Some liabilities have low interest rates and some have no interest associated with them. For example, some of a company’s accounts payable may allow payment in 30 days. With those payables it is better to have the liability and to keep your cash in the bank until they become due.

In our personal lives, our first house was probably purchased with a downpayment and mortgage loan. That mortgage loan was a big liability, but it allowed us to upgrade our living space. I viewed my mortgage loan liability as a good thing because it allowed me to own a nice home in a beautiful neighborhood.

So some liabilities are good—especially the ones that have a very low interest rate. Too many liabilities could cause financial hardships.

Learn more about the Balance Sheet.

The reason lies in the definition of contribution margin: selling price minus the variable costs and expenses. Once the contribution margins have covered the total amount of fixed costs and expenses, the entire contribution margin on the next units will go to profit.

Learn more about Breakeven Point.

To illustrate the problem, let’s assume that the total cost is $1,200 when there are 100 units of product manufactured, and $6,000 when there are 400 units of product are manufactured. The high low method computes the variable cost rate by dividing the change in the total costs by the change in the number of units of manufactured. In other words, the $4,800 change in total costs is divided by the change in units of 300 to yield the variable cost rate of $16 per unit of product. Since the fixed costs are the total costs minus the variable costs, the fixed costs will be calculated to a negative $400. This unacceptable answer results from total costs of $1,200 at the low point minus the variable costs of $1,600 (100 units times $16), or total costs of $6,000 at the high point minus the variable costs of $6,400 (400 units times $16).

The negative amount of fixed costs is not realistic and leads me to believe that either the total costs at either the high point or at the low point are not representative. This brings to light the importance of plotting or graphing all of the points of activity and their related costs before using the high low method. (The number of units uses the scale on the x-axis and the related total cost at each level of activity uses the scale on the y-axis.) It is possible that at the highest point of activity the costs were out of line from the normal relationship—referred to as an outlier. You may decide to use the second highest level of activity, if the related costs are more representative.

If the $6,000 of cost at the 400 units of activity is an outlier, you might select the next highest activity of 380 units having total costs of $4,000. Now the variable rate will be the change in total costs of $2,800 ($4,000 minus $1,200) divided by the change in the units manufactured of 280 (380 minus 100) for a variable rate of $10 per unit of product. Using the variable rate of $10 per unit manufactured will result in the fixed costs being a positive $200. The positive $200 of fixed costs is calculated at either 1) the low activity: total costs of $1,200 minus the variable costs of $1,000 (100 units at $10); or at 2) the high activity: total costs of $4,000 minus the variable costs of $3,800 (380 units at $10).

The size of the advantage depends on the income tax rate of the company paying the interest. For example, if a corporation issues $10,000,000 of bonds with an interest rate of 8%, its annual interest expense will be $800,000. When the $800,000 of interest expense is entered on the corporation’s income tax return, its taxable income will decrease by $800,000. If the corporation’s combined federal and state income tax rate on this increment is 40%, the corporation will avoid or save paying income taxes of $320,000 ($800,000 of less taxable income X 40%). If the corporation’s income tax rate on this increment is 30%, the corporation will save paying income taxes of $240,000 ($800,000 X 30%).

Due to the income tax savings, the cost of the borrowed money is reduced. For a corporation in the 40% tax bracket, its net cost of the borrowed money is $480,000 ($800,000 of interest minus $320,000 of income tax savings) for a net rate of 4.8% ($480,000 of net expense divided by $10,000,000). For a corporation with a combined tax rate of 30%, the net cost of the borrowed money will be $560,000 or a net rate of 5.6% of $10,000,000.

A second advantage of financing asset with bonds instead of stock is that the ownership interest in the corporation will not be diluted by adding more owners. Bondholders and other lenders are not owners of the assets or of the corporation. Therefore, all of the gain in the value of the assets belongs to the stockholders. The bondholders will receive only the agreed upon interest.  This is related to the concept of leverage or trading on equity. By issuing debt, the corporation gets to control a large asset by using other people’s money instead of its own. If the asset ends up being very profitable, all of its earnings minus the interest, will enhance the owners’ financial position.

These efficiency ratios include 1) accounts receivable turnover ratio, and the related ratio days’ credit sales in accounts receivable; 2) inventory turnover, and the related ratio days’ cost of sales in inventory; 3) total asset tunover; and 4) fixed asset turnover.

