Chapter 7: Cost-Volume-Profit (Part 3 of 3) Sections 1 and 2 Feb 8, 2013 Professor: Khim Kelly Office: HH386B Office Hours: Mon/Wed 11:30am – 12:30pm and Appointment Email: [email protected]TA: Kun Huo Email: [email protected]Ch. 7 Assignment due Feb 11(Mon), 11.59pm Kun will be teaching Ch. 7 expect mass confusion
Ch. 7 Assignment due Feb 11(Mon), 11.59pm. Chapter 7: Cost-Volume-Profit (Part 3 of 3). Sections 1 and 2 Feb 8, 2013 Professor: Khim Kelly Office: HH386B Office Hours: Mon/Wed 11:30am – 12:30pm and Appointment Email: [email protected] TA : Kun Huo Email : [email protected]. - PowerPoint PPT Presentation
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Chapter 7: Cost-Volume-Profit (Part 3 of 3)
Sections 1 and 2Feb 8, 2013
Professor: Khim KellyOffice: HH386B
Office Hours: Mon/Wed 11:30am – 12:30pm and AppointmentEmail: [email protected]
• Company can choose a particular cost structure (i.e., relative proportion of fixed and variable costs)
• Which cost structure is better (more fixed costs or more variable costs)?
– Depends on many factors• Concept of leverage plays a key role in the
analysis
“Give me a place to stand and with a lever I will move the whole world”
5
Operating Leverage
• Measure of the sensitivity of OI to % change in sales– Acts as a multiplier– Higher leverage: small change in sales leads to larger shift in
OI– Differs at any level of sales (i.e. valid at given X only), greatest
at break-even point and decreases as sales increases• Cost structure drives leverage
– More FC rather than VC yields greater leverage– Drive to automation?
Degree of Operating Leverage = CMOI
Leverage Graph: Cost Structure
Activity
$Case A: Total Expenses
Total Sales Revenue
Case B: Total Expenses
High FC
Low FC
Break-even Point
Lower FC results in a lower break-even point (Fixed expenses/unit CM), so less risk of losses when sales decrease
Leverage Graph: Cost Structure
Activity
$ Case A: Total Expenses
Total Sales Revenue
Case B: Total Expenses
High FC
Low FC
X
Which has a greater degree of operating leverage at point X: A or B?
Higher FC (higher CM) results in higher leverage (CM/OI), so better upside potential in profits when sales increases
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Per Unit Income IncomeRev $100 $100,000 $110,000VC $60 $60,000 $66,000CM $40 $40,000 $44,000FC $30,000 $30,000OI $10,000 $14,000
Units 1,000 1,100Degree of Leverage 4
Operating Leverage Example 1
Degree of Operating Leverage = CMOI
Sales increase by 10%
OI increases by 4 times (i.e., 40%)
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Per Unit Income IncomeRev $100 $100,000 $110,000VC $30 $30,000 $33,000CM $70 $70,000 $77,000FC $60,000 $60,000OI $10,000 $17,000
Units 1,000 1,100Degree of Leverage 7
Operating Leverage Example 2
Degree of Operating Leverage = CMOI
Sales increase by 10%
OI increases by 7 times (i.e., 70%)
Same total sales
Same total expenses, but greater proportion of FC
Higher FC (higher CM) results in higher leverage (CM/OI), so better upside potential in profits when sales increases
The critical assumption about leverage
• As fixed cost increases, variable cost will come down– More roads and infrastructure, people are more
productive because they spend less time on the travel
– Bigger class rooms, fewer instructors need to be hired
It is Clicker Time!!
Feel Free to Work Together on Clicker Questions
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Clicker Question #1
Green Company's variable expenses are 75% of sales. At a sales level of $400,000, the company's degree of operating leverage is 8. At this sales level, fixed expenses equal which of the following?
A) $87,500.B) $100,000.C) DogbertC) $12,500.D) $75,000.
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Clicker Question #1: Answer
Green Company's variable expenses are 75% of sales. At a sales level of $400,000, the company's degree of operating leverage is 8. At this sales level, fixed expenses equal which of the following?
Answer:
Clicker Question #2If two companies produce the same product and have the same total sales and same total expenses, operating leverage will be lower in the company with a higher proportion of fixed expenses in its cost structure.
A. TrueB. False
Leverage Graph: Cost Structure
Activity
$ A - Total Expenses
Total Sales Revenue
B - Total Expenses
High FC
Low FC
X
Which has a greater degree of operating leverage at point X: A or B?
Indifference Point(indifferent wrt profit between high FC vs. low FC)
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Indifference Point (P7-31)
Item Cost 1 Cost 2DM per unit $9.00 $7.50DL per unit 1.2 DLH @
$14/DLH0.75 DLH @ $18/DLH
Variable OH per unit 0.75 of DL costs 0.60 of DL costs
Fixed Man. Costs $1,108,000 $1,494,000Fixed S&A $1,685,000 $1,685,000Selling Price per unit $60.00 $60.00Variable Selling Cost per unit $4.00 $4.00
1) Find equations for both cost lines2) Set the two equations equal to each other and solve for X
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Cost 1 Equation …
Item Cost 1DM per unit $9.00DL per unit 1.2 DLH @
$14/DLHVariable OH per unit 0.75 of DL costs
Fixed Man. Costs $1,108,000Fixed S&A $1,685,000Selling Price per unit $60.00Variable Selling Cost per unit
$4.00
VC per Unit:= $9 + ($14*1.2) + ($14*1.2*0.75) + $4= $42.40 per unit