CHAPTER 2

Cost Behavior,
Operating
Leverage, and
Profitability
Analysis
PowerPoint Author:
Debby Bloom, CMA, CFM, CSCA
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 Learning Objective 2-1
Identify and describe fixed, variable,
and mixed cost behavior.

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 Fixed Cost Behavior
Illustrated

Consider the following

concert example, where the
band will be paid $48,000
regardless of the
number of tickets sold.
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 Fixed Cost Behavior

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

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 Graphical Representation
of Fixed Cost Behavior

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 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.
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 Variable Cost Behavior
Explained
The behavior of
variable cost per
unit is contradictory
Total variable cost to the word variable
increases in because variable
direct proportion cost per unit remains
to the number of constant regardless
units sold. of how many units
are sold.

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 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.
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 Graphical Representation
of Variable Cost Behavior

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 Fixed and Variable Cost
Behavior

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 Mixed 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 × 60 hours) = $2,200
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 Examples of Mixed Costs

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 The Relevant Range
The range of activity over which the
definitions of fixed and variable costs are
valid is commonly called the relevant
range.

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

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 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.

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 Calculating Percentage
Change
(Alternative measure − Base measure) ÷
Base measure = % change

($11,400 − $6,000) ÷ $6,000 = 90%

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 Effect of Operating Leverage
on Profitability 10% Revenue
Increase

90% Gross
Margin Increase
When all costs are fixed, every additional
sales dollar contributes one dollar to gross
profit.
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 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.
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Variable Cost Risk and
Reward Assessment
10% Revenue
Increase

Shifting the cost structure from fixed 10% Gross

to variable not only reduces risk but Margin Increase
also the potential for profits.

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 Profit Stability Illustrated
Part One

Now let’s see what happens when

the number of units sold increases. 2-21
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 Profit Stability Illustrated
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.
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 Profit Stability Illustrated
Part Three

Yes, the decrease in income is

greatest in Company A.
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 Effect of Cost Structure on
Profit Stability

Level of Earnings
Fixed Cost Volatility
High High

Low Low

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 Learning Objective 2-3
Prepare an income statement using
the contribution margin approach.

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 An Income Statement under the
Contribution Margin Approach

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 Comparative Profitability
at 2,000 Hours of Tutoring

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 Profitability at 4,000 Hours
of Tutoring

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 Comparative Profitability
with Price Match

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 Learning Objective 2-4
Calculate the magnitude of operating
leverage.

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 Magnitude of Operating
Leverage
Magnitude of
Contribution margin
Operating =
Net income
Leverage

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 Magnitude of Operating
Leverage Computation
Bragg Company:
Magnitude of
operating leverage = 7

Biltmore Company:
Magnitude of
operating leverage = 4

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 Magnitude of Operating
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

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 Magnitude of Operating
Leverage Comparison

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 Learning Objective 2-5
Select an appropriate time period for
calculating the average cost per unit.

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 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?

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 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.
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 Analysis of Total and Unit
Cost Using Weekly Average

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 Learning Objective 2-6
Use the high-low method,
scattergraphs, and regression analysis
to estimate fixed and variable costs.

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 High-Low Method Data

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 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
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 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

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 Scattergraph for High-Low
Method
Plot the data points on a graph
(total cost versus activity).

Draw a line through the data

points with about an
equal number of points above
and below the line.

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 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

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 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 of 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.
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 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.
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 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.
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 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

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