McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Eleven Cost Behavior, Operating Leverage, and CVP Analysis.

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Eleven

Cost Behavior, Operating Leverage, and CVP Analysis

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Learning Objective 1

• Distinguish between fixed and variable cost behavior.

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Fixed Cost Behavior

Increases Decreases

Total Fixed Cost Remains constant Remains Constant

Fixed Cost Per Unit Decreases Increases

Consider the followingconcert example where theband will be paid $48,000

regardless of the number of tickets sold.

When activity . . . .

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Fixed Cost Behavior

Number of tickets sold 2,700 3,000 3,300

Total cost of band 48,000$ 48,000$ 48,000$

Cost per ticket sold 17.78$ 16.00$ 14.55$

Number of tickets sold 2,700 3,000 3,300

Total cost of band 48,000$ 48,000$ 48,000$

Cost per ticket sold 17.78$ 16.00$ 14.55$

$48,000 ÷ 3,000 Tickets = $16.00 per Ticket

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Learning Objective 2

• Demonstrate the effects of operating leverage on profitability.

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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.

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 where

all costs are fixed.

Fixed Costs

Smallpercentagechange inrevenue

Largepercentagechange in

profits

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Operating Leverage

When all costs are fixed, every additional sales dollar

contributes one dollar to gross profit.

When all costs are fixed, every additional sales dollar

contributes one dollar to gross profit.

10% RevenueIncrease

90% GrossProfit Increase

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Risk and Reward Assessment

Risk refers to the possibility thatsacrifices may exceed benefits.

Risk may be reduced byconverting fixed costs

into variable costs.

Let’s see what happens to the concert example if the band receives $16 per

ticket instead of $48,000.

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The total variable cost increases in direct proportion to the number of tickets sold.

Variable unit cost per ticket remains at$16 regardless of the number of tickets sold.

Risk and Reward Assessment

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Variable Cost Behavior

Increases Decreases

Total Variable Cost

Increases Proportionately

Decreases Proportionately

Variable Cost Per Unit

Remains Constant Remains Constant

When activity . . .

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Shifting the cost structure from fixed to variable not only reduces

risk but also the potential for profits.

Shifting the cost structure from fixed to variable not only reduces

risk but also the potential for profits.

Risk and Reward Assessment10% Revenue

Increase

10% GrossProfit Increase

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Learning Objective 3

• Prepare an income statement using the contribution margin approach.

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Income Statement - Contribution Margin Approach

Total Unit

Sales Revenue 100,000$ 50$

Less: Variable Costs 60,000 30

Contribution Margin 40,000$ 20$

Less: Fixed Costs 30,000

Net Income 10,000$

The contribution margin format emphasizes cost behavior. Contribution margin covers

fixed costsand provides for income.

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Learning Objective 4

• Calculate the magnitude of operating leverage.

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Contribution margin

Net incomeMagnitude of Operating

Leverage=

Show mean example.

Measuring Operating Leverage Using Contribution Margin

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$20,000

$5,000

Operating

Leverage= = 4

A measure of how a percentagechange in sales will effect profits.

Measuring Operating Leverage Using Contribution Margin

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A 10 percent increase in sales results in a 40 percent increase in net income.

(10% × 4 = 40 %)

Measuring Operating Leverage Using Contribution Margin

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Learning Objective 5

• Demonstrate how the relevant range and the decision-making context affect cost behavior.

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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.

Number of Local Calls

Mon

thly

Basic

Tele

ph

on

e B

ill

Total Fixed Cost

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Number of Local Calls

Mon

thly

Basic

Tele

ph

on

e B

ill p

er

Local C

all

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

Cost Behavior Summarized

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

Minutes Talked

Tota

l Lon

g

Dis

tan

ce

Tele

ph

on

e B

ill

Cost Behavior Summarized

Tota

l Var

iabl

e Cos

t

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Minutes Talked

Per

Min

ute

Tele

ph

on

e C

harg

e

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

Cost Behavior Summarized

Variable Cost Per Unit

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Total Cost Cost Per Unit

Fixed CostsRemains Constant

Changes Inversely

Variable CostsChanges in

Direct ProportionRemains Constant

Cost Behavior Summarized

When activity level changes . . .

