Margin of Safety
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Margin of safety represents the strength of the business. It enables a business to know what is the exact amount he/ she has gained or lost and whether they are over or below the break even point.
margin of safety = ( sales – break-even sales) / sales) x 100% If P/V ratio is given then profit/ PV ratio
In unit sales
If the product can be sold in a larger quantity than occurs at the break even point, then the firm will make a profit; below this point, the firm will make a loss. Break-even quantity is calculated by:
- Total fixed costs / (selling price – average variable costs).
Explanation – in the denominator, “price minus average variable cost” is the variable profit per unit, or contribution margin of each unit that is sold.
This relationship is derived from the profit equation: Profit = Revenues – Costs where Revenues = (selling price * quantity of product) and Costs = (average variable costs * quantity) + total fixed costs.
Therefore, Profit = (selling price * quantity) – (average variable costs * quantity + total fixed costs).
Solving for Quantity of product at the breakeven point when Profit equals zero, the quantity of product at break even is Total fixed costs / (selling price – average variable costs).
Firms may still decide not to sell low-profit products, for example those not fitting well into their sales mix. Firms may also sell products that lose money – as a loss leader, to offer a complete line of products, etc. But if a product does not break even, or a potential product looks like it clearly will not sell better than the break even point, then the firm will not sell, or will stop selling, that product.
- Assume we are selling a product for £2 each.
- Assume that the variable cost associated with producing and selling the product is 60p.
- Assume that the fixed cost related to the product (the basic costs that are incurred in operating the business even if no product is produced) is $1000.
- In this example, the firm would have to sell (1000 / (2.00 – 0.60) = 715) 715 units to break even.
Total Income (Net profit) = Total expenses (costs)
NI = TC = Fixed cost + Variable cost
Selling Price x Quantity = Fixed cost + Quantity x Variable cost (cost/unit)
SP x Q = FC + Q x VC
Quantity x (SP-V) = Fc
Break Even = FC / (SP − VC)
where FC is Fixed Cost, SP is Selling Price and VC is Variable Cost