Financial Ratios(Explanation)

Introduction to Financial Ratios

When computing financial ratios and when doing other financial statement analysis always keep in
mind that the financial statements reflect the accounting principles. This means assets are
generally not reported at their current value. It is also likely that many brand names and unique
product lines will not be included among the assets reported on the balance sheet, even though they
may be the most valuable of all the items owned by a company.
These examples are signals that financial ratios and financial statement analysis have limitations. It
is also important to realize that an impressive financial ratio in one industry might be viewed as less
than impressive in a different industry.
Our explanation of financial ratios and financial statement analysis is organized as follows:

Balance Sheet
o General discussion
o

Common-size balance sheet

Financial ratios based on the balance sheet

Income Statement
o General discussion
o

Common-size income statement

Financial ratios based on the income statement

Statement of Cash Flows

Note: To assist you in understanding financial ratios, we developed business forms for computing
24 popular financial ratios. They are included in AccountingCoach PRO.

General Discussion of Balance Sheet

The balance sheet reports a company's assets, liabilities, and stockholders' equity as of a specific
date, such as December 31, 2014, March 31, 2014, etc.
The accountants' cost principle and the monetary unit assumption will limit the assets reported
on the balance sheet. Assets will be reported

(1) only if they were acquired in a transaction, and

(2) generally at an amount that is not greater than the asset's cost at the time of the transaction.
This means that a company's creative and effective management team will not be listed as an asset.
Similarly, a company's outstanding reputation, its unique product lines, and brand names developed
within the company will not be reported on the balance sheet. As you may surmise, these items are
often the most valuable of all the things owned by the company. (Brand names purchased from
another company will be recorded in the company's accounting records at their cost.)
The accountants' matching principle will result in assets such as buildings, equipment,
furnishings, fixtures, vehicles, etc. being reported at amounts less than cost. The reason is these
assets are depreciated. Depreciation reduces an asset's book value each year and the amount of
the reduction is reported as Depreciation Expense on the income statement.
While depreciation is reducing the book value of certain assets over their useful lives, the current
value (or fair market value) of these assets may actually be increasing. (It is also possible that
the current value of some assetssuch as computersmay be decreasing faster than the book
value.)
Current assets such as Cash, Accounts Receivable, Inventory, Supplies, Prepaid Insurance, etc.
usually have current values that are close to the amounts reported on the balance sheet.
Current liabilities such as Notes Payable (due within one year), Accounts Payable, Wages
Payable, Interest Payable, Unearned Revenues, etc. are also likely to have current values that are
close to the amounts reported on the balance sheet.
Long-term liabilities such as Notes Payable (not due within one year) or Bonds Payable (not
maturing within one year) will often have current values that differ from the amounts reported on the
balance sheet.
Stockholders' equity is the book value of the company. It is the difference between the
reported amount of assets and the reported amount of liabilities. For the reasons mentioned above,
the reported amount of stockholders' equity will therefore be different from the current or market
value of the company.
By definition the current assets and current liabilities are "turning over" at least once per year. As a
result, the reported amounts are likely to be similar to their current value. The long-term assets and
long-term liabilities arenot "turning over" often. Therefore, the amounts reported for long-term assets
and long-term liabilities will likely be different from the current value of those items.
The remainder of our explanation of financial ratios and financial statement analysis will use
information from the following balance sheet:

To learn more about the balance sheet, go to:

Explanation of Balance Sheet

Quiz for Balance Sheet
Crossword Puzzles for Balance Sheet

Common-Size Balance Sheet

One technique in financial statement analysis is known as vertical analysis. Vertical analysis results
in common-size financial statements. A common-size balance sheet is a balance sheet where every
dollar amount has been restated to be a percentage of total assets. We will illustrate this by taking
Example Company's balance sheet (shown above) and divide each item by the total asset amount
$770,000. The result is the following common-size balance sheet for Example Company:

The benefit of a common-size balance sheet is that an item can be compared to a similar item of
another company regardless of the size of the companies. A company can also compare its
percentages to the industry's average percentages. For example, a company with Inventory at
4.0% of total assets can look to its industry statistics to see if its percentage is reasonable. (Industry
percentages might be available from an industry association, library reference desks, and from
bankers. Many banks have memberships in Risk Management Association (RMA), an organization
that collects and distributes statistics by industry.) A common-size balance sheet also allows two

businesspersons to compare the magnitude of a balance sheet item without either one revealing the
actual dollar amounts.

Financial Ratios Based on the Balance

Sheet
Financial statement analysis includes financial ratios. Here are three financial ratios that are based
solely on current asset and current liability amounts appearing on a company's balance sheet:

Four financial ratios relate balance sheet amounts for Accounts Receivable and Inventory to
income statement amounts. To illustrate these financial ratios we will use the following income
statement information:

To learn more about the income statement, go to:

Explanation of Income Statement

Quiz for Income Statement
Crossword Puzzle for Income Statement

The next financial ratio involves the relationship between two amounts from the balance sheet: total
liabilities and total stockholders' equity:

General Discussion of Income

Statement
The income statement has some limitations since it reflects accounting principles. For example, a
company's depreciation expense is based on the cost of the assets it has acquired and is using in its
business. The resulting depreciation expense may not be a good indicator of the economic value of
the asset being used up. To illustrate this point let's assume that a company's buildings and
equipment have been fully depreciated and therefore there will be no depreciation expense for those
buildings and equipment on its income statement. Is zero expense a good indicator of the cost of
using those buildings and equipment? Compare that situation to a company with new buildings and
equipment where there will be large amounts of depreciation expense.
The remainder of our explanation of financial ratios and financial statement analysis will use
information from the following income statement:

To learn more about the income statement, go to:

Explanation of Income Statement

Quiz for Income Statement
Crossword Puzzle for Income Statement

Common-Size Income Statement

Financial statement analysis includes a technique known as vertical analysis. Vertical analysis
results in common-size financial statements. A common-size income statement presents all of the
income statement amounts as a percentage of net sales. Below is Example Corporation's commonsize income statement after each item from the income statement above was divided by the net
sales of $500,000:

The percentages shown for Example Corporation can be compared to other companies and to the
industry averages. Industry averages can be obtained from trade associations, bankers, and library
reference desks. If a company competes with a company whose stock is publicly traded, another
source of information is that company's "Management's Discussion and Analysis of Financial
Condition and Results of Operations" contained in its annual report to the Securities and Exchange
Commission (SEC). This annual report is the SEC Form 10-K and is usually accessible under the
"Investor Relations" tab on the corporation's website.

Financial Ratios Based on the Income

Statement

Statement of Cash Flows

The statement of cash flows is a relatively new financial statement in comparison to the income
statement or the balance sheet. This may explain why there are not as many well-established
financial ratios associated with the statement of cash flows.
We will use the following cash flow statement for Example Corporation to illustrate a limited financial
statement analysis:

The cash flow from operating activities section of the statement of cash flows is also used by some
analysts to assess the quality of a company's earnings. For a company's earnings to be of "quality"
the amount of cash flow from operating activities must be consistently greater than the company's
net income. The reason is that under accrual accounting, various estimates and assumptions are
made regarding both revenues and expenses. When it comes to cash, however, the money is either
in the bank or it isn't.
To learn more about the statement of cash flows, go to:

Explanation of Cash Flow Statement

Quiz for Cash Flow Statement
Crossword Puzzle for Cash Flow Statement

Additional Information and Resources

Because the material covered here is considered an introduction to this topic, many
complexities have been omitted. You should always consult with an accounting
professional for assistance with your own specific circumstances.

1.

Which of the following is not a current asset?

Inventory
Prepaid Insurance
Fixtures

2.

2.
Current asset MINUS current liabilities is the
Current Ratio
Net Worth
Working Capital

3.

3.
Current assets DIVIDED BY current liabilities is the
Current Ratio
Net Worth Ratio
Working Capital

4.

4.

The quick ratio EXCLUDES which of the following?

Accounts Receivable
Inventory
Cash
5.

Use the following information to answer items 5 - 7:

At December 31 a company's records show the following information:

6.

5.
The company's working capital is
$60,000
$66,000
$196,000

7.

6.
The company's current ratio is
1.0 : 1
2.0 : 1
2.1 : 1

8.

7.
The company's quick ratio is
0.7 : 1
1.0 : 1
2.0 : 1

9.

Use the following information to answer items 8 - 11:

For its most recent year a company had Sales (all on credit) of $830,000 and Cost of
Goods Sold of $525,000. At the beginning of the year its Accounts Receivable were
$80,000 and its Inventory was $100,000. At the end of the year its Accounts
Receivable were $86,000 and its Inventory was $110,000.
10.
8.
The inventory turnover ratio for the year was
4.8
5.0
7.9
11.

9.
The accounts receivable turnover ratio for the year was
6.3
7.5
10.0

12.

10.
On average how many days of sales were in Accounts Receivable during the year?
27
37
49

13.

11.
On average how many days of sales were in Inventory during the year?
14
46
73

14.

Use the following information for items 12 and 13:

A company's net income after tax was $400,000 for its most recent year. The
company's income statement included Income Tax Expense of $140,000 and Interest
Expense of $60,000. At the beginning of the year the company's stockholders' equity
was $1,900,000 and at the end of the year it was $2,100,000.
15.
12.
What is the times interest earned for the company?

6.7
9.0
10.0
16.

13.
What is the after-tax return on stockholder's equity for the year?
20%
25%
30%

17.

14.The debt to equity ratio is computed as: (Total Liabilities Total

__________
):1
18.
15.
Which of the following are likely to have the reported amounts on the balance sheet
being close to their current value?
Current Assets
Long-term Assets
Stockholders' Equity
19.

16.
A corporation's excellent reputation will be listed among the corporation's assets on its
balance sheet.
True
False

20.

17.
The current market value of a corporation is approximately the amount reported on the
balance sheet as stockholders' equity.
True
False

21.

18.
Free cash flow is the cash provided by operating activities minus the cash used by
financing activities.
True

False
22.

19.
The quality of a company's earnings are suspect when the company's net income is
more than the cash flow from which activities?
Operating
Investing
Financing

23.

20.A balance sheet which reports percentages of total assets instead of dollar
amounts is referred to as a
__________
__________
balance sheet

Q&A

What is the operating cycle?

The operating cycle is also known as the cash conversion cycle. In the context of a
manufacturer the operating cycle has been described as the amount of time that it takes for a
manufacturer's cash to be converted into products plus the time it takes for those products to be
sold and turned back into cash. In other words, the manufacturer's operating cycle involves:

paying for the raw materials needed in its products

paying for the labor and overhead costs needed to convert the raw
materials into products
holding the finished products in inventory until they are sold

waiting for the customers' cash payments for the products that have
been sold
Some calculate the operating cycle to be the sum of:

the days' sales in inventory (365 days/inventory turnover ratio), plus

the average collection period (365 days/accounts receivable turnover
ratio)
The above sum is sometimes reduced by the number of days in the credit terms of the accounts
payable.
The operating cycle has importance in classifying current assets and current liabilities.

While most manufacturers have operating cycles of several months, a few industries require very
long processing times. This could result in an operating cycle that is longer than one year. To
accommodate those industries, the accountants' definitions of current assets and current liabilities
include the following phrase: ...within one year or within the operating cycle,
whichever is longer.

What are turnover ratios?

