Question

What is the difference between a fixed and a variable cost? What is meant by the term relevant range? How is relevant range applicable to CVP analysis? What is operating leverage and how/why would companies use operating leverage?

Answer 1

1. difference between fixed and a variable cost

Variable cost and fixed cost are the two main costs a company has when producing goods and services. A company's total cost is composed of its total fixed costs and its total variable costs. Variable costs vary with the amount produced. Fixed costs remain the same, no matter how much output a company produces.

A variable cost is a company's cost that is associated with the amount of goods or services it produces. A company's variable cost increases and decreases with the production volume. For example, suppose company ABC produces ceramic mugs for a cost of $2 a mug. If the company produces 500 units, its variable cost will be $1,000. However, if the company does not produce any units, it will not have any variable cost for producing the mugs.

On the other hand, a fixed cost does not vary with the volume of production. A fixed cost does not change with the amount of goods or services a company produces. It remains the same even if no goods or services are produced. Using the same example above, suppose company ABC has a fixed cost of $10,000 per month for the machine it uses to produce mugs. If the company does not produce any mugs for the month, it would still have to pay $10,000 for the cost of renting the machine. On the other hand, if it produces 1 million mugs, its fixed cost remains the same. The variable costs change from zero to $2 million in this example.

The below are the Key Differences between both: -

• Fixed cost is a cost that remains same regardless of volume of production while variable cost changes with the level of production.
• Fixed cost is a time related while variable cost is a volume related.
• Fixed cost are required to pay whether there is production or not. Variable costs only occurred when there is production.
• Variable costs remains same per unit while fixed cost per unit changes. In case of large production, per unit fixed cost decrease and vice versa.
• Fixed production is combination of fixed production overhead, fixed administration overhead and fixed selling and distribution overhead. Variable cost is combination of direct material, direct labor, direct expenses, variable production overhead, variable selling and distribution overhead.
• Examples of fixed costs are: depreciation, rent, salary, insurance, tax etc. Examples of variable costs are: material consumed, wages, commission on sales, packaging expenses, etc.

2. Relevant range

The relevant range refers to a specific activity level that is bounded by a minimum and maximum amount. Within the designated boundaries, certain revenue or expense levels can be expected to occur. Outside of that relevant range, revenues and expenses will likely differ from the expected amount. The concept of the relevant range is particularly useful in two forms of analysis, which are:

• Budgeting. When a company constructs a budget for a future period, it makes assumptions about the relevant range of activities within which the business is likely to operate. As long as the actual activity volume falls somewhere within the relevant range, and other assumptions are valid, budgeted revenues and expenses are more likely to be correct. In this case, the relevant range is most likely to be fairly close to the current activity level of a business, with minor modifications.

• Cost accounting. The assumed cost of a product, service, or activity is likely to be valid within a relevant range, and less valid outside of that range. in particular, a "fixed" cost is likely to remain fixed only within a relevant range of activity. Also, volume discounts from suppliers are only valid for certain purchasing volume quantities.

3.Operating leverage

Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is used to evaluate the breakeven point of a business, as well as the likely profit levels on individual sales. The following two scenarios describe an organization having high operating leverage and low operating leverage.

1. High operating leverage. A large proportion of the company’s costs are fixed costs. In this case, the firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs. However, earnings will be more sensitive to changes in sales volume.

2. Low operating leverage. A large proportion of the company’s sales are variable costs, so it only incurs these costs when there is a sale. In this case, the firm earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order to cover its lower fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn outsized profits if it can generate additional sales.

For example, a software company has substantial fixed costs in the form of developer salaries, but has almost no variable costs associated with each incremental software sale; this firm has high operating leverage. Conversely, a consulting firm bills its clients by the hour, and incurs variable costs in the form of consultant wages. This firm has low operating leverage.

To calculate operating leverage, divide an entity’s contribution margin by its net operating income. The contribution margin is sales minus variable expenses.

For example, the Alaskan Barrel Company (ABC) has the following financial results:

Revenues	$100,000
Variable expenses	30,000
Fixed expenses	60,000
Net operating income	$10,000

ABC has a contribution margin of 70% and net operating income of $10,000, which gives it a degree of operating leverage of 7. ABC’s sales then increase by 20%, resulting in the following financial results:

Revenues	$120,000
Variable expenses	36,000
Fixed expenses	60,000
Net operating income	$24,000

The contribution margin of 70% has stayed the same, and fixed costs have not changed. Because of ABC’s high degree of operating leverage, the 20% increase in sales translates into a greater than doubling of its net operating income.

When using the operating leverage measurement, constant monitoring of operating leverage is more important for a firm having high operating leverage, since a small percentage change in sales can result in a dramatic increase (or decrease) in profits. A firm must be especially careful to forecast its sales in these situations, since a small forecasting error translates into much larger errors in both net income and cash flows.

Knowledge of the level of operating leverage can have a profound impact on pricing policy, since a company with a large amount of operating leverage must be careful not to set its prices so low that it can never generate enough contribution margin to fully offset its fixed costs.