195 – 210) / 2
–15
=
202.50
= -7.41%

New price – Old price $1.75 – $1.50

% Change in price = =
(Old price + New price) / 2 ($1.75 + $1.50) / 2
0.25
=
1.625
= 15.38%

%∆ in quantity demanded –7.41%

Price elasticity of demand = = = –0.48
%∆ in price 15.28%
Step 2: Determine whether demand is price elastic. Because the absolute value of price
elasticity of demand is less than one, then the demand is price inelastic; so, when prices
increase, revenue is expected to increase as shown:
yyTotal revenue before price increase = 210 units × $1.50/unit = $315.00
yyTotal revenue after price increase = 195 units × $1.75/unit = $341.25
yyIncrease in revenues = $341.25 – $315.00 = $26.25

(continued)

© Becker Professional Education Corporation. All rights reserved. Module 3 3–53 C.2. Mar
3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

(continued)

Step 3: Determine the change in revenue when the price increases from $1.75/unit to
$1.85/unit.
The percentage change in price is calculated as follows:
New price – Old price $1.85 – $1.75
% Change in price = =
(Old price + New price) / 2 ($1.85 – $1.75) / 2
0.10
=
1.80
= 5.56%
If the relationship between price and quantity demanded remains the same, the estimated
change in quantity demanded is as follows:

%∆ in quantity demanded %∆Q

Price elasticity of demand = = = –0.48
%∆ in price 5.56%
Percentage change in quantity = Price elasticity of demand × % Change in price:

%∆Q = –0.48 × 5.56% = -2.67%

Step 4: Determine the new quantity demanded after the price increase:

% Change New quantity – Old quantity New quantity – 195

= = = –2.67%
in quantity (New quantity + Old quantity) / 2 (195 + New quantity) / 2

→ 2 (New quantity – 195) = –2.67% × (195 + New quantity)

→ 2 (New quantity) – 390 = –5.2065 – 0.0267 (New quantity)
→ 2.0267 (New quantity) = 384.7935

384.7935
→ New quantity = = 190 (round up)
2.0267
Solving for the new quantity results in 190 units.
Step 5: Determine changes in total revenues:
——From Step 2: Total revenue before the price increase = 195 units × $1.75 per unit = $341.25.
——Total revenue after the price increase = 190 units × $1.85 per unit = $351.50.
——Therefore, the increase in total revenue = $351.50 revenues after price increase
– $341.25 revenues before price increase = $10.25 revenue increase.

3–54 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

3 Cost Functions, Marginal Cost, and Marginal Revenue

3.1 Cost Functions

There are three major cost functions underlying microeconomic analysis:

3.1.1 Average Fixed Cost (AFC) LOS 2C2e

Fixed costs are fixed in total and do not change in total as output changes. Average fixed cost is LOS 2C2f
equal to total fixed costs divided by the quantity produced.

Fixed costs
Average fixed cost =
Quantity produced

3.1.2 Average Variable Cost (AVC)

Variable costs are costs that vary with the level of activity. Average variable cost is equal to total
variable costs divided by the quantity produced.

Total variable costs

Average variable cost =
Quantity produced

3.1.3 Average Total Cost (ATC)

Average total cost (ATC) is also called unit cost or average unit cost.

Total costs
Average total cost =
Quantity produced

© Becker Professional Education Corporation. All rights reserved. Module 3 3–55 C.2. Mar
3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

Example 3 Average Cost Calculations

Facts: A company produces 1,000 units of a product incurring the following costs:
yyTotal fixed costs = $10,000
yyTotal variable costs = $25,000
Required:
1. Calculate the average fixed cost per unit.
2. Calculate the average variable cost per unit.
3. Calculate the average total cost per unit.
Solution:
Total fixed costs
Average fixed cost per unit = AFC =
Quantity produced
$10,000
=
1,000
= $10 per unit

Total variable costs

Average variable cost per unit = AVC =
Quantity produced
$25,000
=
1,000
= $25 per unit

(Total fixed costs + Total variable costs)

Average total cost per unit = ATC =
Quantity produced
($10,000 + 25,000)
=
1,000
= $35 per unit

3.2 Marginal Cost (MC)

Marginal cost (MC), or incremental cost, is equal to the change in total cost resulting from a one-unit
increase in quantity produced. For example, the marginal cost of the tenth unit produced is the total
cost of producing 10 units less the total cost of producing 9 units. The marginal cost for producing
one more unit is equal to the variable cost of producing one more unit, assuming that fixed costs do
not change in total when production increases (i.e., within the relevant range of production).

Change in total cost

Marginal cost =
Change in quantity produced

3–56 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

Illustration 2 Marginal Cost

A company has the following cost schedule for a relevant range from 20 to 25 units of output:

No. of Units Total Cost

20 $1,550
21 $1,700
22 $1,860
23 $2,040
24 $2,250
25 $2,500

——The marginal cost of producing the 21st units is $150 ($1,700 – $1,550).
——The marginal cost of producing the 22nd units is $160 ($1,860 – $1,700).
——The marginal cost of producing the 23rd units is $180 ($2,040 – $1,860).
——The marginal cost of producing the 24th units is $210 ($2,250 – $2,040).
——The marginal cost of producing the 25th units is $250 ($2,500 – $2,250).

Marginal cost depends solely on variable costs if the production facility has excess capacity.
Fixed costs do not influence marginal costs if the production facility has excess capacity, but
if production is at capacity and there is a need to increase production, the cost of adding
equipment or a new production facility to accommodate the additional production is a
marginal cost.

Illustration 3 The Cost Functions

The following table summarizes the cost functions for a company that produces and sells a single product.

A B C D E F G H
Marginal Average
Cost (MC) Average Fixed Variable Average Total
Quantity Total Fixed Total Variable Total Cost (TC) (Change in D ÷ Cost (AFC) Cost (AVC)* Cost (ATC)
Produced (Q) Costs (TFC) Costs (TVC) (B + C) Change in A) (B ÷ A) (C ÷ A) (D ÷ A)
10,000 $10,000,000 $ 3,000,000 $13,000,000 $1,000.00 $300.00 $1,300.00
20,000 $10,000,000 $ 5,800,000 $15,800,000 $280 $ 500.00 $290.00 $ 790.00
30,000 $10,000,000 $ 7,500,000 $17,500,000 $170 $ 333.33 $250.00 $ 583.33
40,000 $10,000,000 $ 8,400,000 $18,400,000 $ 90 $ 250.00 $210.00 $ 460.00
50,000 $10,000,000 $10,400,000 $20,400,000 $200 $ 200.00 $208.00 $ 408.00
60,000 $10,000,000 $13,200,000 $23,200,000 $280 $ 166.67 $220.00 $ 386.67
70,000 $10,000,000 $16,100,000 $26,100,000 $290 $ 142.86 $230.00 $ 372.86
80,000 $10,000,000 $19,560,000 $29,600,000 $346 $ 125.00 $244.50 $ 369.50
90,000 $10,000,000 $23,490,000 $33,490,000 $393 $ 111.11 $261.00 $ 372.11
100,000 $10,000,000 $30,400,000 $40,400,000 $691 $ 100.00 $304.00 $ 404.00
110,000 $10,000,000 $40,370,000 $50,370,000 $997 $ 90.91 $367.00 $ 457.91
* In accounting, we assume that variable cost per unit is fixed per unit within the relevant range. On
the large scale (i.e., outside the relevant range), average variable costs change due to economies
and diseconomies of scale.

