Week 8 - Further aspects of CVP - Operating Leverage

Question 1

What is operating leverage? (3)

Answer 1

• Is a leverage of the sensitivity of profits to changes in sales - which is an “effect of” unit contribution
• Is influenced by cost structure - the greater the proportion of fixed costs to variable costs, the greater the leverage
• The greater the degree of operating leverage, the more changes in sales activity will change profit

Question 2

Operating leverage formula

Answer 2

Degree of operating leverage = total contribution / net profit

Question 3

High leveraged entities - Operating leverage interpretations

Answer 3

Have profits which are more sensitive to changes in sales levels, both up and down

Question 4

Periods of positive growth - Operating leverage interpretations (2)

Answer 4

• High operating leverage is good as long as fixed costs do not increase with an increase in activity
• Profits will multiply upwards by the degree of operating leverage

Question 5

Periods of negative growth - operating leverage interpretations (2)

Answer 5

• High operating leverage is bad as fixed costs will not decrease with decreases in activity
• Profits will multiply downwards by the degree of operating leverage

Question 6

What binary decisions is relevant costing used for? (3)

Answer 6

• Invest/don’t invest
• Continue/discontinue
• Accept/reject

Question 7

Relevant costs for decision making

Answer 7

These are only costs that will be affected by the decision which tend to be:

• Future
• Incremental
• Cash flows

(Those 3 are the “future outlay costs”)

Question 8

Costs that are not relevant

Answer 8

• Future costs that will not change such as committed costs that have to be paid, depreciation and common cost allocations

Question 9

Define opportunity cost

Answer 9

Is the value of the opportunity foregone in order to pursue the course of action implicitly within the decision