Margin of Safety (MOS)


Learning Objectives:

  1. Define and explain margin of safety.
  2. Calculate margin of safety ratio.
  3. What is its significance/importance?

Contents:

  1. Definition of Margin of Safety (MOS)
  2. Formula of MOS
  3. Example
  4. Review Problem

Definition and Explanation:

Margin of safety (MOS) is the excess of budgeted or actual sales over the break even volume of sales. It stats the amount by which sales can drop before losses begin to be incurred. The higher the margin of safety, the lower the risk of not breaking even.

Formula of Margin of Safety:

The formula or equation for the calculation of margin of safety is as follows:

[Margin of Safety = Total budgeted or actual sales − Break even sales]

The margin of safety can also be expressed in percentage form. This percentage is obtained by dividing the margin of safety in dollar terms by total sales. Following equation is used for this purpose.

[Margin of Safety = Margin of safety in dollars / Total budgeted or actual sales]

Example:

Sales(400 units @ $250) $100,000
Break even sales $87,500

Calculate margin of safety


Calculation:

Sales(400units @$250) $100,000
Break even sales $  87,500
———
Margin of safety in dollars $ 12,500
=======

Margin of safety as a percentage of sales:

12,500 / 100,000

= 12.5%

It means that at the current level of sales and with the company’s current prices and cost structure, a reduction in sales of $12,500, or 12.5%, would result in just breaking even. In a single product firm, the margin of safety can also be expressed in terms of the number of units sold by dividing the margin of safety in dollars by the selling price per unit. In this case, the margin of safety is 50 units ($12,500 ÷ $ 250 units = 50 units).

Review Problem:

Voltar company manufactures and sells a telephone answering machine. The company’scontribution margin income statement for the most recent year is given below:

Description

Total Per unit Percent of Sales
Sales (20,000 units) $ 1,200,000 $60 100%
Less variable expenses 900,000 $45 ?%
——— ——– ——–
Contribution margin 300,000 $15 ?%
Less fixed expenses 240,000 ====== =====
———
Net operating income

60,000

======

Required: margin of safety of safety both in dollars and percentage form.

Solution to Review Problem:

Margin of safety = Total sales – Break even sales*

= $1,200,000  $960,000

= $240,000

Margin of safety percentage = Margin of safety in dollars / Total sales

= $240,000 / $1,200,000

= 20%

*The break even sales have been calculated as follows:

Sales = Variable expenses + Fixed expenses + Profit

$60Q = $45Q + $240,000 + $0**

$15Q = $240,000

Q = $240,000 / $15 per unit

Q = 16,000 units; or at $60 per unit. $960,000

**We know that break even is the level of sales where profit is zero

In Business Soup NutsyPak Melwani and Kumar Hathiramani, former silk merchants from Bombay, opened a soup store in Manhattan after watching a Seinfeld episode featuring the  “soup Nazi.” The episode parodied a real life soup vendor. Ali Yeganeh, whose loyal customers put up with hour-long lines and “snarling customer service.” Melwani and Hathiramani approached Yeganeh about turning his soup kitchen into a chain, but they were gruffly rebuffed. Instead of giving up, the two hired a French chef with a repertoire of 500 soups and opened a store called Soup Nutsy. For $6 per serving, Soup Nutsy offers 12 homemade soups each day, such as sherry crab bisque and Thai coconut shrimp. Melwani and Hathiramani report that in their first year of operation, they netted $210,000 on sales of $700,000. They report that it costs about $2 per serving to make the soup. So their variable expenses ratio is one-third ($2 cost / 6$ selling price). If so, what are their fixed expenses? We can answer that question using the equation approach as follows:

Sales = Variable expenses + Fixed + Profits

$700,000 = (1/3) × 700,000 + Fixed expenses + $210,000

Fixed expenses = $700,000 – (1/3 of $700,000) – $210,000

= $256,667

With this information we can determine that the break even point is about $385,000 of sales. This gives the store a comfortable margin of safety of 45%.

Source: Silva Sansoni, “The Starbucks of Soup?” Forbes, July7, 19997, pp.90-91.

Click here, If you are looking for the margin of safety book written by Seth Klarman

You may also be interested in other articles from “cost volume profit relationship” chapter

  1. Contribution Margin and Basics of CVP Analysis
  2. Difference Between Gross Margin and Contribution Margin
  3. Cost Volume Profit (CVP) Relationship in Graphic Form
  4. Contribution Margin Ratio (CM Ratio)
  5. Importance of Contribution Margin
  6. Change in fixed cost and sales volume
  7. Change in variable cost and sales volume
  8. Change in fixed cost, sales price and sales volume
  9. Change in variable cost, fixed cost, and sales volume
  10. Change in regular sales price
  11. Break even point analysis (calculation of break-even point by contribution margin andequation method)
  12. Target profit analysis
  13. Margin of safety
  14. Sales Mix and Break Even with Multiple Products
  15. Cost Volume Profit (CVP) Consideration in Choosing a Cost Structure
  16. Operating Leverage and degree of operating leverage
  17. Assumptions of Cost Volume Profit (CVP) Analysis
  18. Limitations of Cost Volume Profit Analysis

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