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3.6: Summary and Key Terms

Last updated

Jun 22, 2023
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- 3.5: Calculate and Interpret a Company’s Margin of Safety and Operating Leverage
- 3.E: Cost-Volume-Profit Analysis (Exercises)

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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

Contributors and Attributions

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