Margin of Safety

The term ‘Margin of Safety’ is a self explanatory term. It shows the amount of sales that act as a safety cover for an enterprise to help it earn profits. From accounting point of view, Margin of safety is the difference between actual sales and sales at break even point. It represents an amount of sales that contributes to the profits of the company i.e. the amount of sales which is over and above the sales at break even point. For example, If break even point sales of a company are $20,000,000 and the actual sales achieved by it are $35,000,000 then $15,000,000 becomes the margin of safety for the company. This amount shows a safety cover for the company.

Since sales at break even point shows a situation of no profit no loss, a situation where the sales of a concern are just sufficient to cover the costs(fixed and variable) of that concern, any sale above the break even point contribute to the profits of the company. With the above discussion, understanding the formula for Margin of safety becomes even more easy.

  • Margin of Safety = Actual Sales – Break Even Sales
  • Margin of safety can also be calculated with the help of P/V ratio:

Margin of Safety=Profits ⁄ PV ratio

  • It can also be expressed as a percentage of sales as:

Margin of Safety×100 ⁄ Sales

 

Let us illustrate the calculation of Margin of Safety with the help of some examples using above given formulas.

Illustration 1.Calculate margin of safety if break even sales of a company are $25,750,000  and it sold 124,500 units at $325 per unit.

Solution: Margin of safety=Actual sales – Break even sales

=(124,500 × 325)−25,750,000=40,462,500−25,750,000=$14,712,500

Illustration 2. Calculate Margin of Safety if Profit-Volume Ratio is 15% and Profits earned is $2,500,000.

Solution: Margin of Safety=Profit ⁄ P/V ratio

= $2,500,000 ⁄ 0.15 = $16,666,667

Illustration 3. Express Margin of Safety as a percentage of Sales from the information provided in Illustration1 above.

Solution: Margin of Safety as a percentage of sales=Margin of Safety×100 ⁄ Sales

=(14,712,500×100) ⁄ 40,462,500=36.36%

ABC Analysis

ABC (Always Better Control) analysis is an important tool used in material control. As we all know that a variety of parts and materials are used in manufacturing each and every industrial product. And efficient material management calls for a selective control over all the items of inventory. Since every item of material is not equally important for controlling point of view, some expensive or critical items require more control as compared to relatively cheaper and less important items. Hence there arises a need for an analysis of these items for the purpose of having selective control over them. So,with an increase in the quantity and variety of material items coming into the stores, we need to segregate these items into different categories. This approach of inventory control through analysis of their monetary value is known as ABC analysis. ABC or Always Better Control analysis originated in the General Electric Company of America.  Under this technique, we measures the cost share of each item of material in relation to total cost and material value. This requires a thorough analysis of money value of the different parts and materials. Under this analysis each item of inventory is studied in terms of its usage, lead time, technical problems and its relative share in the total monetary investment in the inventories. Critical or high value items need close attention and time whereas low value items need less time and attention.
Steps involved in ABC analysis are given below:
1. Find out the expected use of each item of stock in terms of physical units.
2. Determine the price per unit of each item.
3. Find the total cost share of each item of project by multiplying expected usage of each item by price per unit.
4. Arrange different items in order starting with the item with the share in total cost.
5. Express units of each item as a percentage of total units of all items.
6. Express cost of each item as a percentage of total cost of all items.
If possible, divide different items of stocks into three categories and label them as A, B and C. Items labeled as A comprise highest cost, B moderate cost and C the lowest cost.

Thus with the help of ABC analysis it becomes easier for the material management to exercise selective control by concentrating its attention on more important items.