Question

What are three ways that the Margin of Safety can be expressed, and what are their formulas? How does the Margin of Safety help managers? What is the formula for the Degree of Operating Leverage ? How does the Degree of Operating Leverage help managers?

Answer 1

The three ways that the margin of safety can be expressed are:

1. In form of equation:

Margin of safety = Actual or budgeted sales – Sales required to break-even

2. In form of Ratio:

Margin Of Safety ratio = Margin Of Safety/Actual or budgeted sales

3. In form of equation:

Margin Of Safety percentage = (Margin Of Safety/Actual or budgeted sales) × 100

Importance of Margin of Safety for Manager is as follows:

1. The margin of safety is also an important figure because it shows how safe the business is in producing products
2. The size of margin of safety is a very important indicator of the soundness of a business. It shows how much sales may decrease before the firm will suffer a loss. If the size of margin of safety is high, chances of incurring loss by the business will be remote but if it is low, a small reduction in sales may lead to loss.
3. It is useful in knowing how much cushion the company has if sales decline before the company starts making losses.
4. Higher MoS provides freedom to the management of the company to alter the selling price of their product in order to gain market share from its competitors.
5. Higher margin of safety allows the company to spend more on an advertisement or other activities that can help in improving sales in the long run.
6. Margin of safety is also of immense use in making inter-firm comparisons.

Degree of operating leverage can be calculated using any of the following formulas:

Degree of operating leverage =	change in operating income
	changes in sales

Degree of operating leverage =	contribution margin
	operating income

Degree of operating leverage =	sales ? variable costs
	sales ? variable costs ? fixed costs

Degree of operating leverage =	contribution margin percentage
	operating margin

Importance of Degree of Operating Leverage for Manager is as follows:

1. The Degree of Operating Leverage Ratio helps a company in understanding the effects of operating leverage on the company’s probable earnings.
2. It is also important in determining a suitable level of operating leverage which can be used in order to get the most out of the company’s Earnings before interest and taxes or EBIT.
3. The use of operating leverage can multiply profits when a given break-even point is reached, but it can intensify losses when it is not.
4. If the operating leverage is high, then a smallest percentage change in sales can increase the net operating income.