Margin of Safety

SandyHood

Margin of Safety
Definition 1.
An excess of a company's actual sales revenue over the breakeven sales revenue, expressed usually as a percentage. The greater this margin, the less sensitive the company to any abrupt fall in revenue. Formula: (Actual sales revenue - Breakeven sales revenue) x 100 ÷ Actual sales revenue.
Definition 2.
The margin of safety is a measure of risk. It represents the amount of drop in sales which a company can tolerate. 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.

Vital definitions and more words than formulae.
Now read this example:
If a company (or a product) has a margin of safety of 20%, then a fall in sales of more than 20% of the forecast sales would mean a loss would be made.

There are an increasing number of students who don't master costs and revenues before moving on to test their knowledge. One way these students work is by trying mock exams or questions and then looking at the answers.

When you look at the model answer to a question, AND do not have confidence in your own knowledge and understanding you might think that the model answer is correct. If you have confidence you may just wonder why there is a difference to your own answer or even recognise that the model answer is wrong.

I have gone through an exam that someone preparing for the CRS exam showed me.
One question tests Margin of Safety This will be task 2.2 on the exam

Here is an example I've prepared:
If you need to sell 80 units to break even, at what forecast level of sales would you have a margin of safety of 10%?

Step 1.
Actual sales should be 10% lower than forecast sales to be at the break even level. So the break even level must be forecast sales less 10% of forecast sales. In other words 90% of forecast sales.

Step 2.
Divide the break even sales by 90% to find the forecast sales needed for a 10% margin of safety.
Break even sales = 80
divided by 90%
= 88.88888, which we must round up = 89

Now we can take 10% off 89 (8.9 rounded up to 9) and be left with 80
We need to forecast sales at 89 to achieve the 10% Margin of Safety

Do not fall into the trap of thinking that margin of safety is a % of the break even units.

SandyHood

XM Candi Date Plc

Section 2 Task 2.2 tends to catch out a few more candidates than other tasks.

Here is a style of question that would test understanding beyond rote learning of formulas.

XM Candi Date Plc manufacture and sell specialist pumps

The company sell the A80 pumps to regular customers. These same customers buy many other pumps most of which are produced to the customer's own specifications. The other pumps are profitable.
In other words the company makes a profit on the other products, so the A80 pumps do not need to be profitable but are needed to keep the customers coming back for other products.

The A80 pump production incurs the following costs:
Variable costs: £670 per pump
Fixed costs of producing the A80 are £16,000
Sales are forecast as 40 (maximum)
What price should XM Candi Date Plc charge for the A80 pumps to break even?

You know the break even volume, the answer that comes out of a formula endless students learn by heart, but do you understand the relationships between the component figures?
The mathematical candidate can re-arrange the formula

If break even volume 40 =.......... Fixed costs.................... £16,000
........................................ contribution per unit.......... Price less £670

Then Price = Fixed costs + variable cost per unit.......... £16,000 + £670
.......................volume.............................................. 40
= £1,070

Other wise try and think practically.
I've got 40 Pumps that I think I'll sell. They cost me £670 each and I had £16,000 of fixed costs.
Well I've got to charge £670 to recover the variable costs, and then divide the fixed costs by 40, and add that on and I'll have a price where I'll break even.

I'm sure if you speak to any small time trader, this is what they do when they are setting prices they want to charge. I certainly know some one who buys and "does up" cars to sell on. He looks at the variable costs he incurs and shares out the fixed costs and then reaches the minimum he could sell for without making a loss. What we'd call the price he has to charge to break even.

Sometimes you can learn more about costing by taking to a chap doing up a car than you can by learning formulae.

angmc

Thank you Sandy, I'm finding these very useful.

SandyHood

Thank you for your comment angmc, another post said something quite recently. It really helps someone such as me to know when readers find it a help. It is also useful when readers ask for clarification. But if the advice just comes and goes, the writer doesn't know if it has been any help.

janwal

I would like to say a big thank you, you got me through CRS last year. You make things understandable, even though I am studying through college it sometime feels like self study to me as tutors not to good.

Thanks

SandyHood

Margin of Safety by another name

The Company that makes the L product has provided the following information from the budget:

1. Sales 6,300 units
2. Selling price £300
3. Variable cost per unit £100
4. Total fixed cost £1,197,000

1. What percentage reduction in sales volume would bring the forecast profit down to zero?
   
   Going back to the same information (and forecast sales of 6,300 units)
2. What % change in price of L would cause the forecast profit to fall to zero? (This question could have been written: Calculate the sensitivity of The Company's total budgeted profit to a change in the selling price of product L? it would mean exactly the same thing).

Have a go.
No workings provided but I'll provide answers for you to compare with.Attachment not found.

SandyHood

Alex's new restaurant

Alex is a restaurant owner and has been approached by a friend who is another restaurant owner but wishes to retire. Alex's restaurant runs profitably and has the following simplified income statement for last year:

Sales Revenue ..................[ £130,000
Variable Costs ....................[ £39,000
Fixed costs ........................[ £70,000
Profit ................................[ £21,000

Alex thinks he could run the other restaurant.
The fixed costs would be higher: £90,000 as he'll employ a manager.
But he will use the same prices and incur the same variable costs as a proportion of price as he has in his own restaurant.
The other restaurant is in a busier location and Alex has forecast sales next year as £168,000.

Task:

1. Find the break-even sales revenue for Alex's restaurant.
2. Find the Margin of Safety percentage for Alex's restaurant based on last year's sales revenue.
3. Find the break-even sales revenue for the other restaurant.
4. Although Alex has forecast next year's sales revenue with the best information at his disposal, he is unsure exactly how much he will actually take. Calculate the sensitivity of the other restaurant's budgeted profit to sales revenue not being as high as forecast.

Attachment not found.

j1994

Can u help me with aat assesmentb1 2013 task 7 e?

SandyHood

Please can you send me a copy of the question? I no longer have AAT classes. This means I no longer have access to the sample exams.

j1994

What is ur email address?

SandyHood

I can see that you found
sandy@sandyhood.com
Thank you

The question asked you to find:-

1. the number of units of LN60 that Broadsword must sell to achieve its target profit of £20,000
   
2. the revised margin of safety %
   
3. and the margin of safety in sales revenue for the target profit
   

The following budget information is given:

Demand: 5,000 units
Selling Price: £39.00 per unit
Variable cost: £14.00 per unit
Contribution: £25.00 per unit
Fixed Overheads: £60,000

1. Use the formula: Total Fixed Costs + Target Profit divided by contribution per unit
   (£60,000 + £20,000)/ £25.00 = 3,200 units
   
2. Revised Margin of Safety: Forecast Sales - Break Even Sales divided by Forecast Sales
   I will assume the revised break even sales units are the 3,200 calculated for (1.)
   (5,000 - 3,200)/5,000 = 36%
   
3. Revised Margin of Safety Revenue
   As you may have seen in an earlier posting on this thread, there are two ways to work this out. The easier for a single product company is to find the margin of safety in units and multiply it by the price per unit.
   (5,000 - 3,200) x £39.00 = £70,200

I hope you find this helps.
Sandy

with a little plug for my CIMA and ACCA courses for anyone wanting to follow their AAT with one of these on a classroom based course.

http://www.sandyhood.com

j1994

Thankyou so much!