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# Cost Behaviour

Topic 3A

## Classify costs by behaviour and use it to answer the

following questions:

## How will my profits change if I change my selling price,

volume, or costs?

## How can the income statement be presented for better

control purposes?

Slide 2

1.

2.

Variable
Fixed
Mixed

## Use various methods to analyze cost behaviour

Scattergraph Method
High-low Method
Least Squares Regression Method

## McGraw-Hill Education (Asia)

Slide 3

Learning Objective 1

## Understand Various Types

of Cost Behaviour:
Variable, Fixed and Mixed.

Slide 4

Behavior (Recap)

Cost

In Total

Per Unit

Variable

## Total variable cost changes

as activity level changes.

## Variable cost per unit remains

the same over wide ranges
of activity.

Fixed

## Total fixed cost remains

the same even when the
activity level changes.

## Average fixed cost per unit goes

down as activity level goes up.

Slide 5

## The Activity Base (also called a cost driver)

Activity Base:
A measure of what causes the incurrence of a variable
cost
Variable costs

Direct materials

benefits

## Number of labor hours

Delivery/Shipping cost

Slide 6

## The Linearity Assumption and the Relevant Range

A relevant range is the range of activity within which the assumptions
made about cost behaviors are reasonably valid

Total Cost

Economists
Curvilinear Cost
Function

Relevant
Range

A straight line
closely
approximates a
curvilinear
variable cost
line within the
relevant range.

Accountants Straight-Line
Approximation (constant unit
variable cost)

Activity
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Slide 7

Cost

## The amount of a true variable cost used during the

period varies in direct proportion to the activity level.
The apps download charge on a cell phone bill was
one example of a true variable cost.

Volume
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Direct material is
another example
of a cost that
behaves in a true
variable pattern.
Slide 8

Cost

## A step-variable cost is a resource that is obtainable only

in large chunks (such as maintenance workers) and
whose costs change only in response to fairly wide
changes in activity.

## E.g., A maintenance worker is

required for every 1,000 units
of production

Volume
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Slide 9

Cost

## Small changes in the level of production are not

likely to have any effect on the number of
maintenance workers employed.

Volume
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Slide 10

Cost

## Only fairly wide changes

in the activity level will
cause a change in the
number of maintenance
workers employed.

Volume
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Slide 11

## 2. Types of Fixed Costs

Committed

Discretionary

Long-term, cannot be
significantly reduced in
the short term.

## May be altered in the

short-term by current
managerial decisions

Examples

Examples

Depreciation on Buildings
and Equipment and Real
Estate Taxes

Research and
Development

Slide 12

## 2. Fixed Costs and the Relevant Range

For example, assume office space is available at
a rental rate of \$30,000 per year in increments of
1,000 square feet.
Fixed costs would increase
in a step fashion at a rate of
\$30,000 for each additional
1,000 square feet.

Slide 13

of Dollars

90
Relevant

60

Range

30
0

## The relevant range

of activity for a fixed
cost is the range of
activity over which
the graph of the
cost is flat.

1,000
2,000
3,000
Rented Area (Square Feet)
Slide 14

## How does this

step-function
pattern differ from a
step-variable cost?
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Step-variable costs
can be adjusted more
quickly as conditions
change and . . .
The width of the activity
steps is much wider for
the fixed cost.
Slide 15

## Is Labor a Variable or a Fixed Cost?

The behavior of wage and salary costs can differ
across countries, depending on labor regulations,
labor contracts, and custom.
In France, Germany, China, and Japan, management has
little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.
In the United States and the United Kingdom, management
has greater latitude. Labor costs are more variable in nature.
Within countries managers can view labor costs differently
depending upon their strategy. Most companies in the
United States continue to view direct labor as a variable cost.
McGraw-Hill Education (Asia)

Slide 16

Quick Check

## Which of the following statements about

cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.
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Slide 17

3.Mixed Costs
A mixed cost (also called semi-variable cost)
contains both variable and fixed elements.
Consider the example of utility cost.
Total Utility Cost

Variable
Cost per KW

X
Activity (Kilowatt Hours)
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Fixed Monthly

Utility Charge
Slide 18

3.Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where:

Y
a

b
X

## = The total mixed cost.

= The total fixed cost (the
vertical intercept of the line).
= The variable cost per unit of
activity (the slope of the line).
= The level of activity.

Variable
Cost per KW

X
Activity (Kilowatt Hours)
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Fixed Monthly

Utility Charge
Slide 19

## 3.Mixed Costs An Example

If your fixed monthly utility charge is \$40, your
variable cost is \$0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, what is
the amount of your utility bill?