In accounting, turnover ratios are the financial ratios in which an annual income statement
amount is divided by the average balance of an asset (or group of assets) throughout the year.
Turnover ratios include:

accounts receivable turnover ratio

inventory turnover ratio

total assets turnover ratio

fixed assets turnover ratio

working capital turnover ratio

Some of the turnover ratios are also categorized as liquidity ratios, operating ratios, activity
ratios, efficiency ratios, and asset utilization ratios.
The larger the turnover ratio, the better. For instance, a large amount of credit sales in
relationship to a small amount of accounts receivable indicates that the company was efficient
and effective in collecting its accounts receivable. (Remember that ratios are averages. Hence,
some of the accounts receivable could be very old, but they are "hidden" because other
customers paid quickly.)
Turnover ratios are more accurate when they use the asset's average balances for the year (as
opposed to onebalance at the final instant of the accounting year). The reason is that an income
statement amount reflects the total activity during the entire year.

What are accounting ratios?

Accounting ratios (also known as financial ratios) are considered to be part of financial statement
analysis. Accounting ratios usually relate one financial statement amount to another. For
example, the inventory turnover ratio divides a company's cost of goods sold for a recent
year by the cost of its inventory on hand during that year.
For a company with current assets of $300,000 and current liabilities of $150,000
its current ratio is $300,000 to $150,000, or 2 to 1, or 2:1. This ratio of 2:1 can then be
compared to other companies in its industry regardless of size or it can be compared to the
company's ratio from an earlier year.

Other examples of accounting ratios include:

Quick ratio
Current ratio
Debt to equity ratio
Acid-test ratio
Contribution margin ratio
Interest coverage ratio
Debt to total assets ratio
Gross margin ratio
Return on assets ratio
Profit margin (after tax) ratio
Total assets turnover ratio
Fixed asset turnover ratio
Times interest earned ratio
Liquidity ratio
Working capital ratio
Dividend payout ratio
Free cash flow ratio

What is long-term debt?

In accounting, long-term debt generally refers to a company's loans and other liabilities that
will not become due within one year of the balance sheet date. (The amount that will be due
within one year is reported on the balance sheet as a current liability.)
To illustrate, let's assume that a company has a mortgage loan with a principal balance of
$200,000 and 120 monthly payments remaining. The loan payments due in the next 12 months
include $12,000 of principal payments. The $200,000 of debt should be reported on the
company's balance sheet as follows:

$188,000 as a long-term or noncurrent liability such as Noncurrent

portion of mortgage loan

$12,000 as a current liability such as Current portion of mortgage loan

If you use the word "debt" to be interchangeable with "liabilities" (as is done in financial ratios)
then other examples will include vehicle loans, bonds payable, capital lease obligations,
pension and other postretirement benefit obligations, and deferred income taxes.
Some long-term debt that will be due within one year can continue to be reported as a noncurrent
liability if the company intends to refinance it and can prove it will be done within 12 months
without reducing its working capital.

What is leverage?
In accounting and finance, leverage refers to the use of a significant amount of debt
and/or credit to purchase an asset, operate a company, acquire another company,
etc.
Generally the cost of borrowed money is much less than the cost of obtaining
additional stockholders' equity. As a result, it is usually wise for a corporation to use
some debt and leverage. Perhaps this is one of the reasons that leverage is also
known as trading on equity.
Financial ratios such as debt to equity and debt to total assets are indicators of a
corporation's use of leverage. In these ratios debt is the total amount of all liabilities
(current and noncurrent). This means that a corporation's debt includes bonds
payable, loans from banks, loans from others, accounts payable, and all other
amounts owed.
In a related Q&A we illustrate how leverage can increase or decrease the returns on
investments.

What is gross margin?

Gross margin is the difference between 1) the cost to produce or purchase an item,
and 2) its selling price. For example, if a company's manufacturing cost of a product
is $28 and the product is sold for $40, the product's gross margin is $12 ($40 minus
$28), or 30% of the selling price ($12/$40). Similarly, if a retailer has net sales of
$40,000 and its cost of goods sold was $24,000, the gross margin is $16,000 or 40%
of net sales ($16,000/$40,000).
It is important to realize that the gross margin (also known as gross profit) is the
amount before deducting expenses such as selling, general and administrative
(SG&A) and interest. In other words, there is a big difference between gross margin
and profit margin (or net profit margin).\

What is the difference between the current ratio and the quick ratio?
The current ratio is the proportion (or quotient or fraction) of the amount of current
assets divided by the amount of current liabilities.
The quick ratio (or the acid test ratio) is the proportion of 1) only the most liquid
current assets to 2) the amount of current liabilities. In other words, the quick ratio

assumes that only the following current assets will turn to cashquickly: cash, cash
equivalents, short-term marketable securities, and accounts receivable. Hence, the
quick ratio does not include inventories, supplies, and prepaid expenses.
To illustrate the difference between the current ratio and the quick ratio, let's
assume that a company's balance sheet reports current assets of $60,000 and
current liabilities of $40,000. Its current assets include $35,000 of inventory and
$1,000 of supplies and prepaid expenses. The company's current ratio is 1.5 to
1 [$60,000 divided by $40,000]. Its quick ratio is 0.6 to 1 [($60,000 minus $36,000)
divided by $40,000].
AccountingCoach PRO has 24 blank forms to guide you in calculating and
understanding financial ratios. Also included are 24 filled-in forms based on two
financial statements.

What is the difference between the current ratio and working capital?
The current ratio is the proportion (or quotient or fraction) of the amount of current
assets divided by the amount of current liabilities.
Working capital is not a ratio, proportion or quotient, but rather it is an amount.
Working capital is the amount remaining after current liabilities are subtracted from
current assets.
To illustrate the difference between the current ratio and working capital, let's
assume that a company's balance sheet reports current assets of $60,000 and
current liabilities of $40,000. The company's current ratio is 1.5 to 1 (or 1.5:1, or
simply 1.5) resulting from dividing $60,000 by $40,000. The company's working
capital is $20,000 which is the remainder after subtracting $40,000 from $60,000.
AccountingCoach PRO contains 24 blank forms to guide you in computing and
understanding often-used financial ratios. In addition, there are 24 filled-in forms
based on the amounts from two financial statements which are also included.

What is working capital?

Working capital is the amount of a company's current assets minus the amount of
its current liabilities. For example, if a company's balance sheet dated June 30 reports
total current assets of $323,000 and total current liabilities of $310,000 the company's working
capital on June 30 was $13,000. If another company has total current assets of $210,000 and total
current liabilities of $60,000 its working capital is $150,000.

The adequacy of a company's working capital depends on the industry in which it competes, its
relationship with its customers and suppliers, and more. Here are some additional factors to
consider:

The types of current assets and how quickly they can be

converted to cash. If the majority of the company's current assets
are cash and cash equivalents and marketable investments, a smaller
amount of working capital may be sufficient. However, if the current
assets include slow-moving inventory items, a greater amount of working
capital will be needed.

The nature of the company's sales and how customers pay. If a

company has very consistent sales via the Internet and its customers pay
with credit cards at the time they place the order, a small amount of
working capital may be sufficient. On the other hand, a company in an
industry where the credit terms are net 60 days and its suppliers must be
paid in 30 days, the company will need a greater amount of working
capital.

The existence of an approved credit line and no borrowing. An

approved credit line and no borrowing allows a company to operate
comfortably with a small amount of working capital.

How accounting principles are applied. Some companies are

conservative in their accounting policies. For instance, they might have a
significant credit balance in their allowance for doubtful accounts and will
dispose of slow-moving inventory items. Other companies might not
provide for doubtful accounts and will keep slow-moving items in inventory
at their full cost.
In short, analyzing working capital should involve more than simply subtracting current
liabilities from current assets.

What are the limitations of the payback

period?
The payback period (which tells the number of years needed to recover the amount of cash that
was initially invested) has two limitations or drawbacks:
1.
The net incremental cash flows are usually not adjusted for the
time value of money. This means that a net incremental cash inflow of
$50,000 in the fourth year of an investment is deemed to have the same
value or purchasing power as a $50,000 cash outflow that was part of the
initial investment made four years earlier.
2.
The incremental cash flows received after the payback period
are ignored. Let's illustrate what this means by using two hypothetical
projects which are being considered as an investment:

Project #187 has a payback period of 4 years. However, the

amounts of the net incremental cash inflows are expected to decline
beginning in Year 4 and are expected to end in Year 7.

Project #188 has a payback period of 6 years. However, the

amounts of its net incremental cash inflows are positive and are
expected to grow exponentially from Year 4 through Year 15.
While Project #187's payback period is faster, Project #188 is a significantly better investment.
Hence, the limitation of using the payback period for ranking potential investments.

\What are net incremental cash flows?

Net incremental cash flows are the combination of the cash inflows and the cash
outflows occurring in the same time period, and between two alternatives. For example, a
company could use the net incremental cash flows to decide whether to invest in new, more
efficient equipment or to retain its existing equipment.
Net incremental cash flows are necessary for calculating an investment's:

net present value

internal rate of return

payback period
To illustrate net incremental cash flows let's assume that Your Corporation has the opportunity to
purchase a product line from Divesting Company for a single cash payment of $800,000. Your
Corporation expects that the product line will result in the following cash flows occurring in each
year for 10 years:

additional cash receipts or cash inflows of $900,000 (from the

collection of accounts receivable related to product sales)

additional cash payments or cash outflows of $750,000 (for payments

related to the product line's costs and expenses)
These cash flows indicate that the net incremental cash flows are expected to be a
positive $150,000 per year for 10 years, or that there will be net incremental cash
inflows of $150,000 per year for 10 years.

What is the difference between the current

ratio and the acid test ratio?
The difference between the current ratio and the acid test ratio (or quick ratio) generally involves
the current assetsinventory, prepaid expenses, and some deferred income taxes.
The current ratio uses the total amount of all of the current assets.

The acid test ratio uses only the following current assets, which are considered to be quick
assets: cash and cash equivalents, short-term marketable securities, and accounts receivable
(net of the allowance for uncollectible accounts). In other words, the acid test ratio excludes
inventory (which is a significant current asset for retailers and manufacturers) and some other
amounts such as prepaid expenses and deferred income taxes (that are classified as current
assets).
To illustrate the difference between the current ratio and the acid test ratio, let's assume that a
company has current liabilities of $50,000 and has the following current assets:

Cash and cash equivalents $5,000

Short-term marketable securities $10,000

Accounts receivable, net $25,000

Inventory $56,000

Prepaid expenses $4,000

The current ratio is 2 to 1 (or 2:1) calculated as: total current assets of $100,000 divided by
the total current liabilities of $50,000.
The acid test ratio or quick ratio is 0.8 to 1 (or 0.8:1) calculated as: quick assets of
$40,000 ($5,000 + $10,000 + $25,000) divided by the total current liabilities of $50,000.\

What is ROI?
ROI is the acronym for return on investment. Originally the objective of ROI was to
relate a return (the income statement benefit) to the amount invested (such as the
asset information from the balance sheet).
During the first half of the 20th century, ROI was helpful in monitoring the
decentralized divisions of large diverse corporations. The ROI calculation may have
divided a division's operating income by the average amount of operating assets
being utilized by the division. For instance, a division with an operating income of
$1 million that used $10 million of operating assets had an ROI of 10%.
A drawback of ROI is that the accounting amounts (revenues, expenses, asset book
values, etc.) ignore the time value of money. As a result, companies began using
discounted cash flows to better assess the profitability of its investments.
Calculations such as net present value and internal rate of return became common
and ROI was referred to as the accounting rate of return.
In the 21st century we see ROI used in the context of internet marketing and the
adoption of wellness programs at large companies. In these examples the income

statement benefits (more sales, lower health insurance expense) are related to the
amounts being spent. Here, too, the ROI calculations do not consider the time value
of money.

Why is inventory turnover important?

