UAA - ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee Cost Structure

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting2 Introduction  Cost structure is defined as the relationship between a firm’s fixed and variable costs.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting3 Cost Structure Labor-Intensive = High Variable Costs Machine-Intensive = High Fixed Costs

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting4 Abacus Computers  Performs computer services for other firms: – Owns 2 computers – Employs two people  Bulk of costs are... – Rent Expense; and – Depreciation (S/L)

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting5 Abacus Computers Income Statement For Year Ended December 31, 2003 Abacus Computers Income Statement For Year Ended December 31, 2003 Sales$500,000100%Fixed Costs300,000Net Income$100,000Variable Costs100,00020%Contribution Margin$400,00080%

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting6 Tailor Made Company  Manufactures custom made men’s suits – Owns one sewing machine – Employs six people  Bulk of costs are... – Materials; and – Labor

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting7 Tailor Made Company Income Statement For Year Ended December 31, 2003 Tailor Made Company Income Statement For Year Ended December 31, 2003 Sales$500,000100%Fixed Costs100,000Net Income$100,000Variable Costs300,00060%Contribution Margin$200,00040%

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting8 Sales$500VC300CM$200FC100NI$100Sales$500VC300 CM$200 FC100 NI$100  Abacus Abacus and Tailor Made Company Income Statement Comparison For Year Ended December 31, 2003 Abacus and Tailor Made Company Income Statement Comparison For Year Ended December 31, 2003  Tailor Made

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting9 Abacus Computers Income Statement For Year Ended December 31, 2003 Abacus Computers Income Statement For Year Ended December 31, 2003 Sales$500,000100%Fixed Costs300,000Net Income$100,000Variable Costs100,00020%Contribution Margin$400,00080% Abacus Computers will increase its profits by $0.80 for each additional dollar of sales.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting10 Tailor Made Company Income Statement For Year Ended December 31, 2003 Tailor Made Company Income Statement For Year Ended December 31, 2003 Sales$500,000100%Fixed Costs100,000Net Income$100,000Variable Costs300,00060%Contribution Margin$200,00040% Tailor-Made Company will increase its profits by $0.40 for each additional dollar of sales.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting11 Periods of Decreased Activity...  Assuming no change in selling prices, unit VC and FC... – Abacus Computers will reduce its profits by $0.80 for each additional dollar of sales. – Tailor Made Company will reduce its profits by $0.40 for each additional dollar of sales.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting12 Periods of Increased Activity...  Assuming no change in selling prices, unit VC and FC... – Abacus Computers will increase its profits by $0.80 for each additional dollar of sales. – Tailor Made Company will increase its profits by $0.40 for each additional dollar of sales.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting13 Leverage...  To the scientist... – Leverage explains how one is able to move a large object with a small force.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting14 Operating Leverage  Is a measure of the extent to which fixed costs are being used in an organization.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting15 Financial Leverage  Financial leverage is the financing of a portion of the firm’s assets with securities bearing a fixed (limited) rate of return.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting16 Consider this... Labor-Intensive Firms Machine-Intensive Firms FC:TC % % Therefore, machine-intensive firms use more operating leverage than labor- intensive firms.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting17 Consider two firms... Firm A Labor-Intensive Firm B Machine-Intensive Both increase sales by 20%. Which one will have the larger increase in profits? Why?

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting18 Degree of Operating Leverage  The DOL is the measure of how a percentage change in sales volume at a given level of sales activity will affect profits.  A measure of how sensitive net operating income is to percentage changes in sales.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting19 Degree of Operating Leverage  The Formula... Contribution Margin = DOL Net Income

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting20 Sales$500VC300CM$200FC100NI$100Sales$500VC300 CM$200 FC100 NI$100 AAbacus Abacus and Tailor Made Company Income Statement Comparison For Year Ended December 31, 2003 Abacus and Tailor Made Company Income Statement Comparison For Year Ended December 31, 2003 TTailor Made

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting21 Degree of Operating Leverage  For Abacus Computers... $400,000 DOL = = 4 $100,000

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting22 Degree of Operating Leverage  For Tailor Made Company $200,000 DOL = = 2 $100,000

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting23 The Change in Net Income Abacus Computers $100,000 x 20% x 4 = $80,000 Tailor Made Company $100,000 x 20% x 2 = $40,000

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting24 Observations on DOL  The DOL varies at different levels of sales activity... – Highest near the breakeven point – Undefined at breakeven point – Lessens with increased sales volume

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting25 The Margin of Safety  Excess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred. Margin of safety = Total sales - Break-even sales

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting26 The Margin of Safety Exhaustion Unlimited has a break-even point of $200,000. If actual sales are $250,000, the margin of safety is $50,000 or 100 exercise bikes.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting27 The Margin of Safety The margin of safety can be expressed as 20% of sales. ($50,000 ÷ $250,000)

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting28 Sales Mix  Sales mix is the relative proportions in which a company’s products are sold.  Different products have different selling prices, cost structures, and contribution margins.

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting29 Multi-product break- even analysis Wind Bicycle Co. provides the following information: $265,000 $550,000 = 48.2% (rounded)

Dr. Fred BarbeeACCT202 Principles of Managerial Accounting30 Multi-product break- even analysis Rounding error Fixed expenses CM Ratio Break-even sales = $170, = $352,697 =