Computing Margin of Safety and Degree of Operating Leverage for Allison Corporation
Introduction
Analyzing financial metrics such as margin of safety and degree of operating leverage is crucial for assessing a company’s financial performance and risk exposure. In the case of Allison Corporation, understanding these metrics can provide insights into the company’s profitability and operational efficiency. This essay will compute the margin of safety and degree of operating leverage for Allison Corporation based on the provided contribution format income statement.
Computing Margin of Safety
Definition
The margin of safety represents the excess of budgeted or actual sales over the break-even sales. It indicates the cushion available to absorb any potential drop in sales before incurring losses.
Formula
Margin of Safety = Actual Sales – Break-Even Sales
Computation
Given:
– Actual Sales = SR 850,000
– Variable Cost = SR 250,000
– Contribution Margin = SR 600,000
Break-Even Sales = Fixed Expenses / Contribution Margin per unit
Break-Even Sales = SR 450,000 / (850,000 – 250,000) = SR 750,000
Margin of Safety = SR 850,000 – SR 750,000 = SR 100,000
Therefore, Allison Corporation’s Margin of Safety is SR 100,000.
Computing Degree of Operating Leverage
Definition
The degree of operating leverage (DOL) measures the percentage change in net operating income resulting from a percentage change in sales volume. It helps assess the company’s cost structure and the impact of changes in sales on profitability.
Formula
DOL = Contribution Margin / Net Operating Income
Computation
Given:
– Contribution Margin = SR 600,000
– Net Operating Income = SR 150,000
DOL = 600,000 / 150,000 = 4
Therefore, Allison Corporation’s Degree of Operating Leverage is 4.
Conclusion
In conclusion, by computing the Margin of Safety and Degree of Operating Leverage for Allison Corporation based on the provided income statement, we can assess the company’s financial resilience and operational efficiency. A positive Margin of Safety indicates the company’s ability to withstand a decline in sales, while a higher Degree of Operating Leverage suggests that Allison Corporation’s profitability is more sensitive to changes in sales volume. These metrics provide valuable insights for strategic decision-making and financial planning to ensure the company’s long-term success and sustainability in a dynamic business environment.
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