Inventory turnover is important because a company often has a significant amount
of money tied up in its inventory. If the items in inventory do not get sold, the
company's money will not become available to pay its employees, suppliers,
lenders, etc.
It is also possible that a company's inventory will become less in demand, perhaps
become obsolete, or even deteriorate. If that occurs some of the company's money
will be lost. Having slow-moving items in inventory also uses valuable space and
makes the warehouse less efficient.
I assume that the risk of holding inventory was the reason for the quick ratio (also
known as the acid-test ratio). In this financial ratio, inventory is excluded from the
current assets that will be compared to the company's current liabilities.
While inventory is critical for meeting customers' needs, having too much of the
wrong inventory items can result in financial problems.

What are the typical items reported as current liabilities?

Here are the typical items that are reported as current liabilities on a corporation's
balance sheet:
1. Accounts payable. These are the amounts that are due to vendors who have
supplied goods or services. The accounts payable are supported by the vendor
invoices that have been approved and processed, but have not yet been paid.
2. Deferred revenues. This reports the amounts that a customer has prepaid and will
be earned by the company within one year of the balance sheet date. An example is
a retailer's unredeemed gift cards.
3. Accrued compensation. Included in this are payroll related items such as the
amounts due to employees and the amounts to be remitted for payroll taxes.
4. Other accrued expenses or liabilities. This reports the amounts that the company
owes for items not recorded in accounts payable or accrued compensation.
Examples include the interest expense that the company has incurred (but has not

yet paid) and repairs that took place but the vendor's invoice has not been fully
processed.
5. Accrued income taxes and perhaps some deferred income taxes.
6. Short-term notes. These include the loans from banks that will become due within
one year of the balance sheet date.
7. The current portion of long-term debt. The principal payments of a mortgage loan
or an equipment loan that must be paid within one year of the date of the balance
sheet are reported in this item.
To be reported as a current liability the item must be due within one year of the
balance sheet date (unless the company's operating cycle is longer). However,
there is no requirement that the current liabilities be presented in the order in which
they will be paid. Hence, the current portion of long-term debt might be listed last,
but the principal payment might be due within several days of the balance sheet
date.

What is the interest coverage ratio?

The interest coverage ratio is a financial ratio used to measure a company's ability
to pay the interest on its debt. (The required principal payments are not included in
the calculation.) The interest coverage ratio is also known as the times interest
earned ratio.
The interest coverage ratio is computed by dividing 1) a corporation's annual
income before interest and income tax expenses, by 2) its annual interest expense.
To illustrate the interest coverage ratio, let's assume that a corporation's most
recent annual income statement reported net income after tax of $650,000; interest
expense of $150,000; and income tax expense of $100,000. Given these
assumptions, the corporation's annual income before interest and income tax
expenses is $900,000 (net income of $650,000 + interest expense of $150,000 +
income tax expense of $100,000). Since the interest expense was $150,000 the
corporation's interest coverage ratio is 6 ($900,000 divided by $150,000 of annual
interest expense).
A large interest coverage ratio indicates that a corporation will be able to pay the
interest on its debt even if its earnings were to decrease. A small interest coverage
ratio sends a caution signal.
Since the interest coverage ratio is based on the net income under the accrual

method of accounting, we recommend that you also review the cash provided by
operating activities (which is found on the corporation's statement of cash flows) for
the same time period.

What is the meaning of base year?

In accounting, base year may refer to the year in which a U.S. business had adopted
the LIFO cost flow assumption for valuing its inventory and its cost of goods sold.
Under the dollar-value LIFO technique a company's current inventory is restated
to base-year prices in order to determine whether the quantity of inventory has
increased or decreased.
Base year is also the initial year in a series of annual amounts. For instance,
an accountant might prepare a chart that displays the dollar amounts of a
company's sales, gross profit, and net income for each of the years 2010 through
2012. In addition the accountant might add a price index for each line which
expresses each line's amounts as a percentage of the 2010 amount. In this example
the base year is 2010. Assuming that the sales for the years 2010 and 2011 and
2012 were $924,000 and $942,480 and $979,440, each of these would be divided
by the $924,000 of sales in the base year 2010. The result would be the following
index: 100 (for the base year 2010) and 102 (for 2011) and 106 (for 2012).

What is a current liability?

A current liability is an obligation that is 1) due within one year of the date of a company's
balance sheet and 2) will require the use of a current asset or will create another current
liability. If a company's operating cycle is longer than one year, current liabilities are those
obligation's due within the operating cycle.
Current liabilities are usually presented in the following order:
1.
the principal portion of notes payable that will become due within one
year
2.

accounts payable

3.

the remaining current liabilities such as payroll taxes payable, income

taxes payable, interest payable and other accrued expenses
The parties who are owed the current liabilities are referred to as creditors. If the creditors
have a lien on company assets, they are known as secured creditors. The creditors without a lien
are referred to as unsecured creditors.
The amount of current liabilities is used to determine a company's working capital (current

assets minus current liabilities) and the company's current ratio (current assets divided by
current liabilities).

What is a current asset?

A current asset is cash and any other company asset that will be turning to cash
within one year from the date shown in the heading of the company's balance
sheet. (If a company has an operating cycle that is longer than one year, an asset
that will turn to cash within the length of its operating cycle is considered to be a
current asset.)
Current assets are generally listed first on a company's balance sheet and will be
presented in the order of liquidity. That means they will appear in the following
order: cash (which includes currency, checking accounts, petty cash), temporary
investments, accounts receivable, inventory, supplies, and prepaid expenses.
(Supplies and prepaid expenses will not literally be converted to cash. They are
included because they will allow the company to avoid paying cash for these items
during the upcoming year.)
It is important that the amount of each current asset not be overstated. For
example, accounts receivable, inventories, and temporary investments should have
valuation accounts so that the amounts reported will not be greater than the
amounts that will be received when the assets turn to cash. This is important
because the amount of company's working capital and its current ratio are
computed using the current assets' reported amounts.
Current assets are also referred to as short term assets.

Where should a business report cash which is restricted to purchase a long-term asset?
The cash which a business has restricted to purchase a long-term asset should be
reported on the balance sheetunder the asset heading Investments. Investments is
the first of the long-term asset headings and it is positioned immediately
after current assets.
The cash restricted for a long-term asset is not reported as part of the company's
current assets because the cash is not available to pay current liabilities. Expressed
another way, when the business restricts its cash for the purchase of a long-term
asset, the business must reduce the amount it reports as working capital (which is
current assets minus current liabilities).

What is the quick ratio?

The quick ratio is a financial ratio used to gauge a company's liquidity. The quick
ratio is also known as the acid test ratio.
The quick ratio compares the total amount of cash + marketable
securities + accounts receivable to the amount of current liabilities. If a company
has cash + marketable securities + accounts receivable with a total of $1,000,000
and the company's total amount of current liabilities is $1,200,000, its quick ratio is
0.83 to 1. ($1,000,000 divided by $1,200,000 = 0.83)
The quick ratio differs from the current ratio in that some current assets are
excluded from the quick ratio. The most significant current asset that is excluded is
inventory. The reason is that inventory might not turn to cash quickly.

What is the current ratio?

The current ratio is a financial ratio that shows the proportion of current
assets to current liabilities. The current ratio is used as an indicator of a
company's liquidity. In other words, a large amount of current assets in relationship
to a small amount of current liabilities provides some assurance that the obligations
coming due will be paid.
If a company's current assets amount to $600,000 and its current liabilities are
$200,000 the current ratio is 3:1. If the current assets are $600,000 and the current
liabilities are $500,000 the current ratio is 1.2:1. Obviously a larger current ratio is
better than a smaller ratio. Some people feel that a current ratio that is less than
1:1 indicates insolvency.
It is wise to compare a company's current ratio to that of other companies in the
same industry. You are also wise to look at the trend of the current ratio for a given
company over time. Is the current ratio improving over time, or is it deteriorating?
The composition of the current assets is also an important factor. If the current
assets are predominantly in cash, marketable securities, and collectible accounts
receivable, that is more comforting than having the majority of the current assets in
slow-moving inventory.

What is the debt to equity ratio?

The debt to equity ratio or debt-equity ratio is calculated by dividing a corporation's

total liabilities by the total amount of stockholders' equity: (Liabilities/Stockholders'
Equity):1.
A corporation with $1,200,000 of liabilities and $2,000,000 of stockholders' equity
will have a debt to equity ratio of 0.6:1. A corporation with total liabilities of
$1,200,000 and stockholders' equity of $400,000 will have a debt to equity ratio of
3:1.
Generally, the higher the ratio of debt to equity, the greater is the risk for the
corporation's creditors and its prospective creditors.

What is the acid test ratio?

The acid test ratio is similar to the current ratio except that Inventory, Supplies,
and Prepaid Expenses areexcluded. In other words, the acid test ratio compares the
total of the cash, temporary marketable securities, and accounts receivable to
the amount of current liabilities.
Let's illustrate the acid test ratio by assuming that a company has cash of $7,000 +
temporary marketable securities of $20,000 + accounts receivables of $93,000.
This adds up to $120,000 of quick assets. If its current liabilities amount to
$100,000 its acid test ratio is 1.2:1.
The larger the acid test ratio, the more easily will the company be able to meet its
current obligations.
The acid test ratio is also known as the quick ratio.

What is the contribution margin ratio?

The contribution margin ratio is the percentage of sales, service revenues or selling price
that remains after all variable costs and variable expenses have been covered. In other words, the
contribution margin ratio is the percentage of revenues that is available to cover a company's
fixed costs, fixed expenses, and profit. (The contribution margin ratio is different from
the gross margin ratio or gross profit percentage and cannot be computed directly from the
reported amounts on the company's external income statement.)
To illustrate the contribution margin ratio, we will assume that a company manufactures and sells
a single product and has the following facts:

selling price per unit of $20

fixed manufacturing costs per month of $18,000

variable manufacturing costs per unit of $4

fixed SG&A expenses per month of $12,000

variable SG&A expenses per unit of $2

fixed interest expense per month of $1,000

In this example the contribution margin per unit is $14 (the selling price of $20 minus the
variable manufacturing costs of $4 and variable SG&A expenses of $2). Hence,
the contribution margin ratio is 70% (the contribution margin per unit of $14 divided by
the selling price of $20). This contribution margin ratio tells us that 70% of the sales, revenues,
or selling price is available to cover the $31,000 of monthly fixed costs and fixed expenses. Once
the $31,000 has been covered, 70% of the revenues will flow to the company's net income.

What is the interest coverage ratio?

The interest coverage ratio is a financial ratio used to measure a company's ability
to pay the interest on its debt. (The required principal payments are not included in
the calculation.) The interest coverage ratio is also known as the times interest
earned ratio.
The interest coverage ratio is computed by dividing 1) a corporation's annual
income before interest and income tax expenses, by 2) its annual interest expense.
To illustrate the interest coverage ratio, let's assume that a corporation's most
recent annual income statement reported net income after tax of $650,000; interest
expense of $150,000; and income tax expense of $100,000. Given these
assumptions, the corporation's annual income before interest and income tax
expenses is $900,000 (net income of $650,000 + interest expense of $150,000 +
income tax expense of $100,000). Since the interest expense was $150,000 the
corporation's interest coverage ratio is 6 ($900,000 divided by $150,000 of annual
interest expense).
A large interest coverage ratio indicates that a corporation will be able to pay the
interest on its debt even if its earnings were to decrease. A small interest coverage
ratio sends a caution signal.
Since the interest coverage ratio is based on the net income under the accrual
method of accounting, we recommend that you also review the cash provided by
operating activities (which is found on the corporation's statement of cash flows) for
the same time period.

What is the debt to total assets ratio?