Slide 20

## Analysis of Mixed Costs

Account Analysis and the Engineering Approach
In account analysis, each account is
classified as either variable or fixed based
on the analysts knowledge of how
the account behaves.
The engineering approach classifies
costs based upon an industrial
engineers evaluation of production
methods, and material, labor and
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Slide 21

Learning Objective 2
Use Various Methods to Analyze Cost
Behavior.
1. Scattergraph Method
2. High-Low Method
3. Least-Squares Regression
Method

Slide 22

## 1. The Scattergraph Method

Plot the data points on a graph
(Total Cost Y vs. Activity X).

Maintenance Cost
1,000s of Dollars

Y
20

* *
* *

10

* ** *
**

Patient-days in 1,000s
McGraw-Hill Education (Asia)

Slide 23

## 1. The Scattergraph Method

Draw a line through the data points with about an
equal numbers of points above and below the line.

Maintenance Cost
1,000s of Dollars

Y
20

* *
* *

10

* ** *
**

Patient-days in 1,000s
McGraw-Hill Education (Asia)

Slide 24

## 1. The Scattergraph Method

Maintenance Cost
1,000s of Dollars

## Use one data point to estimate the total level of activity

and the total cost.
Y Total maintenance cost = \$11,000
20

* *
* *

10

* ** *
**

## Patient days = 800

McGraw-Hill Education (Asia)

Patient-days in 1,000s
Slide 25

## 1. The Scattergraph Method

Make a quick estimate of variable cost per unit and
determine the cost equation.
Total maintenance at 800 patients
Less: Fixed cost
Estimated total variable cost for 800 patients

## Variable cost per unit = \$1,000

800

\$ 11,000
10,000
\$ 1,000

= \$1.25/patient-day

Y = \$10,000 + \$1.25X
Total maintenance cost
McGraw-Hill Education (Asia)

Slide 26

## 2. The High-Low Method An Example

Assume the following hours of maintenance work
and the total maintenance costs for six months.

7,350

Slide 27

7,350

## The variable cost

per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
\$2,400
= \$6.00/hour
400

Slide 28

## Total Fixed Cost = \$9,800 (\$6/hour 850 hours)

Total Fixed Cost = \$9,800 \$5,100

## Total Fixed Cost = \$4,700

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Slide 29

## The Cost Equation for Maintenance

Y = \$4,700 + \$6.00X
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Slide 30

Quick Check 1
Sales salaries and commissions are \$10,000 when
80,000 units are sold, and \$14,000 when 120,000
units are sold. Using the high-low method, what is the
variable portion of sales salaries and commission?
a. \$0.08 per unit
b. \$0.10 per unit
c. \$0.12 per unit
d. \$0.125 per unit

## McGraw-Hill Education (Asia)

Slide 31

Quick Check 2
Sales salaries and commissions are \$10,000 when
80,000 units are sold, and \$14,000 when 120,000
units are sold. Using the high-low method, what is
the fixed portion of sales salaries and commissions?
a. \$ 2,000
b. \$ 4,000
c. \$10,000
d. \$12,000

Slide 32

## 3. Least-Squares Regression Method

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 of the
data points to estimate
the fixed and variable
cost components of a
mixed cost.

## The goal of this method is

to fit a straight line to the
data that minimizes the
sum of the squared errors.
Slide 33

## Software can be used to fit a

regression line through the data
points.

## The cost analysis objective is

the same: Y = a + bX

=1[( )( )

2
=1( )

; =

## Least-squares regression also provides a statistic, called

the R2, which is a measure of the goodness
of fit of the regression line to the data points.
McGraw-Hill Education (Asia)

Slide 34

Total Cost

## R2 is the percentage of the variation in the dependent

variable (total cost) that is explained by variation in the
independent variable (activity).
Y
20

* *
* *2

10

* ** *
**

## R varies from 0% to 100%, and

the higher the percentage the better.

0
0
McGraw-Hill Education (Asia)

2
3
Activity

Slide 35

## Comparing Results From the Three Methods

The three methods just discussed provide
slightly different estimates of the fixed and
variable cost components of the mixed cost.
This is to be expected because each method
uses differing amounts of the data points to
provide estimates.
Least-squares regression provides the most
accurate estimate because it uses all the data
points.
McGraw-Hill Education (Asia)

Slide 36

End of Topic 3A

## McGraw-Hill Education (Asia)

Slide 37

Cost-Volume-Profit Analysis
Topic 3B

1.

2.

## Prepare an income statement using the contribution

format
Understand cost-volume-profit (CVP) relations using
four approaches:

3.

