11 Flashcards
(8 cards)
- Define fi xed cost and variable cost and give
an example of each.
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 is a cost that in total changes directly proportionately with changes in volume of activity but on a per unit basis is constant as volume of activity changes. An example of a fixed cost is a supervisor’s salary in relation to units produced. An example of a variable cost is direct materials cost in relation to units produced.
- How can knowing cost behavior relative to
volume fluctuations affect decision making?
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 fixed cost stays constant in relation to volume and that variable cost increases proportionately with changes in volume affects a company’s cost structure decisions. Knowing that volume is expected to increase would favor a fixed cost structure because of the potential benefits of operating leverage.
- If volume is increasing, would a company
benefit more from a pure variable or a pure
fixed cost structure? Which cost structure
would be advantageous if volume is
decreasing?
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 fixed costs are covered. If volume is decreasing the variable cost structure would be more advantageous, because costs would decrease proportionately with decreases in volume. With a pure fixed cost structure, costs stay constant even when sales revenue is decreasing, eventually resulting in a loss.
- Explain the risk and rewards to a company
that result from having fixed costs.
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 with fixed costs is that decreases in volume are not accompanied by decreases in costs, eventually resulting in losses.
- Are companies with predominately fixed
cost structures likely to be most profitable?
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 results in increasing profits (decreases in cost per unit). But this does not mean that companies with a fixed cost structure will be most profitable. Predominately fixed cost structures entail risks. Decreases in volume are not accompanied by decreases in costs, which can eventually result in losses (increases in cost per unit).
- Verna Salsbury tells you that she thinks
the terms fixed cost and variable cost are
confusing. She notes that fixed cost per
unit changes when the number of units
changes. Furthermore, variable cost per
unit remains fixed regardless of how many
units are produced. She concludes that
the terminology seems to be backward.
Explain why the terminology appears to
be contradictory.
Verna is confused because the terms apply to total cost rather than to per unit cost. Total fixed cost remains constant regard-less of the level of production. Total variable cost increases or decreases as production increases or decreases. Verna is correct in her description of unit cost behavior. She is incorrect about the use of the terms, for the reasons cited above.
- What does the term break-even point mean?
Name the two ways it can be measured.
Break-even is the point where total revenue is equal to total costs. It can be measured in units or sales dollars.
- How does a contribution margin income
statement differ from the income statement
used in financial reporting?
In the contribution margin income statement all variable costs are subtracted from sales revenues to determine the contribution margin before subtracting all fixed cost to derive profit. The traditional statement does not disclose contribution mar-gin because cost of goods sold and operating expenses consist of both variable and fixed costs.
