Margin of Safety
Accounting (Year 12) - Cost Volume Profit
What is the Margin of Safety?
The Margin of Safety refers to the amount of sales that are above the break-even point.
High Margin of Safety: This indicates that the sales amount well exceeds the breakeven point. The Company has a relatively safe position at making a profit.
Low Margin of Safety: This indicates that the sales amount is at or near the breakeven point. The Company is in a dangerous position as a slight decline in sales volumes could result in a loss.
What is safe and dangerous is dependent on the Company size and relative position to its competitors.
Calculation of Margin of Safety:
To Calculate the Margin of Safety in Units: Margin of Safety (Units) = Sales (Units) - Break-Even Point (Units)
To Calculate the Margin of Safety in Dollars: Margin of Safety Dollars = Sales (Dollars) - Breakeven (Dollars)
To calculate the Margin of Safety as a Percentage: Margin of Safety % = (Margin of Safety in Dollars) / (Actual/Budgeted Sales)
Worked Example: Margin of Safety
MecBooks are a Computer Manufacturing Company. They sell their computers for a sale price of $1000 and expect to sell 250 units this year.
The variable costs for each unit are $800 and the fixed costs for the year is $25,000.
Calculate the Margin of Safety in dollars and as a percentage.
This question requires three separate parts, calculation of the contribution margin, calculation of the breakeven point and then a calculation of the margin of safety.
Step 1: Calculate the Contribution Margin
Recall from previous pages, that the contribution margin formula is as follows: Contribution Margin = Sales Price Per Unit - Variable Cost Per Unit The sale price is $1000 in the question and variable costs are $800. Therefore the Contribution Margin is: Contribution Margin = $1000 - $800 = $200 per unit
Step 2: Calculate the Breakeven Point
Recall from previous pages, that the breakeven point formula is as follows:
Breakeven Point (Units) = Fixed Costs / Contribution Margin
The Fixed Costs are $25,000 and the Contribution Margin has been calculated in Step 1 as $200. Therefore the Breakeven Point is: Breakeven Point (Units) = $25,000 / $200 = 125 units
Step 3: Calculate the Margin of Safety
As stated in above, the Margin of Safety formula is as follows:
Margin of Safety = Sales (Units) - Break-Even Point (Units)
The expected sales is 250 units and the breakeven point is 125 units.
Therefore, the Margin of Safety is: Margin of Safety = 250 units - 125 units = 125 units
Hence, the Margin of Safety in Dollars is: 125 units * $1,000 per unit sale price = $125,000
To calculate the Margin of Safety as a Percentage: Margin of Safety % = (Margin of Safety in Dollars) / (Actual/Budgeted Sales) Budgeted sales was 250 units at $1,000 each.
Hence Budgeted sales is 250 * $1,000 = $250,000. Hence Margin of Safety as a percentage is: Margin of Safety % = $125,000 / $250,000 Margin of Safety % = 50%