Managerial Accounting Chapter 2 Slides

Cost Behaviour
Topic 3A
2012 McGraw-Hill Education (Asia)
Preview of This Weeks Class
Classify costs by behaviour and use it to answer the

following questions:
How will my profits change if I change my selling price,

volume, or costs?
Breakeven and target profit analysis (this week)
How can the income statement be presented for better

control purposes?
Variable costing vs. absorption costing (next week)
McGraw-Hill Education (Asia)
Slide 2
Topic 3A Learning Objectives

1.
Understand various types of cost behaviour
2.
Variable
Fixed
Mixed
Use various methods to analyze cost behaviour
Scattergraph Method
High-low Method
Least Squares Regression Method
Slide 3
Learning Objective 1
Understand Various Types

of Cost Behaviour:
Variable, Fixed and Mixed.
Slide 4
Cost Classifications for Predicting Cost

Behavior (Recap)
Behavior of Cost (within the relevant range)

Cost
In Total
Per Unit
Variable
Total variable cost changes

as activity level changes.
Variable cost per unit remains

the same over wide ranges
of activity.
Fixed
Total fixed cost remains

the same even when the
activity level changes.
Average fixed cost per unit goes

down as activity level goes up.
Slide 5
The Activity Base (also called a cost driver)

Activity Base:
A measure of what causes the incurrence of a variable
cost
Variable costs
Activity base (cost driver)
Direct materials
Number of units produced
Equipment maintenance cost
Number of machine hours
Direct labor cost/Employee fringe

benefits
Number of labor hours
Delivery/Shipping cost
Number of miles driven
Slide 6
The Linearity Assumption and the Relevant Range

A relevant range is the range of activity within which the assumptions
made about cost behaviors are reasonably valid
Total Cost
Economists
Curvilinear Cost
Function
Relevant
Range
A straight line
closely
approximates a
curvilinear
variable cost
line within the
relevant range.
Accountants Straight-Line
Approximation (constant unit
variable cost)
Activity
Slide 7
1a. True Variable Costs
Cost
The amount of a true variable cost used during the

period varies in direct proportion to the activity level.
The apps download charge on a cell phone bill was
one example of a true variable cost.
Volume
Direct material is
another example
of a cost that
behaves in a true
variable pattern.
Slide 8
1b. Step-Variable Costs
Cost
A step-variable cost is a resource that is obtainable only

in large chunks (such as maintenance workers) and
whose costs change only in response to fairly wide
changes in activity.
E.g., A maintenance worker is

required for every 1,000 units
of production
Volume
Slide 9
Cost
Small changes in the level of production are not

likely to have any effect on the number of
maintenance workers employed.
Volume
Slide 10
Cost
Only fairly wide changes

in the activity level will
cause a change in the
number of maintenance
workers employed.
Volume
Slide 11
2. Types of Fixed Costs
Committed
Discretionary
Long-term, cannot be
significantly reduced in
the short term.
May be altered in the

short-term by current
managerial decisions
Examples
Examples
Depreciation on Buildings
and Equipment and Real
Estate Taxes
Advertising and
Research and
Development
Slide 12
2. Fixed Costs and the Relevant Range

For example, assume office space is available at
a rental rate of $30,000 per year in increments of
1,000 square feet.
Fixed costs would increase
in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.
Slide 13
Rent Cost in Thousands

of Dollars
90
Relevant
60
Range
30
0
The relevant range

of activity for a fixed
cost is the range of
activity over which
the graph of the
cost is flat.
1,000
2,000
3,000
Rented Area (Square Feet)
Slide 14
How does this

step-function
pattern differ from a
step-variable cost?
Step-variable costs
can be adjusted more
quickly as conditions
change and . . .
The width of the activity
steps is much wider for
the fixed cost.
Slide 15
Is Labor a Variable or a Fixed Cost?

The behavior of wage and salary costs can differ
across countries, depending on labor regulations,
labor contracts, and custom.
In France, Germany, China, and Japan, management has
little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.
In the United States and the United Kingdom, management
has greater latitude. Labor costs are more variable in nature.
Within countries managers can view labor costs differently
depending upon their strategy. Most companies in the
United States continue to view direct labor as a variable cost.
Slide 16
Quick Check
Which of the following statements about

cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.
Slide 17
3.Mixed Costs
A mixed cost (also called semi-variable cost)
contains both variable and fixed elements.
Consider the example of utility cost.
Total Utility Cost
Variable
Cost per KW
X
Activity (Kilowatt Hours)
Fixed Monthly
Utility Charge
Slide 18
3.Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where:
Y
a
Total Utility Cost
b
X
= The total mixed cost.

