Chapter
Eleven
Cost Behavior,
Operating
Leverage, and
Profitability
Analysis
© 2015 McGraw-Hill Education.
LO 1
LO 9
Identify and describe
fixed, variable, and
mixed cost behavior.
11-2
Fixed Cost Behavior
When activity . . . .
Increases
Decreases
Total Fixed Cost
Remains constant
Remains Constant
Fixed Cost Per Unit
Decreases
Increases
Consider the following
concert example where the
band will be paid $48,000
regardless of the
number of tickets sold.
11-3
Fixed Cost Behavior
Tickets sold
2,700
3,000
3,300
Total cost of band
$ 48,000
$ 48,000
$ 48,000
Per ticket cost of band
$
$
$
17.78
16.00
14.55
$48,000 ÷ 3,000 Tickets = $16.00 per Ticket
11-4
LO 2
LO 9
Demonstrate the
effects of operating
leverage on
profitability.
11-5
Operating Leverage
A measure of the extent to which fixed
costs are being used in an organization.
Operating leverage is greatest in companies
that have a high proportion of fixed costs in
relation to variable costs.
Small
percentage
change in
revenue
Large
percentage
change in
profits
Fixed Costs
Consider the following
concert example where
all costs are fixed.
11-6
Operating Leverage
10% Revenue
Increase
When all costs are fixed, every
additional sales dollar contributes
one dollar to gross profit.
90% Gross
Profit Increase
11-7
Risk and Reward Assessment
10% Revenue
Increase
Shifting the cost structure from fixed to
variable not only reduces risk but also
the potential for profits.
10% Gross
Profit Increase
11-8
Risk and Reward Assessment
Risk refers to the possibility that
sacrifices may exceed benefits.
Risk may be reduced by
converting fixed costs
into variable costs.
Let’s see what happens to the concert
example if the band receives $16 per
ticket sold instead of a fixed $48,000.
11-9
Variable Cost Behavior
The total variable cost increases in direct
proportion to the number of tickets sold.
Variable unit cost per ticket remains at
$16 regardless of the number of tickets sold.
11-10
Variable Cost Behavior
Total variable cost
increases in
direct proportion
to the number of
units sold.
The behavior of
variable cost per
unit is contradictory
to the word variable,
because variable
cost per unit remains
constant regardless
of how many units
are sold.
11-11
Variable Cost Behavior
When activity . . .
Increases
Decreases
Total Variable
Cost
Increases
Proportionately
Decreases
Proportionately
Variable Cost
Per Unit
Remains Constant
Remains Constant
Consider the concert example
where a band receives $16 for
each ticket sold. The more sold
will increase the band’s take from
the concert, but they can only
receive a constant $16 from
each individual ticket sold.
11-12
LO 3
LO 9
Prepare an income
statement using the
contribution margin
approach.
11-13
An Income Statement under the
Contribution Margin Approach
11-14
LO 4
LO 9
Calculate the
magnitude of
operating leverage.
11-15
Measuring Operating Leverage
Using Contribution Margin
Operating
Leverage
Contribution margin
=
Net income
Show me
an example.
11-16
Measuring Operating Leverage
Using Contribution Margin
Bragg
$140
=
Operating $20 =
Leverage
7
Biltmore
Operating =
Leverage
$80
$20 =
4
For Biltmore, this means that a 10 % increase in sales
results in a 40 % increase in net income (or 10% x 4).
11-17
Operating Leverage
Operating leverage itself is neither good nor bad; it
represents a strategy that can work to a company’s
advantage or disadvantage, depending on how it is used.
Shifting the cost structure from fixed to
variable reduces not only the level of risk
but also the potential for profits.
11-18
Effect of Cost Structure
on Profit Stability
Level of
Fixed Cost
Earnings
Volatility
High
High
Low
Low
Fixed
Costs
Variable
Costs
11-19
Cost Behavior Summarized
11-20
Mixed, or Semivariable, Costs
Mixed costs ( or semivariable costs) include
both fixed and variable components.
For example, Star Productions, Inc., has to pay a
janitorial company a base fee of $1,000 plus
$20 per hour required to do each cleanup job.
The $1,000 base fee is fixed. The $20 per hour is
variable. If 60 hours are required to accomplish a
cleanup, the total mixed cost is:
$1,000 + ($20 x 60 hours) = $2,200
11-21
The Relevant Range
Example: Office space
is available at a fixed
rental rate of $30,000
per year in increments
of 1,000 square feet.
As the business grows
more space is rented,
increasing the total
cost.
Continue
11-22
Rent Cost in
Thousands of Dollars
The Relevant Range
$90
$60
Relevant
Range
$30
0
0
1,000
Total fixed cost
remains constant for
a range of activity,
and then jumps to a
new higher cost for
the next higher range
of activity.
