Cost Behaviour, Operating Leverage, and Profitability Analysis

1. Cost Behaviour, Operating Leverage, and Profitability Analysis Chapter 2

2. Fixed Cost Behaviour When activity . . . . Consider the followingconcert example where theband will be paid $48,000 regardless of the number of tickets sold.

3. Fixed Cost Behaviour $48,000 ÷ 3,000 Tickets = $16.00 per Ticket

4. 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. Consider the followingconcert example whereall costs are fixed.

5. Operating Leverage 10% RevenueIncrease 90% GrossProfit Increase When all costs are fixed, every additional sales dollar contributes one dollar to gross profit.

6. Risk and Reward Assessment Risk refers to the possibility thatsacrifices may exceed benefits. Risk may be reduced byconverting fixed costsinto variable costs. Let’s see what happens to the concert example if the band receives $16 perticket instead of $48,000.

7. Risk and Reward Assessment 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.

8. Variable Cost Behaviour When activity . . .

9. Risk and RewardAssessment 10% RevenueIncrease 10% GrossProfit Increase Shifting the cost structure from fixed to variable notonly reduces risk but also the potential for profits.

10. Relationship Between CostBehaviour and Revenue Revenue $ Profit Fixed Cost Loss Units Fixed Cost Structure

11. Relationship Between CostBehaviour and Revenue Revenue $ Variable Cost Profit Units Variable Cost Structure

12. The Effect of Cost Structureon Profit Stability Do companieswith higher levels offixed costs experiencemore earningsvolatility? FixedCosts VariableCosts

13. The Effect of Cost Structureon Profit Stability Now Let’s see what happens whenthe number of units sold increases.

14. The Effect of Cost Structureon Profit Stability The income increase is greaterin the All Fixed Company.

15. The Effect of Cost Structureon Profit Stability If sales decrease,will the incomedecrease be greaterin the All FixedCompany? FixedCosts VariableCosts

16. The Effect of Cost Structureon Profit Stability Yes, the income decrease is greaterin the All Fixed Company.

17. The Effect of Cost Structureon Profit Stability FixedCosts VariableCosts

18. Determining the Contribution Margin The contribution marginformat emphasizes cost behaviour.Contribution margincovers fixed costsand provides for income.

19. OperatingLeverage Contribution marginNet income = Measuring Operating leverage Using the Contribution Margin Show mean example.

20. OperatingLeverage $20,000$5,000 = = 4 Measuring Operating leverage Using the Contribution Margin A measure of how a percentagechange in sales will effect profits.

21. Measuring Operating leverage Using the Contribution Margin A 10 percent increase in sales results in a 40 percent increase in net income.

22. Using Fixed Cost to Provide a Competitive Operating Advantage 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?

23. Using Fixed Cost to Provide a Competitive Operating Advantage Advantage to the All Fixed Company.

24. Using Fixed Cost to Provide a Competitive Operating Advantage What happens toincome if demandfalls to 1,000 hoursfor each company?

25. Using Fixed Cost to Provide a Competitive Operating Advantage Advantage to the All Variable Company.

26. Using Fixed Cost to Provide a Competitive Operating Advantage I suppose fixed costs arebetter if volume is increasing,but variable costs are betterif business is declining.

27. Cost Behaviour Summarized Your monthly basic telephone bill is probablyfixedand does not change when you make more local calls. Total Fixed Cost Monthly Basic Telephone Bill Number of Local Calls

28. Cost Behaviour Summarized The fixedcost per local call decreasesas more local calls are made. Fixed Cost Per Unit Monthly Basic Telephone Bill per Local Call Number of Local Calls

29. Cost Behaviour Summarized Your total long distance telephone bill is based on how many minutes you talk. Total Long DistanceTelephone Bill Total Variable Cost Minutes Talked

30. Cost Behaviour Summarized The cost per minute talked is constant.For example, 10 cents per minute. Variable Cost Per Unit Per MinuteTelephone Charge Minutes Talked

31. Cost Behaviour Summarized When activity level changes . . .

32. Continue 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.

33. The Relevant Range 90 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. Relevant Range 60 Rent Cost in Thousands of Dollars 30 0 0 1,000 2,000 3,000 Rented Area (Square Feet)

34. The Relevant Range Our variable cost assumption (constant unit variable cost) applies within the relevant range. RelevantRange Total Cost Possible VariableCost Behaviour Our VariableCost Assumption Activity

35. Definitions of Fixed and Variable are Context Sensitive 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.

36. Cost Averaging Lake Resorts provides water-skiing lessons for itsguests with the following costs: Equipment rental $80 per day Instructor pay $15 per hour Fuel $ 2 per hour What is the average cost perone-hour lesson for2 lessons per day? 5 lessons per day? 10 lessonsper day?

37. Cost Averaging 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.

38. Mixed Costs A mixed costhas both fixed and variablecomponents. Consider thefollowing electric utility example.

39. Mixed Costs Total mixed cost Variable Utility Charge Total Utility Cost Fixed MonthlyUtility Charge Activity (Kilowatt Hours)

40. Estimating Fixed and Variable Costs High-Low Method Scattergraph Method Regression Method

41. The High-Low Method Grizzly Co. 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.

42. Changein costChange in units • Unit variable cost = The High-Low Method

43. The High-Low Method • Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit

44. The High-Low Method • Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit • Fixed cost = Total cost – Total variable cost • Fixed cost = $9,700 – ($.90 per unit × 9,000 units) • Fixed cost = $9,700 – $8,100 = $1,600

45. The High-Low Method • Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit • Fixed cost = Total cost – Total variable cost • Fixed cost = $9,700 – ($.90 per unit × 9,000 units) • Fixed cost = $9,700 – $8,100 = $1,600 • Total cost = Fixed cost + Variable cost Total cost = $1,600 + $0.90X

46. 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

47. $4,000 ÷ 40,000 units = $.10 per unit 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

48. 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

49. 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

50. Y 20 * * * * * * * * Total Cost in1,000’s of Dollars * * 10 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced The Scattergraph Method Plot the data points on a graph (total cost vs. activity).