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3.6: Summary and Key Terms

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  • Section Summaries

    3.1 Explain Contribution Margin and Calculate Contribution Margin per Unit, Contribution Margin Ratio, and Total Contribution Margin

    • Contribution margin can be used to calculate how much of every dollar in sales is available to cover fixed expenses and contribute to profit.
    • Contribution margin can be expressed on a per-unit basis, as a ratio, or in total.
    • A specialized income statement, the Contribution Margin Income Statement, can be useful in looking at total sales and total contribution margin at varying levels of activity.

    3.2 Calculate a Break-Even Point in Units and Dollars

    • Break-even analysis is a tool that almost any business can use for planning and evaluation purposes. It helps identify a level of activity that is necessary before an organization starts to generate a profit.
    • A break-even point can be found on a per-unit basis or as a dollar amount, depending upon whether a per-unit contribution margin or a contribution margin ratio is applied.

    3.3 Perform Break-Even Sensitivity Analysis for a Single Product Under Changing Business Situations

    • Cost-volume-profit analysis can be used to conduct a sensitivity analysis that shows what will happen if there are changes in any of the variables: sales price, units sold, variable cost per unit, or fixed costs.
    • The break-even point may or may not be impacted by changes in costs depending on the type of cost affected.

    3.4 Perform Break-Even Sensitivity Analysis for a Multi-Product Environment Under Changing Business Situations

    • Companies provide multiple products, goods, and services to the consumer and, as result, need to calculate their break-even point based on the mix of the products, goods, and services.
    • In a multi-product environment, calculating the break-even point is more complex and is usually calculated using a composite unit, which represents the sales mix of the business.
    • If the sales mix of a company changes, then the break-even point changes, regardless of whether total sales dollars change or not.

    3.5 Calculate and Interpret a Company’s Margin of Safety and Operating Leverage

    • Businesses determine a margin of safety (sales dollars beyond the break-even point). The higher the margin of safety is, the lower the risk is of not breaking even and incurring a loss.
    • Operating leverage is a measurement of how sensitive net operating income is to a percentage change in sales dollars. A high degree of operating leverage results from a cost structure that is heavily weighted in fixed costs.

    Key Terms

    break-even point
    dollar amount (total sales dollars) or production level (total units produced) at which the company has recovered all variable and fixed costs; it can also be expressed as that point where Total Cost (TC) = Total Revenue (TR)
    composite unit
    selection of discrete products associated together in relation or proportion to their sales mix
    contribution margin
    amount by which a product’s selling price exceeds its total variable cost per unit
    contribution margin ratio
    percentage of a unit’s selling price that exceeds total unit variable costs
    margin of safety
    difference between current sales and break-even sales
    multi-product environment
    business environment in which a company sells different products, manufactures different products, or offers different types of services
    multiplier effect
    when the change in an input by a certain percentage has a greater effect (a higher percentage effect) on the output
    operating leverage
    measurement of how sensitive net operating income is to a percentage change in sales dollars
    relevant range
    quantitative range of units that can be produced based on the company’s current productive assets; for example, if a company has sufficient fixed assets to produce up to \(10,000\) units of product, the relevant range would be between \(0\) and \(10,000\) units
    sales mix
    relative proportions of the products that a company sells
    sensitivity analysis
    what will happen if sales price, units sold, variable cost per unit, or fixed costs change
    target pricing
    process in which a company uses market analysis and production information to determine the maximum price customers are willing to pay for a good or service in addition to the markup percentage
    total contribution margin
    amount by which total sales exceed total variable costs