© Becker Professional Education Corporation. All rights reserved. Module 3 3–57 C.2. Mar
3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

Illustration 4 Illustration and Analysis of Short-Run Cost Curves

Illustration and Analysis
of Short-Run Cost Curves

$1,200

$1,000

MC

$800
Cost

$600
ATC

$400
AVC

$200
AFC

$0
20,000 40,000 60,000 80,000 100,000 120,000

Quantity

1. As output increases, the average fixed cost (AFC) curve decreases over the range of
quantity produced. Because total fixed costs do not change regardless of the level of
production, the average fixed cost per unit decreases as production increases.
2. The AVC curve initially decreases due to economies of scale as production levels
increase. Economies of scale disappear at very high production levels, resulting in
diseconomies of scale that result in increasing average variable costs.
3. ATC is the sum of AFC and AVC. The ATC curve is U-shaped. At low levels of output,
average total costs are high because average fixed costs are high. As output increases,
average fixed costs fall and lead to lower average total costs. However, as output
continues to increase, average variable costs start to increase due to diseconomies of
scale, causing average total costs to rise.
4. The marginal cost curve (MC) intersects the AVC and ATC curves at their minimum points.
5. The short run supply curve (the point at which producers would choose to produce) is
the point where the marginal cost (MC) curve intersects with the average variable cost
curve (AVC).

3–58 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

3.3 Marginal Revenue

Marginal revenue is the incremental revenue resulting from an additional unit of sales.

Change in total revenues

Marginal revenue =
Change in quantity sold

Illustration 5 Revenue Functions

A B C D E F
Marginal Revenue
Average (MR) (Change in Marginal Cost
Quantity Unit Selling Total Revenue Revenue (AR) Column (C)/Change (MC) – (From
Sold (Q) Price (P) (TR) (A × B) (C ÷ A) in column (A)) Above)
10,000 $1,000 $10,000,000 $1,000 – –
20,000 960 19,200,000 960 $920 $280
30,000 920 27,600,000 920 $840 $170
40,000 900 36,000,000 900 $840 $90
50,000 872 43,600,000 872 $760 $200
60,000 837 50,220,000 837 $662 $280
70,000 802 56,140,000 802 $592 $290
80,000 764 61,120,000 764 $505 $346
90,000 723 65,052,000 723 $393 $393
100,000 689 68,900,000 689 $385 $691
110,000 654 71,940,000 654 $304 $997

To maximize profits, a company produces up to the point at which MC = MR. When

production increases beyond this point, the marginal profit becomes negative, as illustrated
in the following graph.
Revenue Functions

$1,200

$1,000
MC
Marginal
$800 profit is
Demand
Cost/Revenue

negative

$600
Marginal
profit is
$400
positive
MR
$200

$0
20,000 40,000 60,000 80,000 100,000 120,000
Quantity

At production below the intersection of MR and MC, there are marginal profits (MR > MC) and a
company should produce additional units until marginal profit is equal to 0. At production levels
above the intersection of MR and MC, marginal profit is negative and firms should not produce.

© Becker Professional Education Corporation. All rights reserved. Module 3 3–59 C.2. Mar
 3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

3.4 Profit Maximization

All firms, regardless of the market structure, maximize profit by producing where marginal
revenue (MR) equals marginal costs (MC).

Illustration 6 Profit Maximization

Quantity Sold (Q) Total Revenue (TR) Total Cost (TC) Profit
10,000 $10,000,000 $13,000,000 ($3,000,000)
20,000 $19,200,000 $15,800,000 $3,400,000
30,000 $27,600,000 $17,500,000 $10,100,000
40,000 $36,000,000 $18,400,000 $17,600,000
50,000 $43,600,000 $20,400,000 $23,200,000
60,000 $50,220,000 $23,200,000 $27,020,000
70,000 $56,070,000 $26,100,000 $29,970,000
80,000 $61,120,000 $29,560,000 $31,560,000
90,000 $65,052,000 $33,490,000 $31,562,000
100,000 $68,900,000 $40,400,000 $28,500,000
110,000 $71,940,000 $50,370,000 $21,570,000

To maximize profits, the company produces 90,000 units. Producing more units will have a
negative effect on total profits because the marginal cost for units beyond 90,000 is higher
than their marginal cost.

LOS 2C3d 4 Market Structures and Pricing

LOS 2C3f
Operating environments influence a firm's strategic plan. Following is a brief discussion of the
overall market structures in which firms may operate.

4.1 Perfect (Pure) Competition

In a perfectly competitive market, no individual firm can influence the market price of its
product, nor shift the market supply sufficiently to make a good scarcer or more abundant.

4.1.1 Assumptions and Market Conditions

y A large number of suppliers and customers act independently. Firms are small relative to
the industry.
y There are no barriers to entry because firms exert no influence over the market or price
(thus, goods and services are produced at the lowest cost to the consumer in the long run).
y Very little product differentiation (homogeneous products).
y Firms are price takers. Price is set by the market. Note that although the market demand
curve has a downward slope, each firm in a perfectly competitive market has a horizontal
demand curve at the equilibrium price for the industry, making the firm a "price taker" (i.e.,
no one firm by itself can decide to change the price). Because the price of the firm's output
is the same regardless of the quantity produced, actual price equals marginal revenue,
which equals average revenue.

3–60 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

y Firms control only the quantity produced. Each firm can sell as much or as little as it wants
at the given market price.
y Demand is perfectly elastic.
y Because there are no barriers to entry, the entry and exit of new firms ensures that
economic profits are zero in the long run; thus, firms earn a normal rate of return.

4.1.2 Advantages Derived From Perfect Competition

y The market maintains a lower price and larger quantity than in any other market structure.
(If in a perfectly competitive market abnormal profits developed, new competitors would
enter the market, and their presence would drive the price down.)
y Each buyer who is willing to pay the market price will get as many units as the buyer desires;
thus, utility is maximized.

4.2 Monopoly
Monopoly (e.g., the classic utility company, which was a "regulated" monopoly) represents
concentration of supply in the hands of a single firm.
4.2.1 Assumptions and Market Characteristics of Monopoly
y There is a single firm with a unique product.
y Significant barriers to market entry exist.
y Monopolies are "price setters," as opposed to firms in perfect competition (which are
"price takers"). The firm sets both output and prices (e.g., through patents or regulatory
restrictions against competition).
y There are no substitute products (the firm's demand curve is the same as the industry's
demand curve). Demand is inelastic.
y Because of insurmountable barriers to entry, economic profits are positive in the long run.

4.2.2 Maximizing Profits [MR = MC and P > MR (and MC)]

In pure monopoly the firm's demand curve coincides with the industry demand curve for the
product (because the firm and the industry are the same). Because a competitive firm produces
at Q, where MR = MC, the monopolistic firm produces at a lower output and higher price than
the competitive firm and earns above-normal profits.

MC
ATC
P1
$ Total
profit
ATCQ1

MR = MC Firm Industry
=
demand demand

Q1 MR
Quantity of output per period of time

MR = MC and P > MR (and MC)

© Becker Professional Education Corporation. All rights reserved. Module 3 3–61 C.2. Mar

2C_Maximizing Profits
 3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

4.2.3 Natural Monopoly

A natural monopoly exists when economic and/or technical conditions permit only one
efficient supplier.