The debt to total assets ratio is an indicator of financial leverage. It tells you
the percentage of total assets that were financed by creditors, liabilities, debt.
The debt to total assets ratio is calculated by dividing a corporation's total liabilities
by its total assets. Let's assume that a corporation has $100 million in assets, $40
million in liabilities, and $60 million in stockholders' equity. Its debt to total assets
ratio will be 0.4 ($40 million of liabilities divided by $100 million of assets), or 0.4 to
1. In this example, the debt to total assets ratio tells you that 40% of the
corporation's assets are financed by the creditors or debt (and therefore 60% is
financed by the owners). A higher percentage indicates more leverage and more
risk.
Another ratio, the debt to equity ratio, is often used instead of the debt to total
assets ratio. The debt to equity ratio uses the same inputs but provides a different
view. Using the information above, the debt to equity ratio will be .67 to 1 ($40
million of liabilities divided by $60 million of stockholders' equity).

What is the gross margin ratio?

The gross margin ratio is also known as the gross profit margin or the gross profit
percentage.
The gross margin ratio is computed by dividing the company's gross profit dollars by
its net sales dollars.
To illustrate the gross margin ratio, let's assume that a company has net sales of
$800,000 and its cost of goods sold is $600,000. This means its gross profit is
$200,000 (net sales of $800,000 minus its cost of goods sold of $600,000) and its
gross margin ratio is 25% (gross profit of $200,000 divided by net sales of
$800,000).
A company should be continuously monitoring its gross margin ratio to be certain it
will result in a gross profit that will be sufficient to cover its selling and
administrative expenses.
Since gross margin ratios vary between industries, you should compare your
company's gross margin ratio to companies within your industry. However, you
should keep in mind that there can also be differences within your industry. For
example, your company may use LIFO while most companies in your industry
use FIFO. Perhaps your company focuses its sales efforts on smaller customers who
also require special administrative services. In that case, your company's gross
margin ratio should be larger than your industry's in order to cover the higher
selling and administrative expenses.

What is the return on assets ratio?

The return on assets ratio, or return on total assets ratio, relates a company's after
tax net income during a specific year, to the company's average total assets during
the same year.
Let's assume that a company had $60,000 of net income after tax during a recent
year. During the same 12 month period its total assets averaged $1,000,000. Its
return on assets ratio for the year was 6% ($60,000 divided by $1,000,000).
You would compare this company's return on assets to other companies in the same
industry.

What is the profit margin (after tax) ratio?

The after tax profit margin ratio tells you the profit per sales dollar after
all expenses are deducted from sales. In other words, the after tax profit margin
ratio shows you the percentage of net sales that remains after deducting thecost of
goods sold and all other expenses including income tax expense. The calculation is:
Net Income after Taxdivided by Net Sales.
The before tax profit margin ratio expresses the corporation's income before income
tax expense as a percentage of net sales.
The profit margin ratio is most useful when it is compared to 1) the same company's
profit margin ratios from earlier accounting periods, 2) the same company's
targeted or planned profit margin ratio for the current accounting period, and 3) the
profit margin ratios of other companies in the same industry during the same
accounting period.

What is the total asset turnover ratio?

The total asset turnover ratio indicates the relationship of net sales for a specified
year to the average amount of total assets during the same 12 months.
Let's assume that during a recent year a corporation had net sales of $2,100,000
and its total assets during the same 12 month period averaged $1,400,000. The
company's total asset turnover for the year was 1.5 (net sales of $2,100,000 divided
by $1,400,000 of average total assets).
This ratio will vary by industry, as some industries are more capital intensive than

others. Always compare your company's financial ratios to the ratios of other
companies in the same industry.

What is the total asset turnover ratio?

The total asset turnover ratio indicates the relationship of net sales for a specified
year to the average amount of total assets during the same 12 months.
Let's assume that during a recent year a corporation had net sales of $2,100,000
and its total assets during the same 12 month period averaged $1,400,000. The
company's total asset turnover for the year was 1.5 (net sales of $2,100,000 divided
by $1,400,000 of average total assets).
This ratio will vary by industry, as some industries are more capital intensive than
others. Always compare your company's financial ratios to the ratios of other
companies in the same industry.

What is the fixed asset turnover ratio?

The fixed asset turnover ratio shows the relationship between the annual net
sales and the net amount of fixed assets.
The net amount of fixed assets is the amount of property, plant and
equipment reported on the balance sheet after deducting the accumulated
depreciation. Ideally, you should use the average amount of net fixed assets during
the year of the net sales.
A corporation having property, plant and equipment with an average gross amount
of $10 million and an average accumulated depreciation of $4 million would have
average net fixed assets of $6 million. If its net sales were $18 million, its fixed
asset turnover would be 3 ($18 million of net sales divided by $6 million of average
net fixed assets).

What is the times interest earned ratio?

The times interest earned ratio is an indicator of a company's ability to meet the
interest payments on its debt. The times interest earned calculation is a
corporation's income before interest and income tax expense, divided by interest
expense.
To illustrate the times interest earned ratio, let's assume that a corporation's net

income after tax was $500,000; its interest expense was $200,000; and its income
tax expense was $300,000. Given these assumptions, the corporation's income
before interest and income tax expense is $1,000,000 (net income of $500,000 +
interest expense of $200,000 + income tax expense of $300,000). Since the
interest expense was $200,000, the corporation's times interest earned is 5
($1,000,000 divided by $200,000).
The higher the times interest earned ratio, the more likely it is that the corporation
will be able to meet its interest payments.
The times interest earned ratio is also referred to as the interest coverage ratio.

What is a liquidity ratio?

A liquidity ratio is an indicator of whether a company's current assets will be
sufficient to meet the company's obligations when they become due.
The liquidity ratios include the current ratio and the acid test or quick ratio. The
current ratio and quick ratio are also referred to as solvency ratios. Working
capital is an important indicator of liquidity or solvency, even though it is not
technically a ratio.
Liquidity ratios sometimes include the accounts receivable turnover ratio and the
inventory turnover ratio. These two ratios are also classified as activity ratios.

What is the working capital ratio?

Some use the term working capital ratio to mean working capital or net working
capital. Working capital is defined as current assets minus current liabilities. When
used in this manner, working capital ratio is not really a ratio. Rather, it is simply a
dollar amount.
For example, if a company has $900,000 of current assets and has $400,000 of
current liabilities, its working capital is $500,000. If a company has $900,000 of
current assets and has $900,000 of current liabilities, it has no working capital.
Other people use the term working capital ratio to mean the current ratio, which is
defined as the amount of current assets divided by the amount of current liabilities.

What is the dividend payout ratio?

The dividend payout ratio, or simply the payout ratio, is the percentage of a
corporation's earnings that is paid out in the form of cash dividends.
The calculation of the dividend payout ratio is the cash dividends per share
of common stock divided by the earnings per share of common stock.
A fast growing corporation often has a low dividend payout ratio in order to retain
and reinvest its earnings in additional income producing assets.

What is the free cash flow ratio?

The free cash flow ratio is an amount, rather than a ratio.
The free cash flow calculation often begins with the cash flow from operating
activities shown on the statement of cash flows (SCF). Next the amount of capital
expenditures, taken from the investing activities section of the SCF for the same
period, is deducted to arrive at the amount of free cash flow.
There are variations of the above calculation. For example, the dividends to
stockholders might be viewed as a requirement and will be deducted along with the
capital expenditure amount.

Break-even Point(Explanation)
Introduction to Break-even Point
A person starting a new business often asks, "At what level of sales will my company make a profit?"
Established companies that have suffered through some rough years might have a similar question.
Others ask, "At what point will I be able to draw a fair salary from my company?" Our discussion of
break-even point and break-even analysis will provide a thought process that may help to answer
those questions and to provide some insight as to how profits change as sales increase or decrease.
Frankly, predicting a precise amount of sales or profits is nearly impossible due to a company's many
products (with varying degrees of profitability), the company's many customers (with varying
demands for service), and the interaction between price, promotion and the number of units sold.
These and other factors will complicate the break-even analysis.

In spite of these real-world complexities, we will present a simple model or technique referred to by
several names: break-even point, break-even analysis, break-even formula, break-even point
formula, break-even model, cost-volume-profit (CVP) analysis, or expense-volume-profit (EVP)
analysis. The latter two names are appealing because the break-even technique can be adapted to
determine the sales needed to attain a specified amount of profits. However, we will use the terms
break-even point and break-even analysis.
To assist with our explanations, we will use a fictional company Oil Change Co. (a company that
provides oil changes for automobiles). The amounts and assumptions used in Oil Change Co. are
also fictional.
We developed some business forms to assist in the calculation of the break-even point.
You will find these helpful forms as well as exam questions pertaining to the break-even
point in AccountingCoach PRO.

Expense Behavior
At the heart of break-even point or break-even analysis is the relationship
between expenses and revenues. It is critical to know how expenses will change as sales increase
or decrease. Some expenses will increase as sales increase, whereas some expenses will not
change as sales increase or decrease.
Variable Expenses
Variable expenses increase when sales increase. They also decrease when sales decrease.
At Oil Change Co. the following items have been identified as variable expenses. Next to each item
is the variable expense per car or per oil change:

The other expenses at Oil Change Co. (rent, heat, etc.) will not increase when an additional car is
serviced.
For the reasons shown in the above list, Oil Change Co.'s variable expenses will be $9 if it services
one car, $18 if it services two cars, $90 if it services 10 cars, $900 if it services 100 cars, etc.

Fixed Expenses
Fixed expenses do not increase when sales increase. Fixed expenses do not decrease when sales
decrease. In other words, fixed expenses such as rent will not change when sales increase or
decrease.
At Oil Change Co. the following items have been identified as fixed expenses. The amount shown is
the fixed expense per week:

Mixed Expenses
Some expenses are part variable and part fixed. These are often referred to as mixed or semivariable expenses. An example would be a salesperson's compensation that is composed of a salary
portion (fixed expense) and a commission portion (variable expense). Mixed expenses could be split
into two parts. The variable portion can be listed with other variable expenses and the fixed portion
can be included with the other fixed expenses.

Revenues or Sales
Revenues (or sales) at Oil Change Co. are the amounts earned from servicing cars. Oil Change Co.
charges one flat fee of $24 for performing the oil change service. For $24 the company changes the
oil and filter, adds needed fluids, adds air to the tires, and inspects engine belts.
At the present time no other service is provided and the $24 fee is the same for all automobiles
regardless of engine size.
As the result of its pricing, if Oil Change Co. services 10 cars its revenues (or sales) are $240. If it
services 100 cars, its revenues will be $2,400.

Contribution Margin
An important term used with break-even point or break-even analysis is contribution margin. In
equation format it is defined as follows:

The contribution margin for one unit of product or one unit of service is defined as:

At Oil Change Co. the contribution margin per car (or per oil change) is computed as follows:

The contribution margin per car lets you know that after the variable expenses are covered, each
car serviced will provide or contribute $15 toward the Oil Change Co.'s fixed expenses of $2,400 per
week. After the $2,400 of weekly fixed expenses has been covered the company's profit will increase
by $15 per car serviced.

Break-even Point In Units

The break-even point in units for Oil Change Co. is the number of cars it needs to service in order to
cover the company's fixed and variable expenses. The break-even point formula is to divide the total
amount of fixed costs by the contribution margin per car:

It's always a good idea to check your calculations. The following schedule confirms that the breakeven point is 160 cars per week:

Desired Profit In Units

Let's say that the owner of Oil Change Co. needs to earn a profit of $1,200 per week rather than
merely breaking even. You can consider the owner's required profit of $1,200 per week as another
fixed expense. In other words the fixed expenses will now be $3,600 per week (the $2,400 listed
earlier plus the required $1,200 for the owner). The new point needed to earn $1,200 per week is
shown by the following break-even formula:

Always check your calculations:

The above schedule confirms that servicing 240 cars during a week will result in the required $1,200
profit for the week.

