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Margin of Safety (MOS):

Contents:

  1. Definition of Margin of Safety (MOS)

  2. Formula of MOS

  3. Example

  4. Review Problem

Definition and Explanation:

The excess of actual or budgeted sales over the break even volume of sales is called margin of safety. At break even point costs are equal to sales revenue and profit is zero. Margin of safety, therefore, tells us the amount of sales that can be dropped before losses begin to be incurred. With a high margin of safety business have low risk of not breaking even and with a low margin of safety business have high risk of not breaking even.

Formula of Margin of Safety:

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

Margin of Safety Ratio:

The margin of safety can also be expressed in percentage form (Margin of safety ratio). 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

Example:

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).

Review Problem:

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: 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 ratio) = 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.

 

Case Study (A Real Business Example):

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 expenses + 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.

 

Relevant Articles:

Contribution Margin
Contribution Margin Ratio (CM Ratio)
Contribution Margin Income Statement
Break-even Point Analysis
Target Profit Analysis
Margin of Safety (MOS)
Operating Leverage
Break even Analysis with Multiple Products
CVP Consideration in Cost Structure
Importance of Cost Volume Profit (CVP) Analysis

 

 

 

 

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Financial Accounting Topics


  Introduction to Accounting
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  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Accounts of Non-profit Making Organizations
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  Balanced Scorecard
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  Capital Investment Analysis/Capital Budgeting
 
 

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