IMI 203: ESSENTIALS OF ACCOUNTING

Class 8: Introduction to Managerial

Accounting

Michael Marin
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Administrative Issues I’ll purchase Airbus this week.

1. Group Assignment #1:

• Well-Done!
• Average: 42.78/50 or 85.56%
• Winning Team: Team 4.

2. Term Test
• Will have grades after Reading Week.

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Managerial Accounting Is there a risk of accounting manipulation?

What is the goal of accounting? → Provide information that is useful for decision-making

Module 2 • Managerial accounting is concerned with providing

information to inside managers to help make
decisions.
INTERNAL • Managerial accounting provides tools to assist
MANAGEMENNT

management in making decisions and evaluating the

ACCOUNTIG
MANAGERS &
DECISION effectiveness of those decisions.
MAKERS
EXTERNAL STAKEHOLDERS

FINANCIAL
ACCOUNTING Module 1

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High-Level Overview (Hopefully, to generate interest?)

• The role of managerial accountants is

• Identification, Managerial accounting is broad and straddles
competitive strategy, organizational economics,
• Measurement, and finance, operations management and organizational
• Management behavior.

• of key operational and financial value drivers (Institute of Management

Accountants).

• Managerial accountants are

• Problem Solvers (i.e., Provide information for decision making);
• Scorekeepers (i.e., Measure performance of individuals, groups and processes),
• Attention Directors (i.e., strategic cost management).
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Putting it Together: Managerial vs. Financial Accounting

“Now let me
welcome
everybody to the
Wild Wild West.”

Tupac Shakur
Historical vs. Future Perspective
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Planning and Control Cycle Role of Management!

Formulating long • Managerial accounting

and short-term encompasses more than
plans (Planning) reporting numbers.
• Managerial accounting
Comparing Implementing
includes partnering with
actual to plans
Decision other managers and
planned (Directing
Making departments and providing
performance and
tools and reports to those
(Controlling) Motivating)
areas.
Measuring
Good decision making is rarely done by
performance
intuition. Consistently good decisions result
(Controlling)
from diligent accumulation and evaluation of
information.
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Module 2 Map – (i.e., Our Path to the Exam.)

UNDERSTANDING STRATEGIC DECISION EVALUATING

PROFITABILITY MAKING PERFORMANCE
(Class 8 & 9) (Lecture 10 & 11 ) (Class 10 & 12 )

COST DEFINITIONS RELEVANT COSTS VARIANCE ANALYSIS

COST BEHAVIOUR & BUDGETING & PERFORMANCE

COST ANALYSIS PLANNING MEASUREMENT &
COMPENSATION
COSTING ALLOCATION
& COSTING METHODS

Management accounting is extremely important for businesses because it

allows them to translate hard data about their finances into reports that can be
analyzed and used for strategic business decisions
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 What went into this?
Decision Making News Release

“As part of its initiatives to drive long-term profitable

growth and enhance shareholder value, and after
careful consideration of all reasonably available
options, the Company also announced today it has
decided to discontinue support for Nordstrom
Canada's business operations.”

"Despite our best efforts, we do not see a realistic

path to profitability for the Canadian business”

“The Company expects to report

approximately $300 million to $350 million of pre-tax
charges related to the wind-down and is expected
Theme: Managers make to result in an approximately $400 million decline in
decisions, and therefore need total Company net sales and a $35
million improvement in total Company EBIT in fiscal
information. 2023, relative to fiscal 2022, excluding the
aforementioned charges associated with the wind-
down.”

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 Cost Terms,
Concepts, and
Classification Managers rely upon different
classifications of costs for different
purposes. Understanding cost
measurement helps manage
costs.

Do you think this is more important

than ever?

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Cost Definition
Where have we seen this before? Microeconomics? Strategy? Marketing?

• The cost of your product or service is

the amount you spend to produce it
• The price is your financial reward for
providing the product or service
• The value is what your customer
believes the product or service is
worth to them

Every business needs to cover its costs in order to make a profit. Working out
your costs accurately is an essential part of working out your pricing.
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Importance of Costs

• In a perfectly competitive market, when an individual firm has no control over price (i.e.,
total revenue), the only way for the firm to maximize profit is…

Even without perfect competition, cost minimization is important for profitability.

