Edmonds FMAC10 Chap02

CHAPTER 2
Cost Behavior,
Operating
Leverage, and
Profitability
Analysis
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Learning Objective 2-1
Identify and describe fixed, variable,
and mixed cost behavior.
2-2
Fixed Cost Behavior
Illustrated
Consider the following

concert example, where the
band will be paid $48,000
regardless of the
number of tickets sold.
2-3
Fixed Cost Behavior
$48,000 ÷ 3,000 tickets = $16 per ticket

2-4
Graphical Representation
of Fixed Cost Behavior
2-5
Variable Cost
The total variable cost increases in direct

proportion to the number of units sold.
Variable unit cost per ticket remains at

$16 regardless of the number of tickets sold.
2-6
Variable Cost Behavior
Explained
The behavior of
variable cost per
Total variable cost unit is contradictory
increases in to the word variable
direct proportion because variable
to the number of cost per unit remains
units sold. constant regardless
of how many units
are sold.
2-7
Variable Cost Behavior
Consider the concert example

where a band receives $16 for
each ticket sold. The more tickets
sold will increase the band’s take
from the concert, but they can
only receive a constant of $16 from
each individual ticket sold.
2-8
Graphical Representation
of Variable Cost Behavior
2-9
Fixed and Variable Cost
Behavior
2-10
Mixed Costs
Mixed costs (or semivariable costs) include
both fixed and variable components.
For example, Star Productions, Inc., pays a

janitorial company a base fee of $1,000 plus
$20 per hour 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 × 60 hours) = $2,200
2-11
Examples of Mixed Costs
2-12
The Relevant Range
The range of activity

Descriptions of cost over which the
behavior pertain to a definitions of fixed and
specified range of variable costs are valid
activity. is commonly called the
relevant range.
2-13
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. 2-14
Demonstrate the effects of operating
leverage on profitability.
2-15
Operating Leverage
Defined
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.
Consider the following

concert example where
all costs are fixed.
2-16
Effect of Operating Leverage
on Profitability
10% Revenue
Increase
90% Gross
Margin Increase
When all costs are fixed, every sales dollar contributes one
dollar toward the potential profitability of a project.
2-17
Calculating Percentage
Change
(Alternative measure − Base measure) ÷
Base measure = % change
($11,400 − $6,000) ÷ $6,000 = 90%
2-18
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.
2-19
Variable Cost Risk and
Reward Assessment
10% Revenue
Increase
10% Gross
Shifting the cost structure from fixed Margin Increase
to variable not only reduces risk but
also the potential for profits.
2-20
Profit Stability Illustrated
Part One
Now let’s see what happens when

the number of units sold increases. 2-21
Part Two
 Company A has
highest level of
fixed costs.
 Company B has
a 50/50
combination of
fixed and
variable costs.
 Company C has
lowest level of
fixed costs.
The increase in income is greatest
in Company A.
2-22
Part Three
The decrease in income is

greatest in Company A.
2-23
Effect of Cost Structure on
Profit Stability
Level of Fixed Earnings

Cost Volatility
High High
Low Low
2-24
Prepare an income statement using
the contribution margin approach.
2-25
An Income Statement under the
Contribution Margin Approach
2-26
Comparative Profitability
at 2,000 Hours of Tutoring
2-27
Profitability at 4,000 Hours
of Tutoring
2-28
Comparative Profitability
with Price Match
2-29
Calculate the magnitude of operating
leverage.
2-30
Magnitude of Operating
Leverage
Magnitude of
Contribution margin
Operating =
Net income
Leverage
The magnitude of operating leverage is a measure, at

any given level of sales, of how a percentage change in
sales volume will affect profits.
2-31
Leverage Computation
Bragg Company:
Magnitude of
operating leverage = 7
Biltmore Company:
Magnitude of
operating leverage = 4
2-32
Leverage Analysis
Bragg is more highly leveraged than
Biltmore.
• Bragg’s change in profitability will be
seven times greater than a given
percentage change in revenue.
• Biltmore’s profits change by only four
times the percentage change in revenue.
2-33
Leverage Comparison
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.
2-34
Select an appropriate time period for
calculating the average cost per unit.
2-35
Cost Averaging Example
Lake Resorts, Inc. (LRI) provides water skiing
lessons for its guests with the following costs:
Equipment rental $80 per day

