Cost Behavior, Operating Leverage, and Profitability Analysis

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CHAPTER 2

• Cost Behavior, Operating Leverage, and
  Profitability Analysis

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Learning Objective
To identify and describe fixed, variable, and
mixed cost behavior
LO1
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Fixed Cost Behavior
When activity . . . .
Consider the followingconcert example where
theband will be paid 48,000 regardless of the
number of tickets sold.
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Fixed Cost Behavior
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Learning Objective
To demonstrate the effects of operating leverage
on profitability
LO2
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Operating Leverage

• A measure of the extent to which fixedcosts
  are being used in an organization.
• Operating leverage is greatest in companies
  that have a high proportion of fixed costs in
  relation to variable costs.

Consider the followingconcert example whereall
costs are fixed.
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Operating Leverage
10 RevenueIncrease
90 GrossProfit Increase
When all costs are fixed, every additional sales
dollar contributes one dollar to gross profit.
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Risk and Reward Assessment
Risk refers to the possibility thatsacrifices
may exceed benefits.
Risk may be reduced byconverting fixed
costsinto variable costs.
Lets see what happens to the concert example if
the band receives 16 perticket sold instead of
a fixed 48,000.
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Variable Cost Behavior
The total variable cost increases in direct
proportion to the number of tickets sold.
Variable unit cost per ticket remains at16
regardless of the number of tickets sold.
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Learning Objective
To identify and describe fixed, variable, and
mixed cost behavior
LO1
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Variable Cost Behavior
When activity . . .
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Learning Objective
To demonstrate the effects of operating leverage
on profitability
LO2
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Risk and RewardAssessment
10 RevenueIncrease
10 GrossProfit Increase
Shifting the cost structure from fixed to
variable not only reduces risk but also the
potential for profits.
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Effect of Cost Structure on Profit Stability
Revenue

Profit
Fixed Cost
Loss
Activity
Fixed Cost Structure
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Effect of Cost Structure on Profit Stability
Revenue

Variable Cost
Profit
Activity
Variable Cost Structure
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Effect of Cost Structure on Profit Stability
FixedCosts
VariableCosts
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Effect of Cost Structure on Profit Stability
Now lets see what happens whenthe number of
units sold increases.
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Effect of Cost Structure on Profit Stability
The income increase is greaterin the All Fixed
Company.
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Effect of Cost Structure on Profit Stability
FixedCosts
VariableCosts
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Effect of Cost Structure on Profit Stability
Yes, the income decrease is greaterin the All
Fixed Company.
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Effect of Cost Structure on Profit Stability
FixedCosts
VariableCosts
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Learning Objective
To prepare an income statement using the
contribution margin approach
LO3
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An Income Statement under the Contribution Margin
Approach
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Using Fixed Cost to Provide a Competitive
Operating Advantage
Consider the following two companies
What happens if each company cuts the service
revenueto 7 per hour in order to double the
amount of business?
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Using Fixed Cost to Provide a Competitive
Operating Advantage
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Using Fixed Cost to Provide a Competitive
Operating Advantage
What happens if the price is cutto 7 per hour
and the demandremains at 2,000 hours for
eachcompany?
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Using Fixed Cost to Provide a Competitive
Operating Advantage
Both companies incur losses.
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Using Fixed Cost to Provide a Competitive
Operating Advantage
I suppose fixed costs arebetter if volume is
increasing,but variable costs may be betterif
business is declining.
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Learning Objective
To demonstrate how the magnitude of operating
leverage affects profitability
LO4
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Measuring Operating Leverage Using Contribution
Margin
Show mean example.
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Measuring Operating Leverage Using Contribution
Margin
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Measuring Operating Leverage Using Contribution
Margin
A 10 percent increase in sales results in a 40
percent increase in net income.
(10 4 40 )
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Cost Behavior Summarized

• Your monthly basic telephone bill is probably
  fixed and does not change when you make more
  local calls.

Total Fixed Cost
Monthly Basic Telephone Bill
Number of Local Calls
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Cost Behavior Summarized

• The fixed cost per local call decreasesas more
  local calls are made.

Fixed Cost Per Unit
Monthly Basic Telephone Bill per Local Call
Number of Local Calls
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Cost Behavior Summarized

• Your total long distance telephone bill is
  based on how many minutes you talk.

Total Long DistanceTelephone Bill
Total Variable Cost
Minutes Talked
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Cost Behavior Summarized

• The cost per minute talked is constant.For
  example, 10 cents per minute.

Variable Cost Per Unit
Per MinuteTelephone Charge
Minutes Talked
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Cost Behavior Summarized
When activity level changes . . .
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Learning Objective
To demonstrate how the relevant range and
decision context affect cost behavior
LO5
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The Relevant Range

• Example Office space is available at a fixed
  rental rate of 30,000 per year in increments of
  1,000 square feet. As the business grows more
  space is rented, increasing the total cost.

