Deck 11: Cost Behavior, Operating Leverage, and Profitability Analysis

Question 1

What is operating leverage, and how does a company achieve operating leverage?

Answer 1

Answers will vary

Operating leverage exists when a company achieves a disproportionate change in profit from a small increase in sales. For example, a 5% increase in sales could result in a 25 or 50% increase in profit. A company achieves operating leverage through having fixed costs in its cost structure.

Question 2

Assume that wages expense is a variable cost and that the relevant range is 10,000 to 15,000 labor hours. Within that range, the cost is $15 per hour. What can you assume about wages expense outside this range?

Answer 2

Answers will vary

Outside the relevant range, the cost may be more or less than $15 per hour. A cost relationship or behavior that applies within a specified range may not apply outside that range.

Question 3

What is meant by the phrase, "cost structure?"

Answer 3

Answers will vary"Cost structure" refers to the amount of fixed cost and variable cost a company has. For example, a company's managers may be able to make a change that would increase fixed costs and decrease variable costs. Such a change would increase the company's operating leverage.

Question 4

How does variable cost per unit behave when volume decreases?

Question 5

Complete the following table to indicate your understanding of fixed and variable cost behavior by inserting one of the following responses in each box: "Remain constant," "Increase," or "Decrease."
$\begin{array}{llr}&\text { When Activity } & \text { When Activity } \\&\text { Increases } & \text { Decreases }\\ \text { Unit fixed costs} &\\ \text { Total fixed costs} &\\ \text { Unit variable costs } &\\\text { Total variable costs }&\end{array}$

Question 6

What are mixed or semivariable costs? Give an example of a mixed cost.

Question 7

If a company had a pure fixed cost structure, what would be the relationship between a given dollar increase in sales and net income?

Question 8

What is meant by the phrase, "relevant range"? How does the concept of relevant range affect fixed costs?

Question 9

What is an activity base, and how does the activity base relate to a variable cost?

Question 10

Phoenix Corporation manufactures smartphones, generally selling from 200,000 to 300,000 units per year. The following cost data apply to the activity levels shown:
$\begin{array}{lr}\text {Number ot Units }&200,000&250,000&300,000\\\text { Total costs }\\\\\text { Fixed } & \$ 15,000,000 \\\text { Variable } & 24,000,000 \\\text { Total costs } & \$ 39,000,000\\\text {Cost per Unit}\\\text {Fixed}&\$75\\\text {Variable}&120\\\text {Total cost ner unit}&\$195\end{array}$ Required: Complete the preceding table by filling the missing amounts for 250,000 and 300,000 units.Assume that Phoenix actually makes 280,000 units. What would be the total costs and the cost per unit at this level of activity? (Round the cost per unit to two decimal points)If Phoenix sells each unit for $220, what is Phoenix's magnitude of operating leverage at sales of 280,000 units? (Round to two decimal points.)

Question 11

How does total variable cost respond when volume increases?

Question 12

For Marvin Company, the magnitude of operating leverage was 3.5 during the current year. Demonstrate what this magnitude of operating leverage would mean for the company's profitability by creating an example.

Question 13

Income statements for three companies are provided below:
$\begin{array}{lrrr}&\text { company A }&\text { company B }&\text { company C }\\\text { Sales (20 units) } & \$ 1,000 & \$ 1,000 & \$ 1,000 \\\text { Less variable costs } & 600 & 300 & 0 \\\text { Less fixed costs } & 200 & 500 & 500 \\\text { Jet income } & \$ 200 & \$ 200 & \$ 200\end{array}$
Required:Prepare new income statements for the firms assuming each sells one additional unit (i.e. each firm sells 21 units)Briefly describe the effect of cost structure on profitability.

Question 14

How does fixed cost per unit behave when volume decreases?

Question 15

How does total fixed cost behave when volume increases?

Question 16

How is operating leverage related to cost structure?

Question 17

If a company had a pure variable cost structure, what would be the relationship between contribution margin and net income, and what would be the magnitude of operating leverage?

Question 18

Sandford Company manufactures one product. Its variable manufacturing cost is $16 per unit; total fixed manufacturing cost is $600,000.Required:Calculate Sandford's total manufacturing costs if it produces 10,000 units.What would be the total cost per unit (including both fixed and variable costs) assuming that Sandford produces 10,000 units?Calculate Sandford's total manufacturing costs if it produces 20,000 units.What would be the total cost per unit assuming that Sandford produces 20,000 units?Compare your answers from parts 2 and 4. If the cost per unit is different at 10,000 units than at 20,000 units, explain why.