The accounts receivable turnover ratio and the inventory turnover ratio are also used in the context of a firm’s liquidity.

The total asset turnover and fixed asset turnover are indicators of a company’s effectiveness in utilizing its assets.

Learn more about Financial Ratios.

Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation’s common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity.

If the newly purchased assets earn less than the interest expense on the new debt, the earnings of the common stockholders will decrease.

The before tax profit margin ratio expresses the corporation’s income before income tax expense as a percentage of net sales.

The profit margin ratio is most useful when it is compared to 1) the same company’s profit margin ratios from earlier accounting periods, 2) the same company’s targeted or planned profit margin ratio for the current accounting period, and 3) the profit margin ratios of other companies in the same industry during the same accounting period.

Learn more about Financial Ratios.

On the other hand, the fixed cost per unit will change as the level of volume or activity changes. Using the amounts above, the fixed cost per unit is $2 when the volume is 3,000 units ($6,000 divided by 3,000 units). When the volume is 4,000 units, the fixed cost per unit is $1.50 ($6,000 divided by 4,000 units).

AccountingCoach.com has free explanations, drills, Q&A, and puzzles on 27 accounting topics.

Let’s illustrate this by looking at the cost of property insurance. The cost of insuring the factory building is a fixed cost when the independent variable is the number of units produced within the factory. In other words, the factory’s property insurance might be $6,000 per year whether its output is 2 million units, 3 million units, or 5 million units. On the other hand, if the independent variable is the replacement cost of the factory buildings, the insurance cost will be a variable cost. The reason is the insurance cost on $12 million of factory buildings will be more than the insurance cost on $9 million of factory buildings, and less than the insurance premiums on $18 million of factory buildings.

In the case of worker compensation insurance, the cost will vary with the amount of payroll dollars (exluding overtime premium) in each class of workers. For example, if the worker comp premiums are $5 per $100 of factory labor cost, then the worker comp premiums will be variable with respect to the dollars of factory labor cost. If the units of output in the factory correlate with the direct labor costs, then the worker compensation cost will also be variable with respect to the number of units produced. On the other hand, the worker compensation cost for the office staff is usually a much smaller rate and that worker compensation cost will not be variable with respect to the number of units of output in the factory. However, the worker compensation cost of the office staff will be variable with respect to the amount of office staff salaries and wages.

As you have seen, determining which costs are fixed and which are variable can be a bit tricky.

For example, in the decision to replace equipment that has been used for the past six years, the original cost of the equipment does not have relevance. In other words, the original cost is irrelevant or is not relevant in the decision to replace the equipment. What will have relevance are the future amounts, such as the cost of the new equipment, and the savings that will occur when the old equipment is replaced.

Here’s another expression of relevance: Costs that will differ among alternatives. Costs that will not differ among alternatives do not have relevance.

In order to have relevance, accounting information must be timely. Financial statements issued three weeks after the accounting period ends will have more relevance than financial statements issued several months after the period ends. Having timeliness and relevance may mean sacrificing some precision or reliability.

Read more about relevance in paragraphs 46-57 of the Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information, issued by the Financial Accounting Standards Board. You may read it at no cost at www.FASB.org/st.

My recommendation is to calculate the contribution margin and contribution margin ratio for each product (or service) that you offer. I suspect that some of your items have positive contribution margins, but the products with negative contribution margins are greater. You must get into the details.

You also need to look at each of your customers. Perhaps some customers are buying in huge quantities, but those sales are not profitable. See which customers have positive contribution margins.

By definition, the ways to eliminate the negative contribution margin are to 1) raise selling prices, 2) reduce variable costs, or 3) do some combination of the first two. If customers will not accept price increases in order for you to cover your variable costs, you are probably better off not having the sales. Remember that after covering the variable costs, those selling prices must then cover the fixed costs and expenses. A total negative contribution margin means your loss will be larger than the amount of the fixed costs and expenses.

When setting prices or bidding for new work, you must think of the bottom line—profits. Many people focus too much on the top line—sales. 

Learn more about Break-even Point.

Here’s an illustration. A company manufactures products in its 100,000 square foot plant. The company’s depreciation on the plant is $1,000,000 per year. The capacity of the plant is 500,000 units of output and its normal output is 400,000 units per year. When the company is manufacturing between 300,000 and 500,000 units, it needs salaried managers earning $400,000 per year. Below 300,000 units of output, some of the salaried manager positions would be eliminated. Above 500,000 units, the company will need to add plant space and managers.