Instructor pay $15 per hour
Fuel $ 2 per hour
LRI can provide up to 20 lessons per day.
What is the average cost per one-hour lesson for two

lessons per day? Ten lessons per day? Twenty lessons
per day?
2-36
Analysis of Total and Unit
Cost Using Daily Averages
Average costs decline as activity increases when

fixed costs such as equipment rental are involved.
Managers must use these average costs with
caution, as they differ at every level of activity.
2-37
Analysis of Total and Unit
Cost Using Weekly Average
Assume LRI uses the weekly average instead of a daily
average. Further, assume that the costs for the week
include the following:
2-38
Use the high-low method,
scattergraphs, and regression analysis
to estimate fixed and variable costs.
2-39
High-Low Method
Step 1 Assemble sales volume and cost history.
Step 2 Select the high and low points in the

data set.
Step 3 Determine the estimated variable cost

per unit.
Step 4 Determine the estimated total fixed

cost.
2-40
High-Low Method Data
2-41
High-Low Method
Example Part One
Variable cost per unit = Difference in

total cost ÷ difference in volume
($540,000 – $180,000) ÷ (34,000 –

10,000) = $360,000 ÷ 24,000 = $15
2-42
High-Low Method
Example Part Two
The total fixed cost can now be determined
by subtracting the variable cost from the
total cost using either the high or low points.
Fixed cost + Variable cost = Total cost

Fixed cost = Total cost – Variable cost
Fixed cost = $540,000 – ($15 × 34,000)
Fixed cost = $30,000
2-43
Scattergraph for High-Low
Method
Plot the data points on a graph
(total cost versus activity).
Draw a line through the high

and low points in the data set.
Scattergraphs are sometimes used as an estimation

technique for dividing total cost into fixed and
variable cost components.
2-44
Scattergraph Method of Estimating
Fixed and Variable Costs
Variable cost per unit is

represented by the slope of
the line.
The fixed cost is the

intercept
2-45
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 all the

The goal of this method is
data points to estimate
to fit a straight line to the
the fixed and variable
data that minimizes the
cost components of a
sum of the squared errors.
mixed cost.
2-46
Using Excel for Regression
Follow these steps in Excel to
perform regression
analysis:
1. Enter the data in
spreadsheet columns.
2. Click the Data tab.
3. Click Data Analysis.
4. Click Regression and then
OK.
5. Define data ranges and
click Line Fit Plot. The regression function will return
6. Click OK. an estimate for fixed cost and
variable cost per unit.
2-47
The Regression Method
 Software can be used to fit a regression line
through the data points.
 The cost analysis objective is the same:
Y = a + bX
Least-squares regression also provides a statistic,

called the R2, that is a measure of the reliability of
fit of the regression line to the data points.
2-48
Multiple Regression
A statistical tool that permits analysis
of how a number of independent
variables simultaneously affect a
dependent variable.
Improves the accuracy of fixed and

variable cost estimates.
2-49

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CHAPTER 2

Consider the following

$48,000 ÷ 3,000 tickets = $16 per ticket

The total variable cost increases in direct

Variable unit cost per ticket remains at

Consider the concert example

For example, Star Productions, Inc., pays a

The range of activity

The cost of the band is fixed relative to the

The cost of the band is variable relative

Consider the following

($11,400 − $6,000) ÷ $6,000 = 90%

Risk may be reduced by

Let’s see what happens to the concert

Now let’s see what happens when

The decrease in income is

Level of Fixed Earnings

The magnitude of operating leverage is a measure, at

Operating leverage itself is neither good nor bad; it

Equipment rental $80 per day

LRI can provide up to 20 lessons per day.

What is the average cost per one-hour lesson for two

Average costs decline as activity increases when

Step 2 Select the high and low points in the

Step 3 Determine the estimated variable cost

Step 4 Determine the estimated total fixed

Variable cost per unit = Difference in

($540,000 – $180,000) ÷ (34,000 –

Fixed cost + Variable cost = Total cost

Draw a line through the high

Scattergraphs are sometimes used as an estimation

Variable cost per unit is

The fixed cost is the

This method uses all the

Least-squares regression also provides a statistic,

Improves the accuracy of fixed and

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