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Basic Cost Terms

1. Cost
• A sacrifice of resources.
• Different from “Expense”
• Cost that is recognized to match revenue generated [accounting meaning, based on
matching principle].
2. Cost Object
• Any activity or item for which a separate measurement of costs is desired.
• Cost objects are the “something” in the statement: “We need the cost of ‘something’”!
3. Cost Driver
• Any factor whose change “causes” a change in the total cost of a related cost object
• Volume, Labor hours, Product returns, etc.

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Cost Objects
We can come back to this.

Organization Cost Object

Royal Bank - Credit card services Cost of each card
University of Toronto Cost of each program
Air Canada Cost of flight
Walt Disney Cost of producing films
Loblaws Costs of each store location

Discussion: What costs went into these different objects?

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Direct vs. Indirect costs

Classification based on the traceability of costs

1. Direct costs:
• Costs that can be traced to a given cost object (product, department, etc.) in
an economically feasible way.
• Mostly Variable costs
2. Indirect costs (i.e., Overhead costs)
• Costs that cannot be traced to a cost pool
• Indirect costs must be allocated

Let’s return to previous slide. What costs are Direct? Indirect?

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Cost Classification Next Class is all about Allocation.

https://www.linkedin.com/pulse/costs-starbucks-1-make-your-coffee-over-10-when-you-sit-benaroya

DIRECT COSTS

INDIRECT COSTS
COST OBJECT

• Direct costs are traced to a cost object.

• Indirect costs are allocated or assigned to a cost object.
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Cost Definitions and Classifications
1. MANUFACTURING COSTS Can also think about this for service industries

Cost Definition
• Materials that become an integral part of a finished product and
Direct Materials
can be conveniently traced to it.
• Small items of material that may become an integral part of a
Indirect Materials finished product but whose costs of tracing exceed the benefits

• Factory labour costs that can be traced easily to individual units

Direct Labour
of product
• Labour costs of janitors, supervisors, material handlers and
Indirect Labour other factory workers that cannot be conveniently traced
directly to a particular product.
Manufacturing • All costs associated with the manufacturing except direct
Overhead materials and direct labour.

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Cost Definitions and Classifications (cont’d)
2. NON-MANUFACTURING COSTS

Cost Definition
Marketing/Selling • All costs necessary to secure customer orders and get the
Costs finished product or service to the customer.
• All executive, organizational, and clerical costs associated with
Administrative Costs the general management of an organization rather than with
manufacturing, marketing and selling.
Research and • Costs incurred in the research or development phase of a
Development Costs product.

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Cost Definitions and Classifications (cont’d)
3. PRODUCT vs. PERIOD COSTS

Cost Definition
Product Costs • Include all costs involved in purchase or manufacture of goods.

• All costs that are expensed on the income statement in the

Period Costs period in which they are incurred or accrued. Selling
(marketing) and administrative expenses are period costs.

Necessary
distinction for
external
• Costs relate directly to • Costs not directly
making the product. related to the product. financial
• Cost assigned to • Cost expensed when reporting
inventory. incurred.
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Costs and Financial Reporting

Income
Balance Sheet
Statement

Raw Materials Operating Expenses

Selling & Admin Expenses
Work in Process
INVENTORY Finished goods

COGS

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Classification of Inventory

Inventorial Costs:
Costs that end up
on the balance
Raw Materials WIP Finished
sheet as part of Goods COGS
Work-in -process
inventory
Inventory (Asset) Expense

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Cost Definitions and Classifications (cont’d)
4. VARIABLE vs. FIXED COSTS

Cost Definition
• A cost that varies in total, in
Variable direct proportion to
Costs changes in the level of
activity.
• A cost that remains
constant in total, regardless
Fixed Costs of changes in the level of Cost Structure: Proportion of
activity within the relevant variable vs. fixed costs in a company
range. and will depend on the organization
• A cost that has a
Mixed component that is fixed and
Costs a component that is
variable.
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Cost Classification for Decision Making

Differential
Costs that differ between 2 alternatives.
Cost

Differential
Revenue
Revenues that differ between 2 alternatives.

Incremental
Cost Increase in cost between 2 alternatives.
Cost Classification for Decision Making (cont’d)

Opportunity Potential benefit given up when one alternative is

Cost selected over another

Sunk Cost Cost that has already been incurred and cannot
be changed.
What’s relevant?

What were some of the relevant costs and benefits in this decision?

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What’s relevant? (cont’d)

What were some of the relevant costs and benefits in this decision?

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 Cost Behaviour

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“Recap” What is the “shut-down” point?

Make Sure you understand this concept.