Question 19

Describe the format of an income statement prepared using the contribution margin approach.

Question 20

Grant Company and Lee Company compete in the same market. The following budgeted income statements illustrate their cost structures.
$\begin{array}{lrr}&\text {Grant Company}&\text {Lee Company}\\ \text { Number of customers } & 200 & 200 \\\text { Sales revenue }(200 \times \$ 1 5 0) & \$ 30,000 & \$ 30,000 \\\text { Less variable costs } & 6,000 & 18,000 \\\text { Contribution margin } & \$ 24,000 & \$ 12,000 \\\text { Less fixed costs } & 19,000 & 7,000 \\\text { Net income } & \$ 5,000 & \$ 5,000\end{array}$
Required:If Grant Company lowers its price to $135, it will lure 80 customers away from Lee Company. Prepare Grant's income statement based on 280 customers.If Lee Company lowers its price to $135 (assuming that Grant Company is still charging $150 per customer), Lee would lure 80 customers away from Grant. Prepare Lee's income statement based on 280 customers.Which of the companies would benefit more from lowering its sales price to attract more customers, and why?

Question 21

Maryland Novelties Company produces and sells souvenir products. Monthly income statements for two activity levels are provided below:
Required:Identify the mixed expense(s).Prepare a contribution margin income statement at the 20,000-unit level.

Question 22

During the current year, Goldblum Company sold 160,000 units of its product at a selling price of $40. The variable cost per unit was $30, and Goldblum reported net income for the year of $220,000. What was the amount of Goldblum's fixed costs for the year?

Question 23

During the current year, Vanguard Company sold 80,000 of its only product at a selling price of $60 per unit. Variable costs were $18 per unit, and Vanguard's margin of safety for the year was 25,000 units.
Required:Calculate Vanguard's margin of safety ratio for the current year.What was the amount of Vanguard's fixed costs for the current year?

Question 24

Ruiz Company produces and sells a product that has variable costs of $50 and a selling price of $90. Its current sales total $270,000 per month. Fixed manufacturing costs total $40,000 per month and fixed selling and administrative costs total $35,000 per month.
Required:Compute the company's current break-even point in units.Compute the company's current income and margin of safety in dollars.

Question 25

What does the margin of safety measure?

Question 26

Larimore Company sales are $560,000. The company has variable costs equal to 40% of sales and total fixed costs of $150,000.Required:What is the company's break-even point in sales dollars?Compute the company's operating leverage at its current sales level.Compute the percentage change in income that will accompany a 10% increase in sales.

Question 27

Goff Corporation sells products for $75 each that have variable costs of $50 per unit. Goff's fixed cost is $350,000.
Required:Calculate the contribution margin per unit, then use the per unit contribution margin approach to find the break-even point in units and dollars.

Question 28

How can contribution margin per unit be used to find the break-even point in units?

Question 29

Lush Lawn, Incorporated produces and sells electric lawn trimmers for $120 each. The variable costs of each mower total $80 while total monthly fixed costs are $6,000. Current monthly sales are $48,000.
Required:Compute the company's current break-even point in units and dollars.What is the company's current margin of safety in units, dollars, and percentage?

Question 30

Canton Company produces and sells toasters. The following unit cost information assumes a production and sales volume of 15,000 units:
Required:Compute the budgeted selling price per unit assuming Canton uses a cost-plus pricing strategy and a markup equal to 75% of production cost.Compute the firm's total fixed costs.Compute the firm's contribution margin per unit given the budgeted selling price you computed in Requirement 1.Compute the firm's breakeven point in units and dollars, using the selling price you calculated in part 1.Estimate the profit when 15,000 units are sold.

Question 31

The following information is for a product manufactured and sold by Drake Company:
Sales price per unit: $100Variable cost per unit: $30Total annual fixed costs: $350,000Required:Calculate the contribution margin per unit.How many units must Drake sell to break-even?How many units must Drake sell to achieve a profit of $35,000?

Question 32

Assume that Microsoft and Sony both plan to introduce a new hand-held video game. Microsoft plans to use a heavily automated production process to produce its product while Sony plans to use a labor-intensive production process. The following revenue and cost relationships are provided:
$\begin{array}{lrr}&\text { Microsott Game }&\text { sony Game }\\ \text {Selling price per unit }&150&150\\ \text {Variable costs ner unit}\\\\\text { Direct materials } & \$ 27.00 & 27.00 \\\text { Direct labor } & 7.50 & 30.00 \\\text { Overhead } & 7.50 & 30.00 \\\text { Selling and administrative } & 3.00 & 3.00\\\text { Annual fixed costs }\\\\\text { Overhead } & \$ 600,000 & \$ 240,000 \\\text { Selling and adminstrative } & 135,000 & 135,000 \end{array}$
Required:Compute the contribution margin per unit for each company.Prepare a contribution income statement for each company assuming each company sells 8,000 units.Compute each firm's net income if the number of units sold increases by 10%.Which firm will have more stable profits when sales change? Why?

