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Tutorial 2 - Student Answer

Operating leverage is using fixed costs to magnify small changes in revenue into dramatic changes in profitability. One small change in revenue will lead to a big change in profitability. The document provides examples and exercises on identifying fixed and variable costs, using contribution margin format income statements, analyzing operating leverage, and estimating fixed and variable costs using the high-low method. Advice is given to an investor to choose an investment with lower earnings volatility due to its lower risk, but one that could provide higher gains if the investor is aware of the risks.

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311 views

Tutorial 2 - Student Answer

Operating leverage is using fixed costs to magnify small changes in revenue into dramatic changes in profitability. One small change in revenue will lead to a big change in profitability. The document provides examples and exercises on identifying fixed and variable costs, using contribution margin format income statements, analyzing operating leverage, and estimating fixed and variable costs using the high-low method. Advice is given to an investor to choose an investment with lower earnings volatility due to its lower risk, but one that could provide higher gains if the investor is aware of the risks.

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DâmDâmCôNương
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BUSN 9117 - Management and Cost Accounting


Phuong Giang Nguyen
ID: 2225141

TUTORIAL QUESTION WEEK 2


Q3, E2-1A, E-2-6A, E-2.13A, E2.15A, P2-23A, P2-26A a,b,c only

Q3. Define the term operating leverage and explain how it affects profits.
Answer: Operating leverage is using fixed cost to magnify small changes in revenue into
dramatic changes in profitability. One small change in revenue will lead to a big change in
profitability.

Exercise 2-1A Identifying cost behavior


Rachael’s Restaurant, a fast-food restaurant company, operates a chain of restaurants across
the nation. Each restaurant employs eight people; one is a manager paid a salary plus a bonus
equal to 4 percent of sales. Other employees, two cooks, one dishwasher, and four servers, are
paid salaries. Each manager is budgeted $3,000 per month for advertising costs.
Required
Classify each of the following costs incurred by Rachael’s Restaurant as fixed, variable, or
mixed: a. Advertising costs relative to the number of customers for a particular restaurant.
Fixed cost
b. Rental costs relative to the number of restaurants. Variable cost
c. Cooks’ salaries at a particular location relative to the number of customers. Fixed cost
d. Cost of supplies (cups, plates, spoons, etc.) relative to the number of customers. Mixed cost
e. Manager’s compensation relative to the number of customers. Variable cost
f. Servers’ salaries relative to the number of restaurants. Variable cost

Exercise 2-6A Fixed versus variable cost behavior


Leach Trophies makes and sells trophies it distributes to little league ballplayers. The company
normally produces and sells between 6,000 and 12,000 trophies per year. The following cost
data apply to various activity levels:
Required
a. Complete the preceding table by filling in the missing amounts for the levels of activity shown
in the first row of the table. Round all cost-per-unit figures to the nearest whole penny.
Number of trophies 6,000 8,000 10,000 12,000
Total cost inccured
Fixed 60,000 60,000 60,000 60,000
Variable 60,000 80,000 100,000 120,000
Total costs 120,000 140,000 160,000 180,000
Cost per unit
Fixed 10 7.5 6 5
Variable 10 10 10 10
Total cost per trophy 20 17.5 16 15

b. Explain why the total cost per trophy decreases as the number of trophies increases.
The number of Trophies increase but the fixed cost is the same  fixed cost per unit decreases
when number of trophies increases.

Exercise 2-13A Using contribution margin format income statement to measure the
magnitude of operating leverage
The following income statement was drawn from the records of Joel Company, a merchandising
firm:
Required
a. Reconstruct the income statement using the contribution margin format.
JOEL COMPANY
Revenue $ 250,000
Variable Expenses ($ 157,000)
Contribution Margin $ 93,000
Fixed Expenses ($74,000)
Net income $ 19,000

