Margin of safety is the difference between the actual sales and sales at break-even point. Sales beyond break-even volume bring in profits. Such sales represent a margin of safety. Margin of safety is calculated as follows:
Margin of safety = Total sales – Break even sales
Margin of safety can also be calculated with the help of P/V ratio i.e.
Margin of safety = Profit / P/V Ratio
Margin of safety can also be expressed as percentage of sales
i.e. (Margin of safety) / Total sales x 100
It is important that there should be reasonable margin of safety; otherwise, a reduced level of activity may prove disastrous. The soundness of a business is gauged by the size of the margin of safety. A low margin of safety usually indicates high fixed overheads so that profits are not made until there is a high level of activity to absorb fixed costs.
A high margin of safety shows that break-even point is much below the actual sales, so that even if there is a fall in sales, there will still be a point. A low margin of safety is accompanied by high fixed costs, so action is called for reducing the fixed costs or increasing sales volume.
The margin of safety may be improved by taking the following steps:
- Lowering fixed costs.
- Lowering variable costs so as to improve marginal contribution.
- Increasing volume of sales, if there is unused capacity.
- Increasing the selling price, if market conditions permit, and
- Changing the product mix as to improve contribution.
