Margin of Safety (MOS):
Learning Objectives:
- Define and explain margin of safety.
- Calculate margin of safety ratio.
- What is its significance/importance?
Contents:
-
Definition of Margin of Safety (MOS)
-
Formula of MOS
-
Example
-
Review Problem
Margin of safety
(MOS) is the excess
of budgeted or actual sales over the
break even volume of sales. It stats the
amount by which sales can drop before losses begin to be incurred. The higher
the margin of safety, the lower the risk of not breaking even.
The formula or equation for the calculation of margin of
safety is as follows:
[Margin of Safety = Total budgeted or actual
sales − Break even sales]
The margin of safety can also be expressed in
percentage form. This percentage is obtained by dividing the margin of safety in
dollar terms by total sales. Following equation is used for this purpose.
[Margin of Safety = Margin of safety in dollars /
Total budgeted or actual sales]
|
Sales(400 units @
$250) |
$100,000 |
|
Break even sales |
$87,500 |
|
Calculate margin
of safety |
|
Calculation: |
|
Sales(400units
@$250) |
$100,000 |
|
Break even sales |
$
87,500 |
| |
--------- |
|
Margin of safety in
dollars |
$
12,500 |
| |
======= |
|
Margin of safety as a percentage of sales:
12,500 / 100,000
= 12.5%
|
It means
that at the current level of sales and with the company's current prices and
cost structure, a reduction in sales of $12,500, or 12.5%, would result in just
breaking even. In a single product firm, the margin of safety can also be
expressed in terms of the number of units sold by dividing the margin of safety
in dollars by the selling price per unit. In this case, the margin of safety is
50 units ($12,500 ÷ $ 250 units = 50 units).
Voltar company manufactures and
sells a telephone answering machine. The company's contribution margin income
statement for the most recent year is given below:
|
Description |
Total |
Per unit |
Percent of Sales |
|
Sales (20,000 units) |
$ 1,200,000 |
$60 |
100% |
|
Less variable expenses |
900,000 |
$45 |
?% |
| |
--------- |
-------- |
-------- |
|
Contribution margin |
300,000 |
$15 |
?% |
|
Less fixed expenses |
240,000 |
====== |
===== |
| |
--------- |
|
|
|
Net operating income |
60,000 |
|
|
| |
====== |
|
|
|
Required: Calculate margin of safety both in
dollars and percentage form.
Solution to Review Problem:
|
Margin of safety = Total sales
– Break even sales*
= $1,200,000 – $960,000
= $240,000
Margin of safety percentage =
Margin of safety in dollars / Total sales
= $240,000 / $1,200,000
= 20%
*The
break even sales have been calculated as follows:
Sales = Variable expenses +
Fixed expenses + Profit
$60Q = $45Q + $240,000 + $0**
$15Q = $240,000
Q = $240,000 / $15 per unit
Q = 16,000 units; or at $60 per unit. $960,000
|
**We
know that break even is the level of sales where profit is zero
|
In Business |
Soup Nutsy
Pak Melwani and Kumar Hathiramani, former
silk merchants from Bombay, opened a soup store in Manhattan after
watching a Seinfeld episode featuring the "soup Nazi." The episode
parodied a real life soup vendor. Ali Yeganeh, whose loyal customers put
up with hour-long lines and "snarling customer service." Melwani and
Hathiramani approached Yeganeh about turning his soup kitchen into a
chain, but they were gruffly rebuffed. Instead of giving up, the two
hired a French chef with a repertoire of 500 soups and opened a store
called Soup Nutsy. For $6 per serving, Soup Nutsy offers 12 homemade
soups each day, such as sherry crab bisque and Thai coconut shrimp.
Melwani and Hathiramani report that in their first year of operation,
they netted $210,000 on sales of $700,000. They report that it costs
about $2 per serving to make the soup. So their variable expenses ratio
is one-third ($2 cost / 6$ selling price). If so, what are their fixed
expenses? We can answer that question using the equation approach as
follows:
Sales = Variable expenses
+ Fixed + Profits
$700,000 = (1/3) × 700,000 + Fixed
expenses + $210,000
Fixed expenses = $700,000
– (1/3 of $700,000) – $210,000
= $256,667
With this information we can determine
that
the
break even point is about $385,000 of sales. This gives the store a
comfortable margin of safety of 45%.
Source: Silva Sansoni, "The Starbucks of
Soup?" Forbes, July7, 19997, pp.90-91. |
Click here,
If you are looking for the margin of safety
book written by Seth Klarman
You may also be interested in
other relevant articles:
|
Dear visitor! Do you like this article? If you like, then please bookmark
this page and also share with your friends. Thank you for your support.
[Report Errors and Omissions]
|
Back to
Home Page |
Back to Cost
Volume Profit CVP Relationship Main Page |
A free website
that explains financial and managerial
accounting with amazing clarity
