Managerial Accounting For Dummies by Mark P. Holtzman

Author:Mark P. Holtzman
Language: eng
Format: epub
Publisher: Wiley
Published: 2013-01-17T16:00:00+00:00

Illustration by Wiley, Composition Services Graphics

Figure 9-7: Graphing margin of safety.

Making use of formulas

To compute margin of safety directly, without drawing pictures, first calculate the break-even point and then subtract it from actual or projected sales. You can use dollars or units:

For guidance on finding the break-even point, check out the earlier section Generating a Break-Even Analysis.

You can compute margin of safety either in sales dollars or in units, but be consistent. Don’t subtract break-even sales in units from actual sales in dollars!

Taking Advantage of Operating Leverage

Operating leverage measures how changes in sales can affect net income. For a company with high operating leverage, a relatively small increase in sales can have a fairly significant impact on net income. Likewise, a relatively small decrease in sales for that same company will have a devastating effect on earnings.

Operating leverage is typically driven by a company’s blend of fixed and variable costs. The larger the proportion of fixed costs to variable costs, the greater the operating leverage. For example, airlines are notorious for their high fixed costs. Airlines’ highest costs are typically depreciation, jet fuel, and labor — all costs that are fixed with respect to the number of passengers on each flight. Their most significant variable cost is probably just the cost of the airline food, which, judging from some recent flights I’ve been on, couldn’t possibly be very much. Therefore, airlines have ridiculously high operating leverage and unspeakably low variable costs. A small drop in the number of passenger-miles can have a dreadful effect on an airline’s profitability.

Graphing operating leverage

In a cost-volume-profit graph (see Figure 9-3 earlier in the chapter), operating leverage corresponds to the slope of the total costs line. The more horizontal the slope of this line, the greater the operating leverage. Figure 9-8 compares the operating leverage for two different entities, Safe Co., which has lower operating leverage, and Risky Co., which has higher operating leverage.

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