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# Managerial Accounting Ch 2.docx

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Department
Accounting
Course Code
ACCT 2301
Professor
Ed Dinan

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Anna Wang Managerial Accounting 2 Chapter 2 Cost Behavior, Operating Leverage, & Profitability Analysis Fixed Cost Behavior - Total fixed cost and per-unit costs behave differently Ex – SPI hires a band to play for \$48,000; need to sell enough tickets to cover costs Fixed Cost = \$48,000 Per-unit Fixed Cost = \$48,000 ÷ tickets sold (not really fixed) Total Cost of Band 48,000 48,000 48,000 # Ticket Sold 2,700 3,000 3,300 Cost per Ticket 17.78 16 14.55 WhenActivity Increases WhenActivity Decreases Total Fixed Cost Remains Constant Remains Constant Fixed Cost per Unit Decreases Increases - Influences potential pricing choices - Fixed Cost per Unit represents the minimum ticket price in order to cover costs Operating Leverage - Use fixed costs to magnify small changes in revenue into dramatic changes in profitability - Lever = fixed cost - can be good or bad - When all costs are fixed, every sales dollars contributes \$1 toward potential profitability. Once fixed costs are covered, additional sales dollar represent pure profit - operating leverage ≠ financial leverage (Financial leverage – use debt to profit from investing money at a higher rate Of return than the rate they pay for the borrowed funds) Calculating Percentage Change (Alternative Measure – Base Measure) ÷ Base Measure = % Change Risk and RewardAssessment - Risk – possibility that sacrifices may exceed benefit 1 Anna Wang Managerial Accounting 2 - Fixed costs represent a commitment to an economic sacrifice - avoid risks by substituting variable costs for fixed costs - Higher earnings volatility Variable Cost Behavior - Total variable cost increases in direct proportion to # units sold Ex – pay the band \$16 per ticket sold instead of the fixed \$48,000 Total Variable Costs = # tickets sold x variable cost per unit Variable Cost per Unit = \$16 (not really variable) Total Cost of Band 43,200 48,000 52,800 # Ticket Sold 2,700 3,000 3,300 Cost per Ticket 16 16 16 WhenActivity Increases WhenActivity Decreases Total Variable Cost Increases Proportionally Decreases Proportionally Fixed Variable Cost per Unit Remains Constant Remains Constant Risk and RewardAssessment - shifting cost structure form fixed to variable reduces risk, but also potential for profit because no operating leverage Effect of Cost Structure on Profit Stability - When sales changes, the corresponding change in net income is directly influenced by the company’s cost structure - More fixed costs = more fluctuation in net income - Ex - 3 companies (A, B, and C) produce and sell the same products and incur \$60 in the process of making and selling 10 units at \$10 each. A: Fixed Cost - \$60 B: Fix Cost - \$30 Variable Cost \$30 (\$3/unit) C: Variable Cost - \$60 (\$6/unit) 2 Anna Wang Managerial Accounting 2 IncomeStatement (Sell10unitsat \$10each) IncomeStatement (Sell11unitsat \$10each) A B C A B C SalesRev 100 100 100 SalesRev 110 110 110 Var Cost 0 (30) (60) Var Cost 0 (33) (66) FixedCost (60) (30) 0 FixedCost (60) (30) 0 Net Income 40 40 40 Net Income 50 47 44 - Which cost structure is better? Depends on sales volume expectation Expect revenue to increase  fixed structure Expect revenue to decrease / uncertain growth  variable cost structure An Income Statement Under the Contribution MarginApproach Revenue - Variable Cost -------------------------- Contribution margin  amt available to cover fixed costs and provide profit - Fixed Cost --------------------------- Net Income - This approach cannot be used for external (financial) reporting, but often used for internal reporting managerial acct – contribution margin financial acct – gross margin Using Fixed Cost to Provide a Competitive OperationAdvantage Ex – Tutoring Companies (Aand B) both currently provide 2000hr of service at \$11/hr. Both currently make the same profit A: Fixed Cost - \$16,000 per year regardless of # hr B: Variable Cost - \$8/hr A B Rev 22,000 22,000 Cost of Tutors (16,000) (16,000) Net Income 6,000 6,000 Adecides to cut price from \$11/hr to \$7/hr in attempt to win over all of B’s customers 3 Anna Wang Managerial Accounting 2 If successful, net income would double If B decides to match the price cut, both would suffer A B Rev 14,000 14,000 Cost of Tutors (16,000) (16,000) Net Income (2,000) (2,000) Measuring Operating Leverage Using Contribution Margin Magnitude of Contribution Margin Operat Leverage Net Income If operating leverage is 4, change in profit will be 4 times greater than change in revenue Cost Behavior Summarized Fixed Cost Behavior Variable Cost Behavior A Rev 28,000 Cost of Tutors (6,000) Net Income 12,000
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