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

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

Chapter Fifteen

Cost Behavior, Operating Leverage, and Profitability Analysis

15-2

Learning Objective 1

• Distinguish between fixed and variable cost behavior.

15-3

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 . . . .

15-4

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

15-5


• Demonstrate the effects of operating leverage on profitability.

15-6

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

15-7

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

15-8

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.

15-9

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

15-10

Variable Cost Behavior

Increases Decreases

Total Variable Cost

Increases Proportionately

Decreases Proportionately

Variable Cost Per Unit

Remains Constant Remains Constant

When activity . . .

15-11

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

15-12

Relationship Between Cost Behavior & Revenue

Fixed Cost Structure

Fixed Cost

Profit

Loss

Revenue$

Units1

0

15-13

Relationship Between Cost Behavior & Revenue

Variable Cost Structure

Variable Cost

Revenue

Profit

$

Units01

15-14


• Show how cost behavior affects profitability.

15-15

The Effect of Cost Structure on Profit Stability

VariableCosts

FixedCosts

Do companieswith higher levels of

fixed costs experiencemore earnings

volatility?

15-16


Now let’s see what happens whenthe number of units sold increases.

15-17


The income increase is greaterin the All Fixed Company.

15-18


VariableCosts

FixedCosts

If sales decrease,will the income

decrease be greaterin the All Fixed

Company?

15-19


Yes, the income decrease is greaterin the All Fixed Company.

15-20


VariableCosts

FixedCosts

Level of Fixed Cost

Earnings Volatility

High High

Low Low

15-21


• Prepare an income statement using the contribution margin approach.

15-22

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.

15-23


• Calculate the magnitude of operating leverage.

15-24

Contribution margin

Net income

Operating

Leverage=

Show mean example.

Measuring Operating Leverage Using Contribution Margin

15-25

$20,000

$5,000

Operating

Leverage= = 4

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


15-26

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

(10% × 4 = 40 %)


15-27


• Use cost behavior to create a competitive operating advantage.

15-28

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?

Using Fixed Cost to Provide a Competitive Operating Advantage

15-29

Advantage to MaHall, the all fixed company.


15-30

What happens if the price is cutto $7 per hour and the demandremains at 2,000 hours for each

company?


15-31

Both companies incur losses.


15-32

One suppose fixed costs arebetter if volume is increasing,

but variable costs may be betterif business is declining.


15-33

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

15-34

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.


15-35

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


Tota

l Var

iabl

e Cos

t

15-36

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.


Variable Cost Per Unit

15-37

Total Cost Cost Per Unit

Fixed CostsRemains Constant

Changes Inversely

Variable CostsChanges in

Direct ProportionRemains Constant


When activity level changes . . .

15-38


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

15-39

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

15-40

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.

15-41

Activity

Tota

l C

ost RelevantRange

The Relevant RangeOur variable

cost assumption

(constant unit variable cost) applies within the relevant

range.

Our variable cost

assumption (constant unit variable cost) applies within the relevant

range.Possible VariableCost Behavior

Our VariableCost Assumption

15-42

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.

15-43


• Select an appropriate time period for calculating the average cost per unit.

15-44

Lake Resorts provides water-skiing lessons for itsguests with the following costs:

Equipment rental $80 per dayInstructor pay $15 per hourFuel $ 2 per hour

What is the average cost per one-hour lesson fortwo lessons per day? Five lessons per day? Ten lessons

per day?

Cost Averaging

15-45

Cost Averaging

Number of Lessons 2 5 10

Cost of Equipment Rental 80$ 80$ 80$ Cost of Instruction 30 75 150 Cost of Fuel 4 10 20 Total Cost 114$ 165$ 250$

Cost Per Lesson 57$ 33$ 25$

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.

15-46


• Define the term mixed costs.

15-47

A mixed costhas both fixed and variablecomponents.

Mixed Costs

Consider thefollowing

electric utility example.

15-48

Fixed Monthly

Utility Charge

Variable

Utility

Charge

Activity (Kilowatt Hours)

Tota

l U

tility

Cost

Mixed Costs

Total mixed cost

15-49


• Use the high-low method and scattergraphs to estimate fixed and variable costs.

15-50

Estimating Fixed and Variable Costs

High-Low Method

Scattergraph Method

15-51

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

The High-Low Method

15-52

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

The High-Low Method

15-53

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 commissions?

a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit


a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit

The High-Low Method

15-54


a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit


a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit$4,000 ÷ 40,000 units = $.10 per unit

Units Cost

High level 120,000 14,000$

Low level 80,000 10,000

Change 40,000 4,000$

The High-Low Method

15-55

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


a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000

The High-Low Method

15-56


a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000


a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000

Total cost = Total fixed cost + Total variable cost

$14,000 = Total fixed cost +($.10 × 120,000 units)

Total fixed cost = $14,000 - $12,000

Total fixed cost = $2,000

The High-Low Method

15-57

Plot the data points on a graph (total cost vs. activity).

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*

Activity, 1,000’s of Units Produced

X

Y

The Scattergraph Method

15-58

Draw a line through the data points with about an

equal number of points above and below the line.

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*


X

Y


15-59

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*


X

Y

Estimated fixed

is $10,000

Vertical distance is total cost,

approximately $16,000.

Variable cost per unit is represented by the slope of the

line.


15-60

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*


X

Y

Total variable cost = Total cost – Total fixed costTotal variable cost = $16,000 – $10,000 = $6,000Unit variable cost = $6,000 ÷ 3,000 units = $2


Estimated fixed

is $10,000

Vertical distance is total cost,

approximately $16,000.

15-61

End of Chapter Fifteen

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

Documents

fixed cost behavior

variable cost behavior

fixed company

ticket slide

contribution margin

variable unit cost

effect of cost structure

high proportion of fixed