Cost Behaviour, Operating Leverage, and Profitability Analysis Chapter 2

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-2 Fixed Cost Behaviour Consider the following concert example where the band will be paid $48,000 regardless of the number of tickets sold. When activity....

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-3 Fixed Cost Behaviour $48,000 ÷ 3,000 Tickets = $16.00 per Ticket

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-4 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. Consider the following concert example where all costs are fixed.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-5 Operating Leverage When all costs are fixed, every additional sales dollar contributes one dollar to gross profit. 10% Revenue Increase 90% Gross Profit Increase

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-6 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. Let’s see what happens to the concert example if the band receives $16 per ticket instead of $48,000.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-7 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

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-8 Variable Cost Behaviour When activity...

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-9 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

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-10 Relationship Between Cost Behaviour and Revenue Fixed Cost Structure $ Units Revenue Fixed Cost Profit Loss

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-11 Relationship Between Cost Behaviour and Revenue Variable Cost Structure Variable Cost Revenue Profit $ Units

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-12 The Effect of Cost Structure on Profit Stability Variable Costs Fixed Costs Do companies with higher levels of fixed costs experience more earnings volatility?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-13 The Effect of Cost Structure on Profit Stability Now Let’s see what happens when the number of units sold increases.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-14 The Effect of Cost Structure on Profit Stability The income increase is greater in the All Fixed Company.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-15 The Effect of Cost Structure on Profit Stability Variable Costs Fixed Costs If sales decrease, will the income decrease be greater in the All Fixed Company?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-16 The Effect of Cost Structure on Profit Stability Yes, the income decrease is greater in the All Fixed Company.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-17 The Effect of Cost Structure on Profit Stability Variable Costs Fixed Costs

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-18 Determining the Contribution Margin The contribution margin format emphasizes cost behaviour. Contribution margin covers fixed costs and provides for income.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-19 Measuring Operating leverage Using the Contribution Margin Contribution margin Net income Operating Leverage = Show me an example.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-20 Measuring Operating leverage Using the Contribution Margin $20,000 $5,000 Operating Leverage == 4 A measure of how a percentage change in sales will effect profits.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-21 Measuring Operating leverage Using the Contribution Margin A 10 percent increase in sales results in a 40 percent increase in net income.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-22 Using Fixed Cost to Provide a Competitive Operating Advantage Consider the following two companies: What happens if each company cuts the service revenue to $7 per hour in order to double the amount of business?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-23 Using Fixed Cost to Provide a Competitive Operating Advantage Advantage to the All Fixed Company.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-24 Using Fixed Cost to Provide a Competitive Operating Advantage What happens to income if demand falls to 1,000 hours for each company?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-25 Using Fixed Cost to Provide a Competitive Operating Advantage Advantage to the All Variable Company.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-26 Using Fixed Cost to Provide a Competitive Operating Advantage I suppose fixed costs are better if volume is increasing, but variable costs are better if business is declining.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-27 Cost Behaviour 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

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-28 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 Behaviour Summarized

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-29 Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill Cost Behaviour Summarized Total Variable Cost

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-30 Minutes Talked Per Minute Telephone Charge The cost per minute talked is constant. For example, 10 cents per minute. Cost Behaviour Summarized Variable Cost Per Unit

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-31 Cost Behaviour Summarized When activity level changes...

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-32 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

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-33 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 doesn’t change for a range of activity, and then jumps to a new higher cost for the next higher range of activity.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-34 Activity Total Cost Relevant Range The Relevant Range Our variable cost assumption (constant unit variable cost) applies within the relevant range. Possible Variable Cost Behaviour Our Variable Cost Assumption

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-35 Definitions of Fixed and Variable are Context Sensitive 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-36 Cost Averaging Lake Resorts provides water-skiing lessons for its guests with the following costs: Equipment rental$80 per day Instructor pay$15 per hour Fuel$ 2 per hour What is the average cost per one-hour lesson for 2 lessons per day? 5 lessons per day? 10 lessons per day?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-37 Cost Averaging Average costs decline as activity increases when fixed costs such as equipment rental are involved. Managers must use these average costs with caution as they differ at every level of activity.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-38 A mixed cost has both fixed and variable components. Mixed Costs Consider the following electric utility example.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-39 Fixed Monthly Utility Charge Variable Utility Charge Activity (Kilowatt Hours) Total Utility Cost Mixed Costs Total mixed cost

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-40 Estimating Fixed and Variable Costs High-Low Method Scattergraph Method Regression Method

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-41 Grizzly Co. recorded the following production activity and maintenance costs for two months: Using these two levels of activity, compute:  the variable cost per unit.  the fixed cost.  the total cost. The High-Low Method

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-42  Unit variable cost = Change  in cost Change in units The High-Low Method

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-43  Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit The High-Low Method

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-44 The High-Low Method  Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit  Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($.90 per unit × 9,000 units) Fixed cost = $9,700 – $8,100 = $1,600

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-45  Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit  Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($.90 per unit × 9,000 units) Fixed cost = $9,700 – $8,100 = $1,600  Total cost = Fixed cost + Variable cost Total cost = $1,600 + $0.90X The High-Low Method

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-46 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $.08 per unit b. $.10 per unit c. $.12 per unit d. $.125 per unit If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $.08 per unit b. $.10 per unit c. $.12 per unit d. $.125 per unit The High-Low Method

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-47 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $.08 per unit b. $.10 per unit c. $.12 per unit d. $.125 per unit If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $.08 per unit b. $.10 per unit c. $.12 per unit d. $.125 per unit The High-Low Method $4,000 ÷ 40,000 units = $.10 per unit

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-48 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 The High-Low Method

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-49 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 The High-Low Method

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-50 The Scattergraph Method Plot the data points on a graph (total cost vs. activity) * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-51 Draw a line through the data points with about an equal numbers of points above and below the line * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y The Scattergraph Method

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y Estimated fixed is $10,000 Vertical distance is total cost, approximately $16,000. The Scattergraph Method Variable cost per unit is represented by the slope of the line.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y Estimated fixed is $10,000 Vertical distance is total cost, approximately $16,000. Total variable cost = Total cost – Total fixed cost Total variable cost = $16,000 – $10,000 = $6,000 Unit variable cost = $6,000 ÷ 3,000 units = $2 The Scattergraph Method

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-54 Regression Method Least-squares regression also provides a statistic, called the adjusted R 2, that is a measure of the goodness of fit of the regression line to the data points. I can use spread sheet software to fit a regression line through the data points.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 2-55 End of Chapter 2