Cost Volume Profit Relationships Chapter 3

Questions and Answers

What is operating leverage?

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

What is the formula for the degree of operating leverage?

Contribution margin divided by net operating income.

What happens when higher fixed costs and lower variable costs are present?

Will experience wider swings in net operating income; greater profits in good years and greater losses in bad years.

What is the implication of lower fixed costs and higher variable costs?

Will enjoy greater profitability stability and will be more protected from losses during bad years but at the cost of lower net operating income in good years. Signup and view all the answers

How does the margin of safety relate to contribution margin ratio?

Margin of safety is greater and contribution margin ratio lower indicates less vulnerability to downturns. Signup and view all the answers

What can be said about a company with a high ratio of fixed costs?

Is more likely to experience greater profits when sales are up and is more likely to experience a loss when sales are down compared to a company with mostly variable costs. Signup and view all the answers

What is the formula for the percentage change in operating income?

Degree of operating leverage multiplied by percentage change in sales. Signup and view all the answers

If sales increased by 5% and the degree of operating leverage is 4, by what percentage should net operating income increase?

20%. Signup and view all the answers

Degree of operating leverage is a constant.

False Signup and view all the answers

What factors determine whether a cost structure with higher variable costs is better than one with higher fixed costs?

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Study Notes

Operating Leverage

Operating leverage measures the sensitivity of net operating income to changes in sales volume.
It indicates how a percentage change in sales affects net operating income.

Degree of Operating Leverage

Calculated as the contribution margin divided by net operating income.
Represents how much operating income will change with a change in sales.

Impact of Fixed and Variable Costs

Higher fixed costs and lower variable costs lead to greater volatility in net operating income, with substantial gains in profitable years and larger losses in downturns.
Conversely, lower fixed costs and higher variable costs provide more stability during downturns at the expense of lower net operating income in prosperous years.

Margin of Safety

A greater margin of safety combined with a lower contribution margin ratio indicates reduced vulnerability to sales downturns.

Fixed vs. Variable Cost Structures

Companies with high fixed costs tend to see more significant profit increases as sales rise but are at greater risk of losses when sales decline.
Companies with mostly variable costs may face less risk during downturns but also have less potential for profit in good years.

Operating Income Change

The formula for percentage change in operating income is the degree of operating leverage multiplied by the percentage change in sales.
For instance, if sales increase by 5% and the degree of operating leverage is 4, net operating income should rise by 20%.

Characteristics of Operating Leverage

Degree of operating leverage is not a constant and varies depending on the sales level and cost structure.

Cost Structure Considerations

Key factors determining the effectiveness of a cost structure include the trade-off between fixed and variable costs, and their impact on stability and profitability.

Description

This quiz covers fundamental concepts related to cost volume profit relationships, including operating leverage and the impact of fixed and variable costs on net operating income. Perfect for students seeking to reinforce their understanding of these key principles in managerial accounting.