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Chapter 11 Cost Behavior, Operating Leverage, and Profitability Analysis
Answer to questions
1. 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
2. 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
3. Operating leverage is the condition whereby a small percentage change in sales
volume can produce a significantly larger percentage change in profitability. It is the
4. Operating leverage is calculated by dividing the contribution margin by net income.
5. The concept of operating leverage is limited in predicting profitability because, in
6. 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
7. Fixed costs can provide financial rewards with increases in volume because increases
in volume reduce fixed costs per unit, thereby increasing profits. The risk involved
8. 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
in costs, which can eventually result in losses (increases in cost per unit).
9. The definitions of both fixed and variable costs are based on volume being within the
relevant range (normal range of activity). If volume is outside the relevant range,
fixed cost may increase in total if volume increases require that additional fixed assets
10. 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
11. The president appears to be in error because fixed costs frequently can be changed.
For example, fixed costs such as advertising expense, training, and product
changed by selling long-term assets.
12. 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
13. Verna is confused because the terms apply to total cost rather than to per unit cost.
Total fixed cost remains constant regardless of the level of production. Total variable
14. Break-even is the point where total revenue is equal to total costs. It can be measured
in units or sales dollars.
15. In the contribution margin income statement all variable costs are subtracted from
16. The margin of safety is the decrease in sales that can occur before experiencing a loss.
The margin of safety expressed as a percentage would mean Company A’s actual sales
17. From Hartwell’s perspective, the $2,000 cost of the computer is a fixed cost. The
Exercise 11-1
Requirement
Fixed
Variable
Mixed
a.
x
b.
x
c.
x
d.
x
e.
x
f.
x
Exercise 11-2
Requirement
Fixed
Variable
Mixed
a.
x
b.
x
c.
x
d.
x
e.
x
f.
x
g.
x
h.
x
i.
x
j.
x
Exercise 11-3
Total Fixed Cost:
Item
Cost
Depreciation
$ 75,000
Officers' salaries
160,000
Long-term lease
38,000
Property taxes
12,000
Total fixed
$285,000
Units Produced (a)
4,000
4,500
5,000
Total fixed cost (b)
$285,000
$285,000
$285,000
Fixed cost per unit (b ÷ a)
$71.25
$63.33
$57.00
Exercise 11-4
Units Produced (a)
5,000
15,000
25,000
Variable cost per unit (b)
$14
$14
$14
Total variable cost (a x b)
$70,000
$210,000
$350,000
Exercise 11-5
a.
March
April
Units Produced (a)
200
400
Total rent cost (b)
$1,800
$1,800
Rent cost per unit (b ÷ a)
$9.00
$4.50
Total utility cost (c)
$600
$1,200
Utility cost per unit (c ÷ a)
$3.00
$3.00
b.
Since the total rent cost remains unchanged when the number of units produced changes, it
is a fixed cost. Since the total utility cost changes in direct proportion with changes in the
number of units, it is a variable cost.
Exercise 11-6
Number of Units
6,000
8,000
10,000
12,000
Total costs incurred
Fixed
$48,000
$ 48,000
$ 48,000
$ 48,000
Variable
48,000
64,000
80,000
96,000
Total costs
$96,000
$112,000
$128,000
$144,000
Cost per unit
Fixed
$ 8.00
$ 6.00
$ 4.80
$ 4.00
Variable
8.00
8.00
8.00
8.00
Total cost per unit
$16.00
$14.00
$12.80
$12.00
b. The total cost per unit declines as volume increases because the same amount of fixed
cost is spread over an increasingly larger number of units of product.
Exercise 11-7
Exercise 11-8
a.
a.
Total fixed cost
a.
Total variable cost
b.
Fixed cost per unit
Units
Units
$
$
$
$
b.
Variable cost per unit
Exercise 11-9
Begin by calculating the fixed cost based on the March sales. Calculate the fixed cost
by subtracting the variable cost from the total cost.
April
Total costs incurred
$7,500
Less: Variable cost ($25 x 200)
5,000
Fixed cost
$2,500
The fixed portion of the mixed cost will remain at $2,500 for any volume of sales within
the relevant range. Accordingly, this cost will be the same for all of the months under
consideration.
