Accounting: Chapter 7

Fixed costs are those that _____________ with \n changes in the volume of production

do not change

Therefore: as sales increase,

fixed costs do not increase

The degree to which a firm locks into fixed costs is referred to as its

leverage position

The more highly leveraged a firm, the _________ it is because of the obligations related to fixed costs that must be met even if the firm is having a bad year with low sales

riskier

At the same time, the more highly leveraged, the greater the profits when

sales are high

Financial leverage is the extent to which a firm \n obtains capital from debt versus equity

(D/E ratio)

The greater the D/E ratio, the more highly leveraged the firm, because debt legally obligates the firm to annual interest payments (which are a ___________)

fixed costs

Operating leverage is concerned with the extent to which a firm commits itself to high levels of fixed costs _______________________

other than interest payments

\n A firm that rents property using cancelable leases has less leverage than with

non-cancelable leases

A firm that has substantial vertical integration has created a

highly leveraged situation

To a great degree, your desired leverage position depends on the degree to which your sales and profits ___________

fluctuate

The greater the fluctuation in sales and profits

the less leverage you can safely afford

If your firm is a _________, noncyclical firm, then \n use of debt will improve the rate of return earned by your shareholders

Stable

If cyclical factors in your industry or the economy at large tend to cause your business to have both good and bad years

then debt entails a greater risk

Both these financial decisions—how much financial leverage and how much operating leverage the firm should have

are fundamental to the firm

The level of operating leverage a firm selects \n should be based in part on input from the \n managers directly involved in the _______________

\
E.g., technology decisions affect company’s _________ \n

Financial leverage decisions: CEO/CFO (top managers)

Production Process;

\
Operations

More often than not, the firms that have solvency problems are the ones that didn’t formally address the

leverage issues head on

Contribution Margin = _______ – Variable Cost

Price

This margin represents the amount of money \n available to be used to pay fixed costs and provide the firm with ________ (also CM% = CM / Revenue)

profit

So if your selling price is lower than your variable cost per unit, you are ______________________!

guaranteed to lose money!

Operating leverage decisions are extremely \n important, but after-the-fact you can’t do anything about it (sunk cost: ignore for decision-making)

Importance for profit discovery: what is/isn’t profitable

Break-even Quantity

Fixed Costs / (Price – Variable Cost)

Break-even Quantity

Fixed Costs / (Contribution Margin)

Higher fixed _______________ increase the BEQ \n

But life is simple if there are no fixed costs (price > VC)

and variable costs

Larger fixed costs – higher operating leverage – places pressure on the __________________

volume of sales

Risk-return tradeoff: the lower the variability in our sales,

the lower the risk associated with high fixed costs

Your fixed cost is $595,000, your sales price is \n $1,500/unit, and your variable cost is $1,138/unit

\n How many units must you sell to break even? \n ($595,000) ÷ (_______ – $1,138) = 1,643.6

\n You need to sell 1,644 units to break even

1,500

You’re considering a $50,000 advertising campaign \n

($595,000 __________) ÷ ($1,500 – $1,138) = 1,781.8 \n

You need to sell 1,782 units to break even

\+50,000

You’re considering lowering the price to $1,350 \n ($595,000) ÷ ($1,350 _________) = 2,806.6 \n

You need to sell 2,807 units to break even

\-1,138

This break-even analysis is an example of Cost- \n Volume-Profit (CVP) analysis that used to make \n business decisions

\n Planning tool that looks at the relationships among costs and volume and how they affect profits

Assumptions inherent in CVP analysis:

\n The _____________ per unit does not change with volume

\
Managers can classify each cost as fixed or variable \n

Fixed costs ____________ (do not change with volume) \n

Variable costs (per unit) do not change with volume

selling price;

\
are constant

Let’s consider a company that sells 2 products \n

A necessary assumption for breakeven analysis here is that the ______________ (% of units sold) is constant

product mix

Say their fixed cost is $88,000 and their sales mix is 75% Product A and 25% Product B \n ($88,000) ÷ (____) = 16,000 weighted average units \n

You need to sell 16,000 weighted avg units to break even

\n Is this the same as just “sell 16,000 units”? Why?

$5.50