Question

Margin of Safety and Operating Leverage

Medina Company produces a single product. The projected income statement for the coming year is as follows:

Sales (56,000 units @ $25.00)	$1,400,000
Total variable cost	868,000
Contribution margin	$ 532,000
Total fixed cost	513,000
Operating income	$ 19,000

Required:

1. Compute the break-even sales dollars.
$

2. Compute the margin of safety in sales dollars.
$

3. Compute the degree of operating leverage.

4. Compute the new operating income if sales are 20% higher than expected.
$

Answer 1

Answer :

1) break even sales : $ 13,50,000

2) margin of safety : $ 50,000

3) degree of operating leverage : 28

4) new operating income sales increased by 20% : $ 1,25,400

Explanation :

Step 1 :-

The break-even point serves as a base indicating how many units of product must be sold if a company is to operate without loss.

Break-even sales (in dollars) = Fixed costs ÷ C/S ratio (also known as P/V ratio)

P/V ratio = (contribution ÷ sales )× 100

= ($5,32,000 ÷ $14,00,000) × 100

= 0.38 × 100

= 38%

Therefore

Break even sales = $5,13,000 ÷ 38 % = $ 13,50,000

Step 2 :-

Margin of safety in dollars can be calculated by multiplying the margin of safety in units with the price per unit.

Margin of Safety(in Dollars)=Margin of Safety (in Units)times Price per Unit

Alternatively, it can also be calculated as the difference between total budgeted sales and break-even sales in dollars.

Margin of safety (in dollars) = budgeted sales - break even sales

= $14,00,000 - $ 13,50,000

= $50,000

Step 3 :-

To calculate operating leverage, divide an entity's contribution margin by its net operating income. The contribution margin is sales minus variable expenses.

Degree of operating leverage = contribution margin ÷ net operating income

= $ 5,32,000 ÷ $ 19,000

= 28

Step 4 :-

Calculation of new operating income when sales increased by 20%

Sales ($14,00,000 + 20%) = $16,80,000

Less: variable cost ($8,68,000 + 20%) = $10,41,600

Contribution (sales - variable cost) = $6,38,400

Less : fixed cost (remains constant) = $ 5,13,000

Operating income (contribution - fixed cost) = $ 1,25,400