Question 33

The following information is for a product of Lanier Company:Last year, the variable cost per unit was $25. Total fixed costs were $800,000. At a volume of 170,000 units, the company achieved a profit of $50,000.
Required:What was the unit sales price for the product last year?

Question 34

Select the term from the list provided that best describes each of the following descriptions or definitions.

Question 35

What is the break-even point for a company?

Question 36

Cannon Company operates a clothing store that reported the following operating results for the current year:
$\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$ $\quad$$\text { Income statement }$
$\begin{array}{lr}\text { Sales revenue } & \$ 2,000,000 \\\text { Cost of goods sold } & \underline{(1,200,000) }\\\text { Gross margin } & \$ 800,000 \\\text { Employee commissions and bonuses ( } 5 \% \text { of sales) } & (100,000) \\\text { Depreciation expense } & (150,000) \\\text { Salaries expense } & (260,000)\\\text { Shipping and delivery expense ( \( 2 \% \) of sales)} &(40,000) \\\text { Advertising expense}&\underline{(80,000) }\\\text { Net income }&\underline{\$170,000}\end{array}$
Required: Prepare an income statement for Cannon Company using the contribution margin format.

Question 37

Former NFL coach Joe Gibbs is highly sought after as a guest speaker. His fee can run as high as $150,000 for a single two-hour appearance. Recently, he was asked to speak at a seminar offered by the National Sports in Education Foundation (NSEF). Due to the charitable nature of the organization, Mr. Gibbs offered to speak for $100,000. NSEF planned to invite 350 guests who would each make a $500 contribution to the organization. The Foundation's executive director was concerned about committing so much of the organization's cash to this one event. So instead of the $100,000 fee she countered with an offer to pay Mr. Gibbs 50% of the revenue received from the seminar and no other payments.
Required: Classify the two offers in terms of cost behavior (fixed vs. variable):
Scenario A, NSEF pays Gibbs a $100,000 fee.
Scenario B, NSEF pays Gibbs 50% of revenue.Compute the budgeted income (assuming there are no other expenses) under each of the following scenarios:NSEF agrees to pay the $100,000 fee, and 350 guests actually attend the seminar; andNSEF pays Mr. Gibbs 50% of revenue, and 350 guests attend the seminar.For each scenario ($100,000 fee vs. 50% of revenue), compute the percentage increase in profit that would result if the Foundation is able to increase attendance by 20 percent over the original plan (to a total of 420). (Round the percentages to the nearest whole numbers.)
For each scenario, compute NSEF's cost per contributor if 350 attend and if 420 contributors attend. (Round the cost per contributor to two decimal points.)
Summarize the impact on risk and profits of shifting the cost structure from fixed to variable costs.

Question 38

The Varsity Club sells souvenir items at university sporting events for $24 each. The souvenir items cost $16 each. The club is negotiating with the university administration to sell the items in a kiosk in the university student center. Three rental arrangements are under consideration:
Option 1: Pay rent of $2,000Option 2: Pay rent of $1,200 plus 10% of revenueOption 3: Pay the university 25% of revenue
The club estimates that it will be able to sell 300 souvenir items during the period.
Required:Compute the break-even point in units for each of the three options.Assuming the club reaches its sales target, which option should be chosen?

Question 39

Explain how to calculate contribution margin per unit.

Question 40

Gamble Company has contribution margin of $20 per unit and a break-even point of 10,000 units. If Gamble sells 9,999 units, what would be its net income or loss? Explain how you calculated your answer.

Question 41

Lex Company produces products that it sells for $10 each. Variable costs per unit are $4, and annual fixed costs are $120,000.Required:Use the equation method to determine the break-even point in units and dollars.

Question 42

Houston Company produces a product that sells for $175 per unit and has variable costs of $50 per unit. Houston's annual fixed costs are $200,000, and the company wishes to earn a profit of $80,000.
Required:Use the equation method to determine the sales volume in units and dollars required to earn the desired profit.

Question 43

Write an equation for each item provided:
Contribution margin per unit = _______Break-even in units = _______Break-even in dollars = _______Units required to achieve desired profit = _______Dollars required to achieve desired profit = _______Margin of safety ratio = _______