Break-even Point In Sales Dollars

One can determine the break-even point in sales dollars (instead of units) by dividing the company's
total fixed expenses by the contribution margin ratio.
The contribution margin ratio is the contribution margin divided by sales
(revenues)
The ratio can be calculated using company totals or per unit amounts. We will compute the
contribution margin ratio for the Oil Change Co. by using its per unit amounts:

The break-even point in sales dollars for Oil Change Co. is:

The break-even point of $3,840 of sales per week can be verified by referring back to the break-even
point in units. Recall there were 160 units necessary to break-even. At $24 per unit the necessary
sales in dollars would be $3,840.

Desired Profit In Sales Dollars

Let's assume a company needs to cover $2,400 of fixed expenses each week plus earn $1,200 of
profit each week. In essence the company needs to cover the equivalent of $3,600 of fixed expenses
each week.

Presently the company has annual sales of $100,000 and its variable expenses amount to $37,500
per year. These two facts result in a contribution margin ratio of 62.5%:

The amount of sales necessary to give the owner a profit of $1,200 per week is determined by this
break-even point formula:

To verify that this answer is reasonable, we prepared the following schedule:

As you can see, for the owner to have a profit of $1,200 per week or $62,400 per year, the
company's annual sales must triple. Presently the annual sales are $100,000 but the sales need to
be $299,520 per year in order for the annual profit to be $62,400.

Break-even Point(Quiz)
1.

1.
Fixed Expenses do not change in total when there is a modest change in sales.

True
False
2.

2.
An example of a fixed expense would be a 5% sales commission.
True
False

3.

3.
Property taxes and rent are often fixed expenses.
True
False

4.

4.
Variable expenses change in total as volume changes.
True
False

5.

5.
An example of a variable expense is an office manager's monthly salary.
True
False

6.

6.
A retailer's cost of goods sold is an example of a variable expense.
True
False

7.

7.
Contribution margin is defined as sales (or revenues) minus variable expenses.
True
False

8.

8.
Break-even point is the point where revenues equal the total of all expenses including
the cost of goods sold.
True
False

9.

9.
The break-even point in dollars of revenues is equal to the total of the fixed expenses
divided by the contribution margin per unit.
True
False

10.

10.
If a company requires a profit of $30,000 (instead of breaking even), the $30,000 should
be combined with the fixed expenses in order to compute the point at which the
company will earn $30,000.
True
False

11.

11.
If a company has mixed expenses, the fixed component can be combined with the
company's fixed expenses and the variable component can be combined with the
company's variable expenses.
True
False

12.

12.
Decreasing a company's fixed expenses should reduce the break-even point.
True
False

13.

13.
The contribution margin per unit is the selling price per unit minus the fixed expenses
per unit.
True
False

14.

14.
Break-even analysis is useful for companies that sell products, but it is not useful for
companies that provide services.
True
False

15.

16.

Use this information to answer questions 15 through 17:

15.
What is the company's contribution margin?
$10
$13
$14

17.

16.
What is the break-even point in units?
10,000
14,000
20,000

18.

17.
If the company wants to earn a profit of $42,000 instead of breaking even, what is the
number of units the company must sell?
14,000
18,200
26,000

19.

20.

Use this information to answer questions 18 through 20:

18.
What is the company's contribution margin ratio?
30%
70%
Cannot Be Determined

21.

19.
What is the break-even point in dollars?
$77,000
$110,000
$256,667

22.

20.
If the company wants to earn a profit of $35,000 instead of breaking even, what is the
amount of sales or revenue dollars the company must achieve?
$112,000
$145,000
$373,333

40 Q&A
What is a variable expense?

An expense is a variable expense when its total amount changes in proportion to

the change in sales, production, or some other activity.
To illustrate a variable expense, let's assume that a website business sells a product
and requires that the customer use a credit card. The credit card processor charges
the business a fee of 3% of the amount charged. Therefore, in a month when sales
are $10,000 the business will have a credit card expense of $300. If sales are
$30,000 there will be a credit card expense of $900. The total credit card expense
varies with sales because the fee has a fixed rate of 3% of sales.
Another example of a variable expense is a retailer's cost of goods sold. For
instance, if a company purchases a product for $30 and then sells it for $50, its cost
of goods sold will be a constant rate of 60%. Hence when its sales are $10,000 the
cost of goods will be $6,000. When the sales are $30,000 the cost of goods sold will
be $18,000.
Knowing how costs behave when sales or other activities change will allow you to
better understand how a company's net income will change. It also allows you to
quickly calculate a product's contribution margin and to estimate the
company's break-even point.

What is a fixed expense?

A fixed expense is an expense that will be the same total amount regardless of changes in the
amount of sales, production, or some other activity. For example, a retailer's monthly rent
expense of $2,000 is a fixed expense because it will be a total of $2,000 whether the monthly
sales are $15,000 or $30,000. We usually qualify the definition of a fixed expense by
adding: within a relevant or reasonable range of activity. In other words, if the
retailer needs to have monthly sales of $80,000 it is likely that the retailer will need to rent
additional space, thereby increasing rent expense to be more than $2,000 per month.
The following are some examples of expenses that are likely to be fixed within a reasonable
range of sales:

the compensation of the store manager who receives the same salary
and fringe benefits every month

the depreciation expense for a store's buildings, fixtures, and

equipment

the constant monthly amounts for security, maintenance fees, phones,

internet service, insurance, lighting, advertising, etc.
Knowing the amount of a company's fixed expenses assists in understanding how its net
income will change as volume changes. The total amount of fixed expenses can also be used to
quickly estimate a company's break-even point.

What is the difference between break-even point and payback period?

Break-even point is the volume of sales or services that will result in no net income
or net loss on a company's income statement. In other words, the break-even point
focuses on the revenues needed to equal exactly all of the expenses on a single
income statement prepared under the accrual method of accounting.
The break-even point in dollars of revenues can be calculated by dividing a
company's total fixed expenses by itscontribution margin ratio. The break-even
calculation assumes that the selling prices, contribution margin ratio, and fixed
expenses will not change.
Payback period is the number of years needed for a company to receive net cash
inflows that aggregate to the amount of an initial cash investment. Hence the
payback period focuses on the pertinent cash flows of multiple accounting
years instead of the net income of a single accounting period. The payback period is
often computed when evaluating potential capital expenditures. However, the
payback period is considered to be flawed because it ignores 1) the cash flows
occurring after the payback period, and 2) the time value of money.

What is the coefficient of correlation?

In simple linear regression analysis, the coefficient of correlation (or correlation
coefficient) is a statistic which indicates the relationship between the independent
variable and the dependent variable. The coefficient of correlation is represented
by r and it has a range of -1.00 to +1.00.
When the coefficient of correlation is a positive amount, such as +0.80, it means an
increase in the independent variable will result in an increase in the dependent
variable. (Also, a decrease in the independent variable will mean a decrease in the
dependent variable.) When the coefficient of correlation is negative, such as -0.80,
there is an inverse relationship. (An increase in the independent variable will mean
a decrease in the dependent variable. A decrease in the independent variable will
mean an increase in the dependent variable.)
A coefficient of correlation of +0.8 or -0.8 indicates a strong correlation between the
independent variable and the dependent variable. An r of +0.20 or -0.20 indicates
a weak correlation between the variables. When the coefficient of correlation is 0.00
there is no correlation.
When the coefficient of correlation is squared, it becomes the coefficient of
determination. This means that an rof +0.80 or -0.80 will result in a coefficient of

determination of 0.64 or 64%. (This tells you that 64% of the change in the total of
the dependent variable is associated with the change in the independent variable.)
An r of +0.20 or -0.20 indicates that only 4% (0.20 x 0.20) of the change in the
dependent variable is explained by the change in the independent variable.
It is important to realize that correlation does not guarantee that a cause-and-effect
relationship exists between the independent variable and the dependent variable.
However, a cause-and-effect relationship will mean there is correlation. It is also
important to plot the data/observations used in the regression analysis in order to
detect and review any outlier.

What is simple linear regression analysis?

Simple linear regression analysis is a statistical tool for quantifying the relationship between
just one independent variable (hence "simple") and one dependent variable based on
past experience (observations). For example, simple linear regression analysis can be used to
express how a company's electricity cost (the dependent variable) changes as the company's
production machine hours (the independent variable) change.
Fortunately there is software to compute the best fitting straight line (hence "linear") that
expresses the past relationship between the dependent and independent variable. Continuing our
example, you will enter 1) the amount of the past monthly electricity bills, and 2) the number of
machine hours occurring during the period of each of the bills. Next, the software will likely use
the least squares method to produce the formula for the best fitting line. The line will appear in
the form y = a + bx. In addition, the software will provide statistics regarding the correlation,
confidence, dispersion around the line, and more.
(In all likelihood there are many independent variables causing a change in the amount of the
dependent variable. Therefore, you should not expect that only one independent variable will
explain a high percentage of the change in the dependent variable. To increase the percentage,
you should think of the many independent variables that could cause a change in the dependent
variable. Next you should test the effect of the combination of these independent variables or
drivers by using multiple regression analysis software.)
Prior to using simple linear regression analysis it is important to follow these preliminary steps:

seek an independent variable that is likely to cause or drive the change

in the dependent variable

make certain that the past amounts for the independent variable occur
in the exact same period as the amount of the dependent variable

plot the past observations on a graph using the y-axis for the cost
(monthly electricity bill) and the x-axis for the activity (machine hours
used during the exact period of the electricity bill)
review the plotted observations for a linear pattern and for any outliers

keep in mind that there can be correlation without cause and effect

What is the contribution margin ratio?

The contribution margin ratio is the percentage of sales, service revenues or selling price
that remains after all variable costs and variable expenses have been covered. In other words, the
contribution margin ratio is the percentage of revenues that is available to cover a company's
fixed costs, fixed expenses, and profit. (The contribution margin ratio is different from
the gross margin ratio or gross profit percentage and cannot be computed directly from the
reported amounts on the company's external income statement.)
To illustrate the contribution margin ratio, we will assume that a company manufactures and sells
a single product and has the following facts:

selling price per unit of $20

fixed manufacturing costs per month of $18,000

variable manufacturing costs per unit of $4

fixed SG&A expenses per month of $12,000

variable SG&A expenses per unit of $2

fixed interest expense per month of $1,000

In this example the contribution margin per unit is $14 (the selling price of $20 minus the
variable manufacturing costs of $4 and variable SG&A expenses of $2). Hence,
the contribution margin ratio is 70% (the contribution margin per unit of $14 divided by
the selling price of $20). This contribution margin ratio tells us that 70% of the sales, revenues,
or selling price is available to cover the $31,000 of monthly fixed costs and fixed expenses. Once
the $31,000 has been covered, 70% of the revenues will flow to the company's net income.

What is sales mix?

Sales mix is the relative proportion or ratio of a business's products that are sold.
Sales mix is important because a company's products are likely to vary in their
profitability.
To illustrate sales mix, let's assume that an automobile company plans to sell
100,000 units in the current year. The planned sales mix is 20,000 units of the lowprofit models + 50,000 units of the medium-profit models + 30,000 units of the
high-profit models. In other words, the planned sales mix is 20%, 50%, 30%.
Next, lets assume that the total units actually sold amounted to 95,000 units (which
is 5,000 fewer units than planned). This could be a problem for the company

attaining its planned earnings. However, it depends on the actual sales mix. What if
the actual sales mix is 15%, 45%, 40%? This actual sales mix shows a smaller
proportion of low-profit and medium-profit units being sold and a larger proportion
of high-profit units being sold. In other words, this improved sales mix could mean
greater earnings even though 5,000 fewer units were sold.
Sales mix also applies to service businesses since the services provided are likely to
vary in their profitability.

