Cost Structure UAA ACCT 202 Principles of Managerial

Cost Structure UAA - ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting

Introduction u Cost structure is defined as the relationship between a firm’s fixed and variable costs. Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 2

Cost Structure Labor-Intensive = High Variable Costs Cost Structure Machine-Intensive = High Fixed Costs Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 3

Abacus Computers u Performs firms: computer services for other – Owns 2 computers – Employs two people u Bulk of costs are. . . – Rent Expense; and – Depreciation (S/L) Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 4

Abacus Computers Income Statement For Year Ended December 31, 2003 Sales Variable Costs Contribution Margin $500, 000 100% 100, 000 20% $400, 000 80% Fixed Costs 300, 000 Net Income $100, 000 Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 5

Tailor Made Company u Manufactures custom made men’s suits – Owns one sewing machine – Employs six people u Bulk of costs are. . . – Materials; and – Labor Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 6

Tailor Made Company Income Statement For Year Ended December 31, 2003 Sales Variable Costs Contribution Margin $500, 000 100% 300, 000 60% $200, 000 40% Fixed Costs 100, 000 Net Income $100, 000 Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 7

Abacus and Tailor Made Company Income Statement Comparison For Year Ended December 31, 2003 u Abacus Sales u $500 Tailor Made Sales $500 VC 300 CM $200 FC 100 NI $100 Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 8

Abacus Computers Income Statement For Year Ended December 31, 2003 Sales $500, 000 Abacus Computers will increase 100% its profits by $0. 80 for each Variable Costs 100, 000 additional dollar of sales. 20% Contribution Margin 80% $400, 000 Fixed Costs 300, 000 Net Income $100, 000 Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 9

Tailor Made Company Income Statement For Year Ended December 31, 2003 Sales. Tailor-Made Company will $500, 000 100% increase its profits by $0. 40 for Variable Costs 300, 000 each additional dollar of sales. 60% Contribution Margin 40% $200, 000 Fixed Costs 100, 000 Net Income $100, 000 Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 10

Periods of Decreased Activity. . . u Assuming no change in selling prices, unit VC and FC. . . – Abacus Computers will reduce its profits by $0. 80 for each additional dollar of sales. – Tailor Made Company will reduce its profits by $0. 40 for each additional dollar of sales. Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 11

Periods of Increased Activity. . . u Assuming no change in selling prices, unit VC and FC. . . – Abacus Computers will increase its profits by $0. 80 for each additional dollar of sales. – Tailor Made Company will increase its profits by $0. 40 for each additional dollar of sales. Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 12

Leverage. . . u To – the scientist. . . Leverage explains how one is able to move a large object with a small force. Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 13

Operating Leverage u Is a measure of the extent to which fixed costs are being used in an organization. Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 14

Financial Leverage u Financial leverage is the financing of a portion of the firm’s assets with securities bearing a fixed (limited) rate of return. Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 15

Consider this. . . Labor-Intensive Firms % FC: TC Machine-Intensive Firms % FC: TC Therefore, machine-intensive firms use more operating leverage than laborintensive firms. Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 16

Consider two firms. . . Firm A Labor-Intensive Firm B Machine-Intensive Both increase sales by 20%. Which one will have the larger increase in profits? Why? Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 17

Degree of Operating Leverage u The DOL is the measure of how a percentage change in sales volume at a given level of sales activity will affect profits. u A measure of how sensitive net operating income is to percentage changes in sales. Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 18

Degree of Operating Leverage u The Formula. . . Contribution Margin ------------------ = DOL Net Income Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 19

Abacus and Tailor Made Company Income Statement Comparison For Year Ended December 31, 2003 u Abacus Sales u $500 Tailor Made Sales $500 VC 300 CM $200 FC 100 NI $100 Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 20

Degree of Operating Leverage u For Abacus Computers. . . $400, 000 DOL = ------------- = 4 $100, 000 Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 21

Degree of Operating Leverage u For Tailor Made Company $200, 000 DOL = ------------- = 2 $100, 000 Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 22

The Change in Net Income Abacus Computers $100, 000 x 20% x 4 = $80, 000 Tailor Made Company $100, 000 x 20% x 2 = $40, 000 Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 23

Observations on DOL u The DOL varies at different levels of sales activity. . . – Highest near the breakeven point – Undefined at breakeven point – Lessens with increased sales volume Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 24

The Margin of Safety u Excess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred. Margin of safety = Total sales - Break-even sales Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 25

The Margin of Safety Exhaustion Unlimited has a break-even point of $200, 000. If actual sales are $250, 000, the margin of safety is $50, 000 or 100 exercise bikes. Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 26

The Margin of Safety The margin of safety can be expressed as 20% of sales. ($50, 000 ÷ $250, 000) Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 27

Sales Mix u Sales mix is the relative proportions in which a company’s products are sold. u Different products have different selling prices, cost structures, and contribution margins. Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 28

Multi-product break-even analysis Wind Bicycle Co. provides the following information: Dr. Fred Barbee $265, 000 = 48. 2% (rounded) $550, 000 ACCT 202 Principles of Managerial Accounting 29

Multi-product break-even analysis Fixed expenses Break-even sales = CM Ratio $170, 000 = 0. 482 = $352, 697 Rounding error Dr. Fred Barbee ACCT 202 Principles of Managerial Accounting 30