Margin of Safety

The margin of safety is a tool used in CVP analysis. 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.

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 and the number of units.

Margin of Safety Formula

1) Margin of Safety in terms of Dollars

The 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

Margin of Safety Ratio

It can also be written as a percentage of sales or revenue.

Margin of Safety= (Revenue-Breakeven Point)/Revenue

MOS

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 camshaft unit. In addition, the polishing and grinding cost is about USD 5 per unit. XYZ sells one camshaft at USD 100/unit. What is the margin of safety if the company produces:

  1. 5000 units annually
  2. 10000 units annually
  3. 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

You can also use the Margin of Safety Calculator.

Now, the margin of safety for various production scenarios is as follows:

Breakeven RevenueA$608,000
Selling Price/UnitB$100
Case 1   
 No. of UnitsC5000
 Total RevenueD = C*B$500,000
 Margin of SafetyE = D-A($108,000)
Case 2   
 No. of UnitsC10000
 Total RevenueD = C*B$1,000,000
 Margin of SafetyE = D-A$392,000
Case 3   
 No. of UnitsC20000
 Total RevenueD = C*B$2,000,000
 Margin of SafetyE = D-A$1,392,000

Clearly, the margin of safety goes up as XYZ manufactures and sells a higher No. of units.

Also, read the Difference between Breakeven Point vs. Margin of Safety.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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