= The total fixed cost (the
vertical intercept of the line).
= The variable cost per unit of
activity (the slope of the line).
= The level of activity.
Variable
Cost per KW
X
Activity (Kilowatt Hours)
Fixed Monthly
Utility Charge
Slide 19
3.Mixed Costs An Example

If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, what is
the amount of your utility bill?
Slide 20
Analysis of Mixed Costs

Account Analysis and the Engineering Approach
In account analysis, each account is
classified as either variable or fixed based
on the analysts knowledge of how
the account behaves.
The engineering approach classifies
costs based upon an industrial
engineers evaluation of production
methods, and material, labor and
overhead requirements.
Slide 21
Use Various Methods to Analyze Cost
Behavior.
1. Scattergraph Method
2. High-Low Method
3. Least-Squares Regression
Method
Slide 22
1. The Scattergraph Method

Plot the data points on a graph
(Total Cost Y vs. Activity X).
Maintenance Cost
1,000s of Dollars
Y
20
* *
* *
10
* ** *
**
Patient-days in 1,000s
Slide 23

Draw a line through the data points with about an
equal numbers of points above and below the line.
Maintenance Cost
1,000s of Dollars
Y
20
* *
* *
10
* ** *
**
Slide 24
Maintenance Cost
1,000s of Dollars
Use one data point to estimate the total level of activity

and the total cost.
Y Total maintenance cost = $11,000
20
* *
* *
10
* ** *
**
Intercept = Fixed cost: $10,000
Patient days = 800

Slide 25

Make a quick estimate of variable cost per unit and
determine the cost equation.
Total maintenance at 800 patients
Less: Fixed cost
Estimated total variable cost for 800 patients
Variable cost per unit = $1,000

800
$ 11,000
10,000
$ 1,000
= $1.25/patient-day
Y = $10,000 + $1.25X
Total maintenance cost
Number of patient days

Slide 26
2. The High-Low Method An Example

Assume the following hours of maintenance work
and the total maintenance costs for six months.
7,350
Slide 27
7,350
The variable cost

per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
$2,400
= $6.00/hour
400
Slide 28
Total Fixed Cost = Total Cost Total Variable Cost
Total Fixed Cost = $9,800 ($6/hour 850 hours)

Total Fixed Cost = $9,800 $5,100
Total Fixed Cost = $4,700

Slide 29
The Cost Equation for Maintenance
Y = $4,700 + $6.00X
Slide 30
Quick Check 1
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is the
variable portion of sales salaries and commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit
Slide 31
Quick Check 2
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
Slide 32
3. Least-Squares Regression Method

A method used to analyze mixed costs if a
scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
This method uses all of the
data points to estimate
the fixed and variable
cost components of a
mixed cost.
The goal of this method is

to fit a straight line to the
data that minimizes the
sum of the squared errors.
Slide 33
Software can be used to fit a

regression line through the data
points.
The cost analysis objective is

the same: Y = a + bX
=1[( )( )
2
=1( )
; =
Least-squares regression also provides a statistic, called

the R2, which is a measure of the goodness
of fit of the regression line to the data points.
Slide 34
Total Cost
R2 is the percentage of the variation in the dependent

variable (total cost) that is explained by variation in the
independent variable (activity).
Y
20
* *
* *2
10
* ** *
**
R varies from 0% to 100%, and

the higher the percentage the better.
0
0
2
3
Activity
Slide 35
Comparing Results From the Three Methods

The three methods just discussed provide
slightly different estimates of the fixed and
variable cost components of the mixed cost.
This is to be expected because each method
uses differing amounts of the data points to
provide estimates.
Least-squares regression provides the most
accurate estimate because it uses all the data
points.
Slide 36
End of Topic 3A
Slide 37
Cost-Volume-Profit Analysis
Topic 3B
2012 McGraw-Hill Education (Asia)
Topic 3B Learning Objectives

