Question

1. What is meant by the term break-even point?

2.What is meant by the margin of safety?

3.What is meant by a product’s contribution margin ratio? How is this ratio useful in planning business operations?

4. What is significant about the relevant range?

5. What does the contribution margin ratio's calculate and how is that useful for

business operations?

Answer 1

• What is meant by the term break-even point?

Break Even point is a term given to that point or ‘level’ where there are neither loss nor income and the total cost equals to revenues.

For example: In the below case scenario, a level of 10,000 units is a Break Even point for the company,

Sales	$                             50,000.00	[10000 units x $5]
Variable cost	$                             40,000.00	[10000 units x $4]
Contribution margin	$                             10,000.00
Fixed costs	$                             10,000.00
Net Income	$                                            -

• What is meant by the margin of safety?

Margin of Safety is used in connection with Break Even point. The amount by which the Actual sales revenue exceeds the Break Even sales is termed as Margin of Safety. For example:

Total Sales Revenue	$                       4,000,000.00
Break Even Sales [calculated]	$                       3,000,000.00
Margin of Safety	$                       1,000,000.00
Margin of Safety %	25%

• What is meant by a product’s contribution margin ratio? How is this ratio useful in planning business operations?

A products CM ratio tells how much a product’s contribution per $ 100 sale is. CM Ratio = (Contribution margin/Sales Revenues) x 100

Example:

Sales	$                   50,000.00
Variable cost	$                   40,000.00
Contribution margin	$                   10,000.00
CM Ratio	20%

This shows that for each $ 100 sales, the product earns $ 20 of Contribution margin.

CM Ratio is used to calculate:

>Break Even point in Sales Dollar,
>predicted increase in Operating income when sales revenue increases.

• What is significant about the relevant range?

The relevant range is used in connection with the FIXED COST. Fixed cost are the costs that remains CONSTANT and do not change with a change in level of activity. However, once a limit of level is achieved, the fixed will be increased. The range within which the fixed cost stays constant is called the ‘relevant range’. For example, a company is operating and producing 80,000 units, while its capacity is 100,000 units. Fixed Costs are $ 40,000. Now this means that for any ‘range of activity’ from 0 units to 100,000 units, Fixed cost will be same and this ‘range’ is the ‘relevant range’ for the fixed costs.

• What does the contribution margin ratio's calculate and how is that useful for business operations?

As mentioned earlier, CM Ratio is used to:

>calculate Break Even point in sales dollars,
>calculate increase (decrease) in Operating income if sales revenue increases (or decreases)

This helps business operations to:

>increase or decrease the sale price per unit.
>Increase or decrease the no. of units to be produced and sold.
>decide no. of units to sell to attain Break Even.
>to analyse no. of units to be sold to earn a target income.