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 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.

Required

Write a memorandum that explains how a 3 percent decline in sales could cause a 21 percent decline in profits. Y our 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.