McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Eleven Cost Behavior, Operating Leverage, and CVP Analysis

1-2 Learning Objective 1 Distinguish between fixed and variable cost behavior.

1-3 Fixed Cost Behavior Consider the following concert example where the band will be paid $48,000 regardless of the number of tickets sold. When activity....

1-4 Fixed Cost Behavior $48,000 ÷ 3,000 Tickets = $16.00 per Ticket

1-5 Learning Objective 2 Demonstrate the effects of operating leverage on profitability.

1-6 Operating Leverage A measure of the extent to which fixed costs 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 fixed costs 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 following concert example where all costs are fixed. Fixed Costs Small percentage change in revenue Large percentage change in profits

1-7 Operating Leverage When all costs are fixed, every additional sales dollar contributes one dollar to gross profit. 10% Revenue Increase 90% Gross Profit Increase

1-8 Risk and Reward Assessment Risk refers to the possibility that sacrifices may exceed benefits. Risk may be reduced by converting fixed costs into variable costs. Lets see what happens to the concert example if the band receives $16 per ticket instead of $48,000.

1-9 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

1-10 Variable Cost Behavior When activity...

1-11 Shifting the cost structure from fixed to variable not only reduces risk but also the potential for profits. Risk and Reward Assessment 10% Revenue Increase 10% Gross Profit Increase

1-12 Learning Objective 3 Prepare an income statement using the contribution margin approach.

1-13 Income Statement - Contribution Margin Approach The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.

1-14 Learning Objective 4 Calculate the magnitude of operating leverage.

1-15 Contribution margin Net income Magnitude of Operating Leverage = Show me an example. Measuring Operating Leverage Using Contribution Margin

1-16 $20,000 $5,000 Operating Leverage == 4 A measure of how a percentage change in sales will effect profits. Measuring Operating Leverage Using Contribution Margin

1-17 A 10 percent increase in sales results in a 40 percent increase in net income. (10% × 4 = 40 %) Measuring Operating Leverage Using Contribution Margin

1-18 Learning Objective 5 Demonstrate how the relevant range and the decision-making context affect cost behavior.

1-19 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 Monthly Basic Telephone Bill Total Fixed Cost

1-20 Number of Local Calls Monthly Basic Telephone Bill per Local Call The fixed cost per local call decreases as more local calls are made. Cost Behavior Summarized

1-21 Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill Cost Behavior Summarized Total Variable Cost

1-22 Minutes Talked Per Minute Telephone Charge The cost per minute talked is constant. For example, 10 cents per minute. Cost Behavior Summarized Variable Cost Per Unit

1-23 Cost Behavior Summarized When activity level changes...

1-24 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

1-25 Rent Cost in Thousands of Dollars 0 1,000 2,000 3,000 Rented Area (Square Feet) The Relevant Range 90 Relevant Range Total fixed cost doesnt change for a range of activity, and then jumps to a new higher cost for the next higher range of activity.

1-26 Context Sensitive Definitions of Fixed and Variable Recall the earlier concert example, where the band was paid $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 relative to the number of concerts produced.

1-27 Mixed Costs Some costs have both fixed and variable components. These costs are known as mixed costs or semivariable costs. Several techniques exist to mixed costs into estimates fixed and variable components.

1-28 Learning Objective 6 Determine the sales price of a product using a cost-plus pricing approach.

1-29 Determining Contribution Margin per Unit Bright Day produces one product called Delatine. The company uses a cost-plus-pricing strategy; it sets prices at cost plus a markup of 50% of cost. Delatine cost $24 per bottle to manufacture, so a bottle sells for $36 ($24 + [50% × $24]). The contribution margin per bottle is: The companys first concern is if it can sell enough bottles of Delatine to cover it fixed costs and make a profit!

1-30 Learning Objective 7 Use the contribution per unit approach to calculate the break-even point.

1-31 Determining the Break-even Point total revenue equals total costs The break-even point is the point where total revenue equals total costs (both variable and fixed). For Bright Day, the cost of advertising is estimated to be $60,000. Advertising costs are the fixed costs of the company. We use the following formula to determine the break-even point in units. Break-even volume in units = Fixed costs Contribution margin per unit = $60,000 $12 5,000 units = 5,000 units

1-32 Determining the Break-even Point For Delatine, the break-even point in sales dollars is $180,000 (5,000 bottles × $36 selling price).

1-33 Learning Objective 8 Use the contribution per unit approach to calculate the sales volume required to realize a target profit.

1-34 Reaching a Target Profit Level Bright Days president wants the advertising campaign to produce profits of $40,000 for the company. Break-even volume in units = Fixed costs + Desired profit Contribution margin per unit = $60,000 + $40,000 $12 8, units = 8, units

1-35 Reaching a Target Profit Level At $36 per unit selling price, the sales dollars are equal to $300,000, as shown below:

1-36 Learning Objective 9 Calculate the margin of safety in units, dollars and percentage.

1-37 Calculating the Margin of Safety The margin of safety measures the cushion between budgeted sales and the break-even point. It quantifies the amount by which actual sales can fall short of expectations before the company will begin to incur losses.

1-38 Calculating the Margin of Safety Margin of safety = Budgeted sales – Break-even sales Budgeted sales Margin of safety = $299,988 – $180,000 $299,988 40% = 40% X 100

1-39 End of Chapter Eleven