Fundamental Managerial Accounting Concepts Thomas P. Edmonds Bor-Yi Tsay Philip R. Olds Copyright ©...

Fundamental Managerial Accounting ConceptsThomas P. Edmonds

Bor-Yi Tsay

Philip R. Olds

Copyright © Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinMcGraw-Hill/Irwin

Fifth Edition

©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin

Chapter Two

Cost Behavior, Operating Leverage, and Profitability Analysis

Cost Behavior Summarized Your monthly basic telephone bill is

probably fixed and does not change when you make more local calls.

Number of Local Calls

Mon

thly

Basic

Tele

ph

on

e B

ill

Total Fixed Cost

Number of Local Calls

Mon

thly

Basic

Tele

ph

on

e B

ill p

er

Local C

all

The fixed cost per local call decreasesas more local calls are made.

Cost Behavior Summarized

Your total long distance telephone bill is based on how many minutes you talk.

Minutes Talked

Tota

l Lon

g

Dis

tan

ce

Tele

ph

on

e B

ill

Cost Behavior Summarized

Tota

l Var

iabl

e Cos

t

Minutes Talked

Per

Min

ute

Tele

ph

on

e C

harg

e

The cost per minute talked is constant.For example, 10 cents per minute.

Cost Behavior Summarized

Variable Cost Per Unit

Fixed Cost Behavior

Increases Decreases

Total Fixed Cost Remains constant Remains Constant

Fixed Cost Per Unit Decreases Increases

Consider the followingconcert example where theband will be paid $48,000

regardless of the number of tickets sold.

When activity . . . .

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$

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

Operating Leverage A measure of the extent to which fixed

costs are being used in an organization.

Operating leverage is greatest in companies that have a high proportion of fixed costs in relation to variable costs.

A measure of the extent to which fixedcosts 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.

Consider the followingconcert example where

all costs are fixed.

Fixed Costs

Smallpercentagechange inrevenue

Largepercentagechange in

profits

Operating Leverage

When all costs are fixed, every additional sales dollar

contributes one dollar to gross profit.

When all costs are fixed, every additional sales dollar

contributes one dollar to gross profit.

10% RevenueIncrease

90% GrossProfit Increase

Risk and Reward Assessment

Risk refers to the possibility thatsacrifices may exceed benefits.

Risk may be reduced byconverting fixed costs

into variable costs.

Let’s see what happens to the concert example if the band receives $16 per

ticket instead of $48,000.

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.

Risk and Reward Assessment

Variable Cost Behavior

Increases Decreases

Total Variable Cost

Increases Proportionately

Decreases Proportionately

Variable Cost Per Unit

Remains Constant Remains Constant

When activity . . .

Shifting the cost structure from fixed to variable not only reduces

risk but also the potential for profits.

Shifting the cost structure from fixed to variable not only reduces

risk but also the potential for profits.

Risk and RewardAssessment

10% RevenueIncrease

10% GrossProfit Increase

Relationship Between CostBehavior and Revenue

Fixed Cost Structure

Fixed CostProfit

Loss

Revenue$

Activity

Relationship Between CostBehavior and Revenue

Variable Cost Structure

Variable Cost

Revenue

Profit

$

Activity

The Effect of Cost Structureon Profit Stability

VariableCosts

FixedCosts

Do companieswith higher levels of

fixed costs experiencemore earnings

volatility?

The Effect of Cost Structureon Profit Stability

Now let’s see what happens whenthe number of units sold increases.

The Effect of Cost Structureon Profit Stability

The income increase is greaterin the All Fixed Company.

The Effect of Cost Structureon Profit Stability

VariableCosts

FixedCosts

If sales decrease,will the income

decrease be greaterin the All Fixed

Company?

The Effect of Cost Structureon Profit Stability

Yes, the income decrease is greaterin the All Fixed Company.

The Effect of Cost Structureon Profit Stability

VariableCosts

FixedCosts

Level of Fixed Cost

Earnings Volatility

High High

Low Low

Is it Variable, Fixed or Mixed Cost?

2010 2011

Units 500 1200

Cost $ 2,200 5280

Examine the “Percent of Change” of Units and Costs:

500 -1,200 = 700= 140%500 500

2,200 -5,280 = 3,080 = 140%

2,200 2,200

An Income Statement under the Contribution Margin Approach

Total Unit

Sales Revenue 100,000$ 50$

Less: Variable Costs 60,000 30

Contribution Margin 40,000$ 20$

Less: Fixed Costs 30,000

Net Income 10,000$

The contribution margin format emphasizes cost behavior. Contribution margin covers

fixed costsand provides for income.

Contribution margin

Net income

Operating

Leverage=

Show mean example.

Measuring Operating Leverage Using Contribution Margin

$20,000

$5,000

Operating

Leverage= = 4

A measure of how a percentagechange in sales will effect profits.

Measuring Operating Leverage Using Contribution Margin

A 10 percent increase in sales results in a 40 percent increase in net income.

(10% × 4 = 40 %)

Measuring Operating Leverage Using Contribution Margin

Consider the following two companies:

What happens if each company cuts the service revenueto $7 per hour in order to double the amount of business?

Using Fixed Cost to Provide a Competitive Operating Advantage

Advantage to MaHall, the all fixed company.

