CHAPTER 2

PowerPoint Author:
LuAnn Bean, Ph.D., CPA, CIA, CFE
Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objective
Identify and
describe fixed,
variable, and
mixed cost
behavior.
LO1
LO1
2-2

Fixed Cost Behavior

When activity . . . .

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 = $16.00 per Ticke

2-4

Variable Cost Behavior

Total variable cost

increases in
direct proportion
to the number of
units sold.

The behavior of
variable cost per
unit is contradictory
to the word variable,
because variable
cost per unit remains
constant regardless
of how many units
are sold.

2-5

Variable Cost Behavior

When activity . . .
Increases

Decreases

Total Variable
Cost

Increases
Proportionately

Decreases
Proportionately

Variable Cost
Per Unit

Remains Constant

Remains Constant

Consider the concert example

where a band receives $16 for
each ticket sold. The more sold
will increase the bands take from
the concert, but they can only
receive a constant $16 from
each individual ticket sold.
2-6

Learning Objective
Demonstrate the
effects of
operating leverage
on profitability.
LO2
LO2
2-7

Variable Cost Behavior

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.
2-8

Mixed, or Semivariable,
Costs

Mixed costs (or semivariable costs) include

both fixed and variable components.

For example, Star Productions, Inc., has to pay a

janitorial company a base fee of $1,000 plus
$20 per hour required 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 x 60 hours) = $2,200

2-9

Operating Leverage
A
A measure
measure of
of the
the extent
extent to
to which
which fixed
fixed
costs
costs are
are being
being used
used in
in an
an organization.
organization.
Operating
Operating leverage
leverage is
is greatest
greatest in
in companies
companies
that
that have
have aa high
high proportion
proportion of
of fixed
fixed costs
costs in
in
relation
relation to
to variable
variable costs.
costs.
Small
percentage
change in
revenue

Large
percentage
change in
profits

Fixed Costs

Consider the following

concert example where
all costs are fixed.
2-10

Operating Leverage
10% Revenue
Increase

When all costs are fixed, every

additional sales dollar
contributes one dollar to gross
profit.

90% Gross
Profit Increase
2-11

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.
Lets see what happens to the concert
example if the band receives $16 per
ticket sold instead of a fixed $48,000.
2-12

Risk and Reward

Assessment

10% Revenue
Increase

10% Gross
Shifting
Shifting the
the cost
cost structure
structure from
from
Profit Increase
fixed
fixed to
to variable
variable not
not only
only reduces
reduces
risk
risk but
but also
also the
the potential
potential for
for
profits.
profits.
2-13

Effect of Cost Structure

on Profit Stability

Now lets see what happens when

the number of units sold increases.
2-14

Effect of Cost Structure

on Profit Stability

The increase in income is greater

in the All Fixed Company.
2-15

Effect of Cost Structure

on Profit Stability

Yes, the decrease in income is

greater in the All Fixed Company.
2-16

Effect of Cost Structure

on Profit Stability

Level of
Fixed Cost

Earnings
Volatility

High

High

Low

Low

Fixed
Costs

Variable
Costs
2-17

Learning Objective
Prepare an income
statement using
the contribution
margin approach.
LO3
LO3
2-18

An Income Statement under

the Contribution Margin
Approach

2-19

Learning Objective
Calculate the
magnitude of
operating
leverage.
LO4
LO4
2-20

Measuring Operating Leverage

Using Contribution Margin
Operating
Leverage

Contribution margin
=

Net income

Show me
an example.

2-21

Measuring Operating Leverage

Using Contribution Margin

Actual sales
5,000
Hammers
Sales
$
50,000
Less: variable expenses
30,000
Contribution margin
20,000
Less: fixed expenses
15,000
Net income
$
5,000

Operating
Leverage

$20,000
=

$5,000

A measure of how a percentage

change in sales will effect profits.
2-22

Measuring Operating Leverage

Using Contribution Margin

A 10 percent increase in sales results in

a 40 percent increase in net income.
(10% 4 = 40 %)
2-23

The Relevant Range

Example: Office space
is available at a fixed
rental rate of $30,000
per year in increments
of 1,000 square feet.
As the business grows
more space is rented,
increasing the total
cost.

Continue
2-24

The Relevant Range

$9
0

Rent Cost in
Thousands of
Dollars

Total fixed cost

Relevant remains constant
for a range of
Range
activity, and then
jumps to a new
higher cost for the
next higher range
of activity.