What is the break-even point?

In accounting, the break-even point refers to the revenues needed to cover a company's total
amount of fixed and variable expenses during a specified period of time. The revenues could be
stated in dollars (or other currencies), in units, hours of services provided, etc.
The break-even calculations are based on the assumption that the change in a company's
expenses is related to the change in revenues. This assumption may not hold true for the
following reasons:

A company is likely to have many diverse products with

varying degrees of profitability.

A company may have many diverse customers with varying

demands for special attention. Hence some expenses will increase for
reasons other than the sale of additional units of product.

A company may be selling in a variety of markets. This could

result in the selling prices in one market or country being lower than the
selling prices in another market or country.

The company may see frequent fluctuations in its sales mix.

The basic calculation of the break-even point in sales dollars for a year is: fixed
expenses (fixed manufacturing, fixed SG&A, fixed interest) for the year divided by
the contribution margin ratio or percentage.
The basic calculation of the break-even point in units sold for a year is: fixed expenses
for the year divided by thecontribution margin per unit of product.
If we assume that a company's fixed expenses are $480,000 for a year, the variable expenses
(variable manufacturing, variable SG&A, variable interest) average $8 per unit of product, and
the selling prices average $20 per unit (resulting in a contribution margin of $12 or 60% of the
selling price)...

the break-even point in sales dollars is $800,000 [$480,000 divided by

60%]

the break-even point in units of product is 40,000 [$480,000 divided by

$12 per unit]

What is a fixed cost?

A fixed cost is one that does not change in total within a reasonable range of
activity. For example, the rent for a production facility is a fixed cost if the rent will
not change when there are reasonable changes in the amount of output or input.
(Of course, if there is a need to double the output the rent will change when the
company occupies additional work space.)
While a fixed cost remains constant in total, the fixed cost per unit of output or
input will change inversely with the change in the quantity of output or input. For
instance, if the rent of the production facility is fixed at $120,000 per year and there
are 30,000 machine hours of good output during the year, the rent will be $4
($120,000/30,000) per machine hour. If there are 40,000 machine hours during the
year, the rent will be $3 ($120,000/40,000) per machine hour.
Many manufacturing overhead costs are fixed and the amounts occur in large
increments. Some examples include depreciation on a company-owned factory,
depreciation on machinery and equipment, salaries and benefits of manufacturing
supervisors, factory administration costs, etc. One challenge for accountants is the
allocation or assigning of the large fixed costs to the individual units of product
(which likely vary in size and complexity). This allocation (or assigning or absorbing)
is required by the accounting and income tax rules for valuing inventories and the
cost of goods sold. If the fixed overhead is assigned using machine hours, one must
keep in mind that the cost rate per machine hour is not how the fixed costs behave
or occur. In our example, the cost of the rent might be assigned to the products at
the rate of $3 or $4 per machine hour but the rent actually occurs at the rate of
$10,000 per month.

What is contribution margin?

In accounting contribution margin is defined as revenues minus variable expenses.
In other words, the contribution margin reveals how much of a company's revenues
will be contributing (after covering the variable expenses) to the company's fixed
expenses and net income. The contribution margin can be presented as 1) the total
amount for the company, 2) the amount for each product line, 3) the amount for a
single unit of product, and 4) as a ratio or percentage of net sales.
The contribution margin of a manufacturer is the amount of net sales that is in
excess of the variablemanufacturing costs and the variable SG&A expenses. To
illustrate, let's assume that a manufacturer has a single product and 80,000 units
were produced and sold during a recent year. The selling price was $10 per unit,
variable manufacturing costs were $3 per unit, and variable SG&A expenses were

$1 per unit. The company's fixed manufacturing costs were $300,000 and its fixed
SG&A expenses were $90,000. The company's contribution margin was $480,000
($800,000 - $240,000 - $80,000). The contribution margin per unit was $6 ($10 - $3
- $1). The contribution margin ratio was 60% ($6/$10 or $480,000/$800,000).
The contribution margin is also a key component in computing a company's breakeven point.

What are semivariable costs?

Semivariable costs are costs or expenses whose behavior is partially fixed and partially variable.
Semivariable costs are also referred to as mixed costs.
A common example of a semivariable cost is the annual cost of operating a vehicle. Some of the
vehicle's operating costs will vary with the number of miles driven while other costs will be the same
in total regardless of the miles driven. For example, the vehicle's fuel costs will be variable. However,
the depreciation, insurance and licensing may be fixed. Looking only at the vehicle's maintenance
costs may indicate that some maintenance is done each November (regardless of the number of
miles driven) while other maintenance is done every 6,000 miles.
A manufacturer's electricity cost is another example of a semivariable cost. Part of the monthly
electricity bill will include 1) a fixed amount, and 2) a separate amount based on the number of
kilowatt hours of electricity actually used by the company.
The manufacturer's electricity cost is also a semivariable cost in relationship with the company's
machine hours. The portion of the electricity cost used to operate the production equipment is
variable, but the portion of the electricity cost used for lighting and air conditioning the manufacturing
facility is a fixed cost.
These simple examples illustrate that it can be difficult to understand how costs behave. There are
many factors, activities, and drivers that influence the level of costs.

What is a variable cost?

A variable cost is a constant amount per unit produced or used. Therefore,
the total amount of the variable cost will change proportionately with volume or
activity. Generally, a product's direct materials are a variable cost.

To illustrate, let's assume that a bakery uses one pound of flour at a cost of $0.70
per pound for every loaf of bread it produces. If no bread is produced the total cost
of flour is $0. If one loaf is produced the total cost of flour is $0.70. When 10 loaves
are produced the total cost of flour is $7.00. At the volume of 30 loaves the cost of
flour is $21 (30 loaves X 1 pound X $0.70 per pound).
An expense can also be a variable cost. For instance, if a company pays a 5% sales
commission on every sale, the company's sales commission expense will be a
variable cost. When the company has no sales the total sales commission expense
is $0. When sales are $100,000 the sales commission expense will be $5,000. Sales
of $200,000 will mean total sales commission expense of $10,000. Sales of
$400,000 will result in total sales commission expense of $20,000.

What does stepped cost mean?

Stepped cost refers to the behavior of the total cost of an activity at various levels
of the activity. When a stepped cost is plotted on a graph (with the total cost
represented by the y-axis and the quantity of the activity represented by the x-axis)
the lines will appear as steps or stairs rising from left to right.
To illustrate a stepped cost, let's assume that you are developing a website and find
that the monthly cost of hosting the site is based on the number of visits. For 0 to
999 visits per month, the cost is $20 per month. When the visits are in the range of
1,000 to 2,999 the monthly cost jumps to $50. If the visits are 3,000 to 9,999 the
cost will be $200 per month. For monthly visits of 10,000 to 24,999 the cost is $300,
and so on. As the data indicates, the total monthly cost is constant or fixed only for
a given range of activity (number of visits). When the number of visits exceeds the
upper limit of a range, the monthly cost jumps to a higher level and remains fixed
until the visits exceed the new upper limit.
A stepped cost is also referred to as a step cost, a step-variable cost, or a step-fixed
cost. The difference between a step-variable cost and a step-fixed cost has to do
with the width of the range of activity. If the total cost increases with small
increases in activity, it may be referred to as a step-variable cost. If the total cost
will change only with large increases in the quantity of activity, the term step-fixed
cost is more likely to be used.
Knowing how costs behave is important for decision making. For example, a
manufacturer will want to know how its costs will increase if a new product line is
added (or how costs could decrease if an existing product line is eliminated).

What is the high-low method?

The high-low method is a simple technique for computing the variable cost
rate and the total amount of fixed coststhat are part of mixed costs. Mixed costs
are costs that are partially variable and partially fixed. The cost of electricity used in
a factory is likely to be a mixed cost since some of the electricity will vary with the
number of machine hours, while some of the cost will not vary with machine hours.
Perhaps this second part of the electricity cost is associated with circulating and
chilling the air in the factory and from the public utility billing its large customers
with a significant fixed monthly charge not directly tied to the kilowatt hours of
electricity used.
The high-low method uses two sets of numbers: 1) the total dollars of the mixed
costs occurring at the highest volume of activity, and 2) the total dollars of the
mixed costs occurring at the lowest volume of activity. It is assumed that at both
points of activity the total amount of fixed costs is the same. Therefore, the change
in the total costs is assumed to be the variable cost rate times the change in the
number of units of activity. Prior to using the high-low method, it is important to plot
or graph all of the data available to be certain that the two sets of numbers being
used are indeed representative.
To illustrate the high-low method, let's assume that a company had total costs of
electricity of $18,000 in the month when its highest activity was 120,000 machine
hours. (Be sure to match the dates of the machine hours to the electric meter
reading dates.) During the month of its lowest activity there were 100,000 machine
hours and the total cost of electricity was $16,000. This means that the total
monthly cost of electricity changed by $2,000 when the number of machine hours
changed by 20,000. This indicates that the variable cost rate was $0.10 per
machine hour.
Continuing with this example, if the total electricity cost was $18,000 when there
were 120,000 machine hours, the variable portion is assumed to have been $12,000
(120,000 machine hours times $0.10). Since the total electricity cost was $18,000
and the variable cost was calculated to be $12,000, the fixed cost of electricity for
the month must have been the $6,000. If we use the lowest level of activity, the
total cost of $16,000 would include $10,000 of variable cost (100,000 machine
hours times $0.10) with the remainder of $6,000 being the fixed cost for the month.

What is cost accounting?

Cost accounting involves the techniques for:
1.

determining the costs of products, processes, projects, etc. in order to

report the correct amounts on the financial statements, and

2.

assisting management in making decisions and in the planning and

control of an organization.

For example, cost accounting is used to compute the unit cost of a manufacturer's products in
order to report the cost of inventory on its balance sheet and the cost of goods sold on its
income statement. This is achieved with techniques such as the allocation of manufacturing
overhead costs and through the use of process costing, operations costing, and job-order
costing systems.
Cost accounting assists management by providing analysis of cost behavior, cost-volume-profit
relationships, operational and capital budgeting, standard costing, variance analyses for costs
and revenues, transfer pricing, activity-based costing, and more.
Cost accounting had its roots in manufacturing businesses, but today it extends to service
businesses. For example, a bank will use cost accounting to determine the cost of processing a
customer's check and/or a deposit. This in turn may provide management with guidance in the
pricing of these services.

What is cost behavior?

Cost behavior is associated with learning how costs change when there is a change
in an organization's level of activity. The costs which vary proportionately with the
changes in the level of activity are referred to as variable costs. The costs that are
unaffected by changes in the level of activity are classified as fixed costs.
Cost behavior is not required for external reporting under U.S. GAAP. However, the
understanding of cost behavior is very important for management's efforts to plan
and control its organization's costs. Budgets and variance reports are more effective
when they reflect cost behavior patterns.
The understanding of cost behavior is also necessary for calculating a
company's break-even point and for any other cost-volume-profit analysis.

What is elastic demand?

