Cost Behavior, Operating Leverage, and Profitability Analysis PDF

Cost Behavior, Operating Leverage, and Profitability Analysis Chapter 11 CH11 – Key Concepts Cost Behavior – Fixed vs Variable vs Mixed Contribution Margin vs Gross Margin Break Even  Cost Classifications for Predicting Cost Behavior Cost beh...

Cost Behavior, Operating Leverage, and Profitability Analysis Chapter 11 CH11 – Key Concepts Cost Behavior – Fixed vs Variable vs Mixed Contribution Margin vs Gross Margin Break Even  Cost Classifications for Predicting Cost Behavior Cost behavior refers to how a cost will react to changes in the level of activity. The most common classifications are: Fixed Costs Variable costs. Mixed costs. Cost Behavior (Fixed vs Variable) The total amount of a fixed cost does not _______ when volume changes. In contrast, some costs vary in direct proportion with changes in volume. When volume increases, total variable cost increases; when volume decreases, total variable cost decreases.  Fixed Cost Behavior Considering Considering costcost behavior behavior enables enables managers managers to to more more effectively effectively plan plan and and control control costs. costs. –– Total Total versus versus per-unit per-unit fixed fixed costs costs behave behave differently. differently. –– The The total total cost cost remains remains constant constant (fixed). (fixed). –– Fixed Fixed cost cost per per unit unit decreases decreases as as volume volume increases. increases. –– The The term term fixed fixed cost cost is is consistent consistent with with the the behavior behavior ofof total total cost. cost. Fixed Cost Behavior SPI specializes in promoting rock SPI specializes in promoting rock concerts. concerts. It is considering paying a band $48,000 It is considering paying a band $48,000 to to play play aa concert. concert.  Risk and Reward Assessment Risk Risk refers refers to to the the possibility possibility that that sacrifices sacrifices may may exceed exceed benefits. benefits. AA fixed fixed cost cost represents represents aa ______ ______ toto an an economic economic sacrifice. sacrifice. It It represents represents the the ultimate ultimate risk risk of of undertaking undertaking aa particular particular business business project. project. IfIf SPI SPI pays pays the the band band but but nobody nobody buys buys aa ticket, ticket, the the company company willwill lose lose $48,000. $48,000. SPI SPI can can avoid avoid this this risk risk by by substituting substituting variable variable costs costs for for the the fixed fixed costs. costs.  Fixed Cost Behavior Patterns Example – Fixed Scenario Scenari Scenari Costs 1 o2 o3 Annual Rent $100,000 $100,00 $100,00 0 0 Annual Production 100,000 50,000 150,000 (Units)  Variable Cost Behavior SPI SPI arranges arranges to to pay pay the the band band $16 $16 per per ticket ticket sold sold instead instead of of aa fixed fixed $48,000. $48,000. The The total total variable variable cost cost increases increases in in direct direct proportion proportion to to the the number number ofof tickets sold. tickets sold. The The variable variable cost cost per per ticket ticket remains remains $16$16 regardless regardless of of whether whether the the number number of of tickets tickets sold sold is is 1, 1, 2, 2, 3, 3, or or 3,000. 3,000. The The behavior behavior of of variable variable cost cost per per unit unit is is contradictory contradictory to to the the word word variable. variable. Variable Variable cost cost per per unit unit remains remains constant constant regardless regardless of of how how many many tickets tickets are are sold. sold.  Variable Cost Behavior Patterns Example – Variable Scenario Scenari Scenari Costs 1 o2 o3 VC Per Unit $1.00 $1.00 $1.00 Annual Production 100,000 50,000 150,000 (Units) Total VC $100,000 $50,000 $150,00 0  Risk and Reward Assessment Shifting Shifting the the cost cost structure structure from from fixed fixed to to variable variable enables enables SPI SPI to to avoid avoid the the fixed fixed cost cost risk. risk. Under Under the the fixed fixed cost cost structure, structure, SPISPI was was locked locked intointo aa $48,000 $48,000 costcost for for the the band band regardless regardless of of how how many many tickets tickets areare sold. sold. IfIf no no tickets tickets areare sold, sold, SPI SPI will will have have toto report report aa $48,000 $48,000 lossloss onon its its income income statement. statement. The The risk risk of of incurring incurring aa loss loss is is eliminated eliminated by by the the variable variable cost cost structure. structure.  Fixed and Variable Cost Behavior Behavior of Cost (within the relevant range) Cost In Total Per Unit Variable Total variable cost Increase Variable cost per unit and decrease in proportion remains constant. to changes in the activity level. Fixed Total fixed cost is not affected Fixed cost per unit decreases by changes in the activity as the activity level rises and level within the relevant range. increases as the activity level falls. Total $$ $ / Unit Variabl Inc / Dec with No change e volume Fixed No change Inc / Dec opposite volume  Fixed vs Variable Exercise McGreggor Industries makes and sells customized dog collars. The company normally produces and sells between 6,000 and 12,000 collars per year. The following cost data apply to various activity levels. Number of 6,000 8,000 10,000 12,000 Collars Total Costs Incurred Fixed $48,000 Variable 48,000 Total Costs $96,000 Cost Per Unit Fixed $ 8.00 Variable 8.00 Total Cost Problem #1 in Workbook Per $16.00 Collar  Mixed Costs (Semivariable Costs) Mixed Mixed costs costs (semivariable (semivariable costs) costs) include include both both _____ _____ and and _____ _____ components. components. For For example, example, suppose suppose Star Star Productions Productions pays pays aa base base fee fee of of $1,000 $1,000 plusplus $20 $20 per per hour hour for for janitorial janitorial services. services. The The $1,000 $1,000 basebase fee fee is is fixed. fixed. ItIt is is the the same no matter how many hours same no matter how many hours it takes it takes to to clean. clean. The The $20 $20 hourly hourly cost cost is is aa variable variable cost cost because the total cost increases because the total cost increases with with each each additional additional hour hour itit takes takes to to complete complete the cleanup. the cleanup.  