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%