ACTG CHAPTER 5

What is meant by a product's contribution margin ratio? How is this ratio useful in planning business operations?

A product's CM Ratio shows how the contribution margin will be affected by a change in total sales. If the CM ratio is 40%, then for every dollar increase in sales, the contribution margin will increase by 40 cents ($1 Sales X CM Ratio of 40%). Net operating income will also increase by 40 cents, assuming fixed costs are not affected by change in sales. Thus, the CM ratio can be used to determine by what percentage sales need to increase to reach a specific target profit or contribution margin. (Page 191).

Contribution Margin Ratio (CM RATIO)

A ratio computed by dividing contribution by dollar sales.

Variable Expense Ratio

A ratio computed by dividing variable expenses by dollar sales.

In all respects, Company A and Company B are identical except that Company A's costs are mostly variable, whereas Company B's costs are mostly fixed. When sales increase, which company will tend to realize the greatest increase in profits? Explain.

Company B will realize greater profits, as fixed costs are generally not effected by an increase in sales volume. If costs are more variable-oriented, then there will be a lower contribution margin, resulting in lower net operating income.

Target Profit Analysis

Estimating what sales volume is needed to achieve a specific target profit.

What is meant by the term operating leverage?

Operating Leverage is a measure of how sensitive net operating income is to a percent change in dollar sales. Operating leverage acts as a multiplier; if operating leverage is high, then a small percentage increase in sales can produce a much larger percent increase in net operating income.

Margin of Safety

The excess of budgeted or actual sales over the break even dollar sales.

Break-Even Point

The level of sales at which profit is zero.

What is meant by the margin of safety?

The margin of safety is the excess of budgeted or actual sales over the break-even volume of sales dollars. It is the amount that sales can drop before losses are incurred. The higher the margin of safety, the lower the risk of not breaking even and incurring a loss.

Operating Leverage

A measure of how sensitive net operating income is to a given percentage change in dollar sales.

Degree of Operation Leverage

A measure, at any given level of sales, of how a percentage change in sales will affect profits. The degree of operating leverage is computed by dividing contribution margin by net operating income.