Chapter 2 Homework Solutions all other

# Chapter 2 Homework Solutions all other - Chapter 2 Cost...

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Chapter 2 Cost Behavior, Operating Leverage, and Profitability Analysis  Answer to Questions 1. A fixed cost is a cost that in total remains constant as volume of activity changes but on a per unit basis varies inversely with changes in volume of activity. A variable cost is a cost that in total changes directly proportionately with changes in volume of activity but on a per unit basis is constant as volume of activity changes. An example of a fixed cost is a supervisor’s salary in relation to units produced. An example of a variable cost is direct materials cost in relation to units produced. 2. Most business decisions are based on cost information. The beha- vior of cost in relation to volume affects total costs and cost per unit. For example, knowing that fixed cost stays constant in relation to volume and that variable cost increases proportionately with changes in volume affects a company’s cost structure decisions. Knowing that volume is expected to increase would favor a fixed cost structure because of the potential benefits of operating lever- age. 3. Operating leverage is the condition whereby a small percentage in- crease in sales volume can produce a significantly higher percent- age increase in profitability. It is the result of fixed cost behavior and measures the extent to which fixed costs are being used. The higher the proportion of fixed cost to total cost the greater the oper- ating leverage. As sales increase, fixed cost does not increase pro- portionately but stays the same, allowing greater profits with the in- creased volume. 4. Operating leverage is calculated by dividing the contribution margin by net income. The result is the number of times greater the per- centage increase in profit is to a percentage increase in sales. For example, if operating leverage is four, a 20% increase in sales will result in an 80% increase in profit. 5. The concept of operating leverage is limited in predicting profitabil- ity because in practice, changes in sales volume are usually related to changes in sales price, variable costs, and fixed costs, which all affect profitability. 2-1

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Chapter 2 Cost Behavior, Operating Leverage, and Profitability Analysis  6. With increasing volume a company would benefit more from a fixed cost structure because of operating leverage, where each sales dol- lar represents pure profit once fixed costs are covered. If volume is decreasing, the variable cost structure would be more advantage- ous because costs would decrease proportionately with decreases in volume. With a pure fixed cost structure, costs stay constant even when sales revenue is decreasing, eventually resulting in a loss. 7. Economies of scale are possible when the size of an operation is in- creased. Increases in size correspond to increases in volume, which reduces the unit cost of production because of fixed cost be- havior. Economies of scale are found in businesses that are capital intensive (businesses that have a higher percentage of their assets
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## Chapter 2 Homework Solutions all other - Chapter 2 Cost...

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