1.
2.
Prepare an income statement using the contribution

format
Understand cost-volume-profit (CVP) relations using
four approaches:
3.
Equation Method
Formula Method
BE Percentage Method
Graphical Method
Understand the meaning of, and be able to deal with:
Sensitivity Analysis
Margin of Safety
Operating Leverage
Multiple Products CVP
Slide 39
Prepare an income
statement using the
contribution format.
Slide 40
The Contribution Format

Sales Revenue
Less: Variable costs
Contribution margin
Total
$ 100,000
60,000
$ 40,000
Less: Fixed costs

Net operating income
30,000
$ 10,000
Unit
$ 50
30
$ 20
The contribution margin format emphasizes cost

behavior. Contribution margin covers fixed costs
and provides for income.
Slide 41
The Contribution Format
Used primarily for

external reporting.
Used primarily by
management.
Slide 42
Understand cost-volume-profit (CVP)
relations using four approaches:
1) Equation Method
2) Formula Method
3) BE Percentage Method
4) Graphical Method
Slide 43
Basics of Cost-Volume-Profit Analysis

The contribution income statement is helpful to managers in judging the impact
on profits of changes in selling price, cost, or volume. The emphasis is on cost
behavior.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles)
$
250,000
Less: Variable expenses
150,000
Contribution margin
100,000
Less: Fixed expenses
80,000
$
20,000
Contribution Margin (CM) is the amount remaining from sales revenue after
variable expenses have been deducted.
CM is used first to cover fixed expenses. Any remaining CM contributes to

net operating income.
Slide 44

Sales, variable expenses, and contribution margin can
also be expressed on a per unit basis. If Racing sells an
additional bicycle, $200 additional CM will be generated
to cover fixed expenses and profit.
Total
Per Unit
$
250,000
$
500
150,000
300
Contribution margin
100,000
$
200
80,000
$
20,000
Slide 45

Each month, RBC must generate at least
$80,000 in total contribution margin to break-even
(which is the level of sales at which profit is zero).
Total
Per Unit
$
250,000
$
500
150,000
300
Contribution margin
100,000
$
200
80,000
$
20,000
Slide 46
If RBC sells 400 units in a month, it will be

operating at the break-even point.
Total
Per Unit
$
200,000
$
500
120,000
300
Contribution margin
80,000
$
200
80,000
$
-
Slide 47

If RBC sells one more bike (401 bikes), net
operating income will increase by $200.
Total
Per Unit
$
200,500
$
500
120,300
300
Contribution margin
80,200
$
200
80,000
$
200
Slide 48

We do not need to prepare an income statement to
estimate profits at a particular sales volume. Simply
multiply the number of units sold above break-even
by the contribution margin per unit.
If Racing sells
430 bikes, its net
operating income
will be $6,000.
Slide 49
CVP Relationships in Equation Form

The contribution format income statement can be
expressed in the following equation:
Profit = (Sales Variable expenses) Fixed expenses

= (SP x Q VC x Q) Fixed expenses
= (SP VC) x Q Fixed expenses
= Unit CM x Q Fixed expenses
where:
Unit CM = Selling price per unit Variable expenses per unit
= SP - VC
Slide 50
CVP Relationships in Equation Form

To compute RBCs profit where 401 bikes are sold
using the equation method:
Slide 51
Break-even Analysis
Assume the following information for Racing Bicycle
Company (RBC). Determine the breakeven point in:
1) unit sales; 2) dollar sales
Total
Per Unit
$ 250,000
$ 500
150,000
300
Contribution margin
100,000
$ 200
80,000
$ 20,000
Percent
100%
60%
40%
VC Ratio
CM Ratio
Slide 52
Contribution Margin Ratio (CM Ratio)

The contribution margin ratio at Racing Bicycle is:
CM per unit
=
CM Ratio =
SP per unit
$200
$500
= 40%
OR
$100,000
Total CM
= 40%
=
CM Ratio =
$250,000
Total Sales
The relationship between profit and the CM ratio can be
expressed using the following equation:
Profit = CM ratio Sales Fixed expenses
The CM ratio indicates the change in contribution margin

for every dollar change in sales. For e.g. if sales increase
by $50,000, total contribution margin will increase by
$20,000 (40% x $50,000)
Slide 53
Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the CM Ratio for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139
Slide 54
Break-even in Unit Sales:

1. Equation Method
Profits = Unit CM Q Fixed expenses

Profits are zero at the break-even point, hence
Slide 55
Break-even in Unit Sales:

2. Formula Method
Lets apply the formula method to solve for

the break-even point.
Unit sales to
=
break even
Fixed expenses
CM per unit
Slide 56
Break-even in Dollar Sales:

1. Equation Method
Slide 57
Break-even in Dollar Sales:

2. Formula Method
Now, lets use the formula method to calculate the
dollar sales at the break-even point.
Dollar sales to
Fixed expenses
=
break even
CM ratio
Slide 58
Break-even:
3. The BE Percentage Method
Now, lets use the 3rd method: the break-even percentage
(BE%) method to calculate the break-even point in units as
well as in sales $. This method also efficiently calculates
break-even for multiple products.
BE% =
Since BE Sales $ =
BE% =
BE Sales $
Total Sales $
x 100%
FE
CM%
FE
CM%
Total Sales $
x 100% =
FE
CM%
1
Total Sales $
x 100%
Since CM% x Total Sales $ = CM

% =
%
Slide 59
Break-even in Unit and Dollar Sales:

Applying the BE% formula to the same company RBC
% =
% =
$,
$,
% = %
This means that the company requires 80% of its current

sales in order to break-even.
Currently, the companys sales are $250,000 or 500 units.
A BE% of 80% means if the company sales are $200,000
($250,000 x 80%) or 400 units (500 units x 80%), the
company is break-even.
These figures are consistent with both the equation and
the formula methods.
Slide 60
Quick Check 1
What is the break-even sales dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129
Slide 61
Quick Check 2
What is the break-even sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups
Slide 62
Target Profit Analysis in Unit Sales

1. Equation Method
Suppose Racing Bicycle management wants to
know how many bikes must be sold to earn a
target profit of $100,000.
Profit = Unit CM Q Fixed expenses
Slide 63
Target Profit Analysis in Unit Sales

2. Formula Method
Suppose Racing Bicycle management wants to
know how many bikes must be sold to earn a
Unit sales to attain
Target profit + Fixed expenses
=
the target profit
CM per unit
Slide 64
Target Profit Analysis in Dollar Sales

1. Equation Method
Our goal is to solve for the unknown Sales
which represents the dollar amount of sales
that must be sold to attain the target profit.
Suppose RBC management wants to know the
sales volume that must be generated to earn a
Slide 65
Target Profit Analysis in Dollar Sales

2.Formula Method
We can calculate the dollar sales needed to
attain a target profit (net operating profit) of
$100,000 at Racing Bicycle.
Dollar sales to attain
Target profit + Fixed expenses
=
the target profit
CM ratio
Slide 66
Target Profit Analysis:

Modifying the BE% formula to add target profit to FE
+
Target Profit% =
%
$,+$,
Target Profit% =
x % =
$,
This means that the company requires 180% of its current

sales in order to obtain the target profit.
Currently, the companys sales are $250,000 or 500 units.
A Target Profit % of 180% means if the company sales
are $450,000 ($250,000 x 180%) or 900 units (500 units x
180%), the company has a target profit of $100,000.
These figures are consistent with both the equation and
the formula methods.
Slide 67
Quick Check 1
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is
$0.36. The average fixed expense per month is $1,300.
Use the formula method to determine how many cups of
coffee would have to be sold to attain target profits of
$2,500 per month.
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
Slide 68
Quick Check 2
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is
$0.36. The average fixed expense per month is $1,300.
Use the formula method to determine the sales dollars
that must be generated to attain target profits of $2,500
per month.
a. $2,550
b. $5,011
c. $8,458
d. $10,555
Slide 69
CVP Relationships in Graphic Form

The relationships among revenue, cost, profit and volume
can be expressed graphically by preparing a CVP graph.
Racing Bicycle developed contribution margin income
statements at 0, 200, 400, and 600 units sold. We will
use this information to prepare the CVP graph.
Units Sold
200
0
Sales
100,000
400
200,000
600
$
300,000
Total variable expenses
60,000
120,000
180,000
Contribution margin
40,000
80,000
120,000
80,000
80,000
80,000
80,000
Fixed expenses
Net operating income (loss)
(80,000)
(40,000)
40,000
Slide 70
Preparing the CVP Graph

