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Chapter 2 - Part 4

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Chapter 2 - Part 4

management accounting 2

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Faculty of Commerce – Cairo University MA -2022/2023 4th year English Section

Chapter 2 – Part 3: Introduction to Cost Behavior and Cost-


Volume-Profit Relations

C. Operating Leverage
1. Cost Structure: The combination of variable and fixed cost- resources used in carrying out
the organization’s objectives.
1. Lower variable costs are often achieved by incurring higher fixed costs.
2. Firms with high fixed costs and lower variable costs are said to have greater
operating leverage.

2. Operating Leverage: the sensitivity of a firm’s profit to change in the volume of sales.
a. In highly leveraged companies with lower variable costs, small changes in sales
volume result in large changes in net income.
b. In companies with less leverage and higher variable costs, changes in sales volume
have a smaller effect on income.

3. Degree of operating Leverage “DOL”


1. DOL: the ratio of contribution margin to profit, defined at a specific volume of sales.
2. It describes how a percentage change in sales will translate into a percentage change in
profit.

Higher Operating Leverage Lower Operating Leverage


No of units 70,000 90,000 70,000 90,000
80,000 80,000
(1st (2nd (1st (2nd
(base) (base)
change) change) change) change)
Per
Total Total Total Per Unit Total Total Total
unit
Sales Revenue 0.30 24,000 21,000 27,000 0.30 24,000 21,000 27,000
- Variable Cost (0.1
8,000 7,000 9,000 (0.25) 20,000 17,500 22,500
0)
= Contribution
0.20 16,000 14,000 18,000 0.05 4,000 3,500 4,500
Margin
- Fixed cost 14,000 14,000 14,000 2,000 2,000 2,000
= Net income 2,000 0 4000 2,000 1,500 2,500
% Change in
Profit (100%) 100% (25%) 25%
% Change in (12.5%) 12.5% (12.5%) 12.5%
Sales
DOL 8 2

Prepared by Dr. Sabah Soliman Page 1


Faculty of Commerce – Cairo University MA -2022/2023 4th year English Section

Degree of operating leverage 8 means that the percentage change in profit will be 8 times
the percentage change in sales.
Degree of operating leverage 2 means that the percentage change in profit will be 2 times
the percentage change in sales.
Why the higher-leverage cost structure is more risky?
• As it results in more variability in income, it might lead to higher net income but it also
might lead to a large net loss.
• The lower leverage is less risky as variations in sales volume lead to smaller variability
in net income.

Best Cost Structure


The best combination of variable and fixed-cost resources depends on many factors:
• The current level of sales.
• The expected level of future sales.
• The best cost structure is not necessarily the cost structure with the greatest margin of
safety, the lowest break-even point, or the highest operating leverage.
The best cost structure depends on the impact of risk and on the volume of sales both in the
current time period and in the future time period.

Solution
Amounts are in millions
Net sales (.9 × $82,559) $74,303
-Variable costs:
Cost of goods sold (.9 × $40,768) (36,691)
Contribution margin 37,612
-Fixed costs:
Selling, administrative, and general expenses (25,973)

Prepared by Dr. Sabah Soliman Page 2


Faculty of Commerce – Cairo University MA -2022/2023 4th year English Section

= Operating income $11,639

Solution
1.
$9,100 $9,100
= = 1,300 units
($25 - $18) $7

2. Contribution margin ratio: ($43,000 − $30,100) = 30%


$43,000

$8,400 ÷ 30% = $28,000


($30,400 + $8,000) $38,400
= = 2,400 units
3. ($29 - $13) $16

4. ($51,000 - $18,000) × (120%) = $39,600 contribution margin;


$39,600 - $18,000 = $21,600

5. New contribution margin: $48 - ($36 - 25% of $36)


= $48 - ($36 - $9) = $21;
New fixed expenses: $106,000 × 115% = $121,900;
($121,900 + $23,000) $144,900
= = 6,900 units
$21 $21

Prepared by Dr. Sabah Soliman Page 3


Faculty of Commerce – Cairo University MA -2022/2023 4th year English Section

Short Cases on Chapter 2


1. Pioneers Company presented the following information: selling price L.E 100, the total
fixed costs L.E 75,000. The break-even sales in pounds is L.E 250,000. Calculate the
variable cost per unit.
A) L.E30 B) L.E70 C) L.E100 D) L.E125

2. Lama Company presented the following information: selling price L.E 15, variable cost
per unit L.E 10.5, monthly fixed costs L.E 270,000, targeted income L.E 90,000. What is
the required sales volume in pounds to achieve next month?
A) 80,000 B) 120,000 C) 180,000 D) 1,200,000
3. Cleo Company presented the following information: selling price L.E 250, If the variable
cost ratio is 40%, the sales volume of LE 2000 produces LE 400 of net income. Total
fixed costs are :
A) LE 200 B) LE 400 C) LE 800 D) LE 1000
4. In August, a factory sold 3,000 units where the sales revenue totaled LE 60,000, the
variable costs totaled LE 36,000 and the fixed costs totaled LE 24,000. The per unit
contribution margin is:
LE 2 B) LE 8 LE 6 L.E. 4
5. Falls Company has budgeted sales of $120,000 based on 80,000 units. The margin of
safety is $1,000. What is the break-even point in dollars?
A) $81,000 B) $119,000 C) $120,000 D) $121,000

6. Pioneers Company presented the following information: contribution margin ratio 40%,
sales revenue L.E 500, 000, total fixed costs L.E 100,000. Total contribution margin is:
A) L.E400,000 B) L.E160,000 C) L.E 200,000 D) L.E40,000

Prepared by Dr. Sabah Soliman Page 4

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