Variable Costs
• Variable Costs vary in total directly and
proportionately with changes in the
activity level.
• Variable costs remain the same per unit at
every level of activity.

Fixed Costs
• Costs that remain the same in total
regardless of changes in the activity level
within a relevant range.
• Fixed cost per unit cost varies inversely with
activity: As volume increases, unit cost
declines, and vice versa.
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Types of Fixed & Variable Costs

Committed Fixed Costs True Variable Cost

• Cannot be reduced easily • The amount used during a
without significantly period varies in direct
impacting operations and proportion to the level of
objectives. production activity.

Discretionary Fixed Costs Step Variable Cost

• Can be reduced more • The cost of a resource that is
easily in the short run obtainable only in large
without significant changes amounts and the increase or
to operations and decrease only in response to
objectives. fairly wide changes in activity.

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Cost Structure Highly Dependant on the Company/Product/Industry

Taken from 2022 Lender Presentation

• The relative proportion of fixed versus variable costs that a company incurs

Is there a difference
between hardware and
experience cost structure
for Peloton?

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Cost Behavior Example Fixed vs. Variable

How do operating costs change in relation to a change in the level of activity?

If Peloton produces one more bike, what

will be the impact on the following costs?

Rent for CEO Salary Materials Wages of Wages of Utilities

Factory Factory Designer
Workers

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 Cost Behavior Example (cont’d) Fixed vs. Variable

News Release: Sept. 8, 2020

If Peloton introduces an entire new product line,

what will be the impact on the following costs?

Rent for CEO Salary Materials Wages of Wages of Utilities

Factory Factory Designer
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Workers
Relevant Range PS3? Tesla? Taylor Swift?

• Range of activity (ex. production/sales) over Explain This.

which the cost-volume relationships are valid.
• Total fixed costs and per unit variable
costs will remain the same
• Identification of relevant range is important
because knowing the production level at
which costs will change is critical for cost
accounting, budgeting and financial
planning.

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TheThe Linearity
Linearity Assumption
Assumption andand the
the Relevant Range
Relevant Range

Economist’s A straight line

closely
Curvilinear Cost approximates a
Function curvilinear
variable cost
Relevant line within the
relevant range.
Total Cost

Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)

Activity
© 2015 McGraw-Hill Ryerson
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Mixed Costs

• Costs that have both a variable Who remembers those infamous texts about
element and a fixed element. running out of data?
• Change in total but not
proportionately with
changes in activity level.
• Ex. Utilities including
electricity, water and natural
gas

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Mixed Costs Analysis (Regression Light?)

• For purposes of cost-volume-profit analysis, mixed costs must be classified into

their fixed and variable elements.
• High-Low Method uses total costs incurred at high and low levels of activity
to classify mixed costs into fixed and variable components.
• Difference in costs between high and low levels represents variable costs,
since only variable-cost element can change as activity levels change.
• Steps:
Remember Y = mx + b?
1. Find the high point and the low point
2. Find the variable rate Total Cost = VC per Unit *
3. Find the fixed cost Units + Fixed Costs

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High-Low Example (Source: Corporate Finance Institute)

• The manager of a hotel would like to develop a cost model Month Guests Cost
to predict the future costs of running the hotel.
January 1,500 $ 143,000
• The only available data is the level of activity (number of February 2,300 $ 203,100
guests) in a given month and the total costs incurred in
March 1,000 $ 105,450
each month.
April 4,323 $ 454,225
• He anticipates that the number of guests in September
May 4,545 $ 371,225
will be 3,000. What is the expected cost?
June 3,541 $ 296,225
$ Y = a + bx
July 4,312 $ 353,945
August 2,143 $ 191,237
Y = Total mixed costs September 3,000
a = total fixed costs
B = variable cost per unit of activity
Fixed Costs X = the level of activity.

