Definition and explanation
Margin of safety (MOS) is the difference between actual sales and break even sales. In other words, all sales revenue that a company collects over and above its break-even point represents the margin of safety. For example, if actual sales for the month of January 2020 are $250,000 and the break-even sales are $150,000, the difference of $100,000 is the margin of safety. Consider the following exhibition:
Margin of safety is the portion of sales revenue that generates profit for the business because the sales volume achieved up to break-even point can just cover the costs and does not bring any profit. It is an important figure for any business because it tells management how much reduction in revenue will result in break-even. A higher MOS reduces the risk of business losses. Generally, the higher the margin of safety, the better it is.
The formula or equation of MOS is given below:
Margin of safety = Actual or budgeted sales – Sales required to break-even
Margin of safety is also expressed in the form of ratio or percentage that is calculated by using the following formulas/equations:
MOS ratio = MOS/Actual or budgeted sales
MOS percentage = (MOS/Actual or budgeted sales) × 100
The Noor enterprises, a single product company, provides you the following data for the Month of June 2015.
- Sales (3,500 units @ $20/unit): $70,000
- Contribution margin per unit: $12
- Total fixed expenses for the month: $15,000
There was no opening and closing finished goods inventory in stock.
Required: Calculate break even point and margin of safety for Noor enterprises using above data. Also draw a CVP graph and show the sales volume representing break-even point and margin of safety on the graph.
1. Break even point
Break-even point in units:
Fixed cost/Contribution margin per unit
= 1,250 units
Break even point in dollars:
Break even point in units × Selling price per unit
= 1,250 units × $20
2. Margin of safety
Margin of safety in dollars:
Actual sales – Break-even sales
= $70,000 – $25,000
The margin of safety of Noor enterprises is $45,000 for the moth of June. It means if $45,000 in sales revenue is lost, the profit will be zero and every dollar lost in addition to $45,000 will contribute towards loss.
Margin of safety in percentage:
The MOS of Noor Enterprises can be computed in percentage form by dividing the MOS in dollars by the actual sales in dollars as follows:
Margin of safety in units:
The Margin of safety of a single product company like Noor Enterprises can also be expressed in terms of units. It is done by dividing the MOS in dollars by the sales price per unit. The MOS of Noor Enterprises in terms of units is 2,250 as computed below:
= 2,250 units
3. Graphical presentation of break-even point and margin of safety
In CVP graph presented above, red dot represents break even point at a sales volume of 1,250 units or $25,000. The blue dot represents the total sales volume of 3,500 units or $70,000. The margin of safety has been show as the difference between total sales volume and the sales volume required to break even. It has been shown both in terms of dollars and units.
The margin of safety can be computed for a month, a quarter or full year. However, where sales are subject to a significant seasonal variation, monthly or quarterly computations do not make sense. In such situations, it is necessary to use annual data for computing margin of safety.
If margin of safety and one of the other two equation elements are known, we can easily compute the third element. Consider the examples 3 and 4.
Example 3 – computation of actual sales when break-even sales and margin of safety are given
The break even point of Best Inc. is $65,000 for the first quarter of the year 2016. If margin of safety is $45,000, calculate the actual sales for the first quarter.
Margin of safety = Actual sales – Break-even sales
$45,000 = Actual sales – $65,000
Actual sales = $45,000 + $65,000
Actual sales = $110,000
Example 4 – computation of break-even sales when actual sales and margin of safety are given
The Fine Distributors is a trading firm. It provides you the following data:
- Actual sales: $75,000
- Margin of safety: $15,000
Calculate break-even sales of Fine Distributors.
Margin of safety = Actual sales – Break-even sales
$15,000 = $75,000 – Break-even sales
Break-even sales = $75,000 – $15,000
Break-even sales = $60,000
DETERMINING MARGIN OF SAFETY IN A SMALL BUSINESS
Kumar Hathiramani and Pak Melwani opened a soup restaurant named Soup Nutsy in Canada. Currently, Soup Nutsy has a number of successful branches in many cities with a variety of delicious soups, amazing quality and great customer service. Soup Nutsy offers online and in-house ordering and serves thousands of customers each month.
Hathiramani and Melwani, the owners, reported the following data of restaurant’s first branch for the first year of operation:
- Annual sales revenue: $900,000
- Net income: $210,000
- Price charged per serving: $6
- Cost per serving: $2
From above information, we can determine Soup Nutsy’s margin of safety in three steps. In first step, we would compute restaurant’s annual variable and fixed expenses; in second step, we would compute the break even point, and in third step, we would compute the margin of safety in dollars and in percentage form.
Step 1: Computation of variable and fixed expenses
The Soup Nutsy’s variable expenses per serving are $2 and price per serving is $6. The variable expenses to sales ratio is, therefore, 2/6 or 1/3. According to this relationship, the total variable expenses should be $300,000 (= $900,000 × 1/3).
The annual fixed expenses can be computed by using the equation approach as follows:
Sales = Variable expenses + Fixed expenses + profit
$900,000 = $300,000 + Fixed expenses + $210,000
$900,000 = 300,000 + Fixed expenses + $210,000
Fixed expenses = $900,000 – $300,000 – $210,000
Fixed expenses = $390,000
Step 2: Computation of break even point
Since we have found the fixed expenses figure, the break even point Soup Nutsy in dollars and units can be determined as follows:
Break even point in units = Fixed expenses/Unit contribution margin
= 97,500 units
*Unit contribution margin:
= Per unit selling price – Per unit variable expenses
= $6 – $2
Break even point in dollars = Break even point in units × Selling price per unit
= 97,500 × $6
Step 3: Computation of margin of safety
Margin of safety (MOS) in dollars = $900,000 – 585,000
MOS ratio = $315,000/$900,000
MOS percentage = MOS ratio × 100
= 0.35 × 100