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Margin of Safety

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.

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

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

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 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:

  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 WorkersA10
No. of Working Hours/dayB8
No.of Working Days/annumC250
No. of Man Hours/annumD = A*B*C20000
Wage/HourE$12
Annual Labour CostF = D*E$240,000
Monthly RentG$2,000
Monthly UtilitiesH$800
Monthly Rent and UtilitiesI = G+H$2,800
Annual Rent and UtilitiesJ = I*12$33,600
Variable Cost
Raw Material/UnitK$50
Polishing and Grinding/UnitL$5
Variable Cost/UnitM = K+L$55
Revenue
Selling Price/UnitN$100
Breakeven Point
Contribution/UnitO = N-M$45
BreakevenNo. of UnitsP = (F+J)/O6080
Breakeven RevenueQ = P*N$608,000

Now, 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 higher No. of units.

References:

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Last updated on : May 3rd, 2019

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