The margin of safety is a measure of the profitability risk of a business. A business is profitable when revenue exceeds the costs. A part of the revenue is used to cover the breakeven costs, while the remaining part is profit. This remaining part is called the Margin of Safety.
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Margin of Safety Definition
The margin of safety is the difference between revenue and breakeven point. We can afford to lose this safety margin before we start losing money in the business. The margin of Safety can be measured in terms of dollars as well as in a number of units.
Margin of Safety Formula
1) Margin of Safety in terms of Dollars
Margin of Safety ($)=Total Revenue-Breakeven Point
2) Margin of Safety in terms of Units
Margin of Safety (# of units)= (Total Revenue-Breakeven Point)/(Selling Price per Unit)
Margin of Safety Ratio
Margin of Safety can also be written as a percentage of sales or revenue.
Margin of Safety= (Revenue-Breakeven Point)/Revenue
Margin of Safety Calculation with Example
A company XYZ manufactures camshafts. It has 10 workers working 8 hours a day at a wage of USD 12/hour. The company pays out rent on the production facility, which is USD 2000/month. Utilities and other costs come out to be about USD 800/month. The company uses steel as the primary raw material which costs about USD 50 for producing one cam shaft unit. In addition, polishing and grinding cost is about USD 5 per unit. XYZ sells one cam shaft at USD 100/unit. What is the margin of safety if the company produces:
- 5000 units annually
- 10000 units annually
- 20000 units annually
Assume the factory works for 250 days a year.
To get this, we first need to calculate the breakeven point, which is done as follows:
| Fixed Cost | ||||
| No. of Workers | A | 10 | ||
| No. of Working Hours/day | B | 8 | ||
| No.of Working Days/annum | C | 250 | ||
| No. of Man Hours/annum | D = A*B*C | 20000 | ||
| Wage/Hour | E | $12 | ||
| Annual Labour Cost | F = D*E | $240,000 | ||
| Monthly Rent | G | $2,000 | ||
| Monthly Utilities | H | $800 | ||
| Monthly Rent and Utilities | I = G+H | $2,800 | ||
| Annual Rent and Utilities | J = I*12 | $33,600 | ||
| Variable Cost | ||||
| Raw Material/Unit | K | $50 | ||
| Polishing and Grinding/Unit | L | $5 | ||
| Variable Cost/Unit | M = K+L | $55 | ||
| Revenue | ||||
| Selling Price/Unit | N | $100 | ||
| Breakeven Point | ||||
| Contribution/Unit | O = N-M | $45 | ||
| BreakevenNo. of Units | P = (F+J)/O | 6080 | ||
| Breakeven Revenue | Q = P*N | $608,000 | ||
Now, margin of safety for various production scenarios is as follows:
| Breakeven Revenue | A | $608,000 | |
| Selling Price/Unit | B | $100 | |
| Case 1 | |||
| No. of Units | C | 5000 | |
| Total Revenue | D = C*B | $500,000 | |
| Margin of Safety | E = D-A | ($108,000) | |
| Case 2 | |||
| No. of Units | C | 10000 | |
| Total Revenue | D = C*B | $1,000,000 | |
| Margin of Safety | E = D-A | $392,000 | |
| Case 3 | |||
| No. of Units | C | 20000 | |
| Total Revenue | D = C*B | $2,000,000 | |
| Margin of Safety | E = D-A | $1,392,000 | |
Clearly, the margin of safety goes up as XYZ manufactures and sells higher No. of units.
References:
Articles:
- https://www.accountingtools.com/articles/2017/5/13/margin-of-safety-safety-margin
- http://www.myaccountingcourse.com/financial-ratios/margin-of-safety
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