Variable Expenses = COGS + Sales commissions + Shipping and handling expenses


= 130,000 + 25,000 + 2,000 = $ 157,000
Fixed Expenses = Admin Salaries Expense + Advertising expense + Depreciation expense
= 30,000 + 20,000 + 24,000 = $ 74,000
b. Calculate the magnitude of operating leverage.
Magnitude of operating leverage = Contribution margin / Net income = 93,000 / 19,000 = 4.89
c. Use the measure of operating leverage to determine the amount of net income Joel will earn
if sales increase by 10 percent
JOEL COMPANY
Revenue (increased 10%) $ 275,000
Variable Expenses ($ 172,700)
Contribution Margin $ 102,300
Fixed Expenses ($74,000)
Net income $ 28,300

Net income increase by 48% when revenue increase by 10%


Exercise 2-15A Averaging costs
Mountain Camps, Inc. leases the land on which it builds camp sites. Mountain is considering
opening a new site on land that requires $2,500 of rental payment per month. The variable cost
of providing service is expected to be $6 per camper. The following chart shows the number of
campers Mountain expects for the first year of operation of the new site:

Required
Assuming that Mountain wants to earn $5.50 per camper, determine the price it should charge
for a camp site in February and August.
The average fixed cost per camper for a year = 2,500 * 12 / 4,000 = $7.5/camper
 the price should be $7.5+ $6 + $5.5 = $19

Although the price will not make much profit on Feb, however, we cannot increase price
because of the fixed cost. It will not attract customer. Therefore, the whole price for all year
$19/camper is the best solution.
Problem 2-23A Analyzing operating leverage
Arnold Vimka is a venture capitalist facing two alternative investment opportunities. He intends
to invest $800,000 in a start-up firm. He is nervous, however, about future economic volatility.
He asks you to analyze the following financial data for the past year’s operations of the two
firms he is consid-ering and give him some business advice.

Required
Round your figures to two decimal points in all required computation.
a. Use the contribution margin approach to compute the operating leverage for each firm.
Larson Magnitude of Operating Leverage = Contribution margin / Net income = 72,000/48,000 =
1.5  A 10% increase in sales results in a 15% increase in net income.
Benson Magnitude of Operating Leverage = Contribution margin / Net income =
144,000/48,000 = 3  A 10% increase in sales results in a 30% increase in net income.
b. If the economy expands in coming years, Larson and Benson will both enjoy a 10 percent per
year increase in sales, assuming that the selling price remains unchanged. Compute the change
in net income for each firm in dollar amount and in percentage. (Note: Since the number of
units in-creases, both revenue and variable cost will increase.)
Larson’s net income increase by 15% (48,000 * 15% = 7,200)
Benson’s net income increase by 30% (48,000 * 30% = 14,400)
c. If the economy contracts in coming years, Larson and Benson will both suffer a 10 percent
decrease in sales volume, assuming that the selling price remains unchanged. Compute the
change in net income for each firm in dollar amount and in percentage. (Note: Since the
number of units decreases, both total revenue and total variable cost will decrease.)
Larson’s net income decrease by 15% (48,000 * 15% = 7,200)
Benson’s net income decrease by 30% (48,000 * 30% = 14,400)
d. Write a memo to Arnold Vimka with your analyses and advice.
Larson have lower earnings volatility than Bensons  Lower risk. However, if Arnold want to
have a big gain from this investment and aware of this risk, he can invest on Benson.
Problem 2-26A Estimating fixed and variable cost
Thornton Computer Services, Inc. has been in business for six months. The following are basic
operating data for that period:

Required
a. What is the average service revenue per hour in each month and the overall average for the
six-month period?
Average service revenue/hour = revenue / service hours
 Overall average for the six-month period = $50/hour

July $6,000/120 = $50/hour


Aug $6,800/136 = $50/hour
September $13,000/260 = $50/hour
Oct $21,000/420 = $50/hour
Nov $16,000/320 = $50/hour
Dec $16,500/330 = $50/hour

b. Use the high-low method to estimate the total monthly fixed cost and the variable cost per
hour.
Highest point is Oct and lowest cost is July
Vavriable cost per hour = difference in total cost/difference in volume
= (11,200 – 4,300)/(420 – 120) = $23 / hour
Fixed cost = Total operating cost – variable cost = 4,300 - $23 * 120 = $ 1,540
c. Determine the average contribution margin per hour.
Avevage contribution margin per hour = Average service revenue per hour – variable cost per
hour = $50 - $23 = $27/hour

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