Chapter 6: Cost-Volume-Profit

Question 1

What is the purpose of preparing a cost-volume-profit (CVP) income statement?

Answer 1

To determine the contribution margin, which is crucial for profit planning and management decisions such as setting prices and product mix.

Question 2

What are the basic components of CVP analysis?

Answer 2

Sales, volume or level of activity (quantity), unit selling price, unit variable costs, total fixed costs, and sales mix.

Question 3

What are the underlying assumptions of CVP analysis?

Answer 3

Costs and revenues behave linearly within the activity range,

costs are classified as either variable or fixed,

changes in activity affect only costs that are variable,

inventory levels remain constant,

and the sales mix remains constant.

Question 4

How is the contribution margin (CM) defined in a CVP income statement?

Answer 4

CM is the amount of revenue that remains after all variable costs have been deducted, and it can be expressed both as a total amount and on a per-unit basis.

Question 5

What complicates CVP analysis when more than one type of product is sold?

Answer 5

The sales mix, as different products will have different cost relationships and percentages of total sales.

Question 6

What might lead to inaccurate results in CVP analysis?

Answer 6

If the five key assumptions of CVP analysis do not hold true, the results may be inaccurate.

Question 7

What is the purpose of preparing a cost-volume-profit income statement?

Answer 7

To determine the contribution margin, which is critical for profit planning and managerial decisions like setting prices and product mix.

Question 8

What are the basic components of CVP analysis?

Answer 8

Sales, volume or level of activity (quantity), unit selling price, unit variable costs, total fixed costs, and sales mix.

Question 8

What assumptions underlie CVP analysis?

Answer 8

Costs and revenues behave linearly within the relevant range; costs are classified as variable or fixed; activity levels affect costs; inventory levels are constant, with all produced units sold; and the sales mix is constant when multiple products are sold.

Question 9

How does the CVP income statement differ from a traditional GAAP income statement?

Answer 9

The CVP income statement separates costs into variable and fixed and calculates the contribution margin, while the GAAP income statement emphasizes gross profit and differentiates between product and period costs.

Question 10

What is the formula for the contribution margin per unit?

Answer 10

Contribution Margin per Unit = Unit Selling Price - Unit Variable Costs.

Question 11

How is the contribution margin used in decision-making?

Answer 11

It indicates the amount by which sales can decrease before a company reaches its break-even point and is used to calculate the break-even point and target income levels.

Question 12

What does the contribution margin ratio indicate?

Answer 12

It shows how much each dollar of sales contributes to fixed costs and operating income.

Question 13

How can you calculate the increase in operating income with a rise in sales using the contribution margin ratio?

Answer 13

By multiplying the increase in sales by the contribution margin ratio.

For example, if the contribution margin ratio is 40%, a $100,000 increase in sales would result in a $40,000 (40% of $100,000) increase in operating income.

Question 14

What is the break-even point in CVP analysis?

Answer 14

The break-even point is the level of activity at which total revenues equal total costs, resulting in no income and no loss.

Question 15

How can the break-even point be calculated?

Answer 15

Using a mathematical equation.
Using the contribution margin.
Through a CVP graph.

Question 16

What is the formula for the break-even point using the mathematical equation?

Answer 16

Break-Even Point in Units = Fixed Costs / Unit Contribution Margin.

Question 17

How do you find the break-even point in sales dollars?

Answer 17

Multiply the break-even point in units by the unit selling price.

Question 18

What does the CVP graph illustrate?

Answer 18

The relationship between sales volume, costs, and profits, displaying the break-even point visually.

Question 19

Why is the CVP graph useful?

Answer 19

It allows quick assessment of the impact of changes in costs, prices, and sales volume on profits.

Question 20

How is the contribution margin per unit calculated?

Answer 20

Contribution Margin per Unit = Unit Selling Price - Unit Variable Costs.

Question 21

Why is the contribution margin ratio important?

Answer 21

It shows the portion of each sales dollar that contributes to covering fixed costs and generating operating income.

Question 22

How does the contribution margin technique simplify the break-even analysis?

Answer 22

It divides the total fixed costs by the unit contribution margin to find the number of units needed to break even.

Question 23

What is the target operating income?

Answer 23

It is the income objective set by management for a product line, which indicates the sales needed to achieve a specified level of operating income.

Question 24

How is the target operating income before taxes calculated?

Answer 24

By adding the desired target operating income to the fixed costs and dividing by the unit contribution margin or by the contribution margin ratio.

Question 25

What is the formula for determining required sales to meet the target operating income before taxes?

Answer 25

Required Sales in Units = (Fixed Costs + Target Operating Income before Taxes) / Contribution Margin per Unit.

Question 26

How can you find the sales dollars required to meet the target operating income?

Answer 26

By multiplying the required units to be sold at the target operating income by the unit selling price.

Question 27

What is the formula for required sales in dollars using the contribution margin ratio?

Answer 27

Required Sales in Dollars =

(Fixed Costs + Target Operating Income before Taxes) / Contribution Margin Ratio.

Question 28

How does the CVP graph assist in finding the sales required to meet the target operating income?

Answer 28

The CVP graph can show the sales level needed by displaying the point where the total revenue line intersects with the total cost line at the desired operating income.

Question 29

How is operating income after taxes calculated?

Answer 29

Operating income after taxes = Operating income before taxes × (1 − tax rate).

Question 30

If a company targets an operating income of $120,000 after taxes and the tax rate is 40%, what is the required sales in units to meet this target?

Answer 30

2,000 units, using the formula:

(Fixed costs + Target operating income before taxes) ÷ Unit contribution margin.

Question 31

How do you calculate the required sales in dollars to meet the target operating income after taxes?

Answer 31

Multiply the required sales in units by the unit selling price.

Question 32

What is the Margin of Safety?

Answer 32

It is the excess of actual or expected sales over the break-even sales, indicating how much sales can drop before the company incurs a loss.

Question 33

How is the Margin of Safety in dollars calculated?

Answer 33

Margin of Safety in Dollars = Actual (or Expected) Sales − Break-Even Sales.

Question 34

How is the Margin of Safety ratio determined?

Answer 34

Margin of Safety Ratio = Margin of Safety in Dollars ÷ Actual (or Expected) Sales.

Question 35

In the context of a concert, what sales dollars are required for the promoter to break even?

Answer 35

To break even, the promoter must cover all guaranteed payments, costs associated with the event, and reach the break-even point of sales that covers both variable and fixed costs.

For the concert example, assuming the following:

Ticket sales needed: $2.45 million.
Guaranteed payment to artist: $1.2 million.
Percentage of ticket sales to venue: 20%.
Additional costs (insurance, staff, advertising): $400,000.