Chapter 11. Cost Behavior, Operating Leverage, and Profitability Analysis

*LO 11-2*

*Demonstrate the effects of operating leverage on profitability.*

"cost behavior"

- refers to fixed vs. variable costs - can significantly impact profitability

Fixed cost behavior

When Activity Increase: - *Total* fixed cost remains constant - Fixed cost *per unit* decreases Ex/ beach house for spring break When Activity Decreases: - *Total* fixed cost remains constant - Fixed cost *per unit* increases

Variable cost behavior

When Activity Increases: - *Total* variable cost increases proportionally - Variable cost *per unit* remains constant When Activity Decreases: - *Total* variable cost decreases proportionally - Variable cost *per unit* remains constant

equation method

"Cost-volume-profit analysis technique that uses the algebraic relationship among sales, variable costs, fixed costs, and desired net income before taxes to solve for required sales volume." (Breakeven => when "sales = variable + fixed") Sales - Variable costs - Fixed costs = Profit (Net Income) (0)

margin of safety

"Difference between break-even sales and budgeted sales expressed in units, dollars, or as a percentage; the amount by which actual sales can fall below budgeted sales before a loss is incurred." In units/in dollars: Margin of safety = Budgeted sales - Breakeven sales In percentage: Margin of safety = (Budgeted sales - Break-even sales) / Budgeted sales Difference between break-even sales and budgeted sales expressed in units, dollars, or as a percentage; the amount by which actual sales can fall below budgeted sales before a loss is incurred. ***the larger the margin of safety...the more likely the company is to report a profit

Calculating Percentage Change

(Alternate # - Base #) / Base # --> Alternate # = new number --> Base # = original number

Sales volume in units = (to find out how many units you would need to sell in order to obtain your desired profit)

(Fixed costs + Desired profit) / Contribution margin per unit OR Sales - Variable - Fixed = Desired Profit

variable cost

* these costs vary in direct proportion with changes in volume (when volume increases, total variable cost increases; when volume decreases, total variable cost decreases) ***the total cost varies* (and cost per unit remains constant)

*LO 11-1*

*Identify and describe fixed, variable, and mixed cost behavior.*

*LO 11-3*

*Prepare an income statement using contribution margin approach.*

operating leverage

= A measure of the extent to which fixed costs are being used in an organization. = *the effect* (in a fixed costs structure) *that when we increase Sales by some amount, we get a disproportionate impact on GP* --> *fixed costs cause operating leverage* --> sales volume increase = GREAT (increases GP) if sales volume decreases = really bad (decreases GP) --> higher leverage = more risk, but also potential to bigger profits lower leverage = low risk, less big profits * Fixed costs increase risk by adding operating leverage (creates risk, but also the opportunity for big profits) * Variable costs have NO operating leverage (limited risk, limited ability to earn profit) ***managers who are "risk-takers" ---choose fixed cost structure (potential for high profit, but if volume is low will be really bad/risky) ***managers who are "risk-averse" ---choose variable cost structures (low risk, low reward)

contribution margin

= Sales (Revenue) - variable costs = the amount available to cover fixed costs and (after all variable expenses are deducted) & ultimately how much is available for profit * allows managers to easily measure operating leverage * allows us to use the contribution margin to assess the profitability of a company (or the potential for profitability) "The difference between the company's sales revenue and total variable cost; represents the amount available to cover fixed cost and thereafter to provide a profit"

activity base

= a cost is defined as fixed or variable based on this "The same cost can behave as either fixed or variable dep on activity base" (can changed fixed to variable OR variable to fixed) Factor that causes changes in variable cost; is usually some measure of volume when used to define cost behavior. * the same cost can behave as either a fixed cost or a variable cost, depending on the activity base Ex/ When identifying which it is, first ask, fixed or variable relative to what activity base? The cost of the band is fixed relative to the number of tickets sold for a specific concert; it is variable relative to the number of concerts produced.

Risk

= the possibility that sacrifices may exceed benefits (may be reduced by converting fixed costs into variable costs)

LO 11-6

Calculate and interpret margin of safety measure.

LO 11-4

Calculate the magnitude of operating leverage.

Magnitude of operating leverage

Contribution margin/Net income

fixed cost

Cost that in total does not change/vary (remains constant) when (activity) volume changes; varies per unit inversely with changes in the volume of activity. as we increase activity (Ex/ # of friends staying at the beach house), the *total cost* remains fixed ***total fixed cost is fixed* (and cost per unit varies)

LO 11-5

Determine the sales volume necessary to break even or to earn a desired profit.

Total cost =

Fixed cost + (Variable cost per hour * Number of hours)

Break-even point in units =

Fixed costs / Contribution margin per unit

what is the reason that cost structure can really affect profitability?

OPERATING LEVERAGE

Example of equation method

Q: The sales price of a product is $10 per unit; the variable cost is $5 per unit; and fixed costs total $1,000. How many units must be sold to break even? A: 200 [10(x) - 5(x) - 1,000 = 0]

In a Contribution margin formatted Income Stmnt...

Sales Revenue - variable costs = Contribution Margin - fixed costs = Net Income

mixed cost

has both fixed and variable components

...to get from units to dollars,

multiply number of units you need to sell by the sales revenue

relevant range

the *range of activity* over which a cost is defined as either fixed or variable (description of cost behavior pertain to a specific range of activity, the range of activity over which the definition of fixed and variable costs are valid) Ex/ Assume that a law firm incurs rent cost of $3,000 a month. The building the firm rents can staff up to 10 employees. This cost is: *FIXED from 1-10 employees* Ex/ 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.

break-even point

the point at which profit (income) = zero *total revenue = total costs/expenses *don't make or lose any money *can be expressed as units or sales dollars **contribution margin = total fixed costs* = Fixed cost / Contribution margin per unit

A cost is defined as fixed based on how the...

total cost behaves.

A cost is defined as variable based on how the...

total cost behaves.