Cost Accounting For Dummies. Kenneth W. Boyd
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the degree of operating leverage:
Degree of operating leverage = contribution margin ÷ (contribution margin – fixed costs)
Degree of operating leverage = $3,000 ÷ ($3,000 – $1,000)
Degree of operating leverage = $3,000 ÷ $2,000
Degree of operating leverage = 1.5
Degree of operating leverage can also be defined as contribution margin divided by profit. It’s saying the same thing. All the calculations simply amount to this statement: “At sales of 150 units, contribution margin is 1.5 times profit.”
You also can use the degree of operating leverage formula to assess the relationship between costs and profit. If you minimize your fixed costs, you increase your profit. Even better, you can earn more profit without changing your sale price, contribution margin, or units sold.
Here is how the degree of operating leverage looks if fixed costs were only $500:
Degree of operating leverage = $3,000 ÷ ($3,000 – $500)
Degree of operating leverage = $3,000 ÷ $2,500
Degree of operating leverage = 1.2
The ratio went down from 1.5 to 1.2. Now contribution margin ($3,000) is 1.2 times profit ($2,500). Contribution margin did not change. Because fixed costs went down, profit increased.
What if fixed costs went down to zero? Contribution margin/profit would be 1, and that’s a trophy position! Your entire contribution margin goes toward profit.
Assessing e-commerce businesses
A growing percentage of businesses operate as e-commerce firms. As explained in Chapter 2, e-commerce companies sell products and services online, not in physical store or site locations. Have you recently bought a gift for someone online? Yeah, me too. E-commerce is here to stay, and the cost structure is different from brick-and-mortar businesses.
Reviewing how e-commerce works
First, the good news: You don’t have to pay for a physical store location, and most e-commerce businesses don’t need a warehouse to store inventory. Instead, a supplier packages and ships orders on your behalf and takes a fee.
The e-commerce challenge is getting a consumer’s attention and interest, and creating a smooth process to place an order. How you generate interest determines your marketing costs. E-commerce firms write blog posts, create videos, and run online ads to attract customers.
Here’s an example of what I mean. Every ten years or so, my wife insists on buying me new casual clothes. I prefer the Steve Jobs approach of wearing the same thing every day, but that’s not allowed. All the shirts, pants, and shoes are shipped to the house (who’s gonna pay for all this stuff?!) The seller’s marketing efforts got her attention, and she visited the website.
Once a customer visits the website, the seller has to keep the buyer engaged. The site must be easy to navigate, and should include great images of clothing for sale. In addition, the ordering and payment process must be quick and simple, or the customer will go elsewhere.
Online retailers spend big on websites, product images, and online checkout integration. They also pay people to write content, and to create videos. That addresses the cost side of things, now what about pricing?
Applying the CVP formula
Now, consider how the e-commerce business model fits into the CVP formula. You’ve seen throughout this chapter how useful CVP can be, and you can use it for online selling too. To explain, I’ll address each component of the formula.
Not having a physical store location saves money, but e-commerce sellers often pay a fixed monthly cost for IT services. Keeping the website up and running is priority number one, and you need reliable experts to help you. Technology expenses may end up in the fixed cost bucket.
Vary your spending on marketing based on the strategy you implement. Many businesses are seasonal, and you may spend more to get attention when consumers start shopping. If you sell baseball gear, for example, you’re gonna ramp up marketing before the baseball season starts.
E-commerce firms can experience huge swings in demand, and that impacts sales and costs. If an article explaining your product goes viral, sales may spike, and that increases your cost of sales (a variable cost). Head over to Chapter 9 to learn more about capacity issues and costs.
Timing is everything when it comes to costs
Costs are part of almost all the CVP formulas you use. But (shock and amazement!) some costs are not part of your decision-making.
Sunk costs (past costs or retrospective costs) aren’t relevant when you make decisions about the future. By contrast, fixed costs are relevant if they aren’t sunk. A fixed cost that you may have to pay in the future (depending on a business decision) is a relevant cost.
When an airline sells you a ticket a few days in advance of your departure, you can be sure most of the costs of the flight have already been incurred (sunk). Costs include the plane’s maintenance and fuel, salaries for the crew, and the fee paid for the gate at the airport. In fact, the cost of those tasty peanuts they serve has been factored in, too. Nearly all the costs for the flight aren’t fixed costs but are past or sunk costs. The airline can’t change them.
The timing of your ticket purchase is perfect for the airline. Most of the ticket price goes toward profit. That’s because most of the costs have already been incurred.
But something different happens when you buy a ticket six months in advance. The timing might be good for you but dicey for the airline. Whereas you may buy a discounted ticket, many costs for the flight can change. For example, the airline might have to pay more for fuel or have to increase flight attendant salaries. Of course, there’s a chance (slim) that fuel prices will go down, flight attendants will work for lower wages, or the airline will negotiate lower gate fees with the airport.
The rule of thumb is the more time you have before providing a product or service, the more control you have over costs. If you can take action to change costs, they aren’t past or sunk costs. As you get closer to delivering your product or service, more costs become sunk costs.
Using Cost-Volume-Profit Analysis to Make