Margin of Safety:

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's contribution 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

Definition of Break Even point

Definition of Break Even point:


Break even point is the level of sales at which profit is zero. According to this definition, at break even point sales are equal to fixed cost plus variable cost. This concept is further explained by the the following equation:



[Break even sales = fixed cost + variable cost]



The break even point can be calculated using either the equation method or contribution margin method. These two methods are equivalent.



Equation Method:

The equation method centers on the contribution approach to the income statement. The format of this statement can be expressed in equation form as follows:



Profit = (Sales − Variable expenses) − Fixed expenses



Rearranging this equation slightly yields the following equation, which is widely used in cost volume profit (CVP) analysis:



Sales = Variable expenses + Fixed expenses + Profit



According to the definition of break even point, break even point is the level of sales where profits are zero. Therefore the break even point can be computed by finding that point where sales just equal the total of the variable expenses plus fixed expenses and profit is zero.



Example:

For example we can use the following data to calculate break even point.



Sales price per unit = $250



variable cost per unit = $150



Total fixed expenses = $35,000



Calculate break even point





Calculation:

Sales = Variable expenses + Fixed expenses + Profit



$250Q* = $150Q* + $35,000 + $0**



$100Q = $35000



Q = $35,000 /$100



Q = 350 Units



Q* = Number (Quantity) of units sold.

**The break even point can be computed by finding that point where profit is zero





The break even point in sales dollars can be computed by multiplying the break even level of unit sales by the selling price per unit.



350 Units × $250 Per unit = $87,500



Contribution Margin Method:

The contribution margin method is actually just a short cut conversion of the equation method already described. The approach centers on the idea discussed earlier that each unit sold provides a certain amount of contribution margin that goes toward covering fixed cost. To find out how many units must be sold to break even, divide the total fixed cost by the unit contribution margin.

contribution margin format income statement.

contribution margin format income statement.




Masers A. Q. Asem Private Ltd

Contribution Margin Income Statement

For the month of-------------



Total Per Unit

Sales (350 Units) $87,500 $250

Less variable expenses 52,500 150

--------- ---------

Contribution margin 35,000 $100

Less fixed expenses 35,000 ======

----------

Net operating profit $0

======



Note that the break even is the level of sales at which profit is ZERO.



Once the break even point has been reached, net income will increase by unit contribution margin by each additional unit sold. For example, if 351 units are sold during the period then we can expect that the net income for the month will be $100, since the company will have sold 1 unit more than the number needed to break even. This is explained by the following contribution margin income statement.



Masers A. Q. Asem Private Ltd

Contribution Margin Income Statement

For the month of-------------



Total Per Unit

Sales (351 Units) $87,750 $250

Less Variable expenses 52,500 150

---------- ----------

Contribution margin 35,100 100

Less fixed expenses 35,000 ======

----------

Net operating loss $100

======



If 352 units are sold then we can expect that net operating income for the period will be $200 and so forth. To know what the profit will be at various levels of activity, therefore, manager do not need to prepare a whole series of income statements. To estimate the profit at any point above the break even point, the manager can simply take the number of units to be sold above the breakeven and multiply that number by the unit contribution margin. The result represents the anticipated profit for the period. Or to estimate the effect of a planned increase in sale on profits, the manager can simply multiply the increase in units sold by the unit contribution margin. The result will be expressed as increase in profits. To illustrate it suppose company is currently selling 400 units and plans to sell 425 units in near future, the anticipated impact on profits can be calculated as follows:



Increased number of units to be sold 25

Contribution margin per unit ×100



--------------------------------------------------------------------------------



Increase in the net operating income 2,500

======



To summarize these examples, if there were no sales, the company's loss would equal to its fixed expenses. Each unit that is sold reduces the loss by the amount of the unit contribution margin. Once the break even point has been reached, each additional unit sold increases the company's profit by the amount of the unit contribution margin.

example

Assume that Masers A. Q Asem Private Ltd. has been able to sell only one unit of product during the period. If company does not sell any more units during the period, the company's contribution margin income statement will appear as follows:




Masers A. Q. Asem Private Ltd

Contribution margin Income Statement

For the month of-------------



Total Per Unit

Sales (1 Unit only) $250 $250

Less Variable expenses 150 150

--------- ---------

Contribution margin 100 100

Less fixed expenses 35,000 ======

---------

Net operating loss $(34,900)

======



For each additional unit that the company is able to sell during the period, $100 more in contribution margin will become available to help cover the fixed expenses. If a second unit is sold, for example, then the total contribution margin will increase by $100 (to a total of $200) and the company's loss will decrease by $100, to $34800. If enough units can be sold to generate $35,000 in contribution margin, then all of the fixed costs will be covered and the company will have managed to at least break even for the month-that is to show neither profit nor loss but just cover all of its costs. To reach the break even point, the company will have to sell 350 units in a period, since each unit sold contribute $100 in the contribution margin.

Contribution margin

Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus it is the amount available to cover fixed expenses and then to provide profits for the period. Contribution margin is first used to cover the fixed expenses and then whatever remains go towards profits. If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period. This concept is explained in the following equations:




Sales revenue − Variable cost* = Contribution Margin



*Both Manufacturing and Non Manufacturing



Contribution margin − Fixed cost* = Net operating Income or Loss



*Both Manufacturing and Non Manufacturing

Cost Volume Profit Relationship - (CVP Analysis

Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions among the following five elements:




Prices of products

Volume or level of activity

Per unit variable cost

Total fixed cost

Mix of product sold

Because cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit it is a vital tool in many business decisions. These decisions include, for example, what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

Fixed Assets Turnover Ratio:

Definition:

Fixed assets turnover ratio is also known as sales to fixed assets ratio. This ratio measures the efficiency and profit earning capacity of the concern.
Higher the ratio, greater is the intensive utilization of fixed assets. Lower ratio means under-utilization of fixed assets. The ratio is calculated by using following formula:

Formula of Fixed Assets Turnover Ratio:

Fixed assets turnover ratio turnover ratio is calculated by the following formula:

Fixed Assets Turnover Ratio = Cost of Sales / Net Fixed Assets