Mixed Costs The total mixed cost line can be expressed as an equation: Y = a + bX Where: Y = The total mixed cost. a = The total fixed cost (the vertical intercept of the line). b = The variable cost per unit of activity (the slope of the line). X = The level of activity.  Calculating Mixed Costs Given Given $1,000 $1,000 base base plus plus $20 $20 per per hour hour cost cost components, components, the total janitorial cost for any the total janitorial cost for any cleanup cleanup can be easily computed as shown: can be easily computed as shown: Total Total Cost Cost == FC FC + + (VC (VC per per hour hour xx # # of of Hours) Hours) Example – Mixed Scenari Scenari Scenari Costs o1 o2 o3 Total FC (a) $1,000 $1,000 $1,000 VC per Hour (b) $20 $20 $20 Number of Hours ( c) 60 90 40 Total Mixed Costs = a + $2,200 $2,800 $1,800 (b x c) Examples of Mixed Costs Fixed, Variable, or Mixed Exercise Molly’s restaurant, a fast-food restaurant, operates a chain of restaurants across the nation. Each restaurant employs eight people; one is a manager paid a salary plus a bonus equal to 3 percent of sales. Other employees, two cooks, one dishwasher, and four servers, are paid salaries. Each manager is budgeted $3,000 per month for advertising costs Fixed, Variable , or Mixed Manager’s compensation relative to the number of customers Servers’ salaries relative to the number of restaurants Advertising costs relative to the number of customers for a particular restaurant Rental costs relative to number of restaurants Cooks’ salaries at a particular location relative to the number of customers Cost Problemof #2 supplies in Workbook (cups, plates, spoons, etc) relative to the  The Relevant Range The range of activity over which the definitions of fixed and variable costs are valid is commonly called the _____- range. Example: SPI, the concert promoter, must pay $5,000 to rent a concert hall with a capacity of 4,000 people. What if demand is significantly more than 4,000? In that case, SPI might rent a larger concert hall at a higher cost.  Contribution Margin Approach The The impact impact ofof cost cost structure structure on on profitability profitability is is so so significant significant that that managerial managerial accountants accountants frequently frequently construct construct income income statements statements that that classify classify costs costs according according to to their their behavior behavior patterns. patterns. Such Such income income statements statements first first subtract subtract variable variable costs costs from revenue; the resulting subtotal is called the from revenue; the resulting subtotal is called the contribution contribution margin. margin. The The contribution contribution margin margin is is the the amount amount available available to to cover cover fixed fixed expenses expenses and and thereafter thereafter to to provide provide company company profits. profits. Sales Sales –– VC VC = = CM CM Bright Day Distributors: CM & BE Example Bright Day Distributors obtained the rights to distribute the new herb mixture Delatine. The selling price is $36 per bottle and the cost is $24 per bottle. Bright Day suspects that enthusiasm for Delatine will abate quickly. To attract customers, the marketing manager suggests an advertising campaign at an estimated cost of $60,000.  Contribution Margin per Unit Method The total contribution margin is the amount of sales minus total variable cost. The contribution margin per unit is the sales price per unit minus the variable cost per unit. The contribution margin per unit for Delatine is: Every time Bright Day sells a bottle of Delatine, it receives enough money to cover the variable cost of the bottle ($24) and still has $12 left to go toward paying the fixed cost. Determining the Break- Even Point In accounting terms, the break-even point is where profit (income) equals _____-. Equation Method Sales – Variable Costs – Fixed Costs = Net Income Formula Method Fixed expenses Unit sales to break even = Unit CM  Equation Method The equation method begins by expressing the income statement as follows: Sales – Variable costs – Fixed costs = Profit (Net Income)  Break-Even Point in Units This result is the same as that determined under the equation method. Both methods are simply different derivations of the same formula.  Determining Break- even Volume in Dollars To determine the amount of break-even sales measured in dollars, multiply the number of units times the sales price per unit. For Delatine, the break-even sales measured in dollars is $180,000 (5,000 units × $36):  Determining the Sales Volume Necessary to Reach a Desired Profit If Bright Day desires to earn a profit of $40,000. Using the equation method, the sales volume in units required to attain the desired profit is computed as follows:  End of Presentation