LOS 2C3e 4.2.4 Cartels

Cartels are groups of firms acting together to coordinate output decisions and to control prices
as if the group were a single monopoly (e.g., OPEC and the Central Selling Organization of De
Beers). The likely effect of a cartel is to increase prices and to reduce output below the socially
efficient level.

4.2.5 Inefficiencies of Monopoly

Monopolists produce at a point where price is greater than marginal cost (see the following
graph). As a result, the quantity produced by a monopolist is below the socially efficient level (a
deadweight loss).

P
Deadweight
loss MC (Supply)

Demand
MR

Quantity of output
Monopoly Efficient level
level of output of output

4.3 Monopolistic Competition

y Significant non-price competition in the market (e.g., competition to increase brand
awareness and loyalty) 2C_Ineffiencies of Monopoly
y Instead of reducing prices, the firms spend money to create brand loyalty

3–62 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

4.3.1 Maximizing Short-Run Profits (MR = MC)

The graph below illustrates the profit-maximizing output level and price of a monopolistically
competitive firm. Because the firm sells a differentiated product, the firm faces a downward-
sloping demand curve (like a monopolist). The firm maximizes profits by producing the level
of output at the point at which MR and MC intersect for the perfectly competitive firm. In the
following graph, the firm earns an economic profit illustrated as the shaded area.

P
MC

ATC
P

MR Demand

q
Quantity of output

The monopolistically competitive firm earns an economic profit illustrated as the shaded area.

4.4 Oligopoly
An oligopoly is a market structure in which a few sellers (e.g., the "Big Three" U.S. automotive
manufacturers) dominate the sales of a product
2C_Maximizing and entry
Short-Run Profitsof new sellers is difficult or impossible.

4.4.1 Assumptions and Market Conditions

Relatively few firms with differentiated products. Firms are large relative to the industry.
There are fairly significant barriers to entry (e.g., high capital cost of designing a
safety‑tested car and building an auto plant).
Products are differentiated and firms have control over both the quantity produced and the
price charged.
Firms are strongly interdependent.
Oligopolists face a kinked demand curve because firms match price cuts of competitors but
ignore price increases. This causes the demand curves to have different slopes above and
below the prevailing price.
Because of high barriers to entry, economic profits are positive in the long run.

© Becker Professional Education Corporation. All rights reserved. Module 3 3–63 C.2. Mar
 3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

An Oligopolist's Kinked Demand Curve

$
If price is raised above the prevailing level,
rival firms will ignore the increase, and the
firm will lose a large portion of its sales.

A kink in the demand curve appears

D at the prevailing price.
P3
If price is cut, rival firms will match
P1 the reduction, thereby limiting the
potential gain in sales.
P2

D
Q4 Q5 Q1 Q3 Q2
Quantity of output per period of time

The matching of price cuts and the ignoring of price increases by rival firms has the effect
of making an oligopolist's demand curve highly elastic above the ruling (prevailing) price.
This causes the demand curve to be kinked, illustrating that there is not a direct relationship
between price and quantity at all points on the demand curve. Firms would be foolish to engage
in price cutting because rivals merely match the price reduction (e.g., the airline industry).

LOS 2C3r 4.5 Market Assumptions and Conditions

y Regardless of the modelB5_oligopolists
that represents the industry,
kinked the firm will operate best when
demand curve_p46
marginal revenue equals marginal cost (MR = MC).
y Microeconomic theory holds that firms make decisions based on marginal cost and marginal
revenue (essentially ignoring fixed or sunk costs).
y The following table summarizes the market assumptions and conditions underlying perfect
competition, monopolistic competition, oligopoly, and monopoly.

3–64 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

Summary Table: Market Structure

Monopolistic
Characteristic Perfect Competition Competition Oligopoly Monopoly
Firm's control over Firm has control Firm has control Firm has control Firm has control
price and quantity over quantity mostly over over both the over both price
produced only; price quantity produced; quantity produced and quantity
is set by the market, price is primarily and the price
firm must accept the set by the market charged
market price
Number of firms Many Many Few One
in the industry
(Highly competitive) (Highly competitive) (Moderately (No competition)
competitive)
Size of firms Small Small Large 100% of industry
relative to industry
Barriers to entry None Low High Insurmountable
(Easy to enter (Easy to enter (Difficult to enter (No entry is
industry) industry) industry because of possible)
economies of scale)
Differentiation of None Some Various None
product
(All firms sell the (Firms sell slightly (Firms usually (One firm
same commodity different products sell differentiated sells only one
product) that are close products) product)
substitutes)
Elasticity of Perfectly elastic Highly elastic but Inelastic Inelastic
demand downward sloping
(Firm sells as much, (Firms face a kinked (Firm faces the
or as little, as it (Firm can adjust downward-sloping entire demand
wants at the given quantity of products demand curve) curve for
market price) sold without the product,
affecting the price which slopes
very much) downward)
Long-run Zero economic Zero economic Positive economic Positive
profitability profit profit profit economic profit
Strategies Maintaining Maintaining Maintaining or Ignore market
market share and market share, enhancing market share and focus
responsiveness enhanced product share, proper on profitability
of sales price to differentiation, spending on from production
market conditions and allocation advertising, and levels that
of resources proper adaptation maximize profits
to advertising, to price changes
marketing, and and changes in
product research production volume

© Becker Professional Education Corporation. All rights reserved. Module 3 3–65 C.2. Mar
 3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

LOS 2C3a 5 Pricing Methodologies

LOS 2C3b
When setting a price for a product or service, management must consider internal and external
LOS 2C3g
factors, such as cost, competition, customer's perception, and company strategy.

5.1 Cost-Based Pricing

Cost-based pricing calculates price as the cost to produce the product plus a desired profit. The
difficulty with this process is the definition and justification of cost for a particular activity. It can
be difficult to allocate costs that are not directly traceable to a particular activity. Cost allocation
problems include the allocation of joint costs, corporate overhead and taxes, interest expense,
research and development, and advertising.
In cost-based pricing, management determines the selling price by ascertaining the cost of
preparing the product or service for sale to the customer and then adding either a standard
monetary amount to that cost (cost-plus pricing) or a percentage markup (markup pricing) to
that cost.

Markup Pricing Methods

If the markup is set as a percentage of cost → Price = Product cost × (1 + Markup percentage)
Product cost
If markup is set as a percentage of selling price → Price =
(1 − Markup percentage)

Cost-based pricing is easy to consistently implement; a retailer can categorize the items it sells
and can set a certain percentage markup for each category. The disadvantage of the cost-based
approach is that it ignores demand, the market, and customers' perceptions about the product.

LOS 2C2c Example 4 Cost-Plus Pricing Method

Facts: The cost accounting department of a manufacturer determined that cost incurred
to produce and sell an item is $70 per unit. Price is set at cost plus a 60 percent markup
percentage.
Required:
1. Calculate the sales price per unit if markup is set as a percentage of cost.
2. What is the product's selling price per unit if the markup is set as a percentage of
selling price?
Solution:
1. Price = Product costs × (1 + Markup percentage) = $70 × (1 + 60%) = $112
Product cost $70
2. Price = = = $175
(1 − Markup percentage) 1 − 60%
Profit is higher when the markup is set as a percentage of the selling price.