Elastic demand means that demand for a product is sensitive to price changes. For
example, if the selling price of a product is increased, there will be fewer units sold.
If the selling price of a product decreases, there will be an increase in the number of
units sold. Elastic demand is also referred to as the price elasticity of demand.
The term inelastic demand means that the demand for a product is not sensitive to

price changes.
Elastic demand is a major concern for a manufacturer that attempts to set product
prices based on costs. For instance, if the manufacturer's production and sales have
declined and it fails to cut fixed costs, the manufacturer could be worse off by
increasing selling prices.
Use the search box on AccountingCoach.com for our Q&A on death spiral which is
pertinent to elastic demand.

What are the methods for separating mixed

costs into fixed and variable?
I know of three methods for separating mixed costs into their fixed and variable
cost components:
1.
Prepare a scattergraph by plotting points onto a graph.
2.
3.

High-low method.
Regression analysis.

It is wise to prepare the scattergraph even if you use the high-low method or regression analysis.
The benefit of the scattergraph is that it allows you to see if some of the plotted points are simply
out of line. These points are referred to as outliers and will need to be reviewed and possibly
adjusted or eliminated. In other words, you don't want incorrect data to distort your calculations
under any of the three methods.
Let's assume that a company uses only one type of equipment and it wants to know how much of
the monthly electricity bill is a constant amount and how much the electricity bill will increase
when its equipment runs for an additional hour. The scattergraph's vertical or y-axis will indicate
the dollars of total monthly electricity cost. Its horizontal or x-axis will indicate the number of
equipment hours. For each monthly electricity bill, a point will be entered on the graph at the
intersection of the dollar amount of the total electricity bill and the equipment hours occurring
between the meter reading dates shown on the electricity bill. If you plot this information for the
most recent 12 months, you may see some type of pattern, such as a line that rises as the number
of equipment hours increase.
If you draw a line through the plotted points and extend the line through the y-axis, the amount
where the line crosses the y-axis is the approximate amount of fixed costs for each month. The
slope of the line indicates the variable cost per equipment hour. The slope or variable rate is the
increase in the total monthly electricity cost divided by the change in the total number of
equipment hours.

The high-low calculation is similar but it uses only two of the plotted points: the highest point
and the lowest point.
Regression analysis uses all of the monthly electricity bill amounts along with their related
number of equipment hours in order to calculate the monthly fixed cost of electricity and the
variable rate for each equipment hour. Software can be used for regression analysis and it will
also provide statistical insights.
If a scattergraph of data shows no clear pattern, you should not place much confidence in the
calculated amount of the fixed cost and variable rate regardless of the method used.

What is a learning curve?

A common learning curve shows that the cumulative average time to complete a
manual task which involves learning will decrease 20% whenever volume doubles.
This is referred to as an 80% learning curve.
Let's illustrate the 80% learning curve with a person learning to design and code
websites of similar size and complexity. If the first website takes 100 hours, then
after the second website the cumulative average time will be 80 hours (80% of 100
hours). The cumulative average of 80 hours consists of 100 hours for the first
website plus only 60 hours for the second website resulting in a total of 160 hours
divided by 2 websites. After the fourth website the cumulative average time will be
64 hours (80% of 80 hours). After the eighth website the cumulative average will be
51.2 hours (80% of 64 hours). In other words, the total time to have completed all
eight websites will be 409.6 hours (8 websites times an average time of 51.2 hours).
Improvements in technology can mean time and cost reductions beyond those in
the learning curve. For example, software may become available to assist in the
design and coding, computer processing speeds might increase, there may be lower
costs of processing and storage, etc.
The learning curve is important for setting standards, estimating costs, and
establishing selling prices.

What is the difference between a differential cost and an incremental cost?

I use the terms differential cost and incremental cost interchangeably. In other
words, I believe the terms mean the same thing: the difference in cost between two
alternatives. For example, if a company determined that the annual cost of

operating at 80,000 machine hours was $4,000,000 while the annual cost of
operating at 70,000 machine hours was $3,800,000, then the differential
cost or incremental cost of the additional 10,000 machine hours was $200,000.
The term marginal cost refers to the cost of operating for one additional machine
hour.

How do you reduce the break-even point?

Ways to reduce a company's break-even point include 1) reducing the amount
of fixed costs, 2) reducing the variable costs per unitthereby increasing the
unit's contribution margin, 3) improving the sales mix by selling a greater proportion
of the products having larger contribution margins, and 4) increasing selling prices
so long as the number of units sold will not decline significantly.

What is marginal cost?

Marginal cost is the cost of the next unit or one additional unit of volume or output.
To illustrate marginal cost let's assume that the total cost of producing 10,000 units
is $50,000. If you produce a total of 10,001 units the total cost is $50,002. That
would mean the marginal costthe cost of producing the next unitwas $2.
The reason that the marginal cost was $2 instead of the previous average cost of $5
($50,000 divided by 10,000 units) is that some costs did not increase when the
additional unit was produced. For example, fixed costs such as
salaries, depreciation, property taxes generally do not increase when one additional
unit is produced.

What is the margin of safety?

Margin of safety is used in break-even analysis to indicate the amount of sales that
are above the break-even point. In other words, the margin of safety indicates the
amount by which a company's sales could decrease before the company will
become unprofitable.

How much of the contribution margin is profit on units sold in excess of the break-even point?
After the break-even point is reached, the entire contribution margin on the next
units sold will be profit...provided the total fixed costs and expenses do not

increase.
The reason lies in the definition of contribution margin: selling price minus
the variable costs and expenses. Once the contribution margins have covered the
total amount of fixed costs and expenses, the entire contribution margin on the next
units will go to profit.

Are direct costs fixed and indirect costs variable?

Direct product costs such as raw materials are variable costs. Variable product costs
increase in total as more units of products are manufactured.
Costs that are direct to a department could be variable or fixed. For example, a
supervisor in the painting department would be a direct cost to the painting
department. Since the supervisor's salary is likely to be the same amount each
month regardless of the quantity of products manufactured, it is a fixed cost to the
department. The supplies furnished to the painting department will be a direct cost
to the department, but will be a variable cost to the department if the total amount
of supplies used in the department increases as the volume or activity in the
department increases.
An indirect product cost is the electricity used to operate a production machine. The
cost of the electricity is variablebecause the total electricity used is greater when
more products are manufactured on the machine. Depreciationon the production
machine is also an indirect product cost, except it is usually a fixed cost. That is, the
machine's total depreciation expense is the same each year regardless of volume
produced on the machine.
As you can see, costs can be direct and indirect depending on the cost object:
product, department, and others such as division, customer, geographic market.
The cost is fixed if the total amount of the cost does not change as volume changes.
If the total cost does change in proportion to the change in the activity or volume, it
is a variable cost.

What happens when the high-low method ends up with a negative amount?
The high-low method of determining the fixed and variable portions of a mixed
cost relies on only two sets of data: 1) the costs at the highest level of activity, and
2) the costs at the lowest level of activity. If either set of data is flawed, the
calculation can result in an unreasonable, negative amount of fixed cost.
To illustrate the problem, let's assume that the total cost is $1,200 when there are

100 units of product manufactured, and $6,000 when there are 400 units of product
are manufactured. The high-low method computes the variable cost rate by
dividing the change in the total costs by the change in the number of units of
manufactured. In other words, the $4,800 change in total costs is divided by
the change in units of 300 to yield the variable cost rate of $16 per unit of product.
Since the fixed costs are the total costs minus the variable costs, the fixed costs will
be calculated to a negative $400. This unacceptable answer results from total costs
of $1,200 at the low point minus the variable costs of $1,600 (100 units times
$16), or total costs of $6,000 at the high point minus the variable costs of $6,400
(400 units times $16).
The negative amount of fixed costs is not realistic and leads me to believe
that either the total costs at either the high point or at the low point are not
representative. This brings to light the importance of plotting or graphing all of the
points of activity and their related costs before using the high-low method. (The
number of units uses the scale on the x-axis and the related total cost at each level
of activity uses the scale on the y-axis.) It is possible that at the highest point of
activity the costs were out of line from the normal relationshipreferred to as an
outlier. You may decide to use the second highest level of activity, if the related
costs are more representative.
If the $6,000 of cost at the 400 units of activity is an outlier, you might select the
next highest activity of 380 units having total costs of $4,000. Now the variable rate
will be the change in total costs of $2,800 ($4,000 minus $1,200) divided by the
change in the units manufactured of 280 (380 minus 100) for a variable rate of $10
per unit of product. Using the variable rate of $10 per unit manufactured will result
in the fixed costs being a positive $200. The positive $200 of fixed costs is
calculated at either 1) the low activity: total costs of $1,200 minus the variable
costs of $1,000 (100 units at $10); or at 2) the high activity: total costs of $4,000
minus the variable costs of $3,800 (380 units at $10).

What is the difference between gross margin and contribution margin?

Gross Margin is the Gross Profit as a percentage of Net Sales. The calculation of
the Gross Profit is: Sales minus Cost of Goods Sold. The Cost of Goods Sold consists
of the fixed and variable product costs, but it excludes all of the selling and
administrative expenses.
Contribution Margin is Net Sales minus the variable product costs and
the variable period expenses. TheContribution Margin Ratio is the Contribution
Margin as a percentage of Net Sales.
Let's illustrate the difference between gross margin and contribution margin

with the following information: company had Net Sales of $600,000 during the past
year. Its inventory of goods was the same quantity at the beginning and at the end
of year. Its Cost of Goods Sold consisted of $120,000 of variable costs and $200,000
of fixed costs. Its selling and administrative expenses were $40,000 of variable and
$150,000 of fixed expenses.
The company's Gross Margin is: Net Sales of $600,000 minus its Cost of Goods Sold
of $320,000 ($120,000 + $200,000) for a Gross Profit of $280,000 ($600,000 $320,000). The Gross Margin or Gross Profit Percentage is the Gross Profit of
$280,000 divided by $600,000, or 46.7%.
The company's Contribution Margin is: Net Sales of $600,000 minus the variable
product costs of $120,000 and the variable expenses of $40,000 for a Contribution
Margin of $440,000. The Contribution Margin Ratio is 73.3% ($440,000 divided by
$600,000).

Why does the fixed cost per unit change?

Fixed costs such as rent or a supervisor's salary will not change in total within a
reasonable range of volume or activity. For example, the rent might be $2,500 per
month and the supervisor's salary might be $3,500 per month. This total fixed cost
of $6,000 per month will be the same whether the volume is 3,000 units or 4,000
units.
On the other hand, the fixed cost per unit will change as the level of volume or
activity changes. Using the amounts above, the fixed cost per unit is $2 when the
volume is 3,000 units ($6,000 divided by 3,000 units). When the volume is 4,000
units, the fixed cost per unit is $1.50 ($6,000 divided by 4,000 units).

Are insurance premiums a fixed cost?