Using Fixed Cost to Provide a Competitive Operating Advantage

What happens if the price is cutto $7 per hour and the demandremains at 2,000 hours for each

company?

Using Fixed Cost to Provide a Competitive Operating Advantage

Both companies incur losses.

Using Fixed Cost to Provide a Competitive Operating Advantage

I suppose fixed costs arebetter if volume is increasing,

but variable costs may be betterif business is declining.

Using Fixed Cost to Provide a Competitive Operating Advantage

Total Cost Cost Per Unit

Fixed CostsRemains Constant

Changes Inversely

Variable CostsChanges in

Direct ProportionRemains Constant

Cost Behavior Summarized

When activity level changes . . .

Context Sensitive Definitions of Fixed and Variable

Recall the earlier concert example, where the band waspaid $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 relativeto the number of concerts produced.

Lake Resorts provides water-skiing lessons for itsguests with the following costs:

Equipment rental $80 per dayInstructor pay $15 per hourFuel $ 2 per hour

What is the average cost per one-hour lesson for2 lessons per day? 5 lessons per day? 10 lessons

per day?

Cost Averaging

Cost Averaging

Number of Lessons 2 5 10

Cost of Equipment Rental 80$ 80$ 80$ Cost of Instruction 30 75 150 Cost of Fuel 4 10 20 Total Cost 114$ 165$ 250$

Cost Per Lesson 57$ 33$ 25$

Average costs decline as activity increases whenfixed costs such as equipment rental are involved.

Managers must use these average costs withcaution as they differ at every level of activity.

Rental Cost per Lesson:

$80 ÷ 2 Lessons = $40 per lesson

Cost Averaging

Number of Lessons 2 5 10

Cost of Equipment Rental 80$ 80$ 80$ Cost of Instruction 30 75 150 Cost of Fuel 4 10 20 Total Cost 114$ 165$ 250$

Cost Per Lesson 57$ 33$ 25$

Average costs decline as activity increases whenfixed costs such as equipment rental are involved.

Managers must use these average costs withcaution as they differ at every level of activity.

Rental Cost per Lesson:

$80 ÷ 5 Lessons = $16 per lesson

Cost Averaging

Number of Lessons 2 5 10

Cost of Equipment Rental 80$ 80$ 80$ Cost of Instruction 30 75 150 Cost of Fuel 4 10 20 Total Cost 114$ 165$ 250$

Cost Per Lesson 57$ 33$ 25$

Average costs decline as activity increases whenfixed costs such as equipment rental are involved.

Managers must use these average costs withcaution as they differ at every level of activity.

Rental Cost per Lesson:

$80 ÷ 10 Lessons = $8 per lesson

A mixed costhas both fixed and variablecomponents.

Mixed Costs

Consider thefollowing

electric utility example.

Fixed Monthly

Utility Charge

Variable

Utility

Charge

Activity (Kilowatt Hours)

Tota

l U

tility

Cost

Mixed Costs

Total mixed cost

Estimating Fixed and Variable Costs

High-Low Method

Scattergraph Method

Iris Company recorded the following production activity and maintenance costs

for two months:

Using these two levels of activity, compute: the variable cost per unit. the fixed cost. the total cost.

The High-Low Method

Unit variable cost = $4,000 ÷ 5,000 units = $.80 per unit Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($.80 per unit × 10,000 units) Fixed cost = $9,700 – $8,000 = $1,700 Total cost = Fixed cost + Variable cost Total cost = $1,700 + $0.80X

The High-Low Method

Plot the data points on a graph (total cost vs. activity).

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*

Activity, 1,000’s of Units Produced

X

Y

The Scattergraph Method

Draw a line through the data points with about an

equal numbers of points above and below the line.

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*

Activity, 1,000’s of Units Produced

X

Y

The Scattergraph Method

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*

Activity, 1,000’s of Units Produced

X

Y

Estimated fixed

is $10,000

Vertical distance is total cost,

approximately $16,000.

Variable cost per unit is represented by the slope of the

line.

The Scattergraph Method

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*

Activity, 1,000’s of Units Produced

X

Y

Total variable cost = Total cost – Total fixed costTotal variable cost = $16,000 – $10,000 = $6,000Unit variable cost = $6,000 ÷ 3,000 units = $2

The Scattergraph Method

Estimated fixed

is $10,000

Vertical distance is total cost,

approximately $16,000.

Regression Method of Cost Estimation

A method used to analyze mixed costs if a scattergraph plot reveals an approximately linear

relationship between the X and Y variables.

This method uses This method uses allall of the of thedata points to estimatedata points to estimatethe fixed and variablethe fixed and variablecost components of acost components of a

mixed cost.mixed cost.

This method uses This method uses allall of the of thedata points to estimatedata points to estimatethe fixed and variablethe fixed and variablecost components of acost components of a

mixed cost.mixed cost.The goal of this method isThe goal of this method isto fit a straight line to theto fit a straight line to thedata that data that minimizes theminimizes the

sum of the squared errorssum of the squared errors..

The goal of this method isThe goal of this method isto fit a straight line to theto fit a straight line to thedata that data that minimizes theminimizes the

sum of the squared errorssum of the squared errors..

End of Chapter Two