3–66 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

5.2 Market-Based Approaches

Market-based approaches to pricing involve setting prices based on competitors' pricing, as
determined by the marketplace. Market-based approaches to pricing generally occur in highly
competitive commodities-type markets among firms adopting a cost leadership strategy.
Setting a price at the market rate is possible if a company sells products that are similar to
those of competitors. Generally, a company may set a price a little higher or lower than that of a
competitor based on the premise that its product is differentiated from the competitor's product
while enhancing customers' perception of value. If consumers perceive the company's product
as different from, and better than, the competition's product, consumers will pay a slightly
higher price for the company's differentiated product.
If, however, the company is following a cost leadership strategy rather than a differentiation
strategy, the company will focus on reducing its cost of production and maintaining the selling
price at the going market rate. Reducing costs should allow the company to secure a higher
profit margin. Alternatively, companies following a cost leadership strategy can reduce selling
prices and gain a larger market share, thus earning a larger profit margin.

5.3 Market-Based Pricing Compared With Cost-Based Pricing

Market-based or cost-based pricing strategies can be used when markets are defined by product
differentiation strategies. Market-based pricing establishes a price based on what customers
want and how competitors will react to a particular price. Market-based pricing starts with
prices set by the market and works backward to the level of production costs that will allow the
company to achieve its desired profit. Cost-based pricing starts with production costs and then
works forward to a price based on the cost of the product plus a desired profit.

Illustration 7 Target Pricing LOS 2C3j

Bulls-I Manufacturing produces stainless steel silverware. Bulls-I is in a highly competitive

market and uses target costing strategies to ensure that its manufacturing costs are kept
low enough so that it can competitively price its product, maintain adequate profitability
for its owners, and provide resources to reinvest in research and development for
improved productivity.
Bulls-I's target costing utilizes the basic formula that determines the allowable cost of its
products based on the market selling price, net of desired profit, as follows:
Target cost = Competitive price – Desired profit
The main steps in developing target prices and target costs are as follows:
1. Determine competitive market price.
2. Determine the desired profit.
3. Compute the target cost as the difference between price and profit.
4. Use value engineering and other operational techniques to achieve the target cost.
5. Use Kaizen costing (continual cost reduction), including negotiations with suppliers and
operational controls, to reduce costs.

© Becker Professional Education Corporation. All rights reserved. Module 3 3–67 C.2. Mar
 3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

5.4 Value-Based Pricing

Value-based pricing is a strategy of setting prices based primarily on a consumer's perceived
value of a product, rather than considering the cost of producing the item. Value-based pricing
is customer-focused pricing. Companies that offer unique or highly valuable features or services
are better positioned to take advantage of the value pricing model than are companies that
sell commoditized items. Value-based pricing results in receiving the highest possible price
customers are willing to pay, thus earning a higher profit.

LOS 2C3p 5.5 Long-Run and Short-Run Pricing Decisions

Although both short-run and long-run pricing decisions are affected by cost, competition, and
customers' perceptions, there are certain strategic differences based on the time frame.
Costs that are irrelevant in the short run, such as fixed costs, become relevant when considering
long-term pricing. Pricing based on the life cycle of the product is an example of fixed costs
becoming relevant in the long term.
Prices fluctuate in the short run to match changes in demand and supply, whereas long-run
pricing decisions focus on achieving a certain rate of return on investment. The more prices are
stable in the long run, the better the relationship with the customer.
Although short-run pricing decisions are often made based on competitive requirements,
long-run pricing decisions are frequently value-based. Value-based pricing contemplates the cost
of the overall value a firm can provide a customer. This value includes customer service, training,
and other, after-the-sale-type services.

LOS 2C3h 6 Target Costing and Target Pricing

Target costing and target pricing are used to set competitive prices by establishing specific limits
on costs and prices to ensure market share and achieve desired profit margins.

6.1 Target Pricing

Target pricing is a form of market-based pricing. A target price is the estimated price of a
product that customers are willing to pay. Target operating income per unit is set at the amount
of operating income the company seeks to earn on each unit.

6.2 Target Costing

Target cost per unit is equal to target price minus target operating income per unit. The total
cost per unit is the long-run cost per unit that, when units are sold at the target price, will enable
the company to achieve its desired total operating income.

Target cost per unit = Target price – Target operating income per unit

3–68 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

Example 5 Target Costing

Facts: A company, using market research and demand analysis, determines a selling price
of $100 per unit. The target normal profit percentage is 30 percent.
Required: What is the target cost for the product to help management achieve its
profit margin?
Solution: The required profit per unit is 30 percent target normal profit percentage × $100
selling price per unit = $30 target normal profit per unit.
The targeted cost per unit = Selling price per unit – Target profit per unit = $100 per unit
– $30 per unit = $70 per unit
To achieve the target profit, the company must redesign its product to reduce the cost
to $70 per unit. A thorough analysis of costs and activities that incur costs is necessary.
The company should enhance value-added activities and eliminate activities that do not
add value.

6.3 Value Engineering LOS 2C3i

Value engineering is the evaluation of all activities along the value chain of the product. Activities LOS 2C3k
that add value to a product or service should be enhanced and preserved. Activities that do
not add value to a product or service should be eliminated to reduce waste and therefore cost.
Maintaining inventory is an example of a non-value-added cost. Under target costing, value
engineering can be used to manage product costs so that they are less than or equal to the
target cost set by the company.

6.4 Cost-Plus Target Rate of Return LOS 2C3l

The cost-plus target rate of return method prices products at the cost of the product plus
the rate of return established by management. This method is a long-term pricing strategy.
Management not only needs to earn a short-term profit but also needs to ensure that the entity
achieves a certain return on investment.
The procedure for establishing pricing using the cost-plus target rate of return to set prices is
as follows:
y Step 1: Determine the company's target rate of return by dividing the company's annual
desired operating income by the company's total invested capital or total assets.
y Step 2: Calculate the target operating income for the product by multiplying invested capital
used in production of the product by the target rate of return.
y Step 3: Calculate the target operating income per unit of the product by dividing the target
operating income from step 2 by the number of units the company expects to sell over the
product's lifetime.
y Step 4: Add the target per-unit return to the cost per unit to determine the selling price
per unit.

© Becker Professional Education Corporation. All rights reserved. Module 3 3–69 C.2. Mar
 3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

Example 6 Cost-Plus Target Rate of Return

Facts: The following information is taken from the records of Santes Co., which produces
electrical appliances for consumer use at home.

Total assets of Santes $ 10,000,000

Target annual profit $ 3,000,000
Assets used in the production of microwave ovens $ 3,400,000
Estimated quantity of microwave ovens produced and sold per year 15,000 units
Total cost of producing a microwave oven $370 per unit

Required: Calculate the price Santes must charge per unit to achieve the desired (target)
rate of return.
Solution:
Target annual profit $3,000,000
1. The desired rate of return = = = 30%
Total assets $10,000,000
2. The target income from the microwave oven sales = $3,400,000 assets × 30% desired
rate of return = $1,020,000
$1,020,000 target income
3. The target profit per microwave = = $68 per oven
15,000 ovens
4. The target selling price = $370 cost per oven + $68 target profit per oven = $438

LOS 2C3q 7 Product Life Cycle and Life‑Cycle Costing

7.1 Product Life Cycle

The product life cycle extends from research and development to product discontinuation or
redesign. The stages of the product life cycle are:
1. Research and Development Stage: This stage is long and costly as businesses expend
significant resources (capital and labor) to research product possibilities and develop a
viable product. This stage is characterized by high costs and no revenues.
2. Introductory Stage: In this stage, the product is introduced to the market. At this stage
the company has low levels of sales and low profits. The company must invest in marketing
activities in order to promote its new product. To do so, the company may adopt a
penetration strategy under which the company sells the product at relatively low prices
in order to gain market share. Alternatively, the company may adopt a market-skimming
strategy under which the business sells the product at a high price to early adopters in
order to recover the costs incurred during research and development. Market skimming is
typically associated with the introduction of high-tech products.