The cost of the insurance premiums for a company's property insurance is likely to
be a fixed cost. The cost of worker compensation insurance is likely to be a variable
cost. Whether a cost is a fixed cost, a variable cost, or a mixed cost depends on the
independent variable.
Let's illustrate this by looking at the cost of property insurance. The cost of insuring
the factory building is a fixed cost when the independent variable is the number
of units produced within the factory. In other words, the factory's property insurance
might be $6,000 per year whether its output is 2 million units, 3 million units, or 5
million units. On the other hand, if the independent variable is the replacement
cost of the factory buildings, the insurance cost will be a variable cost. The reason

is the insurance cost on $12 million of factory buildings will be more than the
insurance cost on $9 million of factory buildings, and less than the insurance
premiums on $18 million of factory buildings.
In the case of worker compensation insurance, the cost will vary with the amount of
payroll dollars (excluding overtime premium) in each class of workers. For
example, if the worker comp premiums are $5 per $100 of factory labor cost, then
the worker comp premiums will be variable with respect to the dollars of factory
labor cost. If the units of output in the factory correlate with the direct labor costs,
then the worker compensation cost will also be variable with respect to the number
of units produced. On the other hand, the worker compensation cost for the office
staff is usually a much smaller rate and that worker compensation cost will not be
variable with respect to the number of units of output in the factory. However, the
worker compensation cost of the office staff will be variable with respect to the
amount of office staff salaries and wages.
As you have seen, determining which costs are fixed and which are variable can be
a bit tricky

How do we deal with a negative contribution margin ratio when calculating our break-even
point?
The negative contribution margin ratio indicates that your variable
costs and expenses exceed your sales. In other words, if you increase your sales in
the same proportion as the past, you will experience larger losses.
My recommendation is to calculate the contribution margin and contribution margin
ratio for each product (or service) that you offer. I suspect that some of your items
have positive contribution margins, but the products with negative contribution
margins are greater. You must get into the details.
You also need to look at each of your customers. Perhaps some customers are
buying in huge quantities, but those sales are not profitable. See which customers
have positive contribution margins.
By definition, the ways to eliminate the negative contribution margin are to 1) raise
selling prices, 2) reduce variable costs, or 3) do some combination of the first two. If
customers will not accept price increases in order for you to cover your variable
costs, you are probably better off not having the sales. Remember that after
covering the variable costs, those selling prices must then cover the fixed costs and
expenses. A total negative contribution margin means your loss will be larger than
the amount of the fixed costs and expenses.

When setting prices or bidding for new work, you must think of the bottom line
profits. Many people focus too much on the top linesales.

Why would the cost behavior change outside of the relevant range of activity?
Cost behavior often changes outside of the relevant range of activity due to a
change in the fixed costs. When volume increases to a certain point, more fixed
costs will have to be added. When volume shrinks significantly, some fixed costs
could be eliminated.
Here's an illustration. A company manufactures products in its 100,000 square foot
plant. The company's depreciation on the plant is $1,000,000 per year. The capacity
of the plant is 500,000 units of output and its normal output is 400,000 units per
year. When the company is manufacturing between 300,000 and 500,000 units, it
needs salaried managers earning $400,000 per year. Below 300,000 units of output,
some of the salaried manager positions would be eliminated. Above 500,000 units,
the company will need to add plant space and managers.
For this example, the relevant range is between 300,000 units and 500,000 units of
output per year. In that range the total of the two fixed costs is $1,400,000 per year.
Below 300,000 units, the fixed costs will drop to less than $1,400,000 because some
salaries will be eliminated and some of the space might be rented. When the
volume exceeds 500,000 units per year, the company will need to add fixed costs
because of the additional space and the additional managers. Perhaps the total
fixed costs will be $2,000,000 for output between 500,000 units and 700,000 units.

Is the cost of land, buildings, and machinery a fixed cost?

Some people refer to land, buildings, and machinery as fixed assets. They are also
referred to as plant assets, or as property, plant, and equipment.
The depreciation expense on the buildings and machinery is often viewed as
a fixed cost or fixed expense. Hence, in the calculation of the break-even point,
the annual depreciation expense on the fixed assets other than land is part of
the fixed costs or fixed expenses. There is no depreciation of land.

What is the difference between expense and loss?

An expense is a cost used up in earning revenues in a company's main operations.
Some examples of expenses include advertising expense, commission expense, rent

expense, cost of goods sold, salaries expense, and so on. Expenses also include
costs used up during the accounting period such as interest expense, insurance
expense, and depreciation expense.
A loss is associated with a "peripheral" or "incidental" transaction. Examples of
losses include the loss on the sale of an asset used in the business, loss from a
lawsuit settlement, and loss from retirement of bonds. However, there are some
losses that are closer to operations, such as the loss on write-down of
inventory from cost to market.
The FASB's Statement of Financial Accounting Concepts No. 6 (December 1985)
discusses expenses and losses in paragraphs 80-89. You can access this concepts
statement at no cost at www.FASB.org/st.

What increases a break-even point?

The break-even point will increase when the amount of fixed
costs and expenses increases. The break-even point will also increase when the
variable expenses increase without a corresponding increase in the selling prices.
A company with many products can see its break-even point increase when the mix
of products changes. In other words, if a greater proportion of lower contribution
margin products are sold, the break-even point will increase. (Contribution margin is
selling price minus variable expenses.)

Is contribution margin the same as operating income?

Contribution margin is different from operating income.
Contribution margin is revenues minus the variable costs and expenses. For
example, a retailer's contribution margin is sales minus the cost of goods sold and
the variable selling expenses and the variable administrative expenses and any
variable nonoperating expenses. (Perhaps some interest expense varies with sales.)
A retailer's operating income is sales minus the cost of goods sold and all selling
and administrative expenses (fixed and variable). Operating income is the net
income before the nonoperating items such as interest revenue, interest expense,
gain or loss on the sale of plant assets, etc.

What causes an increase in break-even point?

There are several reasons why a company's break-even point will increase. One
reason is an increase in the company's fixed costs, such as rent, depreciation,
salaries of managers and executives, etc.
A second reason for an increase in a company's break-even point is a reduction in
the contribution margin. Contribution margin is sales minus the variable costs and
variable expenses. An increase in the variable costs and expenses without a
corresponding increase in selling prices will cause the contribution margin to shrink.
With less contribution margin, it will take more sales in order to cover the fixed
costs and fixed expenses. Of course, a decrease in selling price will also increase
the break-even point.
Another reason for a change in the break-even point is a change in the mix of
products or services delivered. In other words, some products have higher
contribution margins, and some products have lower contribution margins. If a
company continues to sell the same total number of units of product, but a greater
proportion of the units sold have a lower contribution margin, the company's breakeven point will increase.

How do you calculate the break-even point in terms of sales?

The break-even point in sales dollars can be calculated by dividing a company's
fixed expenses by the company's contribution margin ratio.
The contribution margin is sales minus variable expenses. When the contribution
margin is expressed as a percentage of sales it is referred to as the contribution
margin ratio. (When we use the term "fixed expenses" we mean the company's total
amount of fixed costs plus its fixed expenses. When we say "variable expenses" we
mean the total of the company's variable costs plus its variable expenses.)
Let's illustrate the break-even point in sales dollars with the following information. A
company has fixed expenses of $100,000 per year. Its variable expenses are
approximately 80% of sales. This means that the contribution margin ratio is 20%.
(Sales minus the variable expenses of 80% of sales leaves a remainder of 20% of
sales. In other words, after deducting the variable expenses there remains only 20%
of every sales dollar to go towards the fixed expenses and profits. ) The fixed
expenses of $100,000 divided by the contribution margin ratio of 20% equals
$500,000. This tells you that if the company has sales of approximately $500,000 it
will be at the break-even pointthe point where sales will be equal to all of the
company's expenses.
It is wise to test your calculated break-even point. In our example the sales needed
to be $500,000. If the variable expenses are 80% of sales, the variable expenses

will be $400,000 (80% of $500,000). This leaves $100,000 as the contribution

margin in dollars. After subtracting the fixed expenses of $100,000, the net
income will be zero.

How do you reduce a company's break-even point?

The formula for a product's break-even point expressed in units is: Total Fixed
Costs divided by Contribution Margin per Unit. The contribution margin per unit
is the product's selling price minus its variable costs and expenses. Fixed costs and
fixed expenses are those which do not change as volume changes. Variable costs
and expenses increase as volume increases and they will decrease when volume
decreases.
To reduce a company's break-even point you could reduce the amount of fixed
costs. When an automobile manufacturer cuts thousands of salaried positions and
closes assembly plants that are not fully utilized, the company is reducing its fixed
costs by hundreds of millions of dollars each year. Having fewer fixed costs means
fewer car sales will be required to cover them.
You can also reduce the break-even point by increasing the contribution margin per
unit. The contribution margin will increase if there is a reduction in variable costs
and expenses per unit. For example, if a car company can obtain components at a
reduced cost, the variable costs decrease. The reduced variable costs means that
the contribution margin increased.
The contribution margin will also increase if the company is able to increase its
selling prices. (Of course the company must be careful that the increased selling
price does not cause fewer unit sales.)
Perhaps a combination of reduced fixed costs, reduced variable costs, and slight
increases in prices is possible. Some products might be redesigned to provide
unique features that customers will pay for and the additional revenue is greater
than the variable costs required to add those features.
Reality is more complicated than a simple formula because companies have more
than one product, competition may not allow for increasing selling prices, contracts
may not allow certain actions, etc.

How do you determine the fixed portion of overhead cost?

I suggest that the first step in determining the fixed portion of a mixed cost (a cost
that is partially fixed and partially variable) is to graph the data. Label the vertical

or y-axis of the graph as Total Manufacturing Overhead (or Total Electricity Cost if
you are analyzing the individual components of overhead). Label the horizontal or xaxis of the graph as total machine hours (or some other indicator of volume). Then
put a point on the graph for each of the past 12 months. If January had $100,000 of
overhead and 6,000 MHs, enter a point on the graph where those two amounts
intersect. After plotting all 12 months, you might see a pattern and/or you might see
something unusual. Investigate the unusual before proceeding. Perhaps there was
an accounting error or a very unusual situation that is not likely to recur. Once you
are confident that the data is reasonable you can proceed. (Please note that the
overhead costs need to be on an accrual basis. In other words, you need to have the
costs that occurred when the machine hours occurred. Your data will be misleading
if you relate this month's machine hours to the electricity bill that was paid this
month, if that bill is for the previous month's electricity usage. Check the meter
reading dates on the bill to be sure the dates of the electricity usage agree with the
dates of the machine hours.)
Once you eliminated any "outliers" from the graph (or scattergraph) and you are
confident that the dollar amounts are related to the activity on the x-axis, you can
proceed. One technique is the High-Low method. This method uses only two of the
points or months on your graph: the point where the MHs were the highest and the
point where the MHs were the lowest...so long as those two points are not outliers.
Let's assume that the highest number of MHs occurred in September. At that point
the MHs were 10,000 and the total overhead cost was $140,000. Let's assume that
the lowest activity occurred in January when the MHs were 6,000 and the total
overhead cost was $100,000. If the range of these MHs (6,000 to 10,000) are not
outside the range of normal activity, we know by definition that the fixed
manufacturing costs will not change in this range as the MHs change. That means
that any change in the total manufacturing costs in this range must be the change
in the variable costs. Here's the formula: Variable Cost Rate = Change in total costs
divided by the change in the MHs. In our example, Variable Cost Rate = $40,000
($140,000 minus $100,000) divided by 4,000 MHs (10,000 MHs minus 6,000 MHs)
equals $10 per MH. The total variable costs at the lowest activity = 6,000 MH times
$10 variable rate = $60,000. Since the total overhead costs were $100,000
the fixed costs must have been $40,000. At the highest level of activity, the total
variable costs = 10,000 MHs X $10 = $100,000. Since the total costs at this level
were $140,000 the fixed costs must be $40,000. So we estimate (based on just two
points) that the manufacturing overhead is $40,000 per month + $10 per MH.
A more sophisticated method for separating the fixed costs from the mixed costs
would be to use all of the points (rather than only the highest and lowest). The
technique to accomplish this is regression analysis. The use of regression analysis
not only gives you the best equation for all the points, it also generates statistics on
how much of the change in manufacturing overhead is caused by the MHs.
Undoubtedly you will find that MHs are causing only part of the change in the

overhead costs. This feedback is important if it prompts you to identify the other
variables that are causing the manufacturing overhead costs to change.
In summary, the High-Low method is an overly simplistic tool. Be careful and spend
time understanding the relationships between activities and costs. Manufacturing
processes and costs are probably driven by many activities (not just MHs) and not
all products may require the same activities.