Edmonds Survey7e Chap11 PPT

Chapter 11
Cost Behavior, Operating

Leverage, and Profitability
Analysis
© McGraw Hill LLC. All rights reserved. No

reproduction or distribution without the prior
written consent of McGraw Hill LLC.
Chapter Opening
The total amount of a fixed cost does not

change when volume changes.
In contrast, some costs vary in direct proportion

with changes in volume. When volume
increases, total variable cost increases; when
volume decreases, total variable cost
decreases.
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
11-2
LO 11-1:
Identify and describe fixed, variable, and

mixed cost behavior.
11-3
Fixed Cost Behavior
••Considering
Considering cost cost behavior
behavior enables
enables
managers
managers to to more
more effectively
effectively plan
plan and
and
control
control costs.
costs.
••Total versus per-unit
Total versus per-unit fixed
fixed costs
costs behave
behave
differently.
differently.
••The
The total
total cost
cost remains
remains constant
constant (fixed).
(fixed).
••Fixed
Fixed cost
cost per
per unit
unit decreases
decreases asas volume
volume
increases.
increases.
•• The term fixed
The term fixed cost
cost is
is consistent
consistent with
with the
the
behavior of total
behavior of total cost
cost..
11-4
Fixed Cost Behavior
•• SPI
SPI specializes
specializes inin promoting
promoting rock
rock concerts.
concerts.
•• It
It is
is considering
considering paying
paying aa band
band $48,000
$48,000 to
to play
play
aa concert.
concert.
•• Exhibit
Exhibit 11.1
11.1 illustrates
illustrates the
the fixed
fixed cost
cost behavior
behavior
pattern.
pattern.
11-5
Fixed Cost Behavior Patterns
11-6
LO 11-2:
Demonstrate the effects of operating

leverage on profitability.
11-7
Operating Leverage
•• Business
Business managers
managers
apply
apply operating
operating
leverage
leverage to to magnify
magnify
small
small changes
changes in in
revenue
revenue into
into dramatic
dramatic
changes
changes inin profitability.
profitability.
The lever
•• The lever managers
managers
use
use to
to achieve
achieve
disproportionate
disproportionate
changes
changes between
between
revenue
revenue andand
profitability
profitability is
is fixed
fixed
costs.
costs.
11-8
Effect of Operating Leverage on
Profitability
11-9
Calculating Percentage Change
11-10
Risk and Reward Assessment
•• Risk
Risk refers
refers to
to the
the possibility
possibility that
that sacrifices
sacrifices
may
may exceed
exceed benefits.
benefits.
•• AA fixed
fixed cost
cost represents
represents aa commitment
commitment to to
an
an economic
economic sacrifice.
sacrifice.
•• It
It represents
represents the
the ultimate
ultimate risk
risk of
of
undertaking
undertaking aa particular
particular business
business project.
project.
•• If
If SPI
SPI pays
pays the
the band
band but
but nobody
nobody buys
buys aa
ticket,
ticket, the
the company
company will will lose
lose $48,000.
$48,000.
•• SPI
SPI can
can avoid
avoid this
this risk
risk by
by substituting
substituting
variable
variable costs
costs for the fixed
for the fixed costs
costs..
11-11
Variable Cost Behavior
•• SPI
SPI arranges
arranges to to pay
pay the
the band
band $16
$16 per
per ticket
ticket
sold
sold instead
instead of
of aa fixed
fixed $48,000.
$48,000.
•• Exhibit
Exhibit 11.5
11.5 illustrates
illustrates the
the variable
variable cost
cost
behavior
behavior pattern.
pattern.
11-12
Variable Cost Behavior Continued
•• Since
Since SPI
SPI will
will pay
pay the
the band
band $16
$16 for
for each
each
ticket
ticket sold,
sold, the
the total
total variable
variable cost
cost increases
increases in
in
direct
direct proportion
proportion to to the
the number
number ofof tickets
tickets
sold.
sold.
•• The
The variable cost per
variable cost per ticket
ticket remains
remains $16$16
regardless
regardless of of whether
whether thethe number
number of of tickets
tickets
sold
sold is
is 1,
1, 2,
2, 3,
3, or
or 3,000.
3,000.
•• The
The behavior
behavior of of variable cost per
variable cost per unit
unit is is
contradictory
contradictory to to the word variable
the word variable..
•• Variable
Variable cost
cost per
per unit remains constant
unit remains constant
regardless
regardless of
of how
how many
many tickets
tickets are
are sold.
sold.
11-13
Variable Cost Behavior Patterns
11-14
Risk and Reward Assessment
•• Shifting
Shifting the
the cost
cost structure
structure from
from fixed
fixed to
to
variable
variable enables
enables SPI
SPI to
to avoid
avoid the
the fixed
fixed
cost
cost risk.
risk.
•• Under
Under thethe fixed
fixed cost
cost structure,
structure, SPI SPI was
was
locked
locked into
into aa $48,000
$48,000 cost
cost for
for the
the band
band
regardless
regardless of of how
how many
many tickets
tickets areare sold.
sold.
•• If
If no
no tickets
tickets are
are sold,
sold, SPI
SPI will
will have
have toto
report
report aa $48,000
$48,000 loss
loss on
on its
its income
income
statement.
statement.
•• The
The risk
risk of
of incurring
incurring aa loss
loss is
is eliminated
eliminated byby
the
the variable
variable cost
cost structure.
structure.
11-15
Variable Cost Eliminates Operating
Leverage
11-16
LO 11-3:
Prepare an income statement using the