3–70 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

3. Growth Stage: During the growth stage, the product becomes profitable. Adjustments
to the sales price may be necessary as competitors enter the market. During the growth
stage, the total cost per unit declines as fixed costs are allocated to more units produced.
The business must continue to spend advertising dollars in order to counter intensifying
competition. Businesses at this stage generally must increase investments in productive
capacity as well as promotion and advertising while focusing on cash flow and working
capital management.
4. Maturity Stage: Sales growth is steady and potentially slowing during the maturity stage.
Although profits are high, profits will start to decline at this stage because of both intense
competition and the need to spend considerable amounts on marketing to maintain a
market position.
5. Decline Stage: In this stage, sales and profits decline. Price competition is severe due to the
availability of alternative products. Profit margins further decline because average costs per
unit increase due to the decline in volume. Businesses must make a strategic decision at this
stage. Some companies decide to discontinue the product line either by abandoning it or
by selling it to another business. Other businesses may decide to redesign the product and
improve it and, thus, enter a new growth stage.

Illustration 8 Summary of the Product Life Cycle

Number of
Stage Sales Costs Profits Competitors Price
Development None Heavy Negative None N/A
and R&D investment
in R&D
Introduction Low Highest Negative Very few Either
per unit penetration
or skimming
Growth Rapid Low average Growing Increasing in Cost-plus
growth cost per unit number
Maturity Peak sales Lower High Number Market‑based
average cost profits may start to to match
per unit decline competition
Decline Declining Lowest cost Declining Declining Lower prices
per unit profits number

© Becker Professional Education Corporation. All rights reserved. Module 3 3–71 C.2. Mar
3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

7.2 Life-Cycle Costing

Life-cycle costing is used to establish the total cost of a good or service from the time of
initial research and development and product design through delivery and customer service.
Unlike both traditional costing and ABC costing, which focus on costs incurred during the
manufacturing phase, life-cycle costing expands the focus to measuring costs over the entire
life of the product. Life-cycle costing is sometimes used as a basis for cost planning and product
pricing. Life-cycle costs comprise three broad components: upstream costs, manufacturing
costs, and downstream costs. To determine the estimated life-cycle cost per unit, the following
equation is used:

Total life-cycle costs

Life-cycle cost per unit =
Total number of units expected to be produced
and sold over the life of the product

7.2.1 Upstream Costs

Upstream costs include the costs for the research and development phase and the design
phase. A product's life cycle begins with research and development. The results of the research
and development phase allow management to determine if a product should continue to
the design phase. The design phase includes costs incurred for prototyping, testing, and
engineering. When a firm implements a design, the firm is committed to future manufacturing
plans, marketing plans, and overall customer service and support.

7.2.2 Manufacturing Costs

The manufacturing phase is the phase that most traditional costing methods address.

7.2.3 Downstream Costs

Downstream costs include costs incurred during marketing, distribution, sales, and service.
Marketing and distribution includes the processes of inspecting, packaging, warehousing, and
shipping the product, as well as standard promotion costs and costs of samples provided to
potential customers. Sales and service include a variety of sales and post-sales costs, such as
warranty costs, costs of recalls, customer service, and customer technical support.

3–72 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

Example 7 Life-Cycle Costing

Facts: A company produces electrical appliances. It recently developed a new dishwasher

and is planning to launch the new product in the coming year.
Market research conducted by the marketing department estimates that the product life
cycle of the new dishwasher is five years. The marketing department also estimated that
100,000 units will be sold during the five-year life of the product.
The cost accounting department accumulated the following financial information relevant
to the new dishwasher:

Description Total Fixed Costs Variable Cost per Unit

Research and development cost $1,650,000
Engineering and design cost 770,000
Production costs 390,000 $200
Marketing costs 170,000 35
Distribution costs 80,000 25
Customer after-sale service costs 140,000 30

Required:
1. Calculate the expected total life-cycle cost per dishwasher.
2. Calculate the required selling price per dishwasher if the target markup is 50 percent of
life-cycle cost.
Solution:
1. The expected total life-cycle cost per dishwasher is $322, determined as follows:

Total Total Variable Costs

Description Fixed Costs per Unit
Research and development cost $1,650,000
Engineering and design cost 770,000
Production costs 390,000 $200
Marketing costs 170,000 35
Distribution costs 80,000 25
Customer after-sale service costs 140,000 30
Total $3,200,000 $290
The total life-cycle cost of producing and selling 100,000 dishwashers = $3,200,000 total
fixed costs + ($290 variable cost per dishwasher × 100,000 dishwashers to be produced and
sold) = $32,200,000

The expected life-cycle $32,200,000 total life-cycle cost

= = $322
cost per dishwasher 100,000 dishwashers to be produced and sold

2. Dishwasher selling price = $322 expected life-cycle cost per dishwasher × (1 + 50%
target markup) = $483

© Becker Professional Education Corporation. All rights reserved. Module 3 3–73 C.2. Mar
3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

Question 1 MCQ-12502

A company produced the following table of its total revenues and total costs based on the
company's experiences and estimates of future results.

Quantity in Batches Total Total

of Production Revenues Cost
1 $1,000 $ 700
2 1,800 1,200
3 2,400 2,000
4 3,000 2,400
5 3,500 2,900
6 3,900 3,500

What is the marginal revenue when the company increases its production from three to
four batches?
a. $600
b. $750
c. $800
d. $3,000

Question 2 MCQ-12504

A company's cost information for the normal range of production is presented in the
following table:

Number of
Units Produced Total Cost
100,000 4,000,000
120,000 4,250,000
140,000 4,500,000

What is the marginal cost of producing one additional unit?

a. $40.00
b. $35.42
c. $32.14
d. $12.50

3–74 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
PART 2 UNIT
3 3 C.2. Marginal Analysis, and C.3. Pricing

Question 3 MCQ-12506

A company produces and sells electric industrial boilers and reported the following
information for the year just ended:

Units produced and sold 1,500

Investment $3,000,000
Markup percentage on full cost 10%
Rate of return on investment 20%
Variable cost per unit $3,200

Using the cost-plus target rate of return method, the full cost per unit is:
a. $400.
b. $800.
c. $4,000.
d. $4,400.

Question 4 MCQ-12508

A company intends to launch a new product the company developed recently. The
following table shows both the actual costs incurred for research and development (R&D)
and design during the preparation phases of this product and the estimated cost over the
product's five-year estimated life. The marketing department estimates a total of 500,000
units will be sold over the life of five years.

