Table of Contents
- 1 Interpretation of Breakeven Point and Margin of Safety:
- 2 Breakeven Point vs. Margin of Safety: Example
- 3 Advantages and Use of Breakeven Point Analysis and Margin of Safety Analysis
- 4 Disadvantages of Breakeven Point and Margin of Safety
Break-even point (BEP) is the level of sales where a total of fixed and variable cost equals total revenues. In other words, the breakeven point is a level where the company neither makes profit nor loss.
A margin of safety (MoS) is a difference between actual/budgeted sales and level of breakeven sales.
Although the breakeven point (level) and margin of safety fall under the broad domain of cost-volume-profit analysis (CVP Analysis), they differ in various aspects. Main points of difference between the breakeven point and margin of safety are as listed below:
Breakeven point means an amount of sales that covers entire fixed and variable cost. Sales lower than the BEP will result in losses, while, the sales above the BEP will generate profit after considering all the costs.
As the name suggests, Margin of Safety is the margin between the actual/budgeted sales and breakeven point. It denotes the level of safety that company enjoys before incurring losses (i.e. falling below the breakeven level).
Interpretation of Breakeven Point and Margin of Safety:
- Breakeven point is a measure of sustenance while the margin of safety is a measure of risk.
- Lower the breakeven quantity; better it is for the companies, while higher the margin of safety, the better it is for the company.
Breakeven Point vs. Margin of Safety: Example
Let us calculate and compare breakeven point with the margin of safety using the following data.
Sales price per unit = $ 50
Variable cost per unit = $ 30
Total fixed cost = $ 7,000
Total sales quantity = 500 units
Breakeven Point Formula – Equation
Breakeven Sales = Total Variable Cost + Total Fixed Cost
Assuming a breakeven quantity of ‘q’
Breakeven value of sales will be 50 X q
Total Variable cost will be 30 X q
Total fixed cost will be the same as it does not change with a change in sales quantity.
The formula shall now look as follows:
50q = 30q + 7000 —> 50q – 30q = 7000 —> 20q = 7000 —> q = (7000/20) —> q = 350
Therefore upon solving, the breakeven quantity ‘q’ = 350 units.
Hence the breakeven sales will be 50 X q = 50 X 350 = $ 17,500
Breakeven point can be calculated using a rephrased approach known as the contribution method, which is as follows:
Breakeven Point Formula – Contribution Method
Contribution Per Unit = Selling Price Per Unit – Variable Cost Per Unit
= $ 50 – $ 30 = $ 20
Breakeven Quantity = Total Fixed Cost / Contribution Per Unit
= $ 7000 / $ 20
= 350 units.
Breakeven Sales = 350 (Breakeven Quantity) X $ 50 (Selling Price) = $ 17,500
Margin of safety formula
Margin of Safety = Total budgeted or actual sales – Breakeven sales
Assuming Actual Sales = 500 units
= (500 X 50) – (350 X 50)
= 25,000 – 17,500
= $ 7,500
Margin of Safety as a Percentage of Sales = ($ 7,500/ $ 25,000) %
Advantages and Use of Breakeven Point Analysis and Margin of Safety Analysis
Advantages of Breakeven Point Analysis
- BEP analysis helps in understanding the relationship between fixed cost, variable cost and the level of profitability.
- It provides the business with a minimum sales level which the company needs to achieve to avoid losses.
- It also indicates how any change in selling price would impact the profitability and BEP.
- BEP can be used as one of the indicators which help in deciding whether to manufacture new product yourself or simply outsource.
Advantages of Margin of Safety
- It is useful in knowing how much cushion the company has if sales decline before the company starts making losses.
- Higher MoS provides freedom to the management of the company to alter the selling price of their product in order to gain market share from its competitors.
- Higher margin of safety allows the company to spend more on an advertisement or other activities that can help in improving sales in the long run.
Disadvantages of Breakeven Point and Margin of Safety
- Break-even point analysis is more appropriate in the case of analysis of a single product at a time, it fails to do so appropriately in case of multi-product scenario. Many-a-times it is difficult to classify a cost as fixed or variable
- The margin of safety, if turns out to be very high, may cause management to lead to inappropriate use of excess funds. At times, a higher margin of safety may lead to higher risk taking the behavior of the management which may not always be required.
The CPV Analysis for any company would remain incomplete unless one calculates breakeven point analysis and margin of safety along with other costs and ratios. Though there are limitations of using breakeven point analysis and calculating margin of safety; these continue to remain a vital part of any company cost profit-volume analysis.