Our discussion of CVP analysis has focused on the sales necessary to break even or to reach a desired profit, but two other concepts are useful regarding our break-even sales. Those concepts are margin of safety and operating leverage.
You are watching: Use the following information to determine the margin of safety in dollars:
Margin of Safety
A company’s margin of safety is the difference between its current sales and its break-even sales. The margin of safety tells the company how much they could lose in sales before the company begins to lose money, or, in other words, before the company falls below the break-even point. The higher the margin of safety is, the lower the risk is of not breaking even or incurring a loss. In order to calculate margin of safety, we use the following formula:
Interpreting this information tells Manteo Machine that, when sales equal ?153,000, they will be at the break-even point. However, as soon as sales fall below this figure, they will have negative net operating income. They have decided that they want a margin of safety of ?10,000. They can add this as if it were a fixed cost (very much the same way we added target profit earlier) and then find a new break-even point that includes a ?10,000 margin of safety. If they approached it from this perspective, their new break-even would appear as follows:
From this analysis, Manteo Machine knows that sales will have to decrease by ?72,000 from their current level before they revert to break-even operations and are at risk to suffer a loss.
The Importance of Relevant Range Analysis
Ethical managerial decision-making requires that information be communicated fairly and objectively. The failure to include the demand for individual products in the company’s mixture of products may be misleading. Providing misleading or inaccurate managerial accounting information can lead to a company becoming unprofitable. Ignoring relevant range(s) in setting assumptions about cost behavior and ignoring the actual demand for the product in the company’s market also distorts the information provided to management and may cause the management of the company to produce products that cannot be sold.
Many companies prefer to consider the margin of safety as a percentage of sales, rather than as a dollar amount. In order to express margin of safety as a percentage, we divide the margin of safety (in dollars) by the total budgeted or actual sales volume. The formula to express margin of safety as a percentage is:
What is the effect of switching ?10,000 of fixed costs to variable costs? What is the effect of switching ?10,000 of variable costs to fixed costs?
As you can see from this example, moving variable costs to fixed costs, such as making hourly employees salaried, is riskier in that fixed costs are higher. However, the payoff, or resulting net income, is higher as sales volume increases.
This is why companies are so concerned with managing their fixed and variable costs and will sometimes move costs from one category to another to manage this risk. Some examples include, as previously mentioned, moving hourly employees (variable) to salaried employees (fixed), or replacing an employee (variable) with a machine (fixed). Keep in mind that managing this type of risk not only affects operating leverage but can have an effect on morale and corporate climate as well.
Operating leverage fluctuations result from changes in a company’s cost structure. While any change in either variable or fixed costs will change operating leverage, the fluctuations most often result from management’s decision to shift costs from one category to another. As the next example shows, the advantage can be great when there is economic growth (increasing sales); however, the disadvantage can be just as great when there is economic decline (decreasing sales). This is the risk that must be managed when deciding how and when to cause operating leverage to fluctuate.
Consider the impact of reducing variable costs (fewer employee staffed checkout lanes) and increasing fixed costs (more self-service checkout lanes). A store with ?125,000,000 per year in sales installs some self-service checkout lanes. This increases its fixed costs by 10% but reduces its variable costs by 5%. As (Figure) shows, at the current sales level, this could produce a whopping 35% increase in net operating income. And, if the change results in higher sales, the increase in net operating income would be even more dramatic. Do the math and you will see that each 1% increase in sales would produce a 6% increase in net operating income: well worth the change, indeed.
To explain further the concept of operating leverage, we will look at two companies and their operating leverage positions:
Let’s assume that both company A and company B are anticipating a 10% increase in sales. Based on their respective degrees of operating leverage, what will their percentage change in net operating income be?
(eginarrayl extCompany A:phantom ule0.2em0ex1.71phantom ule0.2em0ex×phantom ule0.2em0ex10%=17.4%hfill \ extCompany B:phantom ule0.2em0ex2.47phantom ule0.2em0ex×phantom ule0.2em0ex10%=24.7%hfill endarray)
For company A, for every 10% increase in sales, net operating income will increase 17.4%. But company B has a much higher degree of operating leverage, and a 10% increase in sales will result in a 24.7% increase in net operating income. These examples clearly show why, during periods of growth, companies have been willing to risk incurring higher fixed costs in exchange for large percentage gains in net operating income. But what happens in periods where income declines?
We will return to Company A and Company B, only this time, the data shows that there has been a 20% decrease in sales. Note that the degree of operating leverage changes for each company. The reduced income resulted in a higher operating leverage, meaning a higher level of risk.
It is equally important to realize the percentage decrease in income for both companies. The decrease in sales by 20% resulted in a 31.9% decrease in net income for Company A. For Company B, the 20% decrease in sales resulted in a 46.9% decrease in net income. This also could have been found by taking the initial operating leverage times the 20% decrease:
(eginarrayl extCompany A:phantom ule0.2em0ex20%phantom ule0.2em0ex extdecreasesphantom ule0.2em0ex×phantom ule0.2em0ex1.74phantom ule0.2em0ex extoperating leverage=34.8%phantom ule0.2em0ex extdecrease in net incomehfill \ extCompany B:phantom ule0.2em0ex20%phantom ule0.2em0ex extdecreasesphantom ule0.2em0ex×phantom ule0.2em0ex2.47phantom ule0.2em0ex extoperating leverage=49.4%phantom ule0.2em0ex extdecrease in net incomehfill endarray)
This example also shows why, during periods of decline, companies look for ways to reduce their fixed costs to avoid large percentage reductions in net operating income.
You are the managerial accountant for a large manufacturing firm. The company has sales that are well above its break-even point, but they have historically carried most of their costs as fixed costs. The outlook for the industry you are in is not positive. How could you move more costs away from fixed costs to put the company in a better financial position if the industry does, in fact, take a downturn?
You might wonder why the grocery industry is not comparable to other big-box retailers such as hardware or large sporting goods stores. Just like other big-box retailers, the grocery industry has a similar product mix, carrying a vast of number of name brands as well as house brands. The main difference, then, is that the profit margin per dollar of sales (i.e., profitability) is smaller than the typical big-box retailer. Also, the inventory turnover and degree of product spoilage is greater for grocery stores. Overall, while the fixed and variable costs are similar to other big-box retailers, a grocery store must sell vast quantities in order to create enough revenue to cover those costs.
This is reflected in the business plan. Unlike a manufacturer, a grocery store will have hundreds of products at one time with various levels of margin, all of which will be taken into account in the development of their break-even analysis. Review a business plan developed by Viking Grocery Stores in consideration of opening a new site in Springfield, Missouri to see how a grocery store develops a business plan and break-even based upon multiple products.
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