# units
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High-Low Example (Source: Corporate Finance Institute)

Variable Costs

Month Guests Cost = ($371,225 - $105,450)/(4,545 – 1000)

= $74.97 per guest
Low March 1,000 $ 105,450
Fixed Cost
High May 4,545 $ 371,225
=$371,225 – $74.97*4,545
= 30,480
Expected Cost = $30,480 + 74.97/guest
= $30,480 + 74.97 * 3,000 Too Simple? Is Regression Better?
= $255,390
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Regression Analysis

• Thoughts?
• What is preferred?
SUMMARY OUTPUT
Cost
Regression Statistics $500,000
Multiple R 0.964781991 $450,000
R Square 0.93080429 y = 84.973x + 13451
$400,000
Adjusted R Square 0.919271671
Standard Error 34895.73533 $350,000

Total Cost
Observations 8 $300,000
$250,000
ANOVA
$200,000
df SS MS F Significance F
Regression 1 98282266296 98282266296 80.71057729 0.000106339 $150,000
Residual 6 7306274067 1217712345 $100,000
Total 7 1.05589E+11
$50,000

Coefficients Standard Error t Stat P-value $0

0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000
Intercept 13450.63097 30577.33183 0.439888969 0.675420175
Guests 84.9730372 9.458361629 8.983906571 0.000106339 Number of Guests

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 CVP Analysis

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Cost-Volume-Profit Analysis

Cost Behavior Analysis is the study of how specific costs respond to changes in the
level of business activity.

• Set of tools to help managers understand the behaviour of total revenues, total
costs and operating income when quantity, selling price, variable or fixed costs
of the product change.
• Focuses on the interactions among:
Types of Activity Levels
1. Prices of products
2. Volume or level of activity 1. Sales dollars (retail company)
2. Miles driven (trucking company).
3. Per unit variable costs 3. Room occupancy (hotel).
4. Total fixed costs 4. Dance classes taught (dance studio).
5. Mix of products sold
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Profit Equation

Price –
Variable Costs

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Levers of Profitability Easier said than done…

Increase Increase Qty

Selling Price Sold

Decrease Decrease
Variable Costs Fixed Costs

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Assumptions of Cost-Volume-Profit Analysis

• All costs may be classified as fixed or variable costs

• Total cost function is linear
• Total revenue function is linear
• Analysis is a single-product or a multiple-product firm with a constant sales mix
• Single activity cost driver – sales volume (units or $)

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Key Formulas

1. Unit Contribution Margin

• Contribution margin is available to cover fixed costs and to contribute to
income.
• Unit Contribution Margin = Price – VC per Unit
2. Contribution Margin Ratio
• Shows the percentage of each sales dollar available to apply toward fixed
costs and profits.
Don’t Trust
• Contribution Margin Ratio = Unit Contribution Margin / Price
Me? Do the
• OR: Contribution Margin Ratio = Total CM/Total Revenue algebra…

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CVP Income Statement

• A statement for internal use. Use to Make Decisions!

• CVP income statement
classifies costs as fixed or
variable and computes a Revenue (Price*Quantity)
contribution margin.
Less: Variable Costs (VC/unit * Quantity)
• Contribution margin is the Contribution Margin
amount of revenue remaining
after deducting variable costs. Less: Fixed Costs
Net Income (CM – FC)
• Reports same net income as
a traditional income
statement.

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How is CM different from Gross Margin?

Gross Margin Contribution Margin

INCOME STATEMENT INCOME STATEMENT
For the period ending Dec 31st, 20XX For the period ending Dec 31st, 20XX

Sales $XXXX Sales $XXXX

COGS XXX Variable Costs XXX
Gross Margin XX Contribution Margin XX
SG&A Expenses X Fixed Costs XX
Net Income $ X Net Income $ X
IN CLASS EXAMPLE

Snowie’s Shaved Ice Business:

Planning and Decision Making
Snowie’s Shaved Ice Business
We will use this example to understand Cost-Volume-Profit Analysis

• Assume that you are evaluating whether to

start a Snowie business.
• Shaved ice is an ice-based refreshment made
by shaving a block of ice into a fluffy, snow-like
ice.
• You could operate a shaved ice kiosk at fairs,
downtown areas, and other outdoor events.
• The flavored shaved ice, a “Snowie,” is
normally offered in three sizes.
• For this case, we are going to assume that
only one size is offered and that it sells for
$4.00.
• See Table for a list of all costs related to
Snowie.
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Calculate the CM and CM Ratio What are your costs with 0 sales?

Identify Fixed and Variable Costs

Price $4.00 $4.00

Less: Variable Ice $0.20
Costs
Spoon $0.02
Variable Cup $0.08
Napkin $0.02
Syrup $.152 $.472
($4.25/28)
Contribution $3.528
Margin
Fixed

Unit CM 88.20%
($3.538/$4.00)

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Break-Even Point Revenues – Variable Costs – Fixed Costs = 0

• Break-Even Point is level of activity at which total revenues equal total costs
(both fixed and variable).
• Expressed either in sales units or in sales dollars
• At the break-even point, contribution margin must equal total fixed costs.
• Break-even point can be computed using either contribution margin per
unit or contribution margin ratio

Fixed ÷ Unit Contribution Margin = Break-Even Point in

Costs Units
Fixed ÷ Contribution Margin = Break-Even Point in
Costs Ratio Dollars

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Break-Even Point (cont’d)

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Calculate the Break-Even Point

• Calculate the number of Snowies that you need to sell each month to break
even.