$350,000
$300,000
$250,000
$200,000
$150,000
In a CVP graph, unit volume is usually

represented on the horizontal (X) axis
and dollars on the vertical (Y) axis.
$100,000
$50,000
$0
100
200
300
400
500
600
Units
Slide 71
Draw a line parallel to the volume axis

to represent total fixed expenses.
$350,000
$300,000
$250,000
$200,000
Fixed expenses
$150,000
$100,000
$50,000
$0
100
200
300
400
500
600
Units
Slide 72
Choose some sales volume, say 400 units, and plot the point representing
$300,000
total expenses
(fixed and variable). Draw a line through the data point
back to where the fixed expenses line intersects the dollar axis.
$350,000
$250,000
$200,000
Total expenses
Fixed expenses
$150,000
$100,000
$50,000
$0
100
200
300
400
500
600
Units
Slide 73
Choose some sales volume, say 400 units, and plot the point representing
$300,000
total sales.
Draw a line through the data point back to the point of origin.
$350,000
$250,000
$200,000
Sales
Total expenses
Fixed expenses
$150,000
$100,000
$50,000
$0
100
200
300
400
500
600
Units
Slide 74

Break-even point
(400 units or $200,000 in sales)
$350,000
Profit Area
$300,000
$250,000
$200,000
Sales
Total expenses
Fixed expenses
$150,000
$100,000
$50,000
$0
Loss Area
100
200
300
400
500
600
Units
Slide 75

Profit = Unit CM Q Fixed Costs
$ 60,000
$ 40,000
Profit
$ 20,000
$0
-$20,000
An even simpler form of

the CVP graph is called
the profit graph.
-$40,000
-$60,000
0
100
200
300
400
Number of bicycles sold
500
600
Slide 76

$ 60,000
Break-even point, where

profit is zero , is 400
units sold.
$ 40,000
Profit
$ 20,000
$0
-$20,000
-$40,000
-$60,000
0
100
200
300
400
Number of bicycles sold
500
600
Slide 77
Understand the meaning of, and be
able to deal with:
1) Sensitivity Analysis
2) Margin of Safety
3) Operating Leverage
4) Multiple Products CVP
Slide 78
1. Sensitivity Analysis: Example 1

Changes in Fixed Costs and Sales Volume
What is the profit impact if Racing

Bicycle can increase unit sales from
500 to 540 by increasing the monthly
advertising budget by $10,000?
Slide 79

$80,000 + $10,000 advertising = $90,000
Sales
Contribution margin
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
540 units
$ 270,000
162,000
108,000
90,000
$
18,000
Sales increased by $20,000, but net operating

income decreased by $2,000.
Slide 80

A shortcut solution using incremental

analysis
Increase in CM (40 units X $200)
Increase in advertising expenses
Decrease in net operating income
$ 8,000
10,000
$ (2,000)
Slide 81

Change in Variable Costs and Sales Volume
What is the profit impact if Racing

Bicycle can use higher quality raw
materials, thus increasing variable costs
per unit by $10, to generate an increase
in unit sales from 500 to 580?
Slide 82
1. Sensitivity Analysis:
Change in Variable Costs and Sales Volume
580 units $310 variable cost/unit = $179,800
Sales
Contribution margin
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
580 units
$ 290,000
179,800
110,200
80,000
$
30,200
Sales increase by $40,000, and net operating income

increases by $10,200.
Slide 83
2. The Margin of Safety in Dollars
The margin of safety in dollars is the

excess of budgeted (or actual) sales over
the break-even volume of sales.
Margin of safety in dollars = Total sales - Break-even sales
Lets look at Racing Bicycle Company and

determine the margin of safety.
Slide 84
2. The Margin of Safety in Units

The margin of safety can be expressed in terms of
the number of units sold. The margin of safety at
RBC is $50,000, and each bike sells for $500;
hence, RBCs margin of safety is 100 bikes.
Margin of
=
Safety in units
$50,000
= 100 bikes
$500
OR
Margin of
=
Safety in units
500 400 = 100 bikes