Fixed Cost During the Variable

Life of the Product Costs
R&D and design $ 700,000
Production 2,750,000 $25
Marketing and distribution 1,800,000 8
After-sale customer service 600,000 2

Assume that the company uses life-cycle costing. What is the selling price per unit if the
markup is determined at 40 percent of selling price?
a. $46.70
b. $65.38
c. $77.83
d. $116.75

© Becker Professional Education Corporation. All rights reserved. Module 3 3–75 C.2. Mar
3 C.2. Marginal Analysis, and C.3. Pricing PART 2 UNIT 3

Question 5 MCQ-12509

A company intends to launch a new product the company developed recently. The
following table shows both the actual costs incurred for research and development (R&D)
and design during the preparation phases of this product and the estimated cost over
the product's five-year estimated life. The marketing department estimates that a total of
500,000 units will be sold over the life of five years.

Fixed Cost During the Variable

Life of the Product Costs
R&D and design $ 700,000
Production 2,750,000 $25
Marketing and distribution 1,800,000 8
After-sale customer service 600,000 2

In an effort to maximize operating income, the manager is evaluating two options:

yyOption 1: Set the selling price at $70. This price will result in estimated sales of 500,000
units over the life of the product.
yyOption 2: Set the selling price initially at $90 for the first year to sell an estimated 60,000
units, then reduce the price to $60, which will lead to estimated sales of 600,000 units
over the product's remaining life.
Assume that the company uses life-cycle costing. Which option should the manager select?
a. Option 1, as it generates higher revenues.
b. Option 1, as it produces a higher per-unit average profit.
c. Option 2, as it generates higher operating income than option 1.
d. Neither option is appropriate, because the suggested selling prices are not
sufficient to cover all relevant costs over the long run.

3–76 Module 3 C.2. Marginal

© Becker Professional Education Analysis,
Corporation. and
All rights C.3. Pricing
reserved.
Class Question Explanations Part 2

UNIT 3

Unit 3, Module 1

1. MCQ-12494
Choice "d" is correct. The breakeven point ("BEP") is the number of units that will result in
no gain and no loss. The BEP is calculated by dividing the fixed costs for the period by the
contribution margin per unit.
The number of BEP units is calculated as follows:
Total fixed costs = $60,000 + $200,000 + $100,000 = $360,000
Variable cost per unit = $16.50 whole cost + (Sales commission of 5% × $30 sales price per unit) = $18
Contribution margin = Selling price per unit − Variable cost per unit = $30 − $18 = $12
Breakeven point in units = Fixed costs / CM per unit = $360,000 / $12 = 30,000 units
Choice "a" is incorrect. Dividing the fixed costs by the selling price per unit ($360,000 / $30 selling
price per unit = 12,000 units) is not correct. The BEP is calculated by dividing the fixed costs for
the period by the contribution margin per unit. The contribution margin per unit is unit sales
price minus all variable costs per unit.
Choice "b" is incorrect. Dividing the fixed costs by the variable cost per unit ($360,000 / $18 VC
per unit = 20,000 units) is not correct. The BEP is calculated by dividing the fixed costs for the
period by the contribution margin per unit. The contribution margin per unit is unit sales price
minus all variable costs per unit.
Choice "c" is incorrect. Not including as a variable cost the $1.50 commission paid per each
unit sold is not correct. The BEP is calculated by dividing the fixed costs for the period by the
contribution margin per unit. The contribution margin per unit is unit sales price minus all
variable costs per unit.

© Becker Professional Education Corporation. All rights reserved. CQ–25

Part 2 Class Question Explanations

2. MCQ-12495
Choice "b" is correct. Operating income is equal to the contribution margin earned for each
unit sold minus total fixed costs. Alternatively, operating income is equal to the CM per unit
multiplied by the difference between quantity sold and the breakeven point quantity. If the
quantity sold is greater than the breakeven point quantity, then operating income is greater than
zero, and the entity has operating income. If the quantity sold is less than the breakeven point
quantity, then operating income is less than zero, and the entity incurred an operating loss.
The number of BEP units is calculated as follows:
Total fixed costs = $60,000 + $200,000 + $100,000 = $360,000.
Variable cost per unit = $16.50 + (Sales commission of 5% × $30 sales price per unit) = $18.
Contribution margin = Selling price per unit − Variable cost per unit = $30 − $18 = $12.
Breakeven point in units = Fixed costs / CM per unit = $360,000 / $12 = 30,000 units
The operating profit = CM per unit × Number of units over the breakeven point = $12 × (35,000
units sold − 30,000 BEP units) = $60,000 operating profit.
Alternatively, [35,000 units to be sold × ($30 sales price per unit − $18 variable cost per unit)] −
$360,000 total fixed costs = $60,000 operating profit.
Choice "a" is incorrect. Ignoring the $1.50 commission paid to the salesperson is incorrect.
Operating income = Total sales − Total VC − Total FC = (35,000 units sold × $30 sales price per
unit) − (35,000 units sold × $16.50 incorrect variable costs per unit) − $360,000 total fixed costs =
$112,500 incorrect operating income.
Choice "c" is incorrect. Income is zero only at the breakeven point. The breakeven point number of
units is 30,000:
Breakeven in units = Fixed costs / CM per unit = $360,000 / $12 = 30,000 units
Choice "d" is incorrect. Because the number of units sold exceeds the breakeven number of
units, the resulting operating income is a positive $60,000, not a negative $60,000.

CQ–26 © Becker Professional Education Corporation. All rights reserved.

Class Question Explanations Part 2

3. MCQ-12496
Choice "b" is correct. The number of units to be sold to achieve breakeven (0 operating income)
depends on the sales mix (also called revenue mix) because each product may have a different
contribution margin per unit. The calculation of the weighted average contribution margin per unit
is needed to determine the breakeven point of all products. Then, a product's share is determined
using relative weight based on that product's units sold as a proportion of all units sold.
The number of units to be sold of Item Y for breakeven is 12,500 units. The calculation is as follows:

X Y Z
Sales in units 100,000 150,000 50,000
CM per unit $6 $4 $3
100,000 150,000 50,000
Product mix ratio in units = /3
1
= /2
1
= /6
1
300,000 300,000 300,000
Weighted average CM per unit:
$2 + $2 + $0.5 = $4.50 $6 × 1/3 = $2 $4 × 1/2 = $2 $3 × 1/6 = $0.50

Breakeven point units = $112,500 total fixed costs/ $4.50 weighted average CM per unit = 25,000
 X = 1/3 × 25,000 units = 8,334 units (rounded up)
 Y = 1/2 × 25,000 units = 12,500 units
 Z = 1/6 × 25,000 units = 4,167 units
Choice "a" is incorrect. 25,000 units are the total units of all items that lead to breakeven, but the
question is asking only for the number of units of Y that must be sold to break even.
Choice "c" is incorrect. 8,334 units is the number of units of X that lead to breakeven, but the
question is asking only for the number of units of Y that must be sold to break even.
Choice "d" is incorrect. $4,167 is the number of units of Z that lead to breakeven, but the
question is asking only for the number of units of Y that must be sold to break even.

