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Home Depot: Operating Leverage, Margin of Safety, and Cost

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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
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.

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Solution Summary

Your tutorial is 661 words and gives an example of the concept, including computations, and reproduces the 21% profit shift in dollars so you can "see" how this can occur. The relevant ratio is given and explained in everyday language suitable for a novice.

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The change in profits that result from a change in sales is an operating leverage issue. That is, the amount of profit that shifts when sales change is a function of the nature of the business' cost. If the business has only fixed costs, then any change in sales impacts profits directly because costs don't change:

Sales ........................ $100
Variable costs .........$-0-
Contribution margin $100
Fixed costs................ $30
Profit ........................ $70

Sales .........................$120
Variable costs .........$-0-
Contribution margin $120
Fixed costs................ $30
Profit ........................ $90

A $20 change in sales results in a $20 change in profits!

Most companies have a "mix" of costs, some variable and some fixed. ...

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