For this example, the relevant range is between 300,000 units and 500,000 units of output per year. In that range the total of the two fixed costs is $1,400,000 per year. Below 300,000 units, the fixed costs will drop to less than $1,400,000 because some salaries will be eliminated and some of the space might be rented. When the volume exceeds 500,000 units per year, the company will need to add fixed costs because of the additional space and the additional managers.  Perhaps the total fixed costs will be $2,000,000 for output between 500,000 units and 700,000 units.

In contrast to the stores with low profit margins and high turnover ratios, is a heavy equipment manufacturer with a high demand product that takes six months to manufacture. If this manufacturer has few or no competitors, a great product, and an excellent reputation for service, its profit margin can be very large. Unlike the discount stores, its inventory turnover will be very very low.

There can also be differences within the same industry. For example, one computer company might assemble and ship computers within hours of receiving the order via its website. Its inventory turnover will be off the charts, perhaps 90 times per year. If most of its customers pay with credit cards at the time the computer is shipped, the company will have very little in accounts receivable and will enjoy great cash flow. Another computer company might sell only through retailers. This company will have to assemble the computers in advance, store them, and then extend 60 days credit to the retailers. Obviously its turnover ratios will be less impressive than the ratios of the first company.

A company’s management is another variable that explains differences in the profit margin and turnover ratios. Some managements are more focused, aggressive and disciplined in processing orders, controlling inventory. and improving processes. Companies with less proficient managers could end up having less impressive turnover ratios and profits.

Learn more about Financial Ratios.

However, the average turnover ratio of 5 might be hiding some important details. What if four items make up 40% of the company’s sales and account for only 10% of the inventory cost? These fast selling items will have a turnover ratio of 20 (cost of goods sold of $2,000,000 divided by their average inventory cost of $100,000) meaning these items turn every 18 days (360 days divided by the turnover of 20). This means that the remaining items in inventory will have a cost of goods sold of $3,000,000 and their average inventory cost will be $900,000. As a result, the majority of the items in inventory will have an average turnover ratio of 3.3 ($3,000,000 divided by $900,000). In other words, the majority of items are turning on average every 109 days (360 days divided by the turnover ratio of 3.3). That’s a significant difference from the 72 days that we first computed on the totals.

People within the company can overcome the shortcomings described above, since they have access to all of the sales and inventory detail. A computer generated report can compute the inventory turnover ratio and the days’ sales in inventory for each and every item sold and/or held in inventory. By reviewing each item, the slow moving items will not be hidden behind an average.

Learn more about Inventory and Cost of Goods Sold. Learn more about Financial Ratios.

AccountingCoach.com also has FREE interactive Crossword Puzzles on each of these topics.

Here’s how it works. If you invest an amount for 8 years at 9% annual interest it will double (because 8 years X 9% = 72). If you invest an amount for 9 years at 8% it will also double (since 9 years X 8% = 72). If your investment earns 6%, it will take 12 years for it to double (since 12 years X 6% = 72; or 72 divided by 6 = 12).

If you invest $1,000 at 12% compounded annually, it will grow to approximately $2,000 in 6 years (6 X 12 = 72; or 72/12 = 6). If the $2,000 continues to earn 12% each year, six years later the investment will be worth $4,000. If the investment continues to earn 12% per year, then in six more years it will have a value of $8,000.

If successful investors were able to earn 18% each year, the value of their portfolios would have doubled every four years (72 divided by 18 = 4). If the investors live a long life and continue to earn 18% compounded annually they will become very wealthy.

Let’s illustrate this with a little story. Suppose that you are the sole owner of a company which uses a special machine to produce a very unique product. Your company has a huge backlog of orders for the product. Every hour that the machine is running, your company is able to generate sales of $500 while incurring incremental costs and expenses of $200. As a result, your company’s profit is increasing by $300 for each hour that the machine is running.

Now suppose an employee failed to perform a routine maintenance task which causes the machine to be shut down for 10 hours. The repair bill to get the machine running was $400. What was the cost of the machine being down for 10 hours? The accounting records will report $400 in the account Repairs and Maintenance Expense. But as the owner, you are likely to be more upset that the employee cost you $3,000 (10 hours X $300) in lost profits and upset customers.

