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Chapter03_b - Chapter 3 Analysis of Cost Volume and Pricing...

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Chapter 3 Analysis of Cost, Volume, and Pricing to Increase Profitability Answers to Questions 1. Break-even is the point where total revenue is equal to total costs. It can be measured in units or sales dollars. 2. In the contribution margin income statement all variable costs are subtracted from sales revenues to determine the contribution mar- gin before subtracting all fixed costs to derive profit. The traditional statement does not disclose contribution margin because cost of goods sold and operating expenses consist of both variable and fixed costs. 3. The contribution margin can be used to determine break-even for the number of units (volume) needed to be produced and sold or the total amount of sales dollars needed to be earned. The concept can also be used to determine the production and sales volume or sales dollars necessary to attain a target profit. Finally, the contribution margin can be used to measure the effects on profitability of changes in sales price, sales volume, cost of sales, or simultaneous changes among these variables. 4. The margin of safety is the decrease in sales that can occur before experiencing a loss. The margin of safety expressed as a percent- age would mean Company A’s actual sales could decline by only 22% below budgeted sales before the company reaches break-even and a greater decline would result in a loss. Company B sales would have to decline by more than 52% below budgeted sales to experi- ence a loss. Accordingly, Company A is at greater risk of a loss when sales are less than budgeted. 5. The variables that affect profitability are sales price, volume, vari- able costs, and fixed costs. Two techniques for analyzing the rela- tionships among these variables in order to estimate profitability are sensitivity analysis, performed by spreadsheet software that ex- ecutes what if statements, and the contribution margin approach. 6. Customers are often willing to pay a premium price for a product that incorporates a new technology they would like to be the first to use, especially when there has been widespread advertising of the product. Products that carry a prestigious brand name are also 3-1
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Chapter 3 Analysis of Cost, Volume, and Pricing to Increase Profitability likely to sell at a premium. Prestige pricing would be an appropriate pricing strategy for such products. Prestige pricing is pricing the product at a greater than average mark-up with the expectation that the increased demand will motivate customers to pay higher than average prices. Other examples are possible. 7. Three approaches for determining break-even are as follows: The per unit contribution margin approach which shows break- even in units. The contribution margin ratio approach which shows break-even in sales dollars.
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