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...

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 change 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 cost behavior enables managers to more effectively plan and control costs. – Total versus per-unit fixed costs behave differently. – The total cost remains constant (fixed). – Fixed cost per unit decreases as volume increases. – The term fixed cost is consistent with the behavior of total cost.  Fixed Cost Behavior SPI specializes in promoting rock concerts. It is considering paying a band $48,000 to play a concert.  Risk and Reward Assessment Risk refers to the possibility that sacrifices may exceed benefits. A fixed cost represents a commitment to an economic sacrifice. It represents the ultimate risk of undertaking a particular business project. If SPI pays the band but nobody buys a ticket, the company will lose $48,000. SPI can avoid this risk by substituting variable costs for the fixed costs.  Fixed Cost Behavior Patterns Example – Fixed Costs Scenario 1 Scenario 2 Scenario 3 Annual Rent $100,000 $100,000 $100,000 Annual Production (Units) 100,000 50,000 150,000 FC per Unit $1.00 $2.00 $0.67 per unit per Unit per unit  Variable Cost Behavior SPI arranges to pay the band $16 per ticket sold instead of a fixed $48,000. The total variable cost increases in direct proportion to the number of tickets sold. The variable cost per ticket remains $16 regardless of whether the number of tickets sold is 1, 2, 3, or 3,000. The behavior of variable cost per unit is contradictory to the word variable. Variable cost per unit remains constant regardless of how many tickets are sold.  Variable Cost Behavior Patterns Example – Variable Costs Scenario 1 Scenario 2 Scenario 3 VC Per Unit $1.00 $1.00 $1.00 Annual Production (Units) 100,000 50,000 150,000 Total VC $100,000 $50,000 $150,000 Risk and Reward Assessment Shifting the cost structure from fixed to variable enables SPI to avoid the fixed cost risk. Under the fixed cost structure, SPI was locked into a $48,000 cost for the band regardless of how many tickets are sold. If no tickets are sold, SPI will have to report a $48,000 loss on its income statement. The risk of incurring a loss is eliminated by the variable cost 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 Variable Inc / Dec with volume No change 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 Collars 6,000 8,000 10,000 12,000 Total Costs Incurred Fixed $48,000 48000 48000 48000 Variable 48,000 64000 80000 96000 Total Costs $96,000 112000 128000 144000 Cost Per Unit Fixed $ 8.00 6.00 4.80 4.00 Variable 8.00 8.00 8.00 8.00 Total Cost Per Collar $16.00 14.00 12.80 12.00 Problem #1 in Workbook Mixed Costs (Semivariable Costs) Mixed costs (semivariable costs) include both fixed and variable components. For example, suppose Star Productions pays a base fee of $1,000 plus $20 per hour for janitorial services. The $1,000 base fee is fixed. It is the same no matter how many hours it takes to clean. The $20 hourly cost is a variable cost because the total cost increases with each additional hour it takes to complete 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 $1,000 base plus $20 per hour cost components, the total janitorial cost for any cleanup can be easily computed as shown: Total Cost = FC + (VC per hour x # of Hours) Example – Mixed Costs Scenario 1 Scenario 2 Scenario 3 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 + (b x c) $2,200 $2,800 $1,800 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 Mixed Servers’ salaries relative to the number of restaurants Variable Advertising costs relative to the number of customers for a particular Fixed restaurant Rental costs relative to number of restaurants Variable Cooks’ salaries at a particular location relative to the number of customers Fixed Cost of supplies (cups, plates, spoons, etc) relative to the number of customers Variable Problem #2 in Workbook  The Relevant Range The range of activity over which the definitions of fixed and variable costs are valid is commonly called the relevant- 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 impact of cost structure on profitability is so significant that managerial accountants frequently construct income statements that classify costs according to their behavior patterns. Such income statements first subtract variable costs from revenue; the resulting subtotal is called the contribution margin. The contribution margin is the amount available to cover fixed expenses and thereafter to provide company profits. Sales – VC = 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