Equation Method
Formula Method
BE Percentage Method
Graphical Method

## Understand the meaning of, and be able to deal with:

Sensitivity Analysis
Margin of Safety
Operating Leverage
Multiple Products CVP

## McGraw-Hill Education (Asia)

Slide 39

Learning Objective 1

Prepare an income
statement using the
contribution format.

Slide 40

## The Contribution Format

Sales Revenue
Less: Variable costs
Contribution margin

Total
\$ 100,000
60,000
\$ 40,000

## Less: Fixed costs

Net operating income

30,000
\$ 10,000

Unit
\$ 50
30
\$ 20

## The contribution margin format emphasizes cost

behavior. Contribution margin covers fixed costs
and provides for income.
McGraw-Hill Education (Asia)

Slide 41

## Used primarily for

external reporting.
McGraw-Hill Education (Asia)

Used primarily by
management.
Slide 42

Learning Objective 2
Understand cost-volume-profit (CVP)
relations using four approaches:
1) Equation Method
2) Formula Method
3) BE Percentage Method

4) Graphical Method

Slide 43

## Basics of Cost-Volume-Profit Analysis

The contribution income statement is helpful to managers in judging the impact
on profits of changes in selling price, cost, or volume. The emphasis is on cost
behavior.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles)
\$
250,000
Less: Variable expenses
150,000
Contribution margin
100,000
Less: Fixed expenses
80,000
Net operating income
\$
20,000

Contribution Margin (CM) is the amount remaining from sales revenue after
variable expenses have been deducted.

## CM is used first to cover fixed expenses. Any remaining CM contributes to

net operating income.
McGraw-Hill Education (Asia)

Slide 44

## Basics of Cost-Volume-Profit Analysis

Sales, variable expenses, and contribution margin can
also be expressed on a per unit basis. If Racing sells an
additional bicycle, \$200 additional CM will be generated
to cover fixed expenses and profit.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
\$
250,000
\$
500
Less: Variable expenses
150,000
300
Contribution margin
100,000
\$
200
Less: Fixed expenses
80,000
Net operating income
\$
20,000

Slide 45

## Basics of Cost-Volume-Profit Analysis

Each month, RBC must generate at least
\$80,000 in total contribution margin to break-even
(which is the level of sales at which profit is zero).
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
\$
250,000
\$
500
Less: Variable expenses
150,000
300
Contribution margin
100,000
\$
200
Less: Fixed expenses
80,000
Net operating income
\$
20,000

Slide 46

## If RBC sells 400 units in a month, it will be

operating at the break-even point.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (400 bicycles)
\$
200,000
\$
500
Less: Variable expenses
120,000
300
Contribution margin
80,000
\$
200
Less: Fixed expenses
80,000
Net operating income
\$
-

Slide 47

## Basics of Cost-Volume-Profit Analysis

If RBC sells one more bike (401 bikes), net
operating income will increase by \$200.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (401 bicycles)
\$
200,500
\$
500
Less: Variable expenses
120,300
300
Contribution margin
80,200
\$
200
Less: Fixed expenses
80,000
Net operating income
\$
200

Slide 48

## Basics of Cost-Volume-Profit Analysis

We do not need to prepare an income statement to
estimate profits at a particular sales volume. Simply
multiply the number of units sold above break-even
by the contribution margin per unit.
If Racing sells
430 bikes, its net
operating income
will be \$6,000.

Slide 49

## CVP Relationships in Equation Form

The contribution format income statement can be
expressed in the following equation:

## Profit = (Sales Variable expenses) Fixed expenses

= (SP x Q VC x Q) Fixed expenses
= (SP VC) x Q Fixed expenses
= Unit CM x Q Fixed expenses
where:
Unit CM = Selling price per unit Variable expenses per unit
= SP - VC

Slide 50

## CVP Relationships in Equation Form

To compute RBCs profit where 401 bikes are sold
using the equation method:

## McGraw-Hill Education (Asia)

Slide 51

Break-even Analysis
Assume the following information for Racing Bicycle
Company (RBC). Determine the breakeven point in:
1) unit sales; 2) dollar sales
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
\$ 250,000
\$ 500
Less: Variable expenses
150,000
300
Contribution margin
100,000
\$ 200
Less: Fixed expenses
80,000
Net operating income
\$ 20,000

Percent
100%
60%
40%

VC Ratio

CM Ratio

Slide 52

## Contribution Margin Ratio (CM Ratio)

The contribution margin ratio at Racing Bicycle is:

