Variable versus Fixed Costs Understanding how costs behave in high and low sales environments

Characteristics differ between fixed and variable Variable (as compared to volume) Fixed (as compared to volume Variable costs per unit do not change Total variable costs increase as volume increases Total variable costs decrease as volume decreases Total fixed costs do not change as volume changes Fixed cost per unit decreases as volume increases Fixed cost per unit increases as volume decreases

Relevant Range of Activity The estimated minimum and maximum volume likely to be achieved Fixed costs are often a “step function” – relevant range allows total fixed costs to be locked in over the likely range of activity Variable costs per unit would change over a large range of activity – relevant range allows a reasonable average to be calculated

To break out fixed from variable costs All costs must be analyzed – sales, administrative, factory Many costs are mixed, so must use math models high-low method, scattergraphs, regression analysis The range of activity must be specified (relevant range allows total fixed costs and an average variable cost per unit )

Contribution Margin Income Statement Sales Revenue Less: Variable Costs Equals: Contribution Margin Less: Fixed Costs Equals: Net Income Contribution Margin Income Statement A managerial statement allowing “what if’s.” Not under U.S. GAAP Often used for short run decisions

Magnitude of Operating Leverage ratio Contribution margin Net Income Or Sales-Variable costs Net income Sales – Variable costs Revenues - expenses Magnitude of Operating Leverage ratio A formula that shows company operating risk higher # means more fixed costs Lower # means more variable costs High magnitude of operating leverage –small change in sales yields large change in profits Low magnitude of operating leverage-small change in sales yields small change in profits Profits are often more stable if company has lower levels of fixed costs