The margin of safety is a measure of how far off the actual sales (or budgeted sales, as the case may be) is to the break-even sales. The higher the margin of safety, the safer the situation is for the business.
Margin of safety (MOS) is often expressed in percentage.
|Margin of safety =||Actual sales - Break-even sales|
Note: Budgeted sales may be used instead of actual sales to measure the degree of risk of expected figures.
Margin of safety may also be expressed in terms of dollar amount or number of units.
|MOS in dollars = Actual sales - Break-even sales|
|MOS in units =||Actual sales - Break-even sales|
Alternatively for MOS in units, it can be computed as: Actual sales in units minus Break-even sales in units.
The following information pertains to the monthly budget of ABC Company.
|Sales (5,000 units)||$15||$75,000|
|Less: Variable Costs||5||25,000|
|Less: Fixed Costs||20,000|
The break-even is properly computed at 2,000 units.
|BEP in Units =||Total Fixed Costs||=||$20,000|
|CM per Unit||$10|
|BEP in Units = 2,000 units|
At 2,000 units, sales revenue is equal to $30,000. This is the break-even sales, which can also be computed using the BEP in dollars formula: the total fixed costs of $20,000 divided by the CM ratio of 0.6667 (10/15).
The margin of safety would be:
|MOS||=||Budgeted sales - Break-even sales|
|=||$75,000 - $30,000|
This means that sales revenue can drop by 60% without incurring losses. This percentage sets the safety cushion for the business. If sales decrease by more than 60% of the budgeted amount, then the company will incur in losses.
When expressed in dollars and units, the margin of safety would be:
|MOS in dollars = Budgeted ales - Break-even sales|
|MOS in dollars = $75,000 - $30,000 = $45,000|
|MOS in units =||Budgeted sales - Break-even sales|
|MOS in units =||$45,000||= 3,000 units|
Sales can decrease by $45,000 or 3,000 units from the budgeted sales without resulting in losses. If it decreases by more than $45,000 (or by more than 3,000 units) the business will have operating loss.
To illustrate, let's say the company will only be able to sell 1,999 units – a decrease by 3,001 units. At 1,999 units, sales would amount to $29,985 (down by $45,015). Operating income would be:
|Sales (1,999 units)||$15||$29,985|
|Less: Variable Costs||5||9,995|
|Less: Fixed Costs||20,000|
|Operating Income (Loss)||( $ 10)|
Margin of safety determines the level by which sales can drop before a business incurs in operating losses.
In other words, it represents the cushion by which actual or budgeted sales can be decreased without resulting in any loss.
Margin of safety is often expressed in percentage, but can also be presented in dollars or in number of units. Higher MOS means more buffer to absorb drops in sales.