In the above story the opportunity cost was $3,000 of lost profit + the cost of the upset customers. (From the owner’s perspective, the total cost was the $400 repair bill + $3,000 of opportunity cost described above + the opportunity cost consisting of future lost profits from lost customers.)

Now let’s modify the story. Suppose the machine that was idled by employee negligence was not a special machine and there was no backlog of orders for the product. The repair bill was the same $400. In this situation you will not be foregoing any sales or losing any customers. Therefore the profit foregone is $0. In other words, there is no opportunity cost of the machine being down for 10 hours. All you have is the $400 repair bill.

This concept of opportunity cost is relevant in making decisions. For example, in deciding whether to make or to buy a component, the opportunity cost is an important consideration: If your plant has idle capacity, you might opt to make a component because there is no opportunity cost — no profit being foregone as you spend time making the component. On the other hand, if your plant is operating at full capacity, you would have to forego the profit on some items presently being produced (an opportunity cost) in order to make the components.

The concept of opportunity cost is also relevant when setting transfer prices between divisions or subsidiaries of a large company.

Learn more about Improving Profits.

A company with many products can see its breakeven point increase when the mix of products changes. In other words, if a greater proportion of lower contribution margin products are sold, the breakeven point will increase. (Contribution margin is selling price minus variable expenses.)

Learn more about Breakeven Point.

Contribution margin is revenues minus the variable costs and expenses. For example, a retailer’s contribution margin is sales minus the cost of goods sold and the variable selling expenses and the variable administrative expenses and any variable nonoperating expenses. (Perhaps some interest expense varies with sales.)

A retailer’s operating income is sales minus the cost of goods sold and all selling and administrative expenses (fixed and variable). Operating income is the net income before the nonoperating items such as interest revenue, interest expense, gain or loss on the sale of plant assets, etc.

Contribution margin is used to determine the Breakeven Point.

The contribution margin is sales minus variable expenses. When the contribution margin is expressed as a percentage of sales it is referred to as the contribution margin ratio. (When we use the term “fixed expenses” we mean the company’s total amount of fixed costs plus its fixed expenses. When we say “variable expenses” we mean the total of the company’s variable costs plus its variable expenses.)

Let’s illustrate the breakeven point in sales dollars with the following information. A company has fixed expenses of $100,000 per year. Its variable expenses are approximately 80% of sales. This means that the contribution margin ratio is 20%. (Sales minus the variable expenses of 80% of sales leaves a remainder of 20% of sales. In other words, after deducting the variable expenses there remains only 20% of every sales dollar to go towards the fixed expenses and profits. ) The fixed expenses of $100,000 divided by the contribution margin ratio of 20% equals $500,000. This tells you that if the company has sales of approximately $500,000 it will be at the breakeven point—the point where sales will be equal to all of the company’s expenses.

It is wise to test your calculated breakeven point. In our example the sales needed to be $500,000. If the variable expenses are 80% of sales, the variable expenses will be $400,000 (80% of $500,000). This leaves $100,000 as the contribution margin in dollars. After subtracting the fixed expenses of $100,000, the net income will be zero.

Learn more about Breakeven Point.

We can demonstrate relevant costs with the following situation. A company is deciding whether or not to eliminate a product line. The product line accounts for approximately 4% of the companies activities. If the product line is eliminated, the officers of the corporation will continue to receive the same salaries and the central office expenses will not change. The product line managers and other employees working directly on the product line will be terminated. Hence, their salaries will be eliminated.

The salaries of the product line managers and other employees whose salaries will be eliminated are relevant to the decision. If these salaries are $700,000 with the product line and $0 without the product line, the $700,000 of savings is relevant. Those cost savings and other possible cost savings will be considered along with the loss of sales revenues.

On the other hand, the officers’ salaries are not relevant in the decision. In other words, it doesn’t matter if the officers’ salaries are $500,000 or $5,000,000. The officers’ salaries will be the same with or without the product line. Similarly, the decision maker does not need to know the amount of its central office expenses, since they will be the same with or without the product line. Expenses from previous years are also irrelevant.

To recap, relevant costs are the future costs that will differ among alternatives. You might use the past costs to help you predict those future costs, but the past costs are otherwise irrelevant to the decision. Accountants refer to the past costs as sunk costs.