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Exam 2: Cost Behavior, Operating Leverage, and Profitability Analysis

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Question 71

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Contribution margin represents the amount available to cover fixed expenses and then provide company profits.

A) True
B) False

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Question 72

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Based on the income statements shown below, which division has the cost structure with the highest operating leverage? $\begin{array} { | l | c | c | c | } \hline & \text { Soft Drinks } & \text { Bottled Water } & \text { Frust Juices } \\\hline \text { Revenue } & \$ 50,000 & \$ 50,000 & \$ 50,000 \\\hline \text { Variable costs } & ( 10,000 ) & ( 5000 ) & ( 30,000 ) \\\hline \text { Contribution margin } & 40,000 & 45,000 & 20,000 \\\hline \text { Fixed costs } & ( 30,000 ) & ( 40,000 ) & ( 10,000 ) \\\hline \text { Net income } & \$ 10,000 & \$ 5,000 & \$ 10,000 \\\hline\end{array}$

A) Bottled Water.
B) Fruit Juices.
C) Soft Drinks.
D) The three divisions have identical operating leverage.

E) B) and C)
F) C) and D)

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Question 73

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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." $\begin{array} { | l | l | l | } \hline & \begin{array} { l } \text { When Activity } \\\text { Increases }\end{array} & \begin{array} { l } \text { When Activity } \\\text { Decre ase s }\end{array} \\\hline \text { Unit fixed costs } & & \\\hline \text { Total fixed costs } & & \\\hline \text { Unit variable costs } & & \\\hline \text { Total variable costs } & & \\\hline\end{array}$

Larry's Lawn Care incurs significant gasoline costs. This cost would be classified as a variable cost if the total gasoline cost:

Income statements for three companies are provided below: $\begin{array}{|l|c|c|c|}\hline& \text { Company A } & \text { Company B } & \text { Company C }\\\hline \text { Sales (20 units) } & \$ 1,000 & \$1,000 & \$1,000 \\\hline \text { Less variable costs } & 600 & 300 &- \\\hline \text { Less fixed costs } & 200 & 500 & 800 \\\hline \text { Net income } & \$ 200 & \$200 &\$ 200 \\\hline\end{array}$ Required: (a) Prepare new income statements for the firms assuming each sells one additional unit (i.e. each firm sells 21 units)(b) Briefly describe the effect of cost structure on profitability.

ETutor is an online tutoring service provider that is particularly popular with college students. The company is interested in estimating the fixed and variable components of its tutoring services costs. The manager believes that these costs are driven by the number of hours of tutoring services provided. The following information was gathered for the last six months of business: Required: $\begin{array} { | l | r | r | } \hline \text { Month } & \text { Number of Hours } & \text { Tutoring costs } \\\hline \text { January } & 25,000 & \$ 308,000 \\\hline \text { February } & 41,000 & 420,000 \\\hline \text { March } & 29,000 & 352,000 \\\hline \text { April } & 31,000 & 373,000 \\\hline \text { May } & 34,000 & 378,000 \\\hline \text { June } & 18,000 & 252,000 \\\hline\end{array}$ 1) Compute the average tutoring cost per hour for the six-month period. (Round the average tutoring cost per hour to two decimal points.)2) Use the high-low method to estimate the total fixed cost and the variable cost per hour. (Round the variable cost per hour to two decimal points.)3) Name one advantage and one disadvantage of the high-low method.4) Describe the scattergraph method that can be used to analyze mixed costs.

One way that computing an average cost per unit facilitates management decision making is that managers are provided more timely and more relevant cost information.

Maryland Novelties Company produces and sells souvenir products. Monthly income statements for two activity levels are provided below: $\begin{array}{|l|l|lr|}\hline \text { Unit volumes } &{20,000 \text { units }} &{30,000 \text { units }} \\\hline \text { Revenue } & \$ 150,000 & \$ 225,000 \\\hline \text { Less cost of goods sold } & 60,000 & 90,000 \\\hline \text { Gross margin } & \$ 90,000 & \$ 135,000 \\\hline \text { Less operating expenses } & & & \\\hline \text { Salaries and commissions } & 20,000 & 25,000 \\\hline \text { Advertising expenses } & 30,000 & 30,000 \\\hline \text { Administrative expenses } & 12,500 & 12,500 \\\hline\text { Total operating expenses }&62,500&67,500\\\hline\text { Net income }&\427,500&\$67,500\\\hline\end{array}$ Required: 1) Identify the mixed expense(s).2) Use the high-low method to separate the mixed costs into variable and fixed components.3) Prepare a contribution margin income statement at the 20,000-unit level.

Companies with low operating leverage will experience lower profits when sales increase than will companies with higher operating leverage.

Production during the current year for California Manufacturing, a producer of high security bank vaults, was at its highest point in the month of June when 80 units were produced at a total cost of $800,000. The lowest point in production was in January when only 20 units were produced at a cost of $440,000. The company is preparing a budget for the current year and needs to project expected fixed cost for the budget year. Using the high-low method, the projected amount of fixed cost per month is:

Pickard Company pays its sales staff a base salary of $4,500 a month plus a $3.00 commission for each product sold. If a salesperson sells 800 units of product in January, the employee would be paid:

Assume that management uses the regression method to separate a mixed cost into its fixed and variable components. Briefly describe the significance of the R Square (R²) when interpreting the reliability of cost estimates that result.

Two different costs incurred by Ruiz Company exhibit the following behavior pattern per unit: $\begin{array} { | l | l | l | l | l | } \hline & &{ \text { Units Sold } } \\\hline & 50 & 100 & 150 & 200 \\\hline \text { Cost \# } 1 & \$ 300 \text { per unit } & \$ 150 \text { per unit } & \$ 100 \text { per unit } & \$ 75 \text { per unit } \\\hline \text { Cost \# } 2 & \$ 2 \text { per unit } & \$ 2 \text { per unit } & \$ 2 \text { per unit } & \$ 2 \text { per unit } \\\hline\end{array}$ Cost #1 and Cost #2 exhibit which of the following cost behavior patterns, respectively?

An advantage of using the scattergraph method over the high-low method is that all points of data are used in determining the cost line.

Select the correct statement regarding fixed costs.

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: $\begin{array}{|l|c|c|}\hline &\text { Microsoft Game } & \text { Sony Game }\\\hline \text { Selling price per unit } & 150 & 150 \\\hline \text { Variable costs per unit } & & \\\hline \text { Direct materials } & \$27.00 &\$ 27.00 \\\hline \text { Direct labor } & 7.50 & 30.0 \\\hline \text { Overhead } & 7.50 & 30.00 \\\hline \text { Selling and administrative } & 3.00 & 3.00 \\\hline \text { Annual fixed costs } & & \\\hline \text { Overhead } & \$ 600,000 & \$240,000 \\\hline \text { Selling and administrative } & 135,000 &135,000 \\\hline \end{array}$ Required: (a) Compute the contribution margin per unit for each company.(b) Prepare a contribution income statement for each company assuming each company sells 8,000 units.(c) Compute each firm's net income if the number of units sold increases by 10%.(d) Which firm will have more stable profits when sales change? Why?

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

Contribution margin can only be determined if costs are separated into product and period costs.

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?

If a profitable company has both fixed and variable costs, its operating leverage will always be greater than 1.