Cost Behavior, Operating Leverage, & Profitability Analysis

Cost Behavior Manner in which a cost changes as a related activity changes. Classifications of Cost Behavior –Variable Costs –Fixed Costs –Mixed Costs

Cost Behavior Behavior is relative to the context it is presented in The term fixed or variable is based on the total cost.

Summer Vacation Let’s say you and 2 friends are going to Cabo for 4 nights. You are going to fly down there and stay in a hotel. The hotel charges $100 per night regardless of how many people stay in the room. TOTAL Expected Lodging Cost = $400

Two days before you leave one more friend decides to come along. How does this affect your hotel bill? No change – total lodging is still $400 This is a fixed cost – The total cost does not change.

The day before you leave one friend gets sick and can’t go. What happens to your hotel bill now? No Change This is a fixed cost – The total cost does not change

How does all this affect you? Total Hotel Bill = $400 How much do you have to pay? Fixed Cost Behavior # of People (a)2 people3 people4 people Total Lodging (b)$400 Lodging per person (b / a) $200$133$100

What about the airfare? You were able to get plane tickets for $200 roundtrip per person. Variable Cost Behavior # of tickets (a)234 Total Airfare (a * b)$400$600$800 Cost per ticket (b)$200

Under a variable cost structure the cost per unit stays the same and the total cost changes Using the Variable Cost Structure avoids Fixed Cost Risk

Whether a cost is fixed or variable depends on the underlying circumstances. Let’s look back at our lodging for vacation. What if we decide to stay 5 nights instead of 4? What if we come home a day early? # of Nights (a)345 Total Lodging (a * b)$300$400$500 Cost per night (b)$100

Here the lodging is a variable cost. The cost per night stays the same and the total cost changes. # of Nights (a)345 Total Lodging (a * b)$300$400$500 Cost per night (b)$100

Relevant Range What happens if three more friends decide to come along and you have a total of 6 people? You will more than likely have to rent 2 rooms each night. Now your total lodging is $200 per night. The structures work within a relevant range. Our range here is 1 to 4 people.

When the activity level increases, total fixed costs 1.Increases 2.Decreases 3.Remains constant

When the activity level increases, fixed cost per unit 1.Increases 2.Decreases 3.Remains constant

When the activity level increases, variable cost per unit 1.Increases 2.Decreases 3.Remains constant

When the activity level increases, total variable costs 1.Increases 2.Decreases 3.Remains constant

Mixed Cost Has characteristics of both a variable and a fixed cost. e.g. – Copy machine lease –Cost = $1,000 per month –Plus $1 for every copy over 2,000

Art on Tour, Inc. (AOTI) Art on Tour Inc. contracts with artists to exhibit their works to the public. AOTI has agreed to pay a well known artist a $20,000 commission for the right to exhibit his work for one month. We need to determine the total commission cost and the commission cost per person if 1,000 / 2,000 / 4,000 people attend the exhibition.

Is this commission cost fixed or variable? Fixed – Total cost does not change # of people (a) Total Commission (b) $20,000 Commission per person (b / a) $20$10$5

AOTI provides patrons with books illustrating the artist’s work. The books cost AOTI $5 each. We need to determine the total cost of books and the cost per person if 1,000 / 2,000 / 4,000 people attend. # of People (a)1,0002,0004,000 Total Cost of Books (a * b) $5,000$10,000$20,000 Cost per Book (b)$5

AOTI expects 4,000 people to attend the exhibition and the tickets are $6 each. AOTI decided not to give the attendees a book. Let’s prepare an income statement Revenue ($6 / ticket)$ 24,000 Commission Cost (20,000) Net Income$ 4,000

What if actual attendance is 10% higher or lower than expected? # of People Revenue$21,600$24,000$26,400 Commission (20,000) (20,000) (20,000) Net Income$ 1,600 $ 4,000 $ 6,400 *Alt. Measure – Base Measure = Difference Difference / Base Measure = % Change 10% 60%

Operating Leverage Magnifies small changes in revenue into dramatic changes in profitability The Lever = Fixed Cost

Risk vs. Reward Risk – refers to the possibility that sacrifices may exceed benefits What if no one comes to the exhibition?

