Definition: Margin of Safety (MOS) is defined as the excess of actual or projected sales over break-even sales, that can be expressed in monetary terms or units, or as a percentage of total sales.
The margin of Safety implies the sales point over and above the break-even point, that results in profit. Break-even point (BEP), is the point wherein total cost and total revenue are at equilibrium and profit is zero. It can be calculated as:
Another way to calculate the margin of safety if to find out the difference between budgeted and break-even sales (in units) and then multiply the result by the contribution per unit. This is because, at BEP, fixed overheads are absorbed and any further contribution, will amount to profit. It can be computed as:
The Margin of Safety is vital to the company, as a reduced activity level, will lead to losses. The size of the margin of safety is an indicator of company’s financial health, i.e. low margin of safety represent high fixed overheads, and profits are not earned, until and unless the activity level so high that it covers fixed costs.
On the other hand, high margin of safety represents that the break-even point is highly less than the actual sales. Therefore, even if there is a decrease in sales, the business will be able to earn profits. So, the higher the margin, the greater are the chances to make profits or responsive to any sudden decline in company’s revenue, thus reducing the risk of losses in business.
Ways to improve Margin of safety
- Increase contribution per unit: One of the most important ways to improve the margin of safety is to improve marginal contribution per unit, which is possible by increasing the selling price (if market conditions are favourable) and lowering the variable cost per unit of the product. Change in product mix can also help to improve contribution.
- Lowering Break-even Output: Margin of safety can be improved by lowering the break-even output, and this can only be possible if the fixed overheads are reduced.
- Increasing sales volume: The easiest technique to increase the margin of safety is to sell as much as the company can if there is underutilised capacity.
The margin of Safety shows the amount by which drop in sales can be tolerated by the company before losses actually start incurring. When the margin is high, decrease in sales will not influence the business profit, while when it is low, a slight decline in sales, abruptly affect the entire business.
I am interested in the formula to improve profit margins in trade business