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# Margin of Safety

SandyHood
Font Of All KnowledgeRegistered, Moderator Posts:

**2,034**

__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.

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## Comments

2,034Section 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 Plcmanufacture and sell specialist pumpsThe 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.

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1,189Thanks

2,034The Company that makes the L product has provided the following information from the budget:

Going back to the same information (and forecast sales of 6,300 units)

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.

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2,034Alex 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 ........................[

£70,000Profit ................................[ £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:Attachment not found.

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Thank you

The question asked you to find:-

- the number of units of LN60 that Broadsword must sell to achieve its target profit of £20,000

- the revised margin of safety %

- 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

- Use the formula: Total Fixed Costs + Target Profit divided by contribution per unit

- Revised Margin of Safety: Forecast Sales - Break Even Sales divided by Forecast Sales

- Revised Margin of Safety Revenue

I hope you find this helps.(£60,000 + £20,000)/ £25.00 = 3,200 units

I will assume the revised break even sales units are the 3,200 calculated for (1.)

(5,000 - 3,200)/5,000 = 36%

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

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

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