Margin of Safety (MOS)
In accounting, margin of safety is the extent by which actual or projected sales exceed the break-even sales. Margin of safety ratio equals the difference between budgeted sales and break-even sales divided by budget sales.
The margin of safety is a measure of business risk. It represents the percentage by which a company’s sales can drop before it starts incurring losses. Higher the margin of safety, the more the company can withstand fluctuations in sales. A drop-in sales greater than margin of safety will cause net loss for the period.
There are different ways in which margin of safety can be expressed: (a) in units of goods sold, (b) in dollars of sales or (c) as a ratio.
Formula
Margin of safety in units equals the difference between actual/budgeted quantity of sales minus the break-even quantity.
$$ \text{Margin of Safety}\ (\text{in Units})\ \\=\ \text{Budgeted Units}\ -\ \text{Break}-\text{even Units} $$
Where break-even units of sales equals fixed costs divided by contribution margin per unit.
Margin of safety in dollars can be calculated by multiplying the margin of safety in units with the price per unit.
$$ \text{Margin of Safety}\ (\text{in Dollars})\ \\=\ \text{Margin of Safety}\ (\text{in Units})\ \times \text{Price per Unit} $$
Alternatively, it can also be calculated as the difference between total budgeted sales and break-even sales in dollars. Break-even point (in dollars) equals fixed costs divided by contribution margin ratio.
$$ \text{Margin of Safety}\ (\text{in Dollars})\ \\=\ \text{Budgeted Sales}\ -\ \text{Break}-\text{even Point}\ (\text{in Dollars}) $$
The margin of safety ratio allows comparison between different companies. It can be calculated by dividing the margin of safety (in units or dollars) by total sales (in units and dollars respectively):
$$ \text{Margin of Safety Ratio}\ \\=\ \frac{\text{MOS}\ (\text{in Units})}{\text{Sales}\ (\text{in Units})}\\=\frac{\text{MOS}\ (\text{in Dollars})}{\text{Sales}\ (\text{in Dollars})} $$
Example
Following is the data for two companies. Find out which company has better margin of safety:
| Company A | Company B | |
|---|---|---|
| Sales Price per Unit | $40 | $90 |
| Variable Cost per Unit | $32 | $60 |
| Total Fixed Cost | $7,000 | $25,000 |
| Budgeted Sales | $40,000 | $110,000 |
Solution
The following table shows calculation of margin of safety in units and dollars and the margin of safety ratio:
| Item | Calculation | Company A | Company B |
|---|---|---|---|
| Sales Price per Unit | P | $40 | $90 |
| Variable Cost per Unit | V | $32 | $60 |
| Total Fixed Cost | FC | $7,000 | $25,000 |
| Budgeted Sales | S | $40,000 | $90,000 |
| Budget Sales (in Units) | U = S/P | 1,000 | 1,000 |
| Break-even Point (in Units) | BU = FC/(P - V) | 875 | 833 |
| Break-even Point (in Dollars) | BD = BU × P | $35,000 | $75,000 |
| Margin of Safety (in Units) | MOSU = U - BU | 125 | 167 |
| Margin of Safety (in Dollars) | MOSD = S - BD | $5,000 | $15,000 |
| Margin of Safety Ratio | MOSU/U = MOSD/S | 12.50% | 16.67% |
Company B has a higher margin of safety.
by Irfanullah Jan, ACCA and last modified on