What if we change the way we pay the commission? Now we pay $5 in commission per person attending the exhibition. # of People Revenue$6$12,000$24,000 Commission (5) (10,000) (20,000) Net Income$1$ 2,000$ 4,000

Using Fixed Cost to Provide a Competitive Operating Advantage My Company and Your Company provide rafting tours on Big Bear River. My Company pays tour guides fixed salaries. It budgets salaries expense at $160,000 per year. Your Company pays tour guides $40 per rafter served. Rafters are charged $50 per tour. Both companies expect to carry approx. 4,000 rafters during the year.

Let’s look at an Income Statement for each Company My Co. Your Co. Revenue ($50 * 4,000) $200,000$200,000 Salary Exp. 160, ,000* Net Income$ 40,000$ 40,000 * $40 * 4,000

In an effort to lure rafters away from Your Company, My Company lowers the price per rafter to $39. Now My Company serves 6,000 rafters who each pay $39 per tour. Your Company serves only 2,000 rafters who pay $50 per tour.

Income Statement My Co.Your. Co. Revenue ($39*6000) $234,000 ($50*2000) $100,000 Salary Exp.( 160,000) ($40*2000) ( 80,000) Net Income$ 74,000$ 20,000

Now let’s say Your Company lowered its price to $39 per rafter and lured 2,000 rafters from My Company that is still charging $50 per rafter. Income Statement My Co. Your Co. Revenue ($50*2000) $100,000 ($39*6000) $234,000 Salary Exp.( 160,000) ($40*6000) ( 240,000) Net Income($ 60,000) ($ 6,000)

What should My Company do? My Company matches the $39 price set by Your Company. Now they each serve 4,000 customer Income Statement MY CO.YOUR CO. Revenue$156,000$156,000 Salary Exp.( 160,000)( 160,000) Net Income($ 4,000)($ 4,000)

I suppose fixed costs are better if volume is increasing, but variable costs may be better if business is declining. Using Fixed Cost to Provide a Competitive Operating Advantage

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

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

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

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

Cost Behavior Summarized When activity level changes...

Contribution Margin CM = Revenue – Variable Costs CM represents the amount available to cover fixed expenses and thereafter provides profits.

Sharon Virgil owns a delivery service company. She charges customers $10 per delivery. The company’s variable expenses average $2 per delivery and fixed costs are $600 per month. Sharon provided 100 deliveries during January.

Contribution Margin Income Statement Revenue$ 1,000 (Variable Costs) ( 200) Contribution Margin$ 800 (Fixed Costs) ( 600) Net Income$ 200

Measuring Operating Leverage Using Contribution Margin Operating Leverage = Contribution Margin Net Income OL = $800 / $200 = 4 What does this 4 tell us? If you take the OL and multiply it by the % increase in sales it gives you the % increase in net income. Let’s say deliveries increase 10% for February. 4 * 10% = 40% in net income

Let’s test our theory! In February sales increased by 10% 100 deliveries * 110% = 110 deliveries Revenue$1,100 (Variable Costs)( 220) Contribution Margin 880 (Fixed Costs)( 600) Net Income $ 280

Sharon made 10 more deliveries in February. Sales rose from $1,000 to $1,100 This is a 10% increase Net income rose from $200 to $280 This is a 40% increase % change = (280 – 200) = / 200 = 40%

Estimating Fixed and Variable Costs

High Low Method Used to estimate future costs Step 1: Assemble Sales Volume and Cost History Step 2: Find High and Low Points Step 3: Determine the estimated variable cost per unit Step 4: Determine the estimated total fixed costs

Units SoldTotal Cost Jan12195,000 Feb10150,000 March11175,000 April18210,000 May30375,000 June35450,000 July25325,000 August20250,000 September15360,000 October11180,000 November10145,000 December12190,000 HIGH LOW

Step 3 (High Cost – Low Cost) = VC per unit (High Units – Low Units) (450,000 – 145,000) = $12,200 / unit (35 – 10)

Step 4 FC + VC = Total Cost FC = TC – VC FC = $450,000 – (35 * $12,200) FC = $450,000 – 427,000 FC = $23,000