Question

If a company has very low operating leverage (i.e., a low proportion of fixed costs in the cost structure) and no changes are expected in operations, then

a. using common-size income statement percentages can serve as a reasonable basis for projecting future operating expenses.
b. using common-size income statement percentages will understate future projected operating expenses.
c. rate of change income statement percentages can serve as a good basis for projecting operating expenses.
d. using common-size income statement percentages will overstate future projected operating expenses.

Answer 1

Common-size income statement percentages can be used as a basis for projecting future operating expenses for a company with low operating leverage and no expected changes in operations. Spreading the overhead leads to a lower average fixed cost per unit as output increases.

Step-by-step explanation:

A company with very low operating leverage that anticipates no changes in operations can likely use common-size income statement percentages as a reasonable basis for projecting future operating expenses. This is because a low operating leverage implies that the company has low fixed costs compared to variable costs. Therefore, as there will be minimal changes in the fixed cost component, the variability in expenses will primarily arise from changes in sales volume or operational efficiency.

Using common-size income statement percentages can serve as a reasonable basis for projecting future operating expenses for a company with low operating leverage and stable operations.

The concept of 'spreading the overhead' refers to the decrease in average fixed cost as the quantity of output increases. Fixed costs such as overhead, when divided by a larger number of units, results in a lower cost per unit. Hence, as production scales, the average fixed cost per unit diminishes, which is represented by a downward-sloping average fixed cost curve.