Cost Behavior, Operating Leverage, and Profitability Analysis Chapter 11 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

11-2 Learning Objectives 1.Identify and describe fixed, variable, and mixed cost behavior. 2.Demonstrate the effects of operating leverage on profitability. 3.Prepare an income statement using the contribution margin approach. 4.Calculate the magnitude of operating leverage. 5.Demonstrate how the relevant range and the decision-making context affect cost behavior. 6.Calculate the break-even point. 7.Calculate the sales volume required to attain a target profit. 8.Calculate the margin of safety in units, dollars and percentage.

11-3 Fixed Cost Behavior When Activity Increases When Activity Decreases Total fixed costs Remains Constant Remains Constant Fixed cost per unit Decreases Increases

11-4 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.  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. Fixed Costs & Variable Costs Fixed Costs Small percentage change in revenue Dramatic percentage change in profitability

11-5 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.

11-6 Variable Cost Behavior When Activity Increases When Activity Decreases Total variable cost Increases Proportionately Variable cost per unit Decreases Proportionately Remains constant Remains constant

11-7 Income Statement - Contribution Margin Approach The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.

11-8 Contribution margin Net income Magnitude of Operating Leverage = Net Income and Contribution Margin are used! Measuring Operating Leverage Using Contribution Margin

11-9 Cost Behavior Summarized When activity level changes...

11-10 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.

11-11 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.

11-12 Contribution Margin per Unit Method: Break-even Point in Units 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

11-13 Contribution Margin per Unit Sales Volume to Achieve Target Profit Bright Day’s 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

11-14 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.

11-15 End of Chapter Eleven