How to Calculate Margin of Safety?

The margin of safety calculation takes the break-even analysis one step further in the cost volume profit analysis. It is the difference between the actual activity level and the break-even activity level. We can calculate the margin of safety for sales, revenue, or in profit terms. It can be expressed in units, dollars, or in percentage terms.

The Margin of safety is widely used in sales estimation and break-even analysis. In simpler terms, it provides useful insights on the sales volume for a company before it incurs losses. For a profit making entity, any changes in production level or product mix may yield substantially lower revenue. The margin of safety provides useful analysis on the price and volume change effects on the break-even point and hence the profitability analysis.

The Margin of Safety Formula

The margin of safety can be calculated in different ways.

In sales or unit terms,

Margin of Safety = Actual Sales – Break-even sales    (In Units or Dollar terms)

In Percentage Terms,

Margin of Safety = [(Actual Sales – Break-Even Sales)/Actual Sales)] × 100

How to Calculate the Margin of Safety

As we can see from the formula, the main component to calculate the margin of safety remains the calculation of the break-even point. The calculation of the break-even point then depends on the costing method adopted by the firm. For simplicity, the break-even point can be calculated as the contribution margin in dollar amount or in unit terms.

  • Step 01: Calculate the contribution margin.
  • Step 02: Calculate the break-even point in dollar or unit terms.
  • Step 03: Is to simply deduct the break-even amount from the targeted or actual sales revenue
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Working Example

In this section, we will cover two examples for the calculation of the margin of safely. The first example is for single product while the second example is for multiple products.

Margin of Safety for Single Product

Let’s assume a company Argus Trading manufactures a single product P1. Its actual production remained at 5,000 units for the current period. The selling price is $15 per unit. Total variable costs per unit are $6. Total Fixed for the period remained $ 25,000.

In order to calculate the margin of safely, we shall need to follow the three steps as mentioned above.

Step 1 – Calculate the contribution margin

We can calculate the contribution margin by using the formula below:

Contribution Margin = Sales – Variable Costs

Where:

The total sales revenue = 5,000 × 15 = $ 75,000

Variable costs = 5,000 × 6 = $30,000

Therefore, the Contribution Margin = 75,000 – 30,000

The Contribution Margin = $ 45,000 or $ 9 per unit

Step 2 – Calculate the break-even point

We can calculate the break-even point by using the below formula:

Break-Even Point = Fixed Costs ÷ Contribution margin per unit

Where:

Fixed costs = $25,000

Contribution margin = $9 per unit

Thus, Break-Even Point = 25,000/9 = 2,777 units or $ 41,655

Step 3 – Calculate margin of safety

The last step is to calculate the margin of safety by simply deducting the actual sales from break-even sales.

The Margin of Safety in Dollar = Actual sales – Break-Even sales

The Margin of Safety = 75,000 – 41,655 = $ 33,345.

In percentage terms,

The margin of safety in percentage = (33,345 / 75,000) × 100 = 44.46%

Margin of Safety for Multiple Products

Continuing with our example, let’s suppose the company Argus produces 3 products instead of just one with total units of 10,000. The data provided changes as below:

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DecriptionProduct P1Product P2Product P3
Sales Price $152520
Variable Costs $61310
Sales percentage25%35%40%
Sales in units2,5003,5004,000
 37,50087,50080,000

The Total Fixed Costs increased to $ 50,000.

Let’s assume the company expects different sales revenue from each product as stated. For multiple products, the margin of safety can be calculated on a weighted average contribution and weighted average break-even basis method.

Step 1 – Calculate the weighted average contribution margin for all the 3 products:

Weighted average sale price = (15×25%) + (25×35%) + (20×40%)

Weighted average sale price = 3.75 + 8.75+8.00 = $ 20.5

Thus, weighted average Variable Costs = (6×25%) + (13×35%) + (10×40%)

Weighted average Variable Costs = 1.5 + 4.55 + 4 = $ 10.05

Weighted average Contribution = 20.5 – 10.05 = $ 10.45 per unit

Step 2 – Calculate the weighted average Break-Even point

The weighted average break-even point can be calculated as below:

W.A. Break-Even Point =   Total Fixed Cost ÷ Weighted average contribution

W.A. Break-Even Point = 50,000 / 10.45 = 4,785 units $ 98,095

Step 3 – Calculate the margin of safety

Margin of Safety      = Actual Sales – Weighted average Break-Even

Margin of Safety   = 205,000 – 98,095 = $ 106,905.

Interpretation and Analysis

The margin of safety offers further analysis of break-even and total cost volume analysis. In particular, multiple product manufacturing facilities can use the margin of safety measure to analyze sales targets before incurring losses. It also offers important information on the right product mix for production to maximize the contribution and hence increase the margin of safety.

For a single product, the calculation provides a straightforward analysis of profits above the essential costs incurred. In a multiple product manufacturing facility, the resources may be limited. Maximizing the resources for products yielding greater contribution can increase the margin of safety. Conversely, it provides insights on the minimum production level for each product before the sales volume reach threshold and revenues drop below the break-even point.

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For multiple products, the right sales mix analysis is essential. Any changes to the sales mix will result in changed contribution and break-even point. As the total fixed costs remain constant, the analysis of contribution margin with variable costs takes the center stage. Usually, the higher the margin of safety for business the better it can cover the total costs and remain profitable.

Advantages of Margin of Safety analysis

The Margin of safety provides extended analysis in terms of percentage or number of units for the minimum production level for profitability. It connects the contribution margin and break-even analysis with the profitability targets. In changing economic conditions, businesses may need to evaluate the sales targets before they drop into the loss making territory. The calculations for the margin of safety become simple once the contribution margin and break-even point sales are calculated.

Limitations of Margin of Safety analysis

The margin safety calculation mainly is a derived result from the contribution margin and the break-even analysis. The contribution margins and separate calculations for variable and fixed costs may become complicated. A too high ratio or dollar amount may make the management to make complacent pricing and manufacturing decisions. For multiple products, the weighted average contribution may not provide the right product mix as many overhead costs change with different product designs.

Conclusion

The margin of safety builds on with break-even analysis for the total cost volume profit analysis. It allows the business to analyze the profit cushion and make changes to the product mix before making losses. However, with the multiple products manufacturing the correct analysis will depend heavily on the right contribution margin collection.

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