the mcgraw-hill companies, inc. 2008mcgraw-hill/irwin chapter 2 cost behavior, operating leverage,...

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin

CHAPTER 2

Cost Behavior, Operating

Leverage, and Profitability

Analysis


2-2

Learning Objective

LO1LO1

To identify and describe fixed, variable, and mixed cost behavior


2-3

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 . . . .


2-4

Fixed Cost Behavior

Tickets sold 2,700 3,000 3,300

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

Per ticket cost of band 17.78$ 16.00$ 14.55$

Tickets sold 2,700 3,000 3,300

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

Per ticket cost of band 17.78$ 16.00$ 14.55$

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


2-5

Learning Objective

LO2LO2

To demonstrate the effects of

operating leverage on profitability


2-6

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


2-7

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


2-8

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 perticket sold instead of a fixed $48,000.


2-9

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.

Variable Cost Behavior


2-10

Learning Objective

LO1LO1



2-11

Variable Cost Behavior

Increases Decreases

Total Variable Cost

Increases Proportionately

Decreases Proportionately

Variable Cost Per Unit

Remains Constant Remains Constant

When activity . . .


2-12

Learning Objective

LO2LO2

To demonstrate the effects of

operating leverage on profitability


2-13

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 RewardAssessment

10% RevenueIncrease

10% GrossProfit Increase


2-14

Fixed Cost Structure

Fixed CostProfit

Loss

Revenue$

Activity

Effect of Cost Structure on Profit Stability


2-15

Variable Cost Structure

Variable Cost

Revenue

Profit

$

Activity



2-16

VariableCosts

FixedCosts

Do companieswith higher levels of

fixed costs experiencemore earnings

volatility?



2-17

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



2-18

The income increase is greaterin the All Fixed Company.



2-19

VariableCosts

FixedCosts

If sales decrease,will the income

decrease be greaterin the All Fixed

Company?



2-20

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



2-21

VariableCosts

FixedCosts

Level of Fixed Cost

Earnings Volatility

High High

Low Low



2-22

Learning Objective

LO3LO3

To prepare an income statement

using the contribution

margin approach


2-23

An Income Statement under the 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.


2-24

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


2-25

Advantage to MaHall, the all fixed company.



2-26

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

company?



2-27

Both companies incur losses.



2-28

I suppose fixed costs arebetter if volume is increasing,

but variable costs may be betterif business is declining.



2-29

Learning Objective

LO4LO4

To demonstrate how the magnitude

of operating leverage affects

profitability


2-30

Contribution margin

Net income

Operating

Leverage=

Show mean example.

Measuring Operating Leverage Using Contribution Margin


2-31

$20,000

$5,000

Operating

Leverage= = 4

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



2-32

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

(10% × 4 = 40 %)



2-33

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


2-34

Number of Local Calls

Mon

thly

Basic

Tele

ph

on

e B

ill p

er

Local C

all

Cost Behavior SummarizedThe fixed cost per local call decreases

as more local calls are made.


2-35

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

Tota

l Var

iabl

e Cos

t


2-36

Minutes Talked

Per

Min

ute

Tele

ph

on

e C

harg

e

Cost Behavior Summarized

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

Variable Cost Per Unit


2-37

Total Cost Cost Per Unit

Fixed CostsRemains Constant

Changes Inversely

Variable CostsChanges in

Direct ProportionRemains Constant

Cost Behavior SummarizedWhen activity level changes . . .


2-38

Learning Objective

LO5LO5

To demonstrate how the relevant

range and decision context affect cost

behavior


2-39

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.

Continue


2-40

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.


2-41

Activity

Tota

l C

ost Relevant

Range

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


2-42Context 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.


2-43

Learning Objective

LO6LO6

To select an appropriate time

period for calculating the average cost per

unit


2-44

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 for2 lessons per day? 5 lessons per day? 10 lessons

per day?

Cost Averaging


2-45

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.


2-46

Learning Objective

LO1LO1



2-47

Mixed Costs

A mixed costhas both fixed and variablecomponents.

Consider thefollowing

electric utility example.


2-48

Fixed Monthly

Utility Charge

Variable

Utility

Charge

Activity (Kilowatt Hours)

Tota

l U

tility

Cost

Mixed Costs

Total mixed cost


2-49

Learning Objective

LO7LO7

To use the high-low method,

scattergraphs, and regression analysis

to estimate fixed and variable costs


2-50

Estimating Fixed and Variable Costs

High-Low Method

Scattergraph Method

Regression Analysis


2-51

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.


2-52

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


2-53

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


a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit


2-54

The High-Low Method


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$


2-55

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


a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000


2-56

The High-Low Method


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


2-57

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


2-58

Draw a line through the data points with about an

equal numbers 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



2-59

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.



2-60

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.


2-61Regression 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 This method uses allall of the of thedata points to estimatedata points to estimatethe fixed and variablethe fixed and variablecost components of acost components of a

mixed cost.mixed cost.

This method uses This method uses allall of the of thedata points to estimatedata points to estimatethe fixed and variablethe fixed and variablecost components of acost components of a

mixed cost.mixed cost.The goal of this method isThe goal of this method isto fit a straight line to theto fit a straight line to thedata that data that minimizes theminimizes the

sum of the squared errorssum of the squared errors..

The goal of this method isThe goal of this method isto fit a straight line to theto fit a straight line to thedata that data that minimizes theminimizes the

sum of the squared errorssum of the squared errors..



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 goodness

of fit of the regression line to the data points.

Least-squares regression also provides a statistic,

called the R2, that is a measure of the goodness

of fit of the regression line to the data points.



Follow these steps in Excel

to perform regression

analysis:

1. Enter the data in

spreadsheet columns.

2. Click Tools.

3. Click Data Analysis.

4. Click Regression and

then OK.

5. Define data ranges and

click Line Fit Plot.

6. Click OK.

Follow these steps in Excel

to perform regression

analysis:

1. Enter the data in

spreadsheet columns.

2. Click Tools.

3. Click Data Analysis.

4. Click Regression and

then OK.

5. Define data ranges and

click Line Fit Plot.

6. Click OK.

0 1 2 3 4T

ota

l C

ost

10

20

0

Activity

****

**

* ***

X

Y

The regression function will return

an estimate for fixed cost and

variable cost per unit.

The regression function will return

an estimate for fixed cost and

variable cost per unit.


2-64

End of Chapter 2

the mcgraw-hill companies, inc. 2008mcgraw-hill/irwin chapter 2 cost behavior, operating leverage,...

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