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Fixed & Variable Costs, Activity-Based Costing, and Operating Leverage

DQ 1.
What are some examples of fixed and variable costs from your workplace? Which costs may have both variable and fixed components? How can this be resolved for analysis purposes? I work for civil service in the Army. We're an international school that trains foreign students. We are funded by DoD.

DQ 2.
When is it appropriate for companies to use activity-based costing? How might activity-based costing be used in your company? What are some differences between ABC and traditional costing?

DQ 3.
What is the definition of operating leverage? How does operating leverage differ in manufacturing, service, merchandising, and e-commerce companies? How can operating leverage be used to increase a company's profitability?

Solution Preview

DQ 1.
What are some examples of fixed and variable costs from your workplace? Which costs may have both variable and fixed components? How can this be resolved for analysis purposes? I work for civil service in the Army. We're an international school that trains foreign students. We are funded by DoD.

Variable costs are those costs " which increase directly in proportion to the level of sales in dollars or units sold. Depending on your type of business, some examples would be cost of goods sold, sales commissions, shipping charges, delivery charges, costs of direct materials or supplies, wages of part-time or temporary employees, and sales or production bonuses.
"Fixed costs," which remain the same regardless of your level of sales. Depending on your type of business, some typical examples would be rent, interest on debt, insurance, plant and equipment expenses, business licenses, and salary of permanent full-time workers.

In the case of international school the variable costs can be:
1. Cost of Study material
2. Transportation charges
3. Faculty expenses
4. Bonus
5. Other direct expenses

The fixed costs can be:
1. Rent
2. Insurance, Depreciation
3. Salary of Staff
4. License fees

There can be some costs which are mixed costs. These have both the elements, such as utility costs, maintenance costs. These can be separated with the use of:

HIGH-LOW METHOD:
This is a method for separating costs into fixed and variable components, based upon the difference between costs at the highest and lowest observed levels of activity
With the high-low technique, the highest and lowest levels of activity are identified for a period of time. Say the highest repair paid is $2000, and the lowest is $1500. The difference in cost between the highest and lowest level of activity represents the variable cost ($2000 - $1500 = $500) associated with the change in activity (1500 tshirts on the high end and 1,000 tshirts on the low end yields a 500 tshirts difference from high to low). The cost difference is divided by the activity difference to determine the variable cost for each additional unit of activity ($500/500 = $1 ). The fixed cost can be calculated by subtracting variable cost (per-unit variable cost multiplied by the activity level) from total cost. Thus fixed cost is 2000-(1500*1)=$500

Another method is METHOD OF LEAST SQUARES. This is more accurate method than the former.
Here both the costs are ascertained by a line so that it fits through a set of points on a graph, where the cumulative sum of the squared distances between the points and the line is minimized (hence, the name "least squares").

Useful in decision making
By knowing the cost nature one can use it to take various decisions such as:
Break-even analysis is one of the tools of the managerial accounting, a device for determining the point at which ...

Solution Summary

Here is just a sample of what you will find in the solution:

"Say the highest repair paid is $2000, and the lowest is $1500. The difference in cost between the highest and lowest level of activity represents..."

$2.19