CHAPTER 2

1. CHAPTER 2 Cost Behavior, Operating Leverage, and Profitability Analysis

2. Learning Objective To identify and describe fixed, variable, and mixed cost behavior LO1

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

4. $48,000 ÷ 3,000 Tickets = $16.00 per Ticket Fixed Cost Behavior

5. Learning Objective To demonstrate the effects of operating leverage on profitability LO2

6. 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. Smallpercentagechange inrevenue Largepercentagechange inprofits Fixed Costs Operating Leverage Consider the followingconcert example whereall costs are fixed.

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

8. 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 sold instead of a fixed $48,000.

9. Variable Cost Behavior 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.

10. Learning Objective To identify and describe fixed, variable, and mixed cost behavior LO1

11. Variable Cost Behavior When activity . . .

12. Learning Objective To demonstrate the effects of operating leverage on profitability LO2

13. Risk and RewardAssessment 10% RevenueIncrease 10% GrossProfit Increase Shifting the cost structure from fixed to variable not only reduces risk but also the potential for profits.

14. Effect of Cost Structure on Profit Stability Revenue $ Profit Fixed Cost Loss Activity Fixed Cost Structure

15. Effect of Cost Structure on Profit Stability Revenue $ Variable Cost Profit Activity Variable Cost Structure

16. Do companieswith higher levels offixed costs experiencemore earningsvolatility? Effect of Cost Structure on Profit Stability FixedCosts VariableCosts

17. Effect of Cost Structure on Profit Stability Now let’s see what happens whenthe number of units sold increases.

18. Effect of Cost Structure on Profit Stability The income increase is greaterin the All Fixed Company.

19. If sales decrease,will the incomedecrease be greaterin the All FixedCompany? Effect of Cost Structure on Profit Stability FixedCosts VariableCosts

20. Effect of Cost Structure on Profit Stability Yes, the income decrease is greaterin the All Fixed Company.

21. Effect of Cost Structure on Profit Stability FixedCosts VariableCosts

22. Learning Objective To prepare an income statement using the contribution margin approach LO3

23. The contribution marginformat emphasizes cost behavior.Contribution margincovers fixed costsand provides for income. An Income Statement under the Contribution Margin Approach

24. 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?

25. Advantage to MaHall, the all fixed company. Using Fixed Cost to Provide a Competitive Operating Advantage

26. Using Fixed Cost to Provide a Competitive Operating Advantage What happens if the price is cutto $7 per hour and the demandremains at 2,000 hours for eachcompany?

27. Using Fixed Cost to Provide a Competitive Operating Advantage Both companies incur losses.

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

29. Learning Objective To demonstrate how the magnitude of operating leverage affects profitability LO4

30. OperatingLeverage Contribution marginNet income = Measuring Operating Leverage Using Contribution Margin Show mean example.

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

32. Measuring Operating Leverage Using Contribution Margin A 10 percent increase in sales results in a 40 percent increase in net income. (10% × 4 = 40 %)

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

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

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

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

37. Cost Behavior Summarized When activity level changes . . .

38. Learning Objective To demonstrate how the relevant range and decision context affect cost behavior LO5

39. 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.

40. The Relevant Range 90 Total fixed costdoesn’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)

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

42. 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. Context Sensitive Definitions of Fixed and Variable Recall the earlier concert example, where the band waspaid $48,000 regardless of the number of tickets sold.

43. Learning Objective To select an appropriate time period for calculating the average cost per unit LO6

44. 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?

45. 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.

46. Learning Objective To identify and describe fixed, variable, and mixed cost behavior LO1

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

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

49. Learning Objective To use the high-low method, scattergraphs, and regression analysis to estimate fixed and variable costs LO7

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