cost behavior, operating leverage, & profitability analysis
TRANSCRIPT
Cost Behavior, Operating Leverage, & Profitability Analysis
Cost Behavior
• Manner in which a cost changes as a related activity changes.
• Classifications of Cost Behavior– Variable Costs– Fixed Costs– Mixed Costs
Cost Behavior
• Behavior is relative to the context it is presented in
• The term fixed or variable is based on the total cost.
Summer Vacation
• Let’s say you and 2 friends are going to Cabo for 4 nights.
• You are going to fly down there and stay in a hotel.
• The hotel charges $100 per night regardless of how many people stay in the room.
• TOTAL Expected Lodging Cost = $400
• Two days before you leave one more friend decides to come along.
• How does this affect your hotel bill?
• No change – total lodging is still $400
• This is a fixed cost – The total cost does not change.
• The day before you leave one friend gets sick and can’t go.
• What happens to your hotel bill now?
• No Change
• This is a fixed cost – The total cost does not change
How does all this affect you?
• Total Hotel Bill = $400• How much do you have to
pay?
Fixed Cost Behavior
# of People (a) 2 people 3 people 4 people
Total Lodging (b) $400 $400 $400
Lodging per person (b / a)
$200 $133 $100
What about the airfare?
• You were able to get plane tickets
for $200 roundtrip per person.
Variable Cost Behavior
# of tickets (a) 2 3 4
Total Airfare (a * b) $400 $600 $800
Cost per ticket (b) $200 $200 $200
• Under a variable cost structure the cost per unit stays the same and the total cost changes
• Using the Variable Cost Structure avoids Fixed Cost Risk
• Whether a cost is fixed or variable depends on the underlying circumstances.
• Let’s look back at our lodging for vacation.• What if we decide to stay 5 nights instead of 4?• What if we come home a day early?
# of Nights (a) 3 4 5
Total Lodging (a * b) $300 $400 $500
Cost per night (b) $100 $100 $100
• Here the lodging is a variable cost.
• The cost per night stays the same and the total cost changes.
# of Nights (a) 3 4 5
Total Lodging (a * b) $300 $400 $500
Cost per night (b) $100 $100 $100
Relevant Range
• What happens if three more friends decide to come along and you have a total of 6 people?
• You will more than likely have to rent 2 rooms each night.
• Now your total lodging is $200 per night.
• The structures work within a relevant range.
• Our range here is 1 to 4 people.
When the activity level increases, total fixed costs
1. Increases
2. Decreases
3. Remains constant
When the activity level increases, fixed cost per unit
1. Increases
2. Decreases
3. Remains constant
When the activity level increases, variable cost per unit
1. Increases
2. Decreases
3. Remains constant
When the activity level increases, total variable costs
1. Increases
2. Decreases
3. Remains constant
Mixed Cost
• Has characteristics of both a variable and a fixed cost.
• e.g. – Copy machine lease– Cost = $1,000 per month– Plus $1 for every copy over 2,000
Art on Tour, Inc. (AOTI)
• Art on Tour Inc. contracts with artists to exhibit their works to the public. AOTI has agreed to pay a well known artist a $20,000 commission for the right to exhibit his work for one month.
• We need to determine the total commission cost and the commission cost per person if 1,000 / 2,000 / 4,000 people attend the exhibition.
• Is this commission cost fixed or variable?
• Fixed – Total cost does not change
# of people (a) 1000 2000 4000
Total Commission (b)
$20,000 $20,000 $20,000
Commission per person (b / a)
$20 $10 $5
• AOTI provides patrons with books illustrating the artist’s work.
• The books cost AOTI $5 each.• We need to determine the total cost of books
and the cost per person if 1,000 / 2,000 / 4,000 people attend.
# of People (a) 1,000 2,000 4,000
Total Cost of Books (a * b)
$5,000 $10,000 $20,000
Cost per Book (b) $5 $5 $5
• AOTI expects 4,000 people to attend the exhibition and the tickets are $6 each.
• AOTI decided not to give the attendees a book.• Let’s prepare an income statement
Revenue ($6 / ticket) $ 24,000
Commission Cost (20,000)
Net Income $ 4,000
• What if actual attendance is 10% higher or lower than expected?
# of People 3600 4000 4400Revenue $21,600 $24,000 $26,400Commission (20,000) (20,000) (20,000)Net Income $ 1,600 $ 4,000 $ 6,400
*Alt. Measure – Base Measure = DifferenceDifference / Base Measure = % Change
10% 10%
60% 60%
Operating Leverage
• Magnifies small changes in revenue into dramatic changes in profitability
• The Lever = Fixed Cost
Risk vs. Reward
• Risk – refers to the possibility that sacrifices may exceed benefits
• What if no one comes to the exhibition?
