Managerial Accounting Chapter 5
Cost-Volume-Profit (CVP) Graph
A graphical representation of the relationships between an organization's revenues, costs, and profits on the one hand and its sales volume on the other hand.
Operating Leverage
A measure of how sensitive net operating income is to a given percentage change in dollar sales.
Degree of Operating Leverage
A measure, at a 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
Contribution Margin Ratio (CM Ratio)
A ratio computed by dividing contribution margin by dollar sales.
Variable Expense Ratio
A ratio computed by dividing variable expenses by dollar sales.
In response to a request from your immediate supervisor, you have prepared a CVP graph portraying the cost and revenue characteristics of your company's product and operations. Explain how the lines on the graph and the break-even point would change if (a) the selling price per unit decreases, (b) fixed cost increased throughout the entire range of activity portrayed on the graph, and (c) variable cost per unit increased?
A) The total revenue line will be less steep if the selling price per unit decreased. Also, if the selling price per unit decreased, more units would have to be sold, making the break-even point at a higher unit of volume. B)The fixed line and the total cost line will shift upwards if fixed costs increased. This will also make the break-even point be at a higher unit volume. C) The total cost line will be steeper if the variable cost increases. This will also make the break-even point be at a higher unit of volume.
Incremental Analysis
An analytical approach that focuses only on those costs and revenues that change as a result of a decision.
Target profit Analysis
Estimating what sales volume is needed to achieve a specific target profit.
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.
If sales are increased by company B, this will realize a greater increase in profit.This is because costs of company B are mostly fixed and if sales increase the cost will remain the same. When sales increase by company A, this will also experience an increase in variable cost, which increases in response to activity. As sales increase for company "A," cost will increase while profit is allowed to grow at a slower rate. On the other hand, as sales increase for company B, cost will remain unchanged while profit is allowed to grow at a greater rate.
Often the most direct route to a business decision is an incremental analysis. What is mean by an incremental analysis?
Incremental analysis is an analytical approach that focuses only on those costs and revenue that change as a result of a decision.
What is meant by the term operating leverage?
Operating leverage is a measure of how sensitive net operating income is to a given percentage change in dollar sales. The degree of operating leverage at a given level of sales is computed by dividing the contribution margin at that level of sales by the net operating income.
Explain how a shift in the sales mix could result in both a higher break-even point and a lower net income.
Profits will depend to some extent on the company's sales mix. Profits will be greater if high-margin rather than low-margin items make-up a relatively large proportion of total sales. Changes in the sales mix cause confusing variations in a company's profits. A shift in the sales mix from high-margin items to low-margin items can cause total profits to decrease even thought total sales may increase.On the other hand, a shift in the sales mix from low-margin to high-margin items can cause the reverse effect. the total profits may increase even though total sales decrease.
What is meant by the term Break-even point?
The break-even point is the level of sales at which profits are zero. It can also be defined as the point where total revenue equals total cost, and as the point where total contribution margin equal total fixed costs.
What is meant by a product's contribution margin ratio? How is this ratio useful in planning business operations?
The contribution margin ratio shows how the contribution margin will be affected by a change in total sales. For example, if a companies CM ratio is 50%, this means that for each dollar increase in sales total contribution margin will increase by 50 cents, assuming that fixed cost are unaffected the increase in sales.
Margin of safety
The excess of budgeted or actual dollar 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. It states the amount by which sales can drop before losses begin to be incurred.
Sales mix
The relative proportions in which a company's products are sold. Sales mix is computed by expressing the sales of each product as a percentage of total sales.
What is meant by the term sales mix? What assumption is usually made concerning sales mix in CVP analysis?
The term sales mix refers to the relative proportions in which a company's products are sold. The idea to achieve the combination, or mix, that will yield the greatest profits. Sales mix is computed by expressing the sales of each product as a percentage of total sales. The following assumptions commonly underlie CVP Analysis: 1. Selling price is constant. The price of a product or service will not change as volume changes. 2. Costs are linear and can be accurately divided into variable and fixed elements. The variable element is constant per unit, and the fixed element is constant in total over the entire relevant range. 3. In multi product companies, the sales mix is constant. 4. In manufacturing companies, inventories do not change. The number of units produced equals the number of units sold.