CM per unit
=
CM Ratio =
SP per unit

\$200
\$500

= 40%

OR

\$100,000
Total CM
= 40%
=
CM Ratio =
\$250,000
Total Sales
The relationship between profit and the CM ratio can be
expressed using the following equation:
Profit = CM ratio Sales Fixed expenses

## The CM ratio indicates the change in contribution margin

for every dollar change in sales. For e.g. if sales increase
by \$50,000, total contribution margin will increase by
\$20,000 (40% x \$50,000)
McGraw-Hill Education (Asia)

Slide 53

Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is \$1.49 and the average variable expense per
cup is \$0.36. The average fixed expense per month is
\$1,300. 2,100 cups are sold each month on average.
What is the CM Ratio for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139

Slide 54

## Break-even in Unit Sales:

1. Equation Method

## Profits = Unit CM Q Fixed expenses

Profits are zero at the break-even point, hence

Slide 55

## Break-even in Unit Sales:

2. Formula Method

## Lets apply the formula method to solve for

the break-even point.
Unit sales to
=
break even

Fixed expenses
CM per unit

Slide 56

## Break-even in Dollar Sales:

1. Equation Method
Profit = CM ratio Sales Fixed expenses

Slide 57

## Break-even in Dollar Sales:

2. Formula Method
Now, lets use the formula method to calculate the
dollar sales at the break-even point.
Dollar sales to
Fixed expenses
=
break even
CM ratio

## McGraw-Hill Education (Asia)

Slide 58

Break-even:
3. The BE Percentage Method
Now, lets use the 3rd method: the break-even percentage
(BE%) method to calculate the break-even point in units as
well as in sales \$. This method also efficiently calculates
break-even for multiple products.
BE% =

Since BE Sales \$ =
BE% =

BE Sales \$
Total Sales \$

x 100%

FE
CM%

FE
CM%

Total Sales \$

x 100% =

FE
CM%

1
Total Sales \$

x 100%

## Since CM% x Total Sales \$ = CM

% =
McGraw-Hill Education (Asia)

%
Slide 59

## Break-even in Unit and Dollar Sales:

3. The BE Percentage Method
Applying the BE% formula to the same company RBC

% =
% =

\$,
\$,

% = %

## This means that the company requires 80% of its current

sales in order to break-even.
Currently, the companys sales are \$250,000 or 500 units.
A BE% of 80% means if the company sales are \$200,000
(\$250,000 x 80%) or 400 units (500 units x 80%), the
company is break-even.
These figures are consistent with both the equation and
the formula methods.
McGraw-Hill Education (Asia)

Slide 60

Quick Check 1
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is \$1.49 and the average variable expense per
cup is \$0.36. The average fixed expense per month is
\$1,300. 2,100 cups are sold each month on average.
What is the break-even sales dollars?
a. \$1,300
b. \$1,715
c. \$1,788
d. \$3,129

## McGraw-Hill Education (Asia)

Slide 61

Quick Check 2
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is \$1.49 and the average variable expense per
cup is \$0.36. The average fixed expense per month is
\$1,300. 2,100 cups are sold each month on average.
What is the break-even sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups

Slide 62

## Target Profit Analysis in Unit Sales

1. Equation Method
Suppose Racing Bicycle management wants to
know how many bikes must be sold to earn a
target profit of \$100,000.

Slide 63

## Target Profit Analysis in Unit Sales

2. Formula Method
Suppose Racing Bicycle management wants to
know how many bikes must be sold to earn a
target profit of \$100,000.
Unit sales to attain
Target profit + Fixed expenses
=
the target profit
CM per unit

Slide 64

## Target Profit Analysis in Dollar Sales

1. Equation Method
Profit = CM ratio Sales Fixed expenses
Our goal is to solve for the unknown Sales
which represents the dollar amount of sales
that must be sold to attain the target profit.
Suppose RBC management wants to know the
sales volume that must be generated to earn a
target profit of \$100,000.

Slide 65

## Target Profit Analysis in Dollar Sales

2.Formula Method
We can calculate the dollar sales needed to
attain a target profit (net operating profit) of
\$100,000 at Racing Bicycle.
Dollar sales to attain
Target profit + Fixed expenses
=
the target profit
CM ratio

Slide 66

## Target Profit Analysis:

3. The BE Percentage Method
Modifying the BE% formula to add target profit to FE
+
Target Profit% =
%

\$,+\$,
Target Profit% =
x % =
\$,

## This means that the company requires 180% of its current

sales in order to obtain the target profit.
Currently, the companys sales are \$250,000 or 500 units.
A Target Profit % of 180% means if the company sales
are \$450,000 (\$250,000 x 180%) or 900 units (500 units x
180%), the company has a target profit of \$100,000.
These figures are consistent with both the equation and
the formula methods.
McGraw-Hill Education (Asia)