Slide 85
2. The Margin of Safety in Percentage

If we assume that RBC has actual sales of $250,000, given that
we have already determined the break-even sales to be
$200,000, the margin of safety is $50,000 as shown.
Break-even
sales
400 units
Sales
$ 200,000
Less: variable expenses
120,000
Contribution margin
80,000
Less: fixed expenses
80,000
$
-
Actual sales
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
RBCs margin of safety can be expressed as 20% of sales

($50,000 $250,000). This is also known as margin of
safety percentage or MoS%
Slide 86
Quick Check
What is the margin of safety expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
Slide 87
Linking Margin of Safety % (to sales) and

Breakeven % (to sales)
Margin of safety in dollars = Total sales - Break-even sales
Margin of safety in dollars
Total sales in dollars
= Margin of safety percentage (MoS%)

Total sales Breakeven sales
=
Total sales
Breakeven in dollars
=1
Total sales in dollars
= 1 Breakeven percentage
= 1 BE%
Therefore:
BE% = 1 MoS %
Slide 88
Calculate Breakeven given MOS (%)
RBCs margin of safety = 20% of sales
Sales
Contribution margin
Actual sales
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
Breakeven sales of RBC = 1 20% = 80% of sales (or BE%)

= $250,000 x 80%
= $200,000
= Breakeven Sales on slide 86
Slide 89
3. Operating Leverage:
Cost Structure and Profit Stability
Cost structure refers to the relative proportion
of fixed and variable costs in an organization.
Managers often have some latitude in
determining their organizations cost structure.
Slide 90
Cost Structure and Profit Stability
There are advantages and disadvantages to high fixed cost
(or low variable cost) and low fixed cost (or high variable
cost) structures.
An advantage of a high fixed

cost structure is that income A disadvantage of a high fixed
will be higher in good years cost structure is that income
compared to companies
will be lower in bad years
with lower proportion of
compared to companies
fixed costs.
with lower proportion of
fixed costs.
Companies with low fixed cost structures enjoy greater
stability in income across good and bad years.
Slide 91
Managing fixed costs
Typical fixed costs: production facilities, rentals, employees

salaries and related benefits and utilities
Converting them into variable may reduce risk of financial commitment

and provide flexibility of capacity utilization
Outsourcing - switching to variable costs

Business with fast and regular change and/or large varieties of
products most likely will benefit from this approach e.g. Nike and
Apple
Non-core business functions with lower value-add to majority
customers e.g. call centers for enquiries, 3rd party logistics, brokerdealers securities back office operations
Offshoring - reducing fixed costs

Honda and Toyota Thailand plants
HSBC back office functions in China
Slide 92
3. Operating Leverage
Operating leverage is a measure of how sensitive net
operating income is to percentage changes in sales.
It is a measure, at any given level of sales, of how a
percentage change in sales volume will affect profits.
Contributi on Margin
DOL Degree of Operating Leverage
Net Operating Income * *
** Profit Before Tax is a commonly used alternative to Net Operating
Income in the degree of operating leverage calculation
Slide 93
To illustrate, lets revisit the contribution income statement
for RBC.
Sales
Contribution margin
Net income
Degree of
Operating
Leverage
Actual sales
500 Bikes
$ 250,000
150,000
100,000
80,000
$
20,000
Slide 94
With an operating leverage of 5, if RBC

increases its sales by 10%, net operating
income would increase by 50%.
Percent increase in sales
Degree of operating leverage
Percent increase in profits
10%
5
50%
Heres the verification!

Slide 95
Actual sales
(500)
Sales
$ 250,000
Less variable expenses
150,000
Contribution margin
100,000
Less fixed expenses
80,000
$
20,000
Increased
sales (550)
$ 275,000
165,000
110,000
80,000
$
30,000
10% increase in sales from

$250,000 to $275,000 . . .
. . . results in a 50% increase in

income from $20,000 to $30,000.
Slide 96
Quick Check 1
Coffee Klatch is an espresso stand in a
downtown office building. The average selling
price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average
fixed expense per month is $1,300. 2,100 cups
are sold each month on average. What is the
operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
Slide 97
Quick Check 2
At Coffee Klatch the average selling price of a cup of
coffee is $1.49, the average variable expense per cup
is $0.36, the average fixed expense per month is
$1,300 and an average of 2,100 cups are sold each
month.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%
Slide 98
What does higher value of Operating

