Chapter 6

How is Operating Leverage used?

%increase in sales x OL = % increase in Profit

For every unit sold, contribution margin will ______ in total.

Increase

What is Operating Leverage?

The measure of the proportion of fixed costs in a company's cost structure. It is used as an indicator of how sensitive profit is to changes in sales volume. OL = CM / NI

Target Profit Analysis: Sales Volume = (# units must sell to reach target profit before tax)

(Fixed Cost + Target Profit) / CM per unit

On the flip side of this card there is a CVP graph. Identify these parts: 1. Operating Loss Area 2. Operating Profit Area 3. Total Costs 4. Break Even Point 5. Total Sales

1. ------> E 2. ------> A 3. ------> C 4. ------> D 5. ------> B

CM Ratio + VC Ratio = ___________

100 % REMEMBER: Sales - VC = CM

What happens to Operating Leverage as a company gets very close to the break-even point?

A company operating near the break-even point will have a high level of operating leverage, and income will be very sensitive to changes in sales volume.

CM ratio = __________

CM / Sales REMEMBER: this is a % Use CM Ratio when dealing in dollars!

Sales Price per Unit - VC per Unit =

CM per Unit (also called Unit Contribution Margin, UCM)

The ______, is computed by dividing the contribution margin by sales dollars.

CMR, Contribution Margin Ratio

Once a company has paid all of its fixed costs, net income increases in an amount equal to ______ for each unit sold to customers.

Contribution Margin

What is Margin of Safety?

It answers the question of how far sales can decrease before the company shows a loss. Sales - Sales@ Break Even Point Usually expressed as a ratio:. Sales-Sales@BEP / Sales

How is Contribution Margin (CM) used?

It is used to predict profit at different sales levels.

What is Sales Mix and what do we need to know to analyze it?

It is used when a company sells more than one product. Need to know how many of each product is budgeted

If a company is unable to increase sales or _________ variable costs, the company can increase net income by reducing ________.

Reduce Fixed Costs

When production and sales are equal, whether a company prepares a traditional income statement or a contribution margin income statement, two numbers do not change. One of these is _____ and the other is _____.

Sales and Net Income

Operating leverage

The contribution margin divided by net income; used as an indicator of how sensitive net income is to a change in sales.

Contribution margin ratio

The contribution margin divided by sales; used to calculate the change in contribution margin resulting from a dollar change in sales.

Break-even point

The level of sales at which contribution margin just covers fixed costs and net income is equal to zero.

Contribution margin per unit

The sales price per unit of product less all variable costs to produce and sell the unit of product; used to calculate the change in contribution margin resulting from a change in unit sales.

Of these two cost categories, only ________ increases and decreases contribution margin.

Variable Costs

________ refers to the relative proportion of fixed and variable costs in a company. a. Income structure b. Cost structure c. Sales structure d. Tax structure

b. Cost structure Cost structure refers to the relative proportion of fixed and variable costs in a company.

The contribution margin per unit and the contribution margin ratio will remain constant as long as: a. the cost of production and selling price changes. b. the volume of sales decreases. c. the sales revenue varies in direct proportion to volume. d. the selling cost remains the same

c. The contribution margin per unit and the contribution margin ratio will remain constant as long as sales vary in direct proportion to volume.

Which of the following is correct regarding the implication of taxes on profits? a. Before-tax profit = After- tax profit × (1 − tax rate) b. Before-tax profit = After-tax profit × (tax rate − 1) c. After-tax profit = Before-tax profit × (1 − tax rate) d. After-tax profit = Before-tax profit × (tax rate − 1)

c. After-tax profit = Before-tax profit × (1 − tax rate) The after-tax profit can be found by multiplying the before-tax profit by (1 − tax rate). Correspondingly, the before-tax profit equals the after-tax profit divided by (1 − tax rate).

________ leverage describes the effects that fixed costs have on operating income as changes occur in the units sold. a. Buyout b. Combined c. Operating d. Financing

c. Operating Operating leverage is a measure of the proportion of fixed costs in a company's cost structure and is used as an indicator of how sensitive profit is to changes in sales volume.

Which of the following would decrease variable costs? a. Reduction in salaries of administrative department b. Reduction in research expenditure c. Reduction in wages paid as direct labor d. Reduction in rent expense

c. Reduction in wages paid as direct labor Rent expense, salaries paid to administrative personnel, and research expenditure constitute fixed costs to the company. The wages paid to the direct labor varies with the number of products produced. Hence, it is a variable cost. Reducing the wages paid as direct labor will reduce the variable costs.

The break-even point is the level of sales at which the contribution margin covers ________. a. net income before tax b. net income after tax c. variable costs d. fixed costs

d. fixed costs The break-even point is the level of sales at which the contribution margin just covers fixed costs. At this level, income is equal to zero.

Cost-volume-profit (CVP) analysis

A tool that focuses on the relationship between a company's profits and (1) the prices of products or services, (2) the volume of products or services, (3) the per unit variable costs, (4) the total fixed costs, and (5) the mix of products or services produced.

If a company has a low CM, how can it increase NI?

Decrease expenses

Break Even Sales $ =

Fixed Costs / CM Ratio

Break Even Point in Units =

Fixed Costs / CM per Unit How many units do we need to sell to break even?

_______, the difference between Sales and COGS, is not reported on the contribution margin income statement.

Gross Profit

If a company has a high CM, how can it increase NI?

Increase Sales

Gross profit

The difference between sales and cost of goods sold.

Which of the following will increase the contribution margin? a. Reduction in fixed costs b. Reduction in variable costs c. Reduction in net income d. Reduction in sales

b. Reduction in variable costs Reduction in variable cost will increase the contribution margin of the product.

With reference to cost-volume-profit analysis, identify the correct statement. a. Sales + Variable cost + Fixed cost = Net operating income b. Sales − Variable cost − Net operating income = Fixed cost c. Sales − Variable cost + Fixed cost = Net operating income d. Sales + Variable cost = Fixed cost − Net operating income

b. Sales − Variable cost − Net operating income = Fixed cost Contribution margin = Sales − Variable cost = Fixed cost + Net operating income. Therefore, subtracting variable cost and income from sales will yield fixed costs.

The difference between sales and cost of goods sold equals ________. a. operating profit b. gross profit c. profit after tax d. net profit

b. gross profit The traditional income statement required for external financial reporting focuses calculating the cost of goods sold and a company's gross profit. Gross profit is the difference between sales and cost of goods sold.

A company operating near the break-even point will have a ________. a. low level of financial leverage b. high level of operating leverage c. high level of financial leverage d. low level of operating leverage

b. high level of operating leverage A company operating near the break-even point will have a high level of operating leverage, and income will be very sensitive to changes in sales volume.

What assumptions are made for CVP analysis?

Costs and Sales can be represented by a straight line Efficiencies don't change with volume Costs are purely fixed and variable Sales mix is constant Existing inventory balances stay constant