© Becker Professional Education Corporation. All rights reserved. CQ–27

Part 2 Class Question Explanations

4. MCQ-12497
Choice "c" is correct. The margin of safety is the excess of sales over breakeven sales. A decline
in sales will not lead to losses as long as the decline is within the margin of safety. The margin of
safety expressed in dollars is calculated as follows: Total sales (in dollars) − Breakeven sales (in
dollars) = Margin of safety (in dollars)
The number of units for breakeven is 30,000, calculated as follows:
Total fixed costs = $60,000 + $200,000 + $100,000 = $360,000
Variable cost per unit = $16.50 per unit + (Sales commission of 5% × $30 sales price per unit) = $18
Contribution margin = Selling price per unit − Variable cost per unit = $30 − $18 = $12
Breakeven (units) = Fixed costs / CM per unit = $360,000 / $12 CM per unit = 30,000 units
Expected sales revenue at 35,000 units = 35,000 units × $30 sales price per unit = $1,050,000
Sales revenue at BEP = 30,000 BEP units × $30 sales price per unit = $900,000
Margin of safety = $1,050,000 expected sales revenue − $900,000 sales revenue at BEP = $150,000
Choice "a" is incorrect. $1,050,000 is the amount of total, expected sales revenue at 35,000 units
sold: 35,000 units expected to be sold × $30 sales price per unit = $1,050,000. However, the
question is asking for the margin of safety in sales revenue.
Choice "b" is incorrect. $900,000 is the amount of BEP sales revenue: 30,000 BEP units × $30 sales
price per unit = $900,000. However, the question is asking for the margin of safety in sales revenue.
Choice "d" is incorrect. Zero is the margin of safety in sales revenue only if the company sells
the BEP quantity, which is 30,000 units. However, the company is expected to sell 35,000 units,
which is more than the BEP quantity of 30,000 units; so, the margin of safety in sales revenue
will be greater than zero as the margin of safety is the excess of actual sales or expected sales
over breakeven sales.

Unit 3, Module 2

1. MCQ-12498
Choice "a" is correct. In a decision to make or buy, managers must determine whether the
opportunity costs associated with making a product with available capacity are less than the
contribution margins associated with using that capacity for additional business and with buying
externally.
By accepting the offer, the company will no longer spend the sum of $7 per unit associated with
DM ($4), DL ($2), and VOH ($1) and $20,000 of the supervisor's salary. If the company buys the
part, the company will rent the facilities to others for $20,000. The savings from costs avoided
and from rental income if the company buys the part is $180,000: $7 variable costs per unit ×
20,000 units + $20,000 salary avoided + $20,000 rental income. The cost for buying the part is
$140,000: $7 purchase price per part × 20,000 parts to be purchased. The net effect on operating
income is an increase of $40,000: $180,000 savings internally − $140,000 cost to buy externally.
Choice "b" is incorrect. The supervisor's salary will decrease by $20,000 if the company buys
from the vendor. Therefore, $20,000 of the supervisor's salary is relevant for the analysis.
Choice "c" is incorrect. The portion of the supervisor's salary to be saved is not the only relevant
cost to be considered in this decision.
Choice "d" is incorrect. In a make-or-buy decision, all relevant information, not just the variable
costs, must be considered.

CQ–28 © Becker Professional Education Corporation. All rights reserved.

Class Question Explanations Part 2

2. MCQ-12499
Choice "d" is correct. To determine the operating income under the two alternatives, all relevant
information must be considered.
Buying from an external vendor will have the following effect on income:
Avoidable cost = [($4 DM + $2 DL + $1 other variable costs) × 20,000 units] + $20,000 savings
from supervisor's salary = $160,000
Incremental revenues from renting the facility = $20,000
Total avoidable cost and incremental income = $180,000
The avoidable cost per unit and the incremental income are computed as follows: $180,000
total avoidable cost and incremental income ÷ 20,000 units = $9 per unit avoidable cost and
incremental income. This amount is the maximum price that the company should pay without
reducing current operating income.
Choice "a" is incorrect. The $6 represents only the direct materials and labor that are saved when
buying the parts externally. This amount is not the only relevant information for the analysis.
Choice "b" is incorrect. The $7 represents only the total variable costs per unit that are saved when
buying the parts externally. This amount is not the only relevant information for the analysis.
Choice "c" is incorrect. The $8 represents the sum of $7-per-unit variable costs and the $1
average fixed cost per unit for the portion of the supervisor's salary that is properly allocated
to the in-house production of the part. These costs are not the only relevant information for
the analysis. The $1 average fixed cost per unit for the portion of the supervisor's salary that
is properly allocated to the in-house production of the part is computed as follows: $20,000
supervisor's salary is properly allocated to the in-house production of the part ÷ 20,000 units =
$1 average fixed cost per unit for the portion of the supervisor's salary is properly allocated to
the in-house production of the part.

3. MCQ-12500
Choice "b" is correct. When deciding to accept or reject a special order, the company must
first determine whether the company has excess capacity. With excess capacity available,
the company will accept the special order if the price exceeds variable costs; fixed costs are
irrelevant. If there is no available capacity, then the company will accept the order only if the
price paid exceeds the sum of the variable costs and the opportunity costs involved.
Because the company has excess capacity, the offer is accepted as the $4.50-per-unit sales
exceeds the $4.00-per-unit variable cost of production. The resulting $0.50-per-unit contribution
margin from this order will increase operating income by $5,000: $0.50-per-unit contribution
margin × 10,000 units per special order = $5,000 increase operating income. Fixed costs are
irrelevant in this case.
Choice "a" is incorrect. The selling price of $4.50 per unit is incorrectly compared with total
costs of $5.50 per unit, resulting in a loss of $1.00 per unit. $10,000 is the computed decrease in
operating income calculated on this basis. However, this calculation is incorrect, because fixed
costs are not relevant and should be excluded from the analysis.
Choice "c" is incorrect. Operating income will increase by $5,000 rather than decrease by $5,000,
on account of the company's accepting the special order.
Choice "d" is incorrect. The selling price of $4.50 per unit is incorrectly compared with total costs
of $5.50 per unit, resulting in a loss of $1.00 per unit. $10,000 is the computed decrease, not the
computed increase, in operating income calculated on this basis. However, this calculation is
incorrect, because fixed costs are not relevant and should be excluded from the analysis.

© Becker Professional Education Corporation. All rights reserved. CQ–29

Part 2 Class Question Explanations

4. MCQ-12501
Choice "c" is correct. When deciding to accept or reject a special order, the company must first
determine whether it has excess capacity. With excess capacity available, the company will
accept the special order if the special-order price exceeds variable costs. If there is no available
capacity, then the company will accept only if the special-order price paid exceeds the sum of
the variable costs and the opportunity costs involved.
Because the company has no excess capacity, the minimum selling price should be the variable
costs plus opportunity costs from accepting the special order.
Elegant shirt opportunity cost = [2,000 elegant shirts × ($20 sales price per elegant shirt − $12
variable costs per elegant shirt)] = $16,000.
Elegant shirt opportunity cost per each special-order T-shirt = $16,000 opportunity cost for all
2,000 elegant shirts ÷ 10,000 special-order T-shirts = $1.60 elegant shirt opportunity cost per
each special-order T-shirt.
Variable cost for each special-order T-shirt + Elegant shirt opportunity cost per each special-
order T-shirt = $2 DM per T-shirt + $1 DL per T-shirt + $1 variable OH per T-shirt + $1.60 elegant
shirt opportunity cost per each special-order T-shirt = $5.60 minimum acceptable price per
T-shirt for the special order.
Choice "a" is incorrect. The amount of variable costs of $4.00 per unit is not the minimum price.
The opportunity costs must be considered because the company is operating at full capacity.
Choice "b" is incorrect. The amount of total costs of $5.50 per unit is not the minimum price.
Fixed costs are irrelevant for this analysis. Furthermore, the opportunity costs must be
considered because the company is operating at full capacity.
Choice "d" is incorrect. $10.00 is not the minimum price, as that amount represents the regular
selling price.