2,000
3,000
Rented Area (Square Feet)
11-23
Total Cost
The Relevant Range
Our variable cost
assumption
(constant unit
variable cost)
applies within the
relevant range.
Relevant
Range
Possible Variable
Cost Behavior
Our Variable
Cost Assumption
Activity
11-24
Context Sensitive Definitions of
Fixed and Variable
Recall the earlier concert example, where the band was
paid $48,000 regardless of the number of tickets sold.
The cost of the band is fixed relative to the
number of tickets sold for a specific concert.
The cost of the band is variable relative
to the number of concerts produced.
11-25
LO 5
LO 9
Determine the sales
volume necessary to
break even or to
earn a desired profit.
11-26
Determining the Break-Even Point
Bright Day Distributors sells one product called Delatine,
a nonprescription herb mixture. The company plans to
sell the product for $36. Delatine costs $24 per bottle.
The company’s first concern is whether it can sell at
least enough bottles of Delatine to cover its fixed
costs!
The break-even point can be
calculated using the equation
method, the contribution
margin per unit method, or the
contribution margin ratio
method.
11-27
The Equation Method
At the break-even point:
Sales = Variable cost + Fixed cost
We can look at the above equation like this:
Selling price per unit
×
Number of units sold
=
Variable cost per unit
×
Number of units sold
+
Fixed cost
11-28
Determining the Break-Even
Point Using the Equation Method
The break-even point is the point where total revenue
equals total costs (both variable and fixed). For Bright
Day, the cost of advertising is estimated to be $60,000.
Advertising costs are the fixed costs of the company. We
use the following formula to determine the break-even
point in units.
The equation method begins by expressing the income statement
as follows. At the break-even point, profit is equal to zero.
Sales – Total variable cost – Total fixed cost = Profit
$36N - $24N - $60,000 = 0
$12N = $60,000
N = $60,000/$12 = 5,000 Units
11-29
Determining the Contribution
Margin per Unit
The contribution margin per bottle of Delatine is:
Sales revenue per bottle
Variable cost per bottle
Contribution margin per bottle
Break-even
volume in units
=
=
$ 36
24
$ 12
Fixed costs
Contribution margin per unit
$60,000
$12 = 5,000 units
11-30
Determining the Break-even Point
The break-even sales volume expressed in dollars
can also be determined by dividing the fixed cost by
the contribution margin ratio (which is contribution
margin divided by sales) computed using either total
or per unit figures.
Contribution margin ratio = Contribution margin ÷ Sales
Break-even
=
volume in dollars
=
$60,000
=
$60,000 / $180,000
Fixed costs
Contribution margin ratio
$60,000
.33333
= $180,000
11-31
Determining the Break-even Point
For Delatine,
the breakeven point in
sales dollars is
$180,000
(5,000 bottles
× $36 selling
price).
11-32
LO 6
LO 9
Calculate and
interpret the margin
of safety measure.
11-33
Calculating the Margin of Safety
Recall that Bright Day must sell 4,375 bottles of Delatine
to earn the desired profit. In dollars, budgeted sales are
$122,500 (4,375 x $28 per bottle).
The margin of safety measures the cushion
between budgeted sales and the break-even
point. It quantifies the amount by which actual
sales can fall short of expectations before the
company will begin to incur losses.
Break-even unit sales assuming no profit would be:
Break-even
=
volume (units)
$30,000 = 1,875 units
$16
11-34
Calculating the Margin of Safety
Budgeted sales
Break-even sales
Margin of safety
In Units
4,375
(1,875)
2,500
In Dollars
$ 122,500
(52,500)
$ 70,000
Margin of
Budgeted sales – Break-even sales
=
safety
Budgeted sales
Margin of
=
safety
$122,500 – $52,500
$122,500
= 57.14%
11-35
Management considers a new product, Delatine
that has a sales price of $36 and variable costs
of $24 per bottle. Fixed costs are $60,000. Breakeven is 5,000 units.
Management wants to earn a $40,000 profit on
Delatine. The sales volume to achieve this
profit level is 8,334 bottles sold.
Marketing advocates a target price of $28 per
bottle. The sales volume required to earn a
$40,000 profit increases to 25,000 bottles.
11-36
Target costing is employed to reengineer the
product and reduces variable cost per unit to
$12. To earn the desired profit of $40,000, sales
volume decreases to 6,250 units.
Target costing is applied and fixed costs are
reduced to $30,000. The sales volume to earn
the desired $40,000 profit is 4,375 units.
In view of the 57.14% margin of safety,
management decides to add Delatine to its
product line.
11-37
End of Chapter Eleven
11-38