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The Relevant Range
90
Total fixed cost doesnt change for a range of
activity, and then jumps to a new higher cost for
the next higher range of activity.
Relevant Range
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Rent Cost in Thousands of Dollars
30
0
0 1,000 2,000
3,000 Rented Area (Square Feet)
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The Relevant Range
Our variable cost assumption (constant unit
variable cost) applies within the relevant range.
RelevantRange
Total Cost
Possible VariableCost Behavior
Our VariableCost Assumption
Activity
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Context Sensitive Definitions of Fixed and
Variable
Recall the earlier concert example, where the
band waspaid 48,000 regardless of the number of
tickets sold.
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Learning Objective
To select an appropriate time period for
calculating the average cost per unit
LO6
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Cost Averaging
Lake Resorts provides water-skiing lessons for
itsguests with the following costs Equipment
rental 80 per day Instructor pay 15 per
hour Fuel 2 per hour
What is the average cost per one-hour lesson
for2 lessons per day? 5 lessons per day? 10
lessonsper day?
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Cost Averaging
Average costs decline as activity increases
whenfixed costs such as equipment rental are
involved. Managers must use these average costs
withcaution as they differ at every level of
activity.
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Learning Objective
To identify and describe fixed, variable, and
mixed cost behavior
LO1
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Mixed Costs

• A mixed costhas both fixed and
  variablecomponents.

Consider thefollowing electric utility example.
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Mixed Costs
Total mixed cost
Variable Utility Charge
Total Utility Cost
Fixed MonthlyUtility Charge
Activity (Kilowatt Hours)
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Learning Objective
To use the high-low method, scattergraphs, and
regression analysis to estimate fixed and
variable costs
LO7
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Estimating Fixed and Variable Costs
Scattergraph Method
Regression Analysis
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The High-Low Method

• Iris Company recorded the following production
  activity and maintenance costs for two months
• Using these two levels of activity, compute
• the variable cost per unit.
• the fixed cost.
• the total cost.

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The High-Low Method

• Unit variable cost 4,000 5,000 units
  .80 per unit
• Fixed cost Total cost Total variable cost
  Fixed cost 9,700 (.80 per unit 10,000
  units) Fixed cost 9,700 8,000 1,700
• Total cost Fixed cost Variable cost
  Total cost 1,700 0.80X

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The High-Low Method
If sales salaries and commissions are 10,000
when 80,000 units are sold and 14,000 when
120,000 units are sold, what is the variable
portion of sales salaries and commission? a.
.08 per unit b. .10 per unit c. .12
per unit d. .125 per unit
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The High-Low Method

• If sales salaries and commissions are 10,000
  when 80,000 units are sold and 14,000 when
  120,000 units are sold, what is the variable
  portion of sales salaries and commission?
• a. .08 per unit
• b. .10 per unit
• c. .12 per unit
• d. .125 per unit

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The High-Low Method
If sales salaries and commissions are
10,000 when 80,000 units are sold and 14,000
when 120,000 units are sold, what is the fixed
portion of sales salaries and commissions? a.
2,000 b. 4,000 c. 10,000 d.
12,000
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The High-Low Method

• If sales salaries and commissions are
  10,000 when 80,000 units are sold and 14,000
  when 120,000 units are sold, what is the fixed
  portion of sales salaries and commissions?
• a. 2,000
• b. 4,000
• c. 10,000
• d. 12,000

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The Scattergraph Method
Plot the data points on a graph (total cost vs.
activity).
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The Scattergraph Method
Draw a line through the data points with about
anequal numbers of points above and below the
line.
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The Scattergraph Method
Variable cost per unit is represented by the
slope of the line.
Y
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Vertical distance is total cost, approximately
16,000.
Total Cost in1,000s of Dollars


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Estimated fixedis 10,000
0
X
0 1 2 3 4
Activity, 1,000s of Units Produced
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The Scattergraph Method
Total variable cost Total cost Total
fixed costTotal variable cost 16,000
10,000 6,000Unit variable cost 6,000
3,000 units 2
Y
20








Vertical distance is total cost, approximately
16,000.
Total Cost in1,000s of Dollars


10
Estimated fixedis 10,000
0
X
0 1 2 3 4
Activity, 1,000s of Units Produced
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Regression Method of Cost Estimation
A method used to analyze mixed costs if a
scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
This method uses all of thedata points to
estimatethe fixed and variablecost components
of amixed cost.
The goal of this method isto fit a straight line
to thedata that minimizes thesum of the squared
errors.
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Regression Method of Cost Estimation

• Software can be used to fit a regression line
  through the data points.
• The cost analysis objective is the same Y a
  bX

Least-squares regression also provides a
statistic, called the R2, that is a measure of
the goodnessof fit of the regression line to the
data points.
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Regression Method of Cost Estimation

• Follow these steps in Excel to perform regression
  analysis
• Enter the data in spreadsheet columns.
• Click Tools.
• Click Data Analysis.
• Click Regression and then OK.
• Define data ranges and click Line Fit Plot.
• Click OK.

The regression function will return an estimate
for fixed cost and variable cost per unit.
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End of Chapter 2