Slide 67

Quick Check 1
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
\$1.49 and the average variable expense per cup is
\$0.36. The average fixed expense per month is \$1,300.
Use the formula method to determine how many cups of
coffee would have to be sold to attain target profits of
\$2,500 per month.
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
McGraw-Hill Education (Asia)

Slide 68

Quick Check 2
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
\$1.49 and the average variable expense per cup is
\$0.36. The average fixed expense per month is \$1,300.
Use the formula method to determine the sales dollars
that must be generated to attain target profits of \$2,500
per month.
a. \$2,550
b. \$5,011
c. \$8,458
d. \$10,555
McGraw-Hill Education (Asia)

Slide 69

## CVP Relationships in Graphic Form

The relationships among revenue, cost, profit and volume
can be expressed graphically by preparing a CVP graph.
Racing Bicycle developed contribution margin income
statements at 0, 200, 400, and 600 units sold. We will
use this information to prepare the CVP graph.
Units Sold
200

0
Sales

100,000

400
200,000

600
\$

300,000

## Total variable expenses

60,000

120,000

180,000

Contribution margin

40,000

80,000

120,000

80,000

80,000

80,000

80,000

Fixed expenses
Net operating income (loss)

(80,000)

(40,000)

40,000

Slide 70

\$350,000

\$300,000

\$250,000

\$200,000

\$150,000

## In a CVP graph, unit volume is usually

represented on the horizontal (X) axis
and dollars on the vertical (Y) axis.

\$100,000

\$50,000

\$0

100

200

300

400

500

600

Units
McGraw-Hill Education (Asia)

Slide 71

## Draw a line parallel to the volume axis

to represent total fixed expenses.

\$350,000

\$300,000

\$250,000

\$200,000

Fixed expenses
\$150,000

\$100,000

\$50,000

\$0

100

200

300

400

500

600

Units
McGraw-Hill Education (Asia)

Slide 72

## Preparing the CVP Graph

Choose some sales volume, say 400 units, and plot the point representing
\$300,000
total expenses
(fixed and variable). Draw a line through the data point
back to where the fixed expenses line intersects the dollar axis.
\$350,000

\$250,000

\$200,000

Total expenses

Fixed expenses

\$150,000

\$100,000

\$50,000

\$0

100

200

300

400

500

600

Units
McGraw-Hill Education (Asia)

Slide 73

## Preparing the CVP Graph

Choose some sales volume, say 400 units, and plot the point representing
\$300,000
total sales.
Draw a line through the data point back to the point of origin.
\$350,000

\$250,000

\$200,000

Sales
Total expenses
Fixed expenses

\$150,000

\$100,000

\$50,000

\$0

100

200

300

400

500

600

Units
McGraw-Hill Education (Asia)

Slide 74

## Preparing the CVP Graph

Break-even point
(400 units or \$200,000 in sales)

\$350,000

Profit Area

\$300,000

\$250,000

\$200,000

Sales
Total expenses
Fixed expenses

\$150,000

\$100,000

\$50,000

\$0

Loss Area
McGraw-Hill Education (Asia)

100

200

300

400

500

600

Units
Slide 75

## Preparing the CVP Graph

Profit = Unit CM Q Fixed Costs
\$ 60,000
\$ 40,000

Profit

\$ 20,000
\$0
-\$20,000

## An even simpler form of

the CVP graph is called
the profit graph.

-\$40,000
-\$60,000
0

## McGraw-Hill Education (Asia)

100

200
300
400
Number of bicycles sold

500

600

Slide 76

\$ 60,000

## Break-even point, where

profit is zero , is 400
units sold.

\$ 40,000

Profit

\$ 20,000
\$0
-\$20,000
-\$40,000
-\$60,000
0

## McGraw-Hill Education (Asia)

100

200
300
400
Number of bicycles sold

500

600

Slide 77

Learning Objective 3
Understand the meaning of, and be
able to deal with:
1) Sensitivity Analysis
2) Margin of Safety
3) Operating Leverage

Slide 78

## 1. Sensitivity Analysis: Example 1

Changes in Fixed Costs and Sales Volume

## What is the profit impact if Racing

Bicycle can increase unit sales from
500 to 540 by increasing the monthly
advertising budget by \$10,000?

