Cost Structure
UAA - ACCT 202
Principles
of Managerial Accounting Dr. Fred
Barbee
Introduction

Cost structure is defined as the
relationship between a firm’s fixed and
variable costs.
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
2
Cost Structure
Labor-Intensive = High Variable
Costs
Cost Structure
Machine-Intensive = High Fixed
Costs
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
3
Abacus Computers


Performs computer services for other
firms:
–
Owns 2 computers
–
Employs two people
Bulk of costs are . . .
–
Rent Expense; and
–
Depreciation (S/L)
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
4
Abacus Computers
Income Statement
For Year Ended December 31, 2003
Sales
Variable Costs
Contribution Margin
$500,000
100%
100,000
20%
$400,000
80%
Fixed Costs
300,000
Net Income
$100,000
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
5
Tailor Made Company


Manufactures custom made men’s suits
–
Owns one sewing machine
–
Employs six people
Bulk of costs are . . .
–
Materials; and
–
Labor
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
6
Tailor Made Company
Income Statement
For Year Ended December 31, 2003
Sales
Variable Costs
Contribution Margin
$500,000
100%
300,000
60%
$200,000
40%
Fixed Costs
100,000
Net Income
$100,000
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
7
Abacus and Tailor Made Company
Income Statement Comparison
For Year Ended December 31, 2003

Abacus
Sales

$500
Tailor Made
Sales
$500
VC
300
VC
300
CM
$200
CM
$200
FC
100
FC
100
NI
$100
NI
$100
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
8
Abacus Computers
Income Statement
For Year Ended December 31, 2003
Sales
$500,000
Abacus Computers will increase
100%
its profits by $0.80 for each
Variable Costs
100,000
additional dollar of sales.
20%
Contribution Margin
80%
$400,000
Fixed Costs
300,000
Net Income
$100,000
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
9
Tailor Made Company
Income Statement
For Year Ended December 31, 2003
SalesTailor-Made Company will
$500,000
100%
increase its profits by $0.40 for
Variable Costs
300,000
each additional dollar of sales.
60%
Contribution Margin
40%
$200,000
Fixed Costs
100,000
Net Income
$100,000
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
10
Periods of Decreased
Activity . . .

Assuming no change in selling
prices, unit VC and FC . . .
–
Abacus Computers will reduce its profits by
$0.80 for each additional dollar of sales.
–
Tailor Made Company will reduce its profits
by $0.40 for each additional dollar of sales.
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
11
Periods of Increased
Activity . . .

Assuming no change in selling
prices, unit VC and FC . . .
–
Abacus Computers will increase its profits
by $0.80 for each additional dollar of sales.
–
Tailor Made Company will increase its
profits by $0.40 for each additional dollar of
sales.
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
12
Leverage . . .

To the scientist . . .
–
Leverage explains how one is able to
move a large object with a small
force.
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
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Operating Leverage
 Is
a measure of the extent to which
fixed costs are being used in an
organization.
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
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Financial Leverage

Financial leverage is the financing of a
portion of the firm’s assets with
securities bearing a fixed (limited) rate
of return.
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
15
Consider this . . .
Labor-Intensive Firms
%
FC:TC
Machine-Intensive
Firms
%
FC:TC
Therefore, machine-intensive firms use
more operating leverage than laborintensive firms.
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
16
Consider two firms . . .
Firm A
Labor-Intensive
Firm B
Machine-Intensive
Both increase sales by 20%.
Which one will have the larger
increase in profits?
Why?
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
17
Degree of Operating
Leverage
The DOL is the measure of how a
percentage change in sales volume at a
given level of sales activity will affect
profits.
 A measure of how sensitive net
operating income is to percentage
changes in sales.

Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
18
Degree of Operating
Leverage
 The
Formula . . .
Contribution Margin
------------------------------------ = DOL
Net Income
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
19
Abacus and Tailor Made Company
Income Statement Comparison
For Year Ended December 31, 2003

Abacus
Sales

$500
Tailor Made
Sales
$500
VC
300
VC
300
CM
$200
CM
$200
FC
100
FC
100
NI
$100
NI
$100
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
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Degree of Operating
Leverage
 For
Abacus Computers . . .
$400,000
DOL = ------------------------- = 4
$100,000
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
21
Degree of Operating
Leverage
 For
Tailor Made Company
$200,000
DOL = ------------------------- = 2
$100,000
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
22
The Change in Net
Income
Abacus Computers
$100,000 x 20% x 4 = $80,000
Tailor Made Company
$100,000 x 20% x 2 = $40,000
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
23
Observations on DOL

The DOL varies at different levels of
sales activity . . .
–
Highest near the breakeven point
–
Undefined at breakeven point
–
Lessens with increased sales volume
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
24
The Margin of Safety

Excess of budgeted (or actual) sales
over the break-even volume of sales.
The amount by which sales can drop
before losses begin to be incurred.
Margin of safety = Total sales - Break-even sales
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
25
The Margin of Safety
Exhaustion Unlimited has a break-even
point of $200,000. If actual sales are
$250,000, the margin of safety is $50,000
or 100 exercise bikes.
Break-even
sales
Actual sales
400 units
500 units
Sales
$ 200,000
$ 250,000
Less: variable expenses
120,000
150,000
Contribution margin
80,000
100,000
Less: fixed expenses
80,000
80,000
Net operating income
$
$
20,000
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
26
The Margin of Safety
The margin of safety can be expressed as
20% of sales.
($50,000 ÷ $250,000)
Break-even
sales
400 units
Sales
$ 200,000
Less: variable expenses
120,000
Contribution margin
80,000
Less: fixed expenses
80,000
Net operating income
$
Dr. Fred Barbee
Actual sales
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
ACCT202 Principles of Managerial Accounting
27
Sales Mix

Sales mix is the relative proportions in
which a company’s products are sold.

Different products have different selling
prices, cost structures, and contribution
margins.
Dr. Fred Barbee
ACCT202 Principles of Managerial Accounting
28
Multi-product break-even
analysis
Wind Bicycle Co. provides the following
information:
Bikes
250,000 100%
150,000
60%
100,000
40%
Carts
$ 300,000
135,000
$ 165,000
250,000
$
Sales
$
Var. exp.
Contrib. margin $
Fixed exp.
Net operating income
Sales mix
Dr. Fred Barbee
$
45%
300,000
100%
45%
55%
55%
Total
$ 550,000
285,000
265,000
170,000
$ 95,000
$ 550,000
100.0%
51.8%
48.2%
100.0%
$265,000
= 48.2% (rounded)
$550,000
ACCT202 Principles of Managerial Accounting
29
Multi-product break-even
analysis
Fixed expenses
Break-even sales =
CM Ratio
$170,000
=
0.482
= $352,697
Bikes
Carts
Sales
$ 158,714 100% $ 193,983
Var. exp.
95,228
60%
87,293
Contrib. margin $ 63,485
40% $ 106,691
Fixed exp.
Rounding error
Net operating income
Dr. Fred Barbee
Sales mix
100%
45%
55%
Total
$ 352,697
182,521
170,176
170,000
$
176
ACCT202 Principles of Managerial Accounting
$ 158,714
45%
$ 193,983
55%
$ 352,697
100.0%
51.8%
48.2%
30
100.0%