ATC 3-4 Writing Assignment Operating leverage, margin of safety, and cost behavior
In the early years of the 21st century the housing market in the United States was booming. Housing prices were increasing rapidly, new houses were being constructed at a record pace, and companies doing business in the construction and home improvement industry were enjoying rising profits. In 2006 the real estate market had slowed considerably, and the slump continued through 2007.
Home Depot was one major company in the building supplies industry that was adversely affected by the slowdown in the housing market. On August 14, 2007, it announced that its revenues for the first half of the year were 3 percent lower than revenues were for the first six H months of 2006. Of even greater concern was the fact that its earnings for the first half of 2007 were 21 percent lower than for the same period in the prior year.
Write a memorandum that explains how a 3 percent decline in sales could cause a 21 percent decline in profits. Your memo should address the following:
a. An identification of the accounting concept involved.
b. A discussion of how various major types of costs incurred by Home Depot were likely affected by the decline in its sales.
c. The effect of the decline in sales on Home Depot’s margin of safety. D ATC 3-5 Ethical Dilemma Opportunity to manipulate earnings E A N
1.(Operating leverage, margin of safety, and cost behavior) In a narrative format, answer the questions posed in the case.
2. Why do managers put such a great amount of emphasis on controlling fixed costs in their organizations?
3. What is meant by the statement, my company has good operating leverage? How does good operating leverage magnify earnings results with modest revenue increases?
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