Month
April
May
June
July
Number of units
240
150
250
160
Total costs incurred
Total variable cost
$6,000
$3,750
$6,250
$4,000
Total fixed cost
2,500
2,500
2,500
2,500
Total salary cost
$8,500
$6,250
$8,750
$6,500
Exercise 11-10
a.
Number Attending (a)
2,000
2,500
3,000
3,500
4,000
Total cost of concert (b)
$105,000
$105,000
$105,000
$105,000
$105,000
Cost per person (b) (a)
$52.50
$42.00
$35.00
$30.00
$26.25
c.
$105,000
Total cost
Exercise 11-10 (continued)
d. Moore’s major business risk is the uncertainty about whether it can generate enough
revenue to cover the fixed cost. Moore must pay the $105,000 cost even if no one buys
To a large extent, Moore’s business risk is the result of its cost structure. To minimize
the risk, Moore could possibly change that structure. For instance, Moore may want
to negotiate with the band to set a flexible compensation scheme. The band may be
Number attending
Cost per unit
$50
Other business risks that may adversely affect Moore’s profit include competition,
unfavorable economy, security, and litigation.
Exercise 11-11
a.
Number shirts sold (a)
2,000
2,500
3,000
3,500
4,000
Total cost of shirts $9 x (a)
$18,000
$22,500
$27,000
$31,500
$36,000
Cost per shirt
$9
$9
$9
$9
$9
c.
Exercise 11-11 (continued)
d. Moore’s major business risk is the uncertainty about whether it can generate a
desirable profit. The cost and the revenue are both variable if Moore can return unsold
Total Cost
$35,000
.
.
0
2,000
2,500
3,000
3,500
4,000
Number of shirts sold
$
Exercise 11-12
Income Statements
a.
b.
Company Name
Kent
Trent
Number of Customers (n)
200
200
Sales revenue (n x $150)
$30,000
$30,000
Variable cost (n x $175)
(35,000)
Variable cost (n x $0)
0
Contribution margin
30,000
(5,000)
Fixed cost
(17,500)
0
Net income
$12,500
$ (5,000)
c. The strategy of cutting prices increases Kent’s revenue by $5,000 (i.e., $30,000 –
$25,000). In other words, selling 200 units at $150 each produces more revenue (i.e.,
$30,000) than selling 100 units at $250 each (i.e., $25,000). Since Kent’s costs are fixed,
Exercise 11-13
a. GAAP format:
Revenue
$160,000
Cost of goods sold ($50,000 fixed + $40,000 variable)
(90,000)
Gross Margin
70,000
Selling and administrative ($16,000 fixed + $13,000 variable)
(29,000)
Net Income
$41,000
b. Contribution margin format:
Revenue
$160,000
Variable Cost ($40,000 product + $13,000 selling and administrative)
(53,000)
Gross Margin
107,000
a. & b.
Fixed Cost ($50,000 product + $16,000 selling and administrative)
(66,000)
Net Income
$41,000
c. Both statements contain the same information. The difference is in how the
information is organized. GAAP requires cost information to be categorized as product
Exercise 11-14
Income Statement
Sales revenue ($35 x 300,000)
$10,500,000
− Gross margin
2,700,000
= Cost of goods sold
7,800,000
Total units
300,000
= Cost of product per unit
$26
− Fixed cost per unit
14
= Variable cost per unit
$12
Variable cost = $12 x 300,000 = $3,600,000
Total contribution margin = $10,500,000 − $3,600,000 = $6,900,000
Exercise 11-15
Income Statement
Sales Revenue (2,000 units x $275)
$550,000
Less: Variable costs
Cost of goods sold 2,000 units x $146)
(292,000)
Sales commissions (10% of Sales)
(55,000)
Shipping and handling expenses (2,000 units x $1.50)
(3,000)
Contribution margin
200,000
Less: Fixed costs
Administrative salaries
(80,000)
Advertising expense
(38,000)
Depreciation expense
(50,000)
Net income
$ 32,000
b.
Contribution margin
Operating leverage
=
—––——————––—
Net income
a.