$6
0

$3
0

0
0
3,000

1,000

2,000
2-25

Total Cost

The Relevant Range

Relevant
Range

Our
Our variable
variable
cost
cost
assumption
assumption
(constant
(constant unit
unit
variable
variable cost)
cost)
applies
applies within
within
the
the relevant
relevant
Possible
Variable
range.
range.
Cost Behavior

Our Variable
Cost Assumption
Activit

2-26

Context Sensitive Definitions

of Fixed and Variable

ecall the earlier concert example, where the band wa

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.
2-27

Learning Objective
Select an
appropriate time
period for
calculating average
cost per unit.
LO5
LO5
2-28

Cost Averaging
Lake Resorts provides water-skiing lessons for
guests with the following costs:
Equipment rental
Instructor pay
Fuel

$80 per day

$15 per hour
$ 2 per hour

What is the average cost per one-hour lesson for

2 lessons per day? 5 lessons per day? 10 lessons
per day?

2-29

Cost Averaging

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.
2-30

Learning Objective
Use the high-low
method,
scattergraphs, and
regression analysis
to estimate fixed and
variable costs.
LO6
LO6
2-31

The High-Low Method

Iris Company recorded the following production
activity and maintenance costs for two months:
High
High activity
activity level
level
Low
Low activity
activity level
level

Units
Units
10,000
10,000
5,000
5,000

Cost
Cost
$$9,700
9,700
5,700
5,700

Using these two levels of activity, compute:

the variable cost per unit.
the fixed cost.
the total cost.
2-32

The High-Low Method

High
High activity
activity level
level
Low
Low activity
activity level
level
Change
Change

Units
Units
10,000
10,000
5,000
5,000
5,000
5,000

Cost
Cost
$$9,700
9,700
5,700
5,700
$$4,000
4,000

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
2-33

The Scattergraph Method

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

Total Cost in
1,000s of Dollars

Y
$20

$10

$0

* *
* *

* ** *
**
X

0
1
2
3
4
Activity, 1,000s of Units Produced
2-34

The Scattergraph Method

Total Cost in
1,000s of Dollars

Draw a line through the data points with

about an
equal numbers of points above and below
Y
the line.
$20

$10

$0

* *
* *

* ** *
**

0
1
2
3
4
Activity, 1,000s of Units Produced
2-35

The Scattergraph Method

Total Cost in
1,000s of Dollars

Variable cost per unit is

represented by the slope of the
line.

$20

$10

$0

* *
* *
Estimated
fixed
is $10,000

* ** *
The horizontal
**
line shows that
the total cost of
3,000 units is
approximately
$16,000.
X

0
1
2
3
4
Activity, 1,000s of Units Produced

2-36

The Scattergraph Method

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

Total Cost in
1,000s of Dollars

$20

$10

* *
* *

$0

Estimated
fixed
is $10,000

* ** *
horizontal line
* * The
shows that the
total cost of 3,000
units is
approximately
$16,000.

0
1
2
3
4
Activity, 1,000s of Units Produced
2-37

Regression Method of Cost

A method used to analyze mixed costs if a
Estimation

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.
2-38

Regression Method of Cost

Estimation

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
Least-squares regression
regression also
also provides
provides aa statistic,
statistic,
called
called the
the R
R22,, that
that is
is aa measure
measure of
of the
the goodness
goodness
of
of fit
fit of
of the
the regression
regression line
line to
to the
the data
data points.
points.
2-39

perform regression
analysis:
analysis:

1.
1. Enter
Enter the
the data
data in
in
spreadsheet
spreadsheet columns.
columns.
2.
2. Click
Click Tools.
Tools.
3.
3. Click
Click Data
Data Analysis.
Analysis.
4.
4. Click
Click Regression
Regression and
and
then
then OK.
OK.
5.
5. Define
Define data
data ranges
ranges and
and
click
click Line
Line Fit
Fit Plot.
Plot.
6.
6. Click
Click OK.
OK.

Total Cost

Regression Method of Cost

Estimation
Follow
Follow these
these steps
steps in
in Excel
Excel to
to
Y
perform regression
20

* ** *
*** * *
*

10
0

2
3
Activity

The
The regression
regression function
function will
will return
return
an
an estimate
estimate for
for fixed
fixed cost
cost and
and
variable
variable cost
cost per
per unit.
unit.
2-40

End of Chapter 2

2-41