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Chapter 9
In the long run, however, all of these factors and their relationships and the
assumptions that underlie CVP regarding these factors are likely to change. This
emphasizes that CVP only holds true for the short run. Results must be
recalculated periodically to maintain validity.
The “bag” or “basket” assumption means that a multiproduct firm will
consider that the products it sells are sold in a constant, proportional sales mix—as
if in a bag of goods. It is necessary to make this assumption to determine the
contribution margin for the entire company product line, since individual
products’ contribution margins may differ significantly. A single contribution
margin must be used in CVP analysis so the “bag” or “basket” assumption allows
CVP computations to be made.
If the company includes more of its higher contribution margin products—
squigees—than its lower contribution margin products—widgees—in its
multiproduct mix, then its weighted average contribution margin will be higher
and its break-even point lower. This is because the contribution margin is
weighted based on the relative quantities of each product. In the contribution
margin weighting process, the product making up the larger proportion of the bag
has the greatest impact on the average contribution margin. Previously, the
product widgees, with the lowest contribution margin had the greater impact on
the average contribution margin. However when the sales mix changed, the
product squigees, with the higher contribution margin, has the greater impact on
the average contribution margin.
Margin of safety is the difference between actual or projected sales and break-
even level sales. Margin of safety can be expressed in units, in dollars, or as a
percentage of total sales dollars. It identifies the amount by which sales could fall
and still leave the firm’s bottom line in the black. Margin of safety measures
provide either comfort or risk depending on whether the margin of safety is
positive or negative. Operating leverage refers to the amount of fixed costs relative
to variable costs in a company’s cost structure. It indicates how sensitive a
company’s sales are to sales volume increases and decreases.
Higher operating leverage is associated with a higher proportion of fixed costs;
lower operating leverage is associated with a lower level of fixed costs. The level
of operating leverage varies with the level of revenues. Further, operating leverage
provides information about how profit will change when revenue changes. High
operating leverage indicates that the level of profit is very sensitive to a change in
revenue level. The reverse is true for low operating leverage. Margin of safety
percentage is 1 ÷ Degree of operating leverage; degree of operating leverage is 1 ÷
Margin of safety percentage. Thus, the margin of safety percentage is the
reciprocal of the degree of operating leverage and the degree of operating level is
the reciprocal of the margin of safety percentage.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.

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