Accounting Business Reporting for Decision Making

CHAPTER 10 Cost–volume–profit analysis 433

An interesting issue relating to break-even calculations is: what do you do if the break-even units

are too high for the period in question? In other words, how does an entity reduce its risk and lower its

break-even point? A range of possibilities exists.

• Are the assumptions and forecasts relating to costs reliable?


• Can costs be lowered?


• Can anything be done about price(s)?


• What would the impact be of increasing some costs (e.g. marketing) in order to achieve higher sales

levels?

• Can the cost mix be altered (i.e. changing the mix between fixed and variable costs)?

10.6 Operating leverage

LEARNING OBJECTIVE 10.6 Outline the concept of operating leverage.

Operating leverage refers to the mix between fixed and variable costs in the cost structure of an entity.

A knowledge of operating leverage helps in understanding the impact of changes in sales on profit.

Those entities with a higher proportion of fixed costs than variable costs within their cost structure are

often classified as having high operating leverage. Such entities are commonly thought to be more risky,

as fluctuations in sales will produce higher fluctuations in profit for entities with high operating leverage

than they would for entities with lower operating leverage. The reason for this is that higher fixed costs

lead to a higher contribution margin; however, more sales need to be achieved to cover the fixed costs.

For example, during the global financial crisis and the swine flu outbreak airlines were struggling to

break even due to their high fixed-cost structure. Passenger loads being achieved were about 71 per cent,

and above 73 per cent is considered necessary for flights to be profitable. Another example was in 2012

when the Indian Pacific railway commenced its usual low season service two months earlier than normal

due to increasing competition from low-cost airlines and cruise ships. The reason given for the earlier

than expected ‘low season’ was to remain financially viable by reducing services in a period of lower

demand. Train travel has a high level of fixed costs such as hiring the locomotives, hiring the track and

employment of staff, all of which occur before welcoming one paying guest.

Let’s revisit the Advantage Tennis Coaching (ATC) example to illustrate the impact of different

cost structures. ATC has variable costs that include $30 per unit (or player) for providing lunch for the

players. The Tennyson Tennis Centre has a catering service that has offered to prepare lunches for a

fixed fee of $1200 per tournament regardless of the number of players. If this proposal were accepted,

it would lead to a change in the cost structure as the lunch costs would be reclassified from a variable

cost to a fixed cost. The change in cost structure would also change the contribution margin as under

existing arrangements the contribution margin per unit (or player) is $60, whereas with the proposed

lunch arrangement the contribution margin would increase to $90 per unit (or player) due to the higher

fixed costs. Given the different cost structures, Nicholas Cash, the owner of ATC, has a choice of which

option to go with. To determine the best option, we need to work out the number of sales (or players)

where ATC is indifferent to either option for providing lunch to the players. This point of indifference is

the sales level (or number of players) where profits are the same for both options. To calculate this level,

we divide the $1200 fixed lunch charge by the $30 variable lunch cost, which gives us the sales level (or

number of players) where the lunch costs are the same. Therefore, the sales level (or number of players)

at which ATC would be indifferent to the lunch options is 40 units or players. To prove this, we can pre-

pare a statement of profit or loss for both options.

Lunch provided @ $30 per player Contract lunch @ $1200 per tournament

Fee (40 players × $150)

Less: Variable costs

(40 players × $90)

$6 000

3 600

Fee (40 players × $150)

Less: Variable costs

(40 players × $60)

$6 000

2 400

(continued)