contribution margin approach.
11-17
Contribution Margin Approach
•• The
The impact
impact of
of cost
cost structure
structure on on profitability
profitability is
is so
so
significant
significant that
that managerial
managerial accountants
accountants
frequently
frequently construct
construct income
income statements
statements that
that
classify
classify costs
costs according
according to to their
their behavior
behavior
patterns.
patterns.
•• Such
Such income
income statements
statements first
first subtract
subtract variable
variable
costs
costs from
from revenue;
revenue; thethe resulting
resulting subtotal
subtotal is is
called
called the
the contribution
contribution margin.
margin.
•• The
The contribution
contribution margin
margin is is the
the amount
amount
available
available to
to cover
cover fixed
fixed expenses
expenses and
and
thereafter
thereafter to
to provide
provide company
company profits.
profits.
11-18
An Income Statement under the
Contribution Margin Approach
11-19
LO 11-4:
Calculate the magnitude of operating

leverage.
11-20
Calculating Magnitude of Operating
Leverage
11-21
Operating Leverage for Bragg Company
The computations show that Bragg is more highly
leveraged than Biltmore. Bragg’s change in profitability
will be seven times greater than a given percentage
change in revenue.
11-22
Operating Leverage for Biltmore
Company
Biltmore’s profits change by only four times the percentage
change in revenue.
11-23
Cost Behavior Summarized – Fixed Costs
The term fixed refers to the behavior of total fixed cost.
The cost per unit of a fixed cost varies inversely with
changes in the level of activity.
11-24
Cost Behavior Summarized – Variable
Costs
The term variable refers to the behavior of total variable
cost. Total variable cost increases or decreases
proportionately with changes in the volume of activity.
11-25
Fixed and Variable Cost Behavior
11-26
Mixed Costs (Semivariable Costs)
•• Mixed
Mixed costs
costs (semivariable
(semivariable costs)
costs) include
include
both
both fixed
fixed and
and variable
variable components.
components.
•• For
For example,
example, suppose
suppose StarStar Productions
Productions pays pays aa
base
base fee
fee of
of $1,000
$1,000 plus
plus $20$20 per
per hour
hour for
for
janitorial
janitorial services.
services.
•• The
The $1,000
$1,000 base
base fee
fee is
is fixed.
fixed. ItIt is
is the
the same
same
no
no matter
matter how
how many
many hours
hours itit takes
takes to to clean.
clean.
•• The
The $20
$20 hourly
hourly cost
cost is
is aa variable
variable cost
cost because
because
the
the total
total cost
cost increases
increases with
with each
each additional
additional
hour
hour itit takes
takes to
to complete
complete the the cleanup.
cleanup.
11-27
Calculating Mixed Costs
11-28
Examples of Mixed Costs
11-29
The Relevant Range
The range of activity over which the definitions of
fixed and variable costs are valid is commonly
called the relevant range.
Example: SPI, the concert promoter,

