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McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Fifteen
Cost Behavior, Operating Leverage, and Profitability Analysis
15-2
Learning Objective 1
• Distinguish between fixed and variable cost behavior.
15-3
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 $48,000
regardless of the number of tickets sold.
When activity . . . .
15-4
Fixed Cost Behavior
Number of tickets sold 2,700 3,000 3,300
Total cost of band 48,000$ 48,000$ 48,000$
Cost per ticket sold 17.78$ 16.00$ 14.55$
Number of tickets sold 2,700 3,000 3,300
Total cost of band 48,000$ 48,000$ 48,000$
Cost per ticket sold 17.78$ 16.00$ 14.55$
$48,000 ÷ 3,000 Tickets = $16.00 per Ticket
15-5
Learning Objective 2
• Demonstrate the effects of operating leverage on profitability.
15-6
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
15-7
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
15-8
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 per
ticket instead of $48,000.
15-9
The total variable cost increases in direct proportion to the number of tickets sold.
Variable unit cost per ticket remains at$16 regardless of the number of tickets sold.
Risk and Reward Assessment
15-10
Variable Cost Behavior
Increases Decreases
Total Variable Cost
Increases Proportionately
Decreases Proportionately
Variable Cost Per Unit
Remains Constant Remains Constant
When activity . . .
15-11
Shifting the cost structure from fixed to variable not only reduces
risk but also the potential for profits.
Shifting the cost structure from fixed to variable not only reduces
risk but also the potential for profits.
Risk and Reward Assessment10% Revenue
Increase
10% GrossProfit Increase
15-12
Relationship Between Cost Behavior & Revenue
Fixed Cost Structure
Fixed Cost
Profit
Loss
Revenue$
Units1
0
15-13
Relationship Between Cost Behavior & Revenue
Variable Cost Structure
Variable Cost
Revenue
Profit
$
Units01
15-14
Learning Objective 3
• Show how cost behavior affects profitability.
15-15
The Effect of Cost Structure on Profit Stability
VariableCosts
FixedCosts
Do companieswith higher levels of
fixed costs experiencemore earnings
volatility?
15-16
The Effect of Cost Structure on Profit Stability
Now let’s see what happens whenthe number of units sold increases.
15-17
The Effect of Cost Structure on Profit Stability
The income increase is greaterin the All Fixed Company.
15-18
The Effect of Cost Structure on Profit Stability
VariableCosts
FixedCosts
If sales decrease,will the income
decrease be greaterin the All Fixed
Company?
15-19
The Effect of Cost Structure on Profit Stability
Yes, the income decrease is greaterin the All Fixed Company.
15-20
The Effect of Cost Structure on Profit Stability
VariableCosts
FixedCosts
Level of Fixed Cost
Earnings Volatility
High High
Low Low
15-21
Learning Objective 4
• Prepare an income statement using the contribution margin approach.
15-22
Income Statement - 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.
15-23
Learning Objective 5
• Calculate the magnitude of operating leverage.
15-24
Contribution margin
Net income
Operating
Leverage=
Show mean example.
Measuring Operating Leverage Using Contribution Margin
15-25
$20,000
$5,000
Operating
Leverage= = 4
A measure of how a percentagechange in sales will affect profits.
Measuring Operating Leverage Using Contribution Margin
15-26
A 10 percent increase in sales results in a 40 percent increase in net income.
(10% × 4 = 40 %)
Measuring Operating Leverage Using Contribution Margin
15-27
Learning Objective 6
• Use cost behavior to create a competitive operating advantage.
15-28
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
15-29
Advantage to MaHall, the all fixed company.
Using Fixed Cost to Provide a Competitive Operating Advantage
15-30
What happens if the price is cutto $7 per hour and the demandremains at 2,000 hours for each
company?
Using Fixed Cost to Provide a Competitive Operating Advantage
15-31
Both companies incur losses.
Using Fixed Cost to Provide a Competitive Operating Advantage
15-32
One suppose fixed costs arebetter if volume is increasing,
but variable costs may be betterif business is declining.
Using Fixed Cost to Provide a Competitive Operating Advantage
15-33
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
15-34
Number of Local Calls
Mon
thly
Basic
Tele
ph
on
e B
ill p
er
Local C
all
The fixed cost per local call decreasesas more local calls are made.
Cost Behavior Summarized
15-35
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
Cost Behavior Summarized
Tota
l Var
iabl
e Cos
t
15-36
Minutes Talked
Per
Min
ute
Tele
ph
on
e C
harg
e
The cost per minute talked is constant.For example, 10 cents per minute.
Cost Behavior Summarized
Variable Cost Per Unit
15-37
Total Cost Cost Per Unit
Fixed CostsRemains Constant
Changes Inversely
Variable CostsChanges in
Direct ProportionRemains Constant
Cost Behavior Summarized
When activity level changes . . .
15-38
Learning Objective 7
• Demonstrate how the relevant range and the decision-making context affect cost behavior.
15-39
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.
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.
The Relevant Range
Continue
15-40
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.
15-41
Activity
Tota
l C
ost RelevantRange
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
15-42
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.
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.
15-43
Learning Objective 8
• Select an appropriate time period for calculating the average cost per unit.
15-44
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 fortwo lessons per day? Five lessons per day? Ten lessons
per day?
Cost Averaging
15-45
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.
15-46
Learning Objective 9
• Define the term mixed costs.
15-47
A mixed costhas both fixed and variablecomponents.
Mixed Costs
Consider thefollowing
electric utility example.
15-48
Fixed Monthly
Utility Charge
Variable
Utility
Charge
Activity (Kilowatt Hours)
Tota
l U
tility
Cost
Mixed Costs
Total mixed cost
15-49
Learning Objective 10
• Use the high-low method and scattergraphs to estimate fixed and variable costs.
15-50
Estimating Fixed and Variable Costs
High-Low Method
Scattergraph Method
15-51
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
The High-Low Method
15-52
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
15-53
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 commissions?
a. $.08 per unit
b. $.10 per unit
c. $.12 per unit
d. $.125 per unit
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 commissions?
a. $.08 per unit
b. $.10 per unit
c. $.12 per unit
d. $.125 per unit
The High-Low Method
15-54
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 commissions?
a. $.08 per unit
b. $.10 per unit
c. $.12 per unit
d. $.125 per unit
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 commissions?
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$
The High-Low Method
15-55
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
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
The High-Low Method
15-56
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
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
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
The High-Low Method
15-57
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
15-58
Draw a line through the data points with about an
equal number 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
***
**
**
*
*
Activity, 1,000’s of Units Produced
X
Y
The Scattergraph Method
15-59
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
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.
The Scattergraph Method
15-60
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
Total variable cost = Total cost – Total fixed costTotal variable cost = $16,000 – $10,000 = $6,000Unit variable cost = $6,000 ÷ 3,000 units = $2
The Scattergraph Method
Estimated fixed
is $10,000
Vertical distance is total cost,
approximately $16,000.
15-61
End of Chapter Fifteen