What if we change the way we pay the commission?
• Now we pay $5 in commission per person attending the exhibition.
# of People 1 2000 4000
Revenue $6 $12,000 $24,000
Commission (5) (10,000) (20,000)
Net Income $1 $ 2,000 $ 4,000
Using Fixed Cost to Provide a Competitive Operating
Advantage• My Company and Your Company
provide rafting tours on Big Bear River. My Company pays tour guides fixed salaries. It budgets salaries expense at $160,000 per year. Your Company pays tour guides $40 per rafter served. Rafters are charged $50 per tour. Both companies expect to carry approx. 4,000 rafters during the year.
Let’s look at an Income Statement for each Company
My Co. Your Co.
Revenue ($50 * 4,000) $200,000 $200,000
Salary Exp. 160,000 160,000*
Net Income $ 40,000 $ 40,000
* $40 * 4,000
• In an effort to lure rafters away from Your Company, My Company lowers the price per rafter to $39.
• Now My Company serves 6,000 rafters who each pay $39 per tour.
• Your Company serves only 2,000 rafters who pay $50 per tour.
Income Statement
My Co. Your. Co.
Revenue($39*6000) $234,000 ($50*2000)$100,000
Salary Exp. ( 160,000) ($40*2000)( 80,000)
Net Income $ 74,000 $ 20,000
• Now let’s say Your Company lowered its price to $39 per rafter and lured 2,000 rafters from My Company that is still charging $50 per rafter.
Income Statement
My Co. Your Co.
Revenue ($50*2000) $100,000 ($39*6000)$234,000
Salary Exp. ( 160,000) ($40*6000)( 240,000)
Net Income ($ 60,000) ($ 6,000)
• What should My Company do?• My Company matches the $39 price set by
Your Company.• Now they each serve 4,000 customer
Income StatementMY CO. YOUR CO.
Revenue $156,000 $156,000Salary Exp. ( 160,000) ( 160,000)Net Income ($ 4,000) ($ 4,000)
I suppose fixed costs arebetter if volume is increasing,
but variable costs may be betterif business is declining.
Using Fixed Cost to Provide a Competitive Operating Advantage
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
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
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
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
Total Cost Cost Per Unit
Fixed CostsRemains Constant
Changes Inversely
Variable CostsChanges in
Direct ProportionRemains Constant
Cost Behavior SummarizedWhen activity level changes . . .
Contribution Margin
• CM = Revenue – Variable Costs
• CM represents the amount available to cover fixed expenses and thereafter provides profits.
• Sharon Virgil owns a delivery service company. She charges customers $10 per delivery. The company’s variable expenses average $2 per delivery and fixed costs are $600 per month. Sharon provided 100 deliveries during January.
Contribution MarginIncome Statement
Revenue $ 1,000
(Variable Costs) ( 200)
Contribution Margin $ 800
(Fixed Costs) ( 600)
Net Income $ 200
Measuring Operating LeverageUsing Contribution Margin
• Operating Leverage = Contribution Margin Net Income
• OL = $800 / $200 = 4• What does this 4 tell us?• If you take the OL and multiply it by the %
increase in sales it gives you the % increase in net income.
• Let’s say deliveries increase 10% for February.
• 4 * 10% = 40% in net income
Let’s test our theory!
• In February sales increased by 10%
• 100 deliveries * 110% = 110 deliveries
Revenue $1,100
(Variable Costs) ( 220)
Contribution Margin 880
(Fixed Costs) ( 600)
Net Income $ 280
• Sharon made 10 more deliveries in February.
• Sales rose from $1,000 to $1,100
• This is a 10% increase• Net income rose from $200
to $280• This is a 40% increase• % change = (280 – 200) = 80
80 / 200 = 40%
Estimating Fixed Estimating Fixed and Variable Costsand Variable Costs
High Low Method
• Used to estimate future costs
Step 1: Assemble Sales Volume and Cost History
Step 2: Find High and Low Points
Step 3: Determine the estimated variable cost per unit
Step 4: Determine the estimated total fixed costs
Units Sold Total Cost
Jan 12 195,000
Feb 10 150,000
March 11 175,000
April 18 210,000
May 30 375,000
June 35 450,000
July 25 325,000
August 20 250,000
September 15 360,000
October 11 180,000
November 10 145,000
December 12 190,000
HIGH HIGH
LOW LOW
Step 3
(High Cost – Low Cost) = VC per unit
(High Units – Low Units)
(450,000 – 145,000) = $12,200 / unit
(35 – 10)
Step 4
FC + VC = Total Cost
FC = TC – VC
FC = $450,000 – (35 * $12,200)
FC = $450,000 – 427,000
FC = $23,000