Slide 79

## 1. Sensitivity Analysis: Example 1

Changes in Fixed Costs and Sales Volume
\$80,000 + \$10,000 advertising = \$90,000

Sales
Less: Variable expenses
Contribution margin
Less: Fixed expenses
Net operating income

500 units
\$ 250,000
150,000
100,000
80,000
\$
20,000

540 units
\$ 270,000
162,000
108,000
90,000
\$
18,000

## Sales increased by \$20,000, but net operating

income decreased by \$2,000.
McGraw-Hill Education (Asia)

Slide 80

## 1. Sensitivity Analysis: Example 1

Changes in Fixed Costs and Sales Volume

## A shortcut solution using incremental

analysis
Increase in CM (40 units X \$200)
Increase in advertising expenses
Decrease in net operating income

\$ 8,000
10,000
\$ (2,000)

Slide 81

## 1. Sensitivity Analysis: Example 2

Change in Variable Costs and Sales Volume

## What is the profit impact if Racing

Bicycle can use higher quality raw
materials, thus increasing variable costs
per unit by \$10, to generate an increase
in unit sales from 500 to 580?

## McGraw-Hill Education (Asia)

Slide 82

1. Sensitivity Analysis:
Change in Variable Costs and Sales Volume
580 units \$310 variable cost/unit = \$179,800

Sales
Less: Variable expenses
Contribution margin
Less: Fixed expenses
Net operating income

500 units
\$ 250,000
150,000
100,000
80,000
\$
20,000

580 units
\$ 290,000
179,800
110,200
80,000
\$
30,200

## Sales increase by \$40,000, and net operating income

increases by \$10,200.
McGraw-Hill Education (Asia)

Slide 83

## The margin of safety in dollars is the

excess of budgeted (or actual) sales over
the break-even volume of sales.
Margin of safety in dollars = Total sales - Break-even sales

## Lets look at Racing Bicycle Company and

determine the margin of safety.

Slide 84

## 2. The Margin of Safety in Units

The margin of safety can be expressed in terms of
the number of units sold. The margin of safety at
RBC is \$50,000, and each bike sells for \$500;
hence, RBCs margin of safety is 100 bikes.
Margin of
=
Safety in units

\$50,000
= 100 bikes
\$500
OR

Margin of
=
Safety in units
McGraw-Hill Education (Asia)

Slide 85

## 2. The Margin of Safety in Percentage

If we assume that RBC has actual sales of \$250,000, given that
we have already determined the break-even sales to be
\$200,000, the margin of safety is \$50,000 as shown.
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
\$
-

Actual sales
500 units
\$ 250,000
150,000
100,000
80,000
\$
20,000

## RBCs margin of safety can be expressed as 20% of sales

(\$50,000 \$250,000). This is also known as margin of
safety percentage or MoS%
McGraw-Hill Education (Asia)

Slide 86

Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is \$1.49 and the average variable expense per
cup is \$0.36. The average fixed expense per month is
\$1,300. 2,100 cups are sold each month on average.
What is the margin of safety expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups

Slide 87

## Linking Margin of Safety % (to sales) and

Breakeven % (to sales)
Margin of safety in dollars = Total sales - Break-even sales
Margin of safety in dollars
Total sales in dollars

## = Margin of safety percentage (MoS%)

Total sales Breakeven sales
=
Total sales
Breakeven in dollars
=1
Total sales in dollars
= 1 Breakeven percentage
= 1 BE%

Therefore:
McGraw-Hill Education (Asia)

BE% = 1 MoS %
Slide 88

## RBCs margin of safety = 20% of sales

Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net operating income

Actual sales
500 units
\$ 250,000
150,000
100,000
80,000
\$
20,000

## Breakeven sales of RBC = 1 20% = 80% of sales (or BE%)

= \$250,000 x 80%
= \$200,000
= Breakeven Sales on slide 86
McGraw-Hill Education (Asia)

Slide 89

3. Operating Leverage:
Cost Structure and Profit Stability
Cost structure refers to the relative proportion
of fixed and variable costs in an organization.
Managers often have some latitude in
determining their organizations cost structure.

## McGraw-Hill Education (Asia)

Slide 90

3. Operating Leverage:
Cost Structure and Profit Stability
There are advantages and disadvantages to high fixed cost
(or low variable cost) and low fixed cost (or high variable
cost) structures.