Is this possible?

We need to make assumptions.

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Calculate the Break-Even Point (cont’d)

1. Number of days you anticipate opening the Snowie kiosk per month?
• Let’s Assume 20
2. Number of hours you will work (no wages required) per day?
• Let’s Assume 0
• Too busy with Accounting Class?
3. Number of hours you will pay an employee to work in the Snowie kiosk per
day?
• 8 (Typical 9-5)

We will come back to critically “evaluate” these assumptions

53
Calculate the Break-Even Point (cont’d)

• Calculate the number of Snowies that you need to sell each month to break
even.
Type Calculation Cost
Hourly Wages 8 hours * $10/hr * 20 $1,600
days
Event Registration $25 *20 days $500
Electricity… $250/month $250
Kiosk Renal $650/month $650
Depreciation of Ice-Shavers $3,180/5*(1/12) $53
Depreciation of Flavor Station $1,080/5*(1/12) $18
TOTAL $3,071

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Calculate the Break-Even Point (cont’d)

$3,071 ÷ $3.528/unit = 870.46 Break-Even Point

FC Unit CM in Units
$3,071 ÷ 88.20% = $3,481.86 Break-Even Point
FC CM Ratio in Dollars

Should we invest? (Think about the assumptions…)

Remember:
“Managerial accounting is broad and straddles competitive strategy, organizational economics, finance,
operations management and organizational behavior.”

55
Break-Even Point (Graph or “Substitution” Method)

Revenues – Variable Costs – Fixed Costs = 0

Revenues = Variable Costs + Fixed Costs

Price * Quantity = VC/unit * Quantity + Fixed Costs
4Q = .472Q + $3,071
3.528Q = $3,071
Q = 870.46 units
Revenues = Price * Quantity
= $4/unit * 870.46 units
Do what is easiest
and convert!
= $3,481.86
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Target Operating Profit Analysis
You want to make

• It is likely that you’d want to do more than break-even.

• Instead, a manager may be more interested in learning the necessary sales level
to achieve a targeted profit.

Is this not just a Break-Even Analysis?

Units to
= Fixed Expenses + Target Profit
attain
Unit CM
target profit Fixed Expenses
Target profits Unit CM
* If given an after tax profit, use 1-tax rate

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Margin of Safety

• Difference between actual or expected sales and sales at break-even point.

• Measures “cushion” that a particular level of sales provides.
• May be expressed in dollars or as a ratio.

Actual (Expected) − Break-Even = Margin of Safety in

Sales Sales Dollars
Margin of Safety In ÷ Actual = Margin of Safety Ratio
Dollars (Expected)
Sales

How much would sales have to drop before I am losing money?

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Sensitivity Analysis

• We have estimated the impact of variables on quantity to be sold and profits to

be made.
• How certain are we of the increase in quantity as a response to change X?
• Sensitivity Analysis is a « what if » technique that examines how results would
change if data predicted is not achieved.

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Operating Leverage

• A measure of how sensitive net operating income is to percentage changes in

sales.
• Income does not rise proportionately with an increase in sales.
• The higher the level of fixed costs, the higher the level of risk. However, as sales
volumes increase, the payoff is typically greater with higher fixed costs

Fixed Costs ÷ Total Costs = Operating Leverage

Contribution Margin ÷ Operating = Degree of Operating
Income Leverage
Degree of Operating x % change in = % change in Operating
Leverage Sales Income

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Operating Leverage: Example Relevant Examples?

Pharma? Netflix?

Company A Company B
Sales $200,000 $200,000
Variable Costs $70,000 $20,000
CM $130,000 $180,000
Fixed Costs $50,000 $100,000
Operating Income $80,000 $80,000

Degree of Operating Leverage 1.625 2.25

Sales ↑ 10% Operating Income ↑ 16.25% Operating Income ↑ 22.5%
Sales ↓ 10% Operating Income ↓ 16.25% Operating Income ↓ 22.5%

Back earlier slides, what cost structure is preferred?

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Thank You!