must pay $5,000 to rent a concert hall
with a capacity of 4,000 people. What if
demand is significantly more than 4,000?
In that case, SPI might rent a larger
concert hall at a higher cost.
11-30
Context-Sensitive Definitions of Fixed and
Variable
The same cost can behave as either a fixed cost or a
variable cost, depending on the activity base. When
identifying a cost as fixed or variable, first ask, fixed or
variable relative to what activity base? The cost of the
band is fixed relative to the number of tickets sold for a
specific concert; it is variable relative to the number of
concerts produced.
11-31
LO 11-5:
Determine the sales volume necessary to

break even or to earn a desired profit.
11-32
Determining the Break-Even Point
• Bright Day Distributors obtained the rights to
distribute the new herb mixture Delatine.
• The selling price is $36 per bottle and the
cost is $24 per bottle.
• Bright Day suspects that enthusiasm for
Delatine will abate quickly.
• To attract customers, the marketing
manager suggests an advertising campaign
at an estimated cost of $60,000.
In accounting terms, the break-even point is

where profit (income) equals zero.
11-33
Equation Method
11-34
Contribution Margin per Unit Method
The total contribution margin is the amount of sales minus
total variable cost. The contribution margin per unit is the
sales price per unit minus the variable cost per unit. The
contribution margin per unit for Delatine is:
Every time Bright Day sells a bottle of Delatine, it

receives enough money to cover the variable cost
of the bottle ($24) and still has $12 left to go
toward paying the fixed cost.
11-35
Break-Even Point in Units
This result is the same as that determined under

the equation method.
Both methods are simply different derivations of the

same formula.
11-36
Determining Break-even Volume in
Dollars
To determine the amount of break-even sales
measured in dollars, multiply the number of units
times the sales price per unit.
For Delatine, the break-even sales measured in

dollars is $180,000 (5,000 units × $36):
11-37
Determining the Sales Volume Necessary
to Reach a Desired Profit
If Bright Day desires to earn a profit of $40,000. Using
the equation method, the sales volume in units required
to attain the desired profit is computed as follows:
11-38
LO 11-6:
Calculate and interpret the margin of

safety measure.
11-39
Calculating the Margin of Safety
The margin of safety measures the cushion
between budgeted sales and the break-even
point. It quantifies the amount by which actual
sales can fall short of expectations before the
company will begin to incur losses.
11-40
The Margin of Safety as a Percentage of
Sales
To help compare diverse products or companies
of different sizes, the margin of safety can be
expressed as a percentage. Divide the margin
of safety by the budgeted sales volume.
11-41
End of Chapter 11
11-42

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Chapter 11

Cost Behavior, Operating

© McGraw Hill LLC. All rights reserved. No

The total amount of a fixed cost does not

In contrast, some costs vary in direct proportion

Identify and describe fixed, variable, and

Demonstrate the effects of operating

Prepare an income statement using the

Calculate the magnitude of operating

Example: SPI, the concert promoter,

Determine the sales volume necessary to

In accounting terms, the break-even point is

Every time Bright Day sells a bottle of Delatine, it

This result is the same as that determined under

Both methods are simply different derivations of the

For Delatine, the break-even sales measured in

Calculate and interpret the margin of

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