## An advantage of a high fixed

cost structure is that income A disadvantage of a high fixed
will be higher in good years cost structure is that income
compared to companies
will be lower in bad years
with lower proportion of
compared to companies
fixed costs.
with lower proportion of
fixed costs.
Companies with low fixed cost structures enjoy greater
stability in income across good and bad years.
McGraw-Hill Education (Asia)

Slide 91

3. Operating Leverage:
Managing fixed costs

## Typical fixed costs: production facilities, rentals, employees

salaries and related benefits and utilities

## Converting them into variable may reduce risk of financial commitment

and provide flexibility of capacity utilization

## Outsourcing - switching to variable costs

Business with fast and regular change and/or large varieties of
products most likely will benefit from this approach e.g. Nike and
Apple
Non-core business functions with lower value-add to majority
customers e.g. call centers for enquiries, 3rd party logistics, brokerdealers securities back office operations

## Offshoring - reducing fixed costs

Honda and Toyota Thailand plants
HSBC back office functions in China

## McGraw-Hill Education (Asia)

Slide 92

3. Operating Leverage
Operating leverage is a measure of how sensitive net
operating income is to percentage changes in sales.
It is a measure, at any given level of sales, of how a
percentage change in sales volume will affect profits.
Contributi on Margin
DOL Degree of Operating Leverage
Net Operating Income * *
** Profit Before Tax is a commonly used alternative to Net Operating
Income in the degree of operating leverage calculation

## McGraw-Hill Education (Asia)

Slide 93

3. Operating Leverage
To illustrate, lets revisit the contribution income statement
for RBC.

Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income

Degree of
Operating
Leverage

## McGraw-Hill Education (Asia)

Actual sales
500 Bikes
\$ 250,000
150,000
100,000
80,000
\$
20,000

Slide 94

3. Operating Leverage

## With an operating leverage of 5, if RBC

increases its sales by 10%, net operating
income would increase by 50%.
Percent increase in sales
Degree of operating leverage
Percent increase in profits

10%
5
50%

## Heres the verification!

McGraw-Hill Education (Asia)

Slide 95

3. Operating Leverage
Actual sales
(500)
Sales
\$ 250,000
Less variable expenses
150,000
Contribution margin
100,000
Less fixed expenses
80,000
Net operating income
\$
20,000

Increased
sales (550)
\$ 275,000
165,000
110,000
80,000
\$
30,000

## 10% increase in sales from

\$250,000 to \$275,000 . . .

## . . . results in a 50% increase in

income from \$20,000 to \$30,000.
McGraw-Hill Education (Asia)

Slide 96

Quick Check 1
Coffee Klatch is an espresso stand in a
downtown office building. The average selling
price of a cup of coffee is \$1.49 and the average
variable expense per cup is \$0.36. The average
fixed expense per month is \$1,300. 2,100 cups
are sold each month on average. What is the
operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
McGraw-Hill Education (Asia)

Slide 97

Quick Check 2
At Coffee Klatch the average selling price of a cup of
coffee is \$1.49, the average variable expense per cup
is \$0.36, the average fixed expense per month is
\$1,300 and an average of 2,100 cups are sold each
month.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%

Slide 98

Leverage mean?

## signals the existence of high fixed costs.

increases risk of making loss in adverse market
conditions.
increases opportunity to make profit when higher
demand exists.
has lower margin of safety percentage (MoS%)

1
DOL
MoS%

Slide 99

## Proof of Operating Leverage and Profit

Movement Relationship
Benchmark Co.

\$3,200,000

\$3,200,000

\$800

\$800

(\$300)

(\$150)

\$500

\$650

4,000

4,000

\$2,000,000

\$2,600,000

(\$1,500,000)

(\$2,100,000)

(P)

500,000

500,000

4.0

5.2

## Total Sales (Same)

Unit selling price (Same)
Unit variable costs

Contribution margin

(CM)

Fixed costs
Net Operating Profit (Same)

Slide 100

## Proof of Operating Leverage and Profit

Movement Relationship
Benchmark Co.

12.5%

12.5%

## Degree of operating leverage

X 4.0

X 5.2

Increase in profits

50%

65%

\$500

\$650

## Unit change in sales (4,000 x 12.5%)

x 500

x 500

\$250,000

\$325,000

50%

65%

Increase in sales

Proof:

Change in profits
Percentage increase from the original
\$500,000 profit

Slide 101

Relationship
Benchmark Co.

## Total Sales (Same)

(S)

\$3,200,000

\$3,200,000

Contribution margin

(CM)

\$2,000,000

\$2,600,000

Fixed costs

(F)

(\$1,500,000)

(\$2,100,000)

(P)

500,000

500,000

4.0

5.2

2,400,000

2,584,615

75%

80.77%

25%

19.23%

4.0

5.2

## Breakeven Sales Dollars [F/(CM/S)]

Breakeven % (to sales)

MoS% = 1 BE%
1/MoS%
= Degree of operating leverage

Slide 102

## 4. The Concept of Sales Mix

Sales mix is the relative proportion in which a
companys products are sold.
Different products have different selling prices,
cost structures, and contribution margins.
When a company sells more than one product,
break-even analysis becomes more complex as
the following example illustrates.