Leverage mean?
High Operating Leverage ratio
signals the existence of high fixed costs.

increases risk of making loss in adverse market
conditions.
increases opportunity to make profit when higher
demand exists.
has lower margin of safety percentage (MoS%)
1
DOL
MoS%
Slide 99
Proof of Operating Leverage and Profit

Movement Relationship
Benchmark Co.
High F.C. Co.
$3,200,000
$3,200,000
$800
$800
($300)
($150)
Unit Contribution margin
$500
$650
Unit sales (Same)
4,000
4,000
$2,000,000
$2,600,000
($1,500,000)
($2,100,000)
(P)
500,000
500,000
Degree of operating leverage (CM/P)
4.0
5.2
Total Sales (Same)

Unit selling price (Same)
Unit variable costs
Contribution margin
(CM)
Fixed costs
Net Operating Profit (Same)
Slide 100
Proof of Operating Leverage and Profit

Movement Relationship
Benchmark Co.
High F.C. Co.
12.5%
12.5%
Degree of operating leverage
X 4.0
X 5.2
Increase in profits
50%
65%
Unit contribution margin
$500
$650
Unit change in sales (4,000 x 12.5%)
x 500
x 500
$250,000
$325,000
50%
65%
Increase in sales
Proof:
Change in profits
Percentage increase from the original
$500,000 profit
Slide 101
Proof of Operating Leverage and MoS%

Relationship
Benchmark Co.
High F.C. Co.
Total Sales (Same)
(S)
$3,200,000
$3,200,000
Contribution margin
(CM)
$2,000,000
$2,600,000
Fixed costs
(F)
($1,500,000)
($2,100,000)
Net Operating Profit (Same)
(P)
500,000
500,000
Degree of operating leverage (CM/P)
4.0
5.2
2,400,000
2,584,615
75%
80.77%
25%
19.23%
4.0
5.2
Breakeven Sales Dollars [F/(CM/S)]

Breakeven % (to sales)
MoS% = 1 BE%
1/MoS%
= Degree of operating leverage
Slide 102
4. The Concept of Sales Mix

Sales mix is the relative proportion in which a
companys products are sold.
Different products have different selling prices,
cost structures, and contribution margins.
When a company sells more than one product,
break-even analysis becomes more complex as
the following example illustrates.
Slide 103
Multi-Product Break-Even Analysis

1. The BE% Method
Virtual Journeys Le Louvre and Le Vin sales and profit data are as follows:
Le Louvre (200)
Sales
$ 20,000
Variable expenses
15,000
Contribution margin
5,000
Fixed expenses
Sales
$ 20,000
Le Vin (400)
$ 80,000
40,000
40,000
$80,000
x
BE% = 60%
Breakeven sales
$12,000
$48,000
Total breakeven sales = $60,000

Breakeven units
120 units
240 units
Total
$ 100,000
55,000
45,000
27,000
$ 18,000
Contribution Margin
1
Net Operating Income MoS%

Net Operating Income
MoS%
Contribution Margin
18,000
MoS%
40%
45,000
MoS% 1 BE%
BE% 1 MoS% 1 40% 60%
DOL
Total breakeven units = 360 units

Slide 104

2. The Weighted-Average CM Ratio Method
Le Louvre comprises 20% of Virtual Journeys total sales
revenue and Le Vin comprises the remaining 80%. Virtual
Journey provides the following information:
Le Louvre (200 units)
Sales
$ 20,000
100%
Variable expenses
15,000
75%
Contribution margin
5,000
25.0%
Fixed expenses
Le Vin (400 units)

$
80,000
100%
40,000
50%
40,000
50%
Total
$ 100,000
100.0%
55,000
55.0%
45,000
45.0%
27,000
$ 18,000
Sales mix
$ 100,000
20,000
20%
Weighted-average CM Ratio
= (20% x 25%) + (80% x 50%) OR
= 45%
80,000
80%
100%
Weighted-average CM Ratio
= 45,000/100,000
= 45%
Slide 105

2. The Weighted-Average CM Ratio Method
Dollar sales to
Fixed expenses
=
break even
CM ratio
Dollar sales to
break even
$27,000
45%
= $60,000