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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.

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.

The Relevant Range

Continue

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Ren

t C

ost

in

Th

ou

san

ds o

f D

ollars

0 1,000 2,000 3,000 Rented Area (Square Feet)

0

30

60

The Relevant Range

90

Relevant

Range

Total fixed cost doesn’t change for a range of

activity, and then jumps to a new higher cost for the next higher

range of 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.

The cost of the band is fixed relative to the number of tickets sold for a specific concert.

The cost of the band is variable relativeto the number of concerts produced.

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Mixed Costs

• Some costs have both fixed and variable components.

• These costs are known as mixed costs or semivariable costs.

• Several techniques exist to mixed costs into estimates fixed and variable components.

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Learning Objective 6

• Determine the sales price of a product using a cost-plus pricing approach.

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Determining Contribution Margin per Unit

Bright Day produces one product called Delatine. The company uses a cost-plus-pricing strategy; it sets prices at cost plus a markup of 50% of cost. Delatine cost $24 per bottle to manufacture, so a bottle sells for $36 ($24 + [50% × $24]). The contribution margin per bottle is:

Sales revenue per bottle 36$ Variable cost per bottle 24 Contribution margin per bottle 12$

The company’s first concern is if it can sell enough The company’s first concern is if it can sell enough bottles of Delatine to cover it fixed costs and make bottles of Delatine to cover it fixed costs and make

a profit!a profit!

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Learning Objective 7

• Use the contribution per unit approach to calculate the break-even point.

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Determining the Break-even Point

The break-even point is the point where total total revenue equals total costsrevenue equals total costs (both variable and

fixed). For Bright Day, the cost of advertising is estimated to be $60,000. Advertising costs are

the fixed costs of the company. We use the following formula to determine the break-even

point in units.

The break-even point is the point where total total revenue equals total costsrevenue equals total costs (both variable and

fixed). For Bright Day, the cost of advertising is estimated to be $60,000. Advertising costs are

the fixed costs of the company. We use the following formula to determine the break-even

point in units.

Break-evenBreak-evenvolume in unitsvolume in units==

Fixed costsFixed costsContribution margin per Contribution margin per

unitunit

= $60,000$12

= 5,000 units5,000 units

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Determining the Break-even Point

For Delatine, the break-even point in sales dollars is $180,000 (5,000 bottles × $36 selling price).

Sales Revenue (5,000 units x $36) 180,000$ Total Variable Expenses (5,000 units x $24) (120,000)

Total Contribution Margin (5,000 units x $12) 60,000 Fixed Expenses (60,000)

Net Income $ 0

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Learning Objective 8

• Use the contribution per unit approach to calculate the sales volume required to realize a target profit.

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Reaching a Target Profit Level

Bright Day’s president wants the advertising campaign to produce profits of $40,000 for the

company.Break-evenBreak-even

volume in unitsvolume in units== Fixed costs + Fixed costs + Desired Desired

profitprofit Contribution margin Contribution margin per unitper unit

=$60,000 + $40,000

$12

= 8,333.33 units8,333.33 units

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Reaching a Target Profit Level

At $36 per unit selling price, the sales dollars are equal to $300,000, as shown below:

IncomeUnits sold 8,333.33 Revenue @ $36 300,000$ Variable Expenses @ $24 (200,000) Contribution Margin @$12 100,000 Fixed Expenses (60,000) Net Income 40,000$

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Learning Objective 9

• Calculate the margin of safety in units, dollars and percentage.

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Calculating the Margin of Safety

The margin of safety measures the cushion between budgeted sales and the break-even point. It quantifies the amount by which actual sales can fall short of expectations before the company will

begin to incur losses.

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Calculating the Margin of Safety

In Units In DollarsBudgeted sales 8,333 299,988$ Break-even sales (5,000) (180,000) Margin of safety 3,333 119,988$

Margin ofsafety

=Budgeted sales – Break-even

salesBudgeted sales

Margin ofsafety

= $299,988 – $180,000$299,988

= 40%40%X 100

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End of Chapter Eleven