You are analyzing Becker Corporation and Newton Corporation, and have concluded that Becker has a higher operating leverage factor than Newton.  Which one of the following choices correctly depicts (1) the relative use of fixed costs (as opposed to variable costs) for the two companies and (2) the percentage change in income caused by a change in sales? Who has the greater used of fixed cost compared to variable, and who has the greater percentage change in income caused by change in sales?

  If Company A has a higher degree of operating leverage than Company B, then:

  a.   Company A has higher variable expenses relative to its fixed expenses.

  b.   Company A’s profits are more sensitive to percentage changes in sales.

  c.   Company A is more profitable.

  d.   Company A is less risky.                                           

a.   Company A has higher variable expenses relative to its fixed expenses.

b.   Company A’s profits are more sensitive to percentage changes in sales.

  c.   Company A is more profitable.

  d.   Company A is less risky.

A 45% contribution margin ratio means that:

        a.   45% of the company’s revenue is available to cover fixed costs and to contribute toward

              net income.

        b.   the company’s revenue has increased by 45% during the current accounting period.

        c.   55% of the company’s revenue is consumed by fixed and variable costs.

        d.   fixed costs make up 45% of sales revenue.

 a.   45% of the company’s revenue is available to cover fixed costs and to contribute toward

              net income.

        b.   the company’s revenue has increased by 45% during the current accounting period.

        c.   55% of the company’s revenue is consumed by fixed and variable costs.

        d.   fixed costs make up 45% of sales revenue.

BEP: Increase

Margin of Safety: Decrease

.   The contribution margin ratio always increases when the:

         a.   variable expenses as a percentage of  sales increase.

         b.   variable expenses as a percentage of sales decrease.

         c.   break-even point increases.

         d.   break-even point decreases.  

a.   variable expenses as a percentage of  sales increase.

         b.   variable expenses as a percentage of sales decrease.

         c.   break-even point increases.

         d.   break-even point decreases.  

The costing method that can be used most easily with break-even analysis and other cost-volume-profit techniques is:

         a.   variable costing

         b.   absorption costing

         c.   process costing

         d.   job-order costing

        a.   variable costing

         b.   absorption costing

         c.   process costing

         d.   job-order costing

Net income reported under variable costing will exceed net income reported under absorption costing for a given period if:

         a.   production exceeds sales for that period.

         b.   production equals sales for that period.

         c.   sales exceed production for that period.

         d.   the variable manufacturing overhead exceeds the fixed manufacturing overhead.

 a.   production exceeds sales for that period.

         b.   production equals sales for that period.

         c.   sales exceed production for that period.

         d.   the variable manufacturing overhead exceeds the fixed manufacturing overhead.

1.    high-low method.

2.    scattergraph method (just conceptual)

3.    least squares regression method (just conceptual)

Y = mx + b

Y     = Total Cost

m    = Variable Cost Rate (or slope of the line)

x     = Activity Level

b     = Total Fixed Cost (where the cost line intersects the Y-Axis

Scattergraph Method (aka visual fit method)

For the scattergraph method, the accountant plots the points on a graph and then visual draws a line to fit the points.

The advantage of this method is it includes ALL points observed in the analysis through the use of a graph.  All points of activity and cost are considered in the placement not just the high and low points.  The disadvantage of this method is its lack of objectivity.  Two different people may draw two different lines.

The least squares regression method

The least squares regression model uses statistics to fit a line to all the data points.  The least squares method plots a line that minimizes the residuals or standard deviation.  This method results in the smallest error and typically the best fit line.  In the past, using regression to calculate a line was time consuming and usually not worth the effort.  However with advances in computer technology, this method is now as easy as the other methods.

The traditional Income Statement is as follows:

SalesRevenue

- Cost of Goods Sold

GrossMargin                                                          

- Selling and Admin Expenses

Net Income         (We ignore taxes for this)

The Contribution Income Statement divides costs into fixed and variable.

Sales Revenue        

Minus Variable Expenses

     Variable Manufacturing

     Variable Selling

     Variable Administrative

Contribution Margin

Minus Fixed Expenses

     Fixed Manufacturing

     Fixed Selling

     Fixed Administratative

NetIncome                                                             

Contribution Margin

Why would a company chose to have a Low Operating Leverage vs. a High Operating Leverage?

The answer is that a company with a Low Operating Leverage has a much lower breakeven point (level of sales at which net income equals zero) than a company with a High Operating Leverage.  This means that a Low Operating Leverage company can sell far fewer units and still make a profit while a high operating leverage company needs to sell many units to make a profit.

the amount of revenue that is available for covering fixed expenses after all variable expenses have been covered.

If Contribution Margin < Fixed Costs -> Loss

If Contribution Margin = Fixed Costs -> Breakeven (just cover all costs; $0 Profit)

If Contribution Margin > Fixed Costs ->Profit

the revenue generated from selling one unit less the costs associated with that unit.

Unit Contribution Margin divided by Sales Price

which is the percentage of each sales dollar that is greater than marginal cost. 

multiplying the unit contribution margin for each product by the percentage of total sales and summing up the values.

is the difference between budgeted sales revenue and the breakeven sales revenue.  It represents the amount sales can decrease before the company starts losing money.

Safety Margin = Budgeted Sales Dollars – Breakeven Sales Dollars

is the percentage by which sales can drop before losses begin to occur.

Safety Margin Percentage = Safety Margin/Budgeted Sales Dollars

is the difference between the budgeted sales volume to be sold and the breakeven sales volume.

Safety Margin in Units = Budgeted Sales Volume – Breakeven Sales Volume

inventory costs have included both variable and fixed costs.....

all fixed manufacturing-overhead costs are applied to inventory.

only variable costs (direct materials, direct labor and variable manufacturing overhead) are applied to inventory.

traditional income statement format

contribution income statement format

• Inventory Effect: Inventory Increases
• Fixed Manufacturing Costs 
  • Absorption LESS THAN Variable
• Net Income
  • Absorption GREATER THAN Variable

• Inventory Effect: Inventory Decreases
• Fixed Manufacturing Costs 
  • Absorption GREATER THAN Variable
• Net Income
  • Absorption LESS THAN Variable

• Inventory Effect: No Change
• Fixed Manufacturing Costs 
  • Absorption EQUAL TO Variable
• Net Income
  • Absorption EQUAL TO Variable

Advantages of Variable Costing

1.    Variable costing does not allow managers to manipulate net income by increasing inventory (helpful for calculating bonuses)-spreading FMOH over more and more units to drive down COGS.

2.    It provides a better basis for short-term pricing decisions, since any price above a product’s variable cost makes a positive contribution to cover fixed costs

Disadvantages of Variable Costing

1.    Both the IRS and Generally Accepted Accounting Principles (GAAP) requires firms to report inventory using absorption costing

2.    Assets should be recorded at their cost.  Since fixed costs are a cost of producing inventory, these costs should be included in the value of the inventory.