Answer to Questions - 2-1 Answer to Questions 1. A fixed cost is a co...

Chapter 2 Cost Behavior, Operating Leverage, and Profitability Analysis 2-1 Answer to Questions

• A fixed cost is a cost that in total remains constant as volume of

activity changes but on a per unit basis varies inversely with changes in volume of activity. A variable cost is a cost that in total changes directly and proportionately with changes in vol- ume of activity but on a per unit basis is constant as volume of activity changes. An example of a fixed cost is a supervisor’s salary in relation to units produced. An example of a variable cost is direct materials cost in relation to units produced.

• Most business decisions are based on cost information. The

behavior of cost in relation to volume affects total costs and cost per unit. For example, knowing that total fixed cost stays constant in relation to volume and that total variable cost in- creases proportionately with changes in volume affects a com- pany’s cost structure decisions. Knowing that volume is ex- pected to increase would favor a fixed cost structure because of the potential benefits of operating leverage.

• Operating leverage is the condition whereby a small percentage

increase in sales volume can produce a significantly higher per- centage increase in profitability. It is the result of fixed cost be- havior and measures the extent to which fixed costs are being used. The higher the proportion of fixed cost to total cost the greater the operating leverage. As sales increase, fixed cost does not increase proportionately but stays the same, allowing greater profits with the increased volume.

• Operating leverage is calculated by dividing the contribution

margin by net income. The result is the number of times greater the percentage increase in profit is to a percentage increase in sales. For example, if operating leverage is four, a 20% increase in sales will result in an 80% increase in profit.

• The concept of operating leverage is limited in predicting profit-

ability because in practice, changes in sales volume are usually related to changes in sales price, variable costs, and fixed costs, which all affect profitability.Fundamental Managerial Accounting Concepts 7th Edition Edmonds Solutions Manual Visit TestBankDeal.com to get complete for all chapters

Chapter 2 Cost Behavior, Operating Leverage, and Profitability Analysis 2-2

• With increasing volume a company would benefit more from a

fixed cost structure because of operating leverage, where each sales dollar represents pure profit once fixed costs are covered.If volume is decreasing, the variable cost structure would be more advantageous because costs would decrease proportion- ately with decreases in volume. With a pure fixed cost struc- ture, costs stay constant even when sales revenue is decreas- ing, eventually resulting in a loss.

• Economies of scale are possible when the size of an operation

is increased. Increases in size correspond to increases in vol- ume, which reduces the unit cost of production because of fixed cost behavior. Economies of scale are found in businesses that are capital intensive (businesses that have a higher percentage of their assets in long-term operational assets that result in large amounts of fixed depreciation cost), e.g., steel and auto- motive industries.

• Fixed costs can provide financial rewards with increases in

volume, since increases in volume reduce fixed costs per unit, thereby increasing profits. The risk involved with fixed costs is that decreases in volume are not accompanied by decreases in costs, eventually resulting in losses.

• Fixed costs can provide financial rewards with increases in

volume, since increases in volume do not cause corresponding increases in fixed costs. This kind of cost behavior results in increasing profits (decreases in cost per unit). But this does not mean that companies with a fixed cost structure will be more profitable. Predominately fixed cost structures entail risks. De- creases in volume are not accompanied by decreases in costs, which can eventually result in losses (increases in cost per unit).

Chapter 2 Cost Behavior, Operating Leverage, and Profitability Analysis 2-3

• The definitions of both fixed and variable costs are based on

volume being within the relevant range (normal range of activi- ty). If volume is outside the relevant range, fixed costs may in- crease in total if volume increases require that additional fixed assets be acquired (whereby, depreciation charges would in- crease). Likewise, variable costs may decrease per unit if in- creases in volume allow quantity discounts on materials. In- creases or decreases in volume that are outside the relevant range can invalidate the definitions of fixed and variable costs.

• The average is more relevant for pricing purposes. Customers

want standardized pricing in order to know the price of a service in advance. They don’t want to wait until after the service is per- formed to know how much it costs. Average cost is also more relevant for performance evaluation and for control purposes.Knowing the actual cost of each service is usually of little value in evaluating cost efficiency and knowing when to take correc- tive action.

• The high-low method is the appropriate method when simplicity

is more important than accuracy. Least squares regression is more appropriate when accuracy is more important.

• A fixed cost structure would have more risk because profits vary

more with changes in volume. Small changes in volume can cause dramatic changes in profits. In addition, with a fixed cost structure, losses occur until fixed costs are covered. Given high fixed costs, a company would need high volume to reap the rewards associated with this cost structure.

• The president appears to be in error because fixed costs fre-

quently can be changed. For example, fixed costs such as ad- vertising expense, training, and product improvement result from short-term decisions and may be easily changed. While it is more difficult, even fixed costs such as depreciation expense can be reduced and changed by selling long-term assets.

Chapter 2 Cost Behavior, Operating Leverage, and Profitability Analysis 2-4

• The statement is false for two reasons. More importantly, the

statement ignores the concept of relevant range. The terms fixed cost and variable cost apply over some level of activity within which the company normally operates. Accordingly, the definitions of fixed and variable costs only apply within the rele- vant range. Secondly, even if a business ceases operations and produces zero products, it incurs some fixed costs such as property taxes, maintenance, and insurance.

• Norel could calculate the average heating cost by dividing total

annual expected heating cost by total annual production. The result could then be multiplied by monthly production to deter- mine the amount of monthly heating cost to assign to inventory.This procedure would have the effect of averaging the seasonal fluctuations and would, therefore, result in a more stable unit cost figure.

• Verna is confused because the terms apply to total cost rather

than to per unit cost. Total fixed cost remains constant regard- less of the level of production. Total variable cost increases or decreases as production increases or decreases. Verna is cor- rect in her description of unit cost behavior. She is incorrect about the use of the terms, for the reasons above.

Exercise 2-1A

Requirement Fixed Variable Mixed

• x
• x
• x
• x
• x
• x