Margin of Safety

The excess of the actual sales revenue (ASR) over the break-even sales revenue (BESR) is known as the margin of safety. Symbolically, margin of safety = (ASR – BESR)

When the margin of safety (amount) is divided by the actual salt (amount), till margin of safety ratio is obtained. Symbolically,

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The M/S ratio indicates the percentage by which the actual sales may be reduced before they below the break-even sales volume. It is important that there should he a reasonable margin of safety lest a reduced of activity should prove disastrous. The higher the margin of safety ratio, the better it is from the point of view of the company as it indicates that a sizable sales volume can fall before the BEP is reached. This measure acquires special significance in depression recession.

Assume in the vendors case that sales is 2,000 units (Rs 6,000): margin of safety (Rs 4,000) and the M/S ratio is 2,400 = 40  per cent.

The amount of profit can be directly determined with reference to the margin of safety and P/V ratio. Symbolically,

Profit = [Margin of safety (amount) x P V ratio

Or Profit = |Margin of safety (units) CM per unit|

In the vendor case, profit = Rs 2.400 x 0.3333  (33.33  per cent) = Rs 800 or 800 x Re = Rs 800.

The reason is that once the total amount of fixed costs has been recovered profits will increase by the difference of sales revenue and variable costs.

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