Unit 3, Module 3

1. MCQ-12502
Choice "a" is correct. Marginal revenue is the incremental revenue resulting from an additional
unit of sales. Marginal revenue is calculated as the change in total revenues divided by the
change in quantity sold.

Change in total revenues

Marginal revenue =
Change in quantity sold

When the company increases production from three to four batches, total revenue increases
from $2,400 to $3,000. The change in the quantity sold is one. Therefore, the change in revenues
is $600: $600 change in total revenues ÷ 1 the change in quantity sold.
Choice "b" is incorrect. $750 is the average revenue from selling four batches: $3,000 total
revenues ÷ 4 batches sold = $750 average revenue.
Choice "c" is incorrect. $800 is the average revenue from selling three batches: $2,400 total
revenues ÷ 3 batches sold = $800 average revenue.
Choice "d" is incorrect. $3,000 is the total revenue when producing four batches.

CQ–30 © Becker Professional Education Corporation. All rights reserved.

Class Question Explanations Part 2

2. MCQ-12504
Choice "d" is correct. Marginal cost (MC), or incremental cost, is equal to the change in total cost
resulting from a one-unit increase in quantity produced. It is calculated as the change in total
cost divided by the change in total units produced.
When the number of units increases from 100,000 to 120,000 units or from 120,000 to 140,000
units, total cost increases by $250,000. That is, for every 20,000 units in number of units produced,
total cost increases by $250,000. Therefore, marginal cost is $12.50, calculated as follows:

Change in total cost $250,000

MC = = = $12.50
Change in total output 20,000

Choice "a" is incorrect. The average total cost when producing 100,000 units is $40.00.
Choice "b" is incorrect. The average total cost when producing 120,000 units is $35.42.
Choice "c" is incorrect. The average total cost when producing 140,000 units is $32.14.

3. MCQ-12506
Choice "c" is correct. The cost-plus target rate of return prices products at the cost of the product
plus the rate of return established by management. This pricing method is a long-term pricing
strategy. The markup percentage on full cost is also a pricing approach that covers the cost plus
a certain markup percentage set by management.
The full cost is $4,000, calculated as follows:
Step 1: Required operating income for the year = $3,000,000 investment × 20% required rate of
return = $600,000.
Step 2: Required operating income per unit sold = ($600,000 required operating income) / (1,500
units produced and sold) = $400 per unit
Step 3: The facts indicate that there is a 10 percent markup on full cost per unit. As such,
operating income per unit will equal that markup: the $400-per-unit operating income is 10% of
the full cost:
$400 operating income per unit sold = 10% × Full cost per unit
$400 per unit = 0.10 full cost per unit
Full cost per unit = $4,000.
Choice "a" is incorrect. The operating income per unit is $400; however, the question asks for the
full cost per unit.
Choice "b" is incorrect. The fixed cost per unit is $800 per unit: $4,000 full cost per unit − $3,200
variable cost per unit.
Choice "d" is incorrect. The selling price per unit is $4,400: $4,000 full cost per unit + ($4,000 full
cost per unit × 10% markup).

© Becker Professional Education Corporation. All rights reserved. CQ–31

Part 2 Class Question Explanations

4. MCQ-12508
Choice "c" is correct. Product life cycle and life-cycle costing develops the total cost of a good
or service from research and development and product design through delivery and customer
service. The product life cycle extends from the research and development efforts up to the
point when customer support is no longer offered for that product.
The selling price is $77.83, calculated as follows:
Fixed cost over the life cycle = $700,000 R&D + $2,750,000 production + $1,800,000 marketing
and distribution + $600,000 after-sale customer service = $5,850,000
Total variable costs = ($25 variable production costs per unit + $8 variable marketing costs
per unit + $2 per unit variable after-sale customer service costs per unit) × 500,000 units to be
produced and sold = $17,500,000
Total cost = $5,850,000 total fixed costs + $17,500,000 total variable costs = $23,350,000
Average full cost per unit = $23,350,000 total costs ÷ 500,000 units to be produced = $46.70 full
cost per unit
Selling price per unit = $46.70 / (1 − 40%) = $77.83
Alternatively:
Sales price per unit − Markup per unit = Full cost per unit
SP − 0.40 SP = $46.70 full cost per unit
SP = $77.83
Choice "a" is incorrect. $46.70 per unit is the full cost of producing a unit.
Choice "b" is incorrect. $65.38 is the selling price per unit if the markup rate were 40 percent of
cost: $46.70 total cost per unit × 1.40 = $65.38 selling price per unit.
Choice "d" is incorrect. $116.75 is the selling price per unit if the markup were 60 percent of
selling price: ($46.70 total cost per unit) / (1 − 60%) = $116.75 per unit.

CQ–32 © Becker Professional Education Corporation. All rights reserved.

Class Question Explanations Part 2

5. MCQ-12509
Choice "c" is correct. Product life cycle and life-cycle costing develops the total cost of a good
or service from research and development and product design through delivery and customer
service. The product life cycle extends from the research and development efforts up to the
point when customer support is no longer offered for that product.
The manager has a target to maximize operating income. Because fixed costs are the same
under either option, the fixed costs are not relevant to the decision; management should select
the option that generates the greater contribution margin (Total revenues − Total variable
expenses). Option 2's contribution margin is $18,300,000; option 1's is $17,500,000. Option 2 is
the better choice and will generate greater operating income than will option 1.
Fixed cost over the life cycle = $700,000 R&D + $2,750,000 production + $1,800,000 marketing
and distribution + $600,000 after-sale customer service = $5,850,000. All of the fixed costs listed
are irrelevant, as they are the same under either option. All that is relevant are total revenues
and total variable costs.
Option 1:
Total revenues = 500,000 units sold × $70 sales price per unit = $35,000,000.
Total variable costs = ($25 variable production costs per unit + $8 variable marketing costs
per unit + $2 per unit variable after-sale customer service costs per unit) × 500,000 units to be
produced and sold = $17,500,000.
Contribution margin = $35,000,000 total revenues − $17,500,000 total variable costs =
$17,500,000.
Option 2:
Total revenues = (60,000 units sold × $90 sales price per unit) + (600,000 units sold × $60 per
unit) = $41,400,000.
Total variable costs = ($25 variable production costs per unit + $8 variable marketing costs
per unit + $2 per unit variable after-sale customer service costs per unit) × 660,000 units to be
produced and sold = $23,100,000.
Contribution margin = $41,400,000 total revenues − $23,100,000 total variable costs =
$18,300,000.
Choice "a" is incorrect. Option 1 does not generate the higher revenues.
Choice "b" is incorrect. It is true that option 1 produces the highest per-unit operating income,
but the objective of the manager is to maximize operating income (and because fixed costs are
the same under either option, the manager maximizes operating income by maximizing the
contribution margin).
Choice "d" is incorrect. All three selling prices in this question cover the full costs over the life of
the product.

© Becker Professional Education Corporation. All rights reserved. CQ–33

Part 2 Class Question Explanations

NOTES

CQ–34 © Becker Professional Education Corporation. All rights reserved.