Sales
$
12,000
100%
Variable expenses
9,000
75%
Contribution margin
3,000
25%
Fixed expenses
Le Vin (400 units)

$ 48,000
100%
24,000
50%
24,000
50%
Sales mix
12,000
20%
48,000
80%
Total
60,000
33,000
27,000
27,000
-
60,000
100.0%
55.0%
45.0%
100.0%
Slide 106

3. The Weighted-Average CM Method
Le Louvre comprises 33.33% of Virtual Journeys total unit
sales and Le Vin comprises the remaining 66.66%. Virtual
Journey provides the following information:
Sales
$ 20,000
100%
Variable expenses
15,000
75%
Contribution margin
5,000
25.0%
Fixed expenses
Unit CM
Sales mix (in units)
$25
200 units
33.33%
Le Vin (400 units)

$
80,000
100%
40,000
50%
40,000
50%
$100
400 units
66.66%
Total
$ 100,000
100.0%
55,000
55.0%
45,000
45.0%
27,000
$ 18,000
600 units
100%
Weighted-average CM
= (1/3 x $25) + (2/3 x $100)
= $75
Slide 107

3. The Weighted-Average CM Method
Unit sales to
break even
Unit sales to
break even

Sales
$
12,000
100%
Variable expenses
9,000
75%
Contribution margin
3,000
25%
Fixed expenses
Sales mix (in units)
120 units
33%
Fixed expenses
Unit CM
$27,000
$75
= 360 units
Le Vin (400 units)

$ 48,000
100%
24,000
50%
24,000
50%
$
240 units
67%
Total
60,000
33,000
27,000
27,000
360 units
100.0%
55.0%
45.0%
100.0%
Slide 108
Key Assumptions of CVP Analysis

Selling price is constant.
Costs are linear and can be accurately divided into
variable (constant per unit) and fixed (constant in
total) elements.
In multiproduct companies, the sales mix is
constant.
In manufacturing companies, inventories do not
change (units produced = units sold).
Slide 109
Quick Check
Slide 110
Quick Check
Slide 111
Quick Check
Slide 112
Quick Check
Slide 113
End of Topic 3B
Slide 114

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Cost Behaviour

2012 McGraw-Hill Education (Asia)

Preview of This Weeks Class

Classify costs by behaviour and use it to answer the

How will my profits change if I change my selling price,

Breakeven and target profit analysis (this week)

How can the income statement be presented for better

Variable costing vs. absorption costing (next week)

McGraw-Hill Education (Asia)

Topic 3A Learning Objectives

Understand various types of cost behaviour

Use various methods to analyze cost behaviour

McGraw-Hill Education (Asia)

Understand Various Types

McGraw-Hill Education (Asia)

Cost Classifications for Predicting Cost

Behavior of Cost (within the relevant range)

Total variable cost changes

Variable cost per unit remains

Total fixed cost remains

Average fixed cost per unit goes

McGraw-Hill Education (Asia)

The Activity Base (also called a cost driver)

Activity base (cost driver)

Number of units produced

Equipment maintenance cost

Number of machine hours

Direct labor cost/Employee fringe

Number of labor hours

Number of miles driven

McGraw-Hill Education (Asia)

The Linearity Assumption and the Relevant Range

1a. True Variable Costs

The amount of a true variable cost used during the

1b. Step-Variable Costs

A step-variable cost is a resource that is obtainable only

E.g., A maintenance worker is

1b. Step-Variable Costs

Small changes in the level of production are not

1b. Step-Variable Costs

Only fairly wide changes

2. Types of Fixed Costs

May be altered in the

McGraw-Hill Education (Asia)

2. Fixed Costs and the Relevant Range

McGraw-Hill Education (Asia)

Rent Cost in Thousands

2. Fixed Costs and the Relevant Range

McGraw-Hill Education (Asia)

The relevant range

2. Fixed Costs and the Relevant Range

How does this

Is Labor a Variable or a Fixed Cost?

Which of the following statements about

Total Utility Cost

= The total mixed cost.

3.Mixed Costs An Example

McGraw-Hill Education (Asia)

Analysis of Mixed Costs

McGraw-Hill Education (Asia)

1. The Scattergraph Method

1. The Scattergraph Method

1. The Scattergraph Method

Use one data point to estimate the total level of activity