Slide 103

## Multi-Product Break-Even Analysis

1. The BE% Method
Virtual Journeys Le Louvre and Le Vin sales and profit data are as follows:
Le Louvre (200)
Sales
\$ 20,000
Variable expenses
15,000
Contribution margin
5,000
Fixed expenses
Net operating income
Sales

\$ 20,000

Le Vin (400)
\$ 80,000
40,000
40,000

\$80,000

x
BE% = 60%
Breakeven sales

\$12,000

\$48,000

## Total breakeven sales = \$60,000

Breakeven units

120 units

240 units

Total
\$ 100,000
55,000
45,000
27,000
\$ 18,000
Contribution Margin
1

## Net Operating Income MoS%

Net Operating Income
MoS%
Contribution Margin
18,000
MoS%
40%
45,000
MoS% 1 BE%
BE% 1 MoS% 1 40% 60%
DOL

## Total breakeven units = 360 units

McGraw-Hill Education (Asia)

Slide 104

## Multi-Product Break-Even Analysis

2. The Weighted-Average CM Ratio Method
Le Louvre comprises 20% of Virtual Journeys total sales
revenue and Le Vin comprises the remaining 80%. Virtual
Journey provides the following information:
Le Louvre (200 units)
Sales
\$ 20,000
100%
Variable expenses
15,000
75%
Contribution margin
5,000
25.0%
Fixed expenses
Net operating income

## Le Vin (400 units)

\$
80,000
100%
40,000
50%
40,000
50%

Total
\$ 100,000
100.0%
55,000
55.0%
45,000
45.0%
27,000
\$ 18,000

Sales mix

\$ 100,000

20,000

20%

Weighted-average CM Ratio
= (20% x 25%) + (80% x 50%) OR
= 45%

## McGraw-Hill Education (Asia)

80,000

80%

100%

Weighted-average CM Ratio
= 45,000/100,000
= 45%

Slide 105

## Multi-Product Break-Even Analysis

2. The Weighted-Average CM Ratio Method
Dollar sales to
Fixed expenses
=
break even
CM ratio

Dollar sales to
break even

\$27,000
45%

= \$60,000

## Le Louvre (200 units)

Sales
\$
12,000
100%
Variable expenses
9,000
75%
Contribution margin
3,000
25%
Fixed expenses
Net operating income

\$ 48,000
100%
24,000
50%
24,000
50%

Sales mix

12,000

20%

48,000

80%

Total
60,000
33,000
27,000
27,000
-

60,000

100.0%
55.0%
45.0%

100.0%

Slide 106

## Multi-Product Break-Even Analysis

3. The Weighted-Average CM Method
Le Louvre comprises 33.33% of Virtual Journeys total unit
sales and Le Vin comprises the remaining 66.66%. Virtual
Journey provides the following information:
Le Louvre (200 units)
Sales
\$ 20,000
100%
Variable expenses
15,000
75%
Contribution margin
5,000
25.0%
Fixed expenses
Net operating income
Unit CM
Sales mix (in units)

\$25
200 units

33.33%

## Le Vin (400 units)

\$
80,000
100%
40,000
50%
40,000
50%

\$100
400 units

66.66%

Total
\$ 100,000
100.0%
55,000
55.0%
45,000
45.0%
27,000
\$ 18,000

600 units

100%

Weighted-average CM
= (1/3 x \$25) + (2/3 x \$100)
= \$75

Slide 107

## Multi-Product Break-Even Analysis

3. The Weighted-Average CM Method
Unit sales to
break even

Unit sales to
break even

## Le Louvre (200 units)

Sales
\$
12,000
100%
Variable expenses
9,000
75%
Contribution margin
3,000
25%
Fixed expenses
Net operating income
Sales mix (in units)

120 units

33%

Fixed expenses
Unit CM
\$27,000
\$75

= 360 units

\$ 48,000
100%
24,000
50%
24,000
50%

\$
240 units

67%

Total
60,000
33,000
27,000
27,000
360 units

100.0%
55.0%
45.0%

100.0%

Slide 108

## Key Assumptions of CVP Analysis

Selling price is constant.
Costs are linear and can be accurately divided into
variable (constant per unit) and fixed (constant in
total) elements.
In multiproduct companies, the sales mix is
constant.
In manufacturing companies, inventories do not
change (units produced = units sold).

Slide 109

Quick Check

Slide 110

Quick Check

Slide 111

Quick Check

Slide 112

Quick Check

Slide 113

End of Topic 3B

Slide 114