Break-even point (BEP) is the level of sales where a total of fixed and variable costs equals total revenues. In other words, the breakeven point is a level where the company neither makes a profit nor a loss. A margin of safety (MoS) is a difference between actual/budgeted sales and the level of breakeven sales. Let us see in detail the breakeven point vs. margin of safety.
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. The main points of difference between the breakeven point and margin of safety are as listed below:
- Interpretation of Breakeven Point and Margin of Safety
- Breakeven Point vs. Margin of Safety: Example
- Advantages and Uses
- Disadvantages of Breakeven Point and Margin of Safety
The breakeven point means an amount of sales that cover entire fixed and variable costs. 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, the Margin of Safety is the margin between the actual/budgeted sales and the breakeven point. It denotes the level of safety that the 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.
- The lower the breakeven quantity, the better it is for the companies, while the higher the margin of safety, the better it is for the company.
Breakeven Point vs. Margin of Safety: Example
Let us calculate and compare the 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.’
The breakeven value of sales will be 50 X q
The total Variable cost will be 30 X q
The 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
The 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 Uses
Advantages of Breakeven Point Analysis
- BEP analysis helps understand 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 that help decide whether to manufacture a new product yourself or outsource.
Advantages of Margin of Safety
- It helps to know how much cushion the company has if sales decline before the company starts making losses.
- Higher MoS provides freedom to the company’s management to alter the selling price of their product to gain market share from its competitors.
- A 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 the case of a multi-product scenario. Many times it isn’t easy to classify a cost as fixed or variable.
- The margin of safety, which 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 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 to using breakeven point analysis and calculating margin of safety, these continue to remain a vital part of any company’s cost profit-volume analysis.
Quiz on Breakeven Point vs Margin of Safety
This quiz will help you assess yourself on how much you have learned about Breakeven Point and Margin of Safety from the above article.