Cost Structure and Profit Stability
Which cost structure is more stable or more profitable? A higher proportion of variable costs or a higher proportion of fixed costs?
A higher proportion of fixed costs implies a lower proportion of variable costs and hence higher CM and CM ratio. When sales are good, profits will increase faster with a higher CM ratio and higher fixed costs relative to variable costs. However, in a downturn, variable costs can be shut off whereas fixed costs cannot. Therefore a higher proportion of fixed costs will lead to higher financial risk. As a result, if sales volumes are widely variable from year to year, a lower CM ratio and a higher proportion of variable costs would lead to lower losses in bad years. Hence, there is a trade off here between profitability and risk and each business has to look at its own future sales prospects to determine which cost structure is best.
Operating leverage is a multiplier tool to measure how sensitive income is to a percentage change in sales.
It is measured as follows: Degree of OL = CM
= # of times
If CM = $40,000 and Op Inc. = $10,000, then the Degree of OL = 4 times
That means that if sales increase by 10%, then Op Inc will increase 4 x 10% or 40%. or .4 x 10,000 = $4,000. Since Op Inc was $10,000, that means that the projected Op Inc. would be $10,000 + $4,000 = $14,000, or $10,000 x 1.40 = $14,000.
Companies with higher OL multipliers are companies with a higher proportion of fixed costs (and hence higher CM ratios. The effect of OL is greatest near the BE pt. Therefore, near the BE point, a small increase in sales will have a fairly dramatic increase in Op. Inc. Conversely, a small decrease in Sales will lead to a relatively large decrease in Op. Inc. Therefore, there is always an incentive to increase sales when you are near the BE pt. because results can turn around dramatically.
CVP analysis can be used to compare the profitability of alternative products or methods of production. A product with a high level of fixed cost and relatively low variable costs (high CM %) will require a higher sales level to break even and earn profits, than a product with low fixed costs a relatively high variable costs (low CM%). Therefore, two similar products with different cost structures will have different break even points.
However, there is some level of activity at which the profits on the two products will become the same. This level of activity is called the indifference point—–that is, the activity level at which you are indifferent between the two cost structures. This indifference point can be determined by stating the cost structure for each product in algebraic terms, equating them, and solving for the quantity (indifference point volume).
See example, p. 241. If selling prices between the two products are different, then selling prices and costs should be built into the equation for each product.
At points above the indifference point, the product with the higher CM% and a relatively higher proportion of fixed costs, will always be more profitable. At volumes below the indifference point, the product with the lower CM% and relatively higher proportion of variable costs, will always be more profitable.
A company is looking at replacing its current labour-intensive manufacturing line with a more machine-intensive line. This will change the cost structure by replacing variable costs (labour) with fixed costs (machine maintenance and depreciation).
The selling price for the product is $50
Current System: VC/unit = $30 TFC = $11,000
Proposed System: VC/unit = $15 TFC = $20,000
At what level of sales (in units) would the company be indifferent between the two manufacturing approaches?
30n + $11,000 = 15n + $20,000
15n = $9,000
n = $9,000/15 = 600 units
At 600 units, the company is indifferent between the two manufacturing approaches. Below 600 units, the current system with its higher VC/unit, lower TFC, and lower CM%, will be more profitable
Above 600 units, the proposed system with its higher TFC, lower VC/unit, and higher CM%, will be more profitable.