Margin of safety is the difference between actual or expected sales and sales at the break‐even point. It measures the “cushion” that a particular level of sales provides. It tells us how far sales could fall before the company begins operating at a loss. The margin of safety is expressed in dollars or as a ratio.
The formula for stating the margin of safety in dollars is actual (or expected) sales minus break‐even sales. Assuming that actual (expected) sales for Vargo Video are $750,000, the computation is as follows.
Actual (Expected) Sales−Break-Even Sales=Margin of Safety in Dollars$750,000−$500,000=$250,000Actual (Expected) Sales−Break-Even Sales=Margin of Safety in Dollars$750,000−$500,000=$250,000
ILLUSTRATION 18-28 Formula for margin of safety in dollars
Vargo’s margin of safety is $250,000. Its sales could fall $250,000 before it operates at a loss.
The margin of safety ratio is the margin of safety in dollars divided by actual (or expected) sales. Illustration 18-29 shows the formula and computation for determining the margin of safety ratio.
Margin of Safety in Dollars÷Actual (Expected) Sales=Margin of Safety Ratio$250,000÷$750,000=33%Margin of Safety in Dollars÷Actual (Expected) Sales=Margin of Safety Ratio$250,000÷$750,000=33%
ILLUSTRATION 18-29 Formula for margin of safety ratio
This means that the company’s sales could fall by 33% before it operates at a loss.
The higher the dollars or the percentage, the greater the margin of safety. Management continuously evaluates the adequacy of the margin of safety in terms of such factors as the vulnerability of the product to competitive pressures and to downturns in the economy.
SERVICE COMPANY INSIGHT
How a Rolling Stones’ Tour Makes Money
Computations of break‐even and margin of safety are important for service companies. Consider how the promoter for the Rolling Stones’ tour used the break‐even point and margin of safety. For example, say one outdoor show should bring 70,000 individuals for a gross of $2.45 million. The promoter guarantees $1.2 million to the Rolling Stones. In addition, 20% of gross goes to the stadium in which the performance is staged. Add another $400,000 for other expenses such as ticket takers, parking attendants, advertising, and so on. The promoter also shares in sales of T‐shirts and memorabilia for which the promoter will net over $7 million during the tour. From a successful Rolling Stones’ tour, the promoter could make $35 million!
What amount of sales dollars are required for the promoter to break even? (Go to WileyPLUS for this answer and additional questions.)
DO IT! 5
Break‐Even, Margin of Safety, and Target Net Income
Zootsuit Inc. makes travel bags that sell for $56 each. For the coming year, management expects fixed costs to total $320,000 and variable costs to be $42 per unit. Compute the following: (a) break‐even point in dollars using the contribution margin (CM) ratio; (b) the margin of safety and margin of safety ratio assuming actual sales are $1,382,400; and (c) the sales dollars required to earn net income of $410,000.
✓ Apply the formula for the break‐even point in dollars.
✓ Apply the formulas for the margin of safety in dollars and the margin of safety ratio.
✓ Apply the formula for the required sales in dollars.
(a) Contribution margin ratio=[($56−$42)÷$56]=25%Contribution margin ratio=[($56−$42)÷$56]=25%
Break‐even sales in dollars=$320,000÷25%=$1,280,000Break‐even sales in dollars=$320,000÷25%=$1,280,000
(b) Margin of safety=$1,382,400−$1,280,000=$102,400Margin of safety=$1,382,400−$1,280,000=$102,400
Margin of safety ratio=$102,400÷$1,382,400=7.4%Margin of safety ratio=$102,400÷$1,382,400=7.4%
(c) Required sales in dollars=($320,000+$410,000)÷25%=$2,920,000Required sales in dollars=($320,000+$410,000)÷25%=$2,920,000
Related exercise material: BE18-10, BE18-11, BE18-12, E18-14, E18-15, E18-17, and DO IT! 18-5.
USING DECISION TOOLS—AMAZON.COM
Amazon.com faces many situations where it needs to apply the decision tools presented in this chapter, such as calculating the break‐even point to determine a product’s profitability. Amazon’s dominance of the online retail space, selling other company’s products, is well known. But not everyone may realize that Amazon also sells its own private‐label electronics, including USB cables, mice, keyboards, and audio cables, under the brand name AmazonBasics. Assume that Amazon’s management was provided with the following information regarding the production and sales of Bluetooth keyboards for tablet computers.
|Direct labor per keyboard||$ 8.00|
|Variable cost per keyboard||$15.00|
|Total fixed costs||$135,000|
|Selling price per keyboard||$25.00|
|Sales, 2017 (20,000 keyboards)||$500,000|
(Ignore any income tax considerations.)
(a) What is the operating income for 2017?
(b) What is the unit contribution margin for 2017?
(c) What is the break‐even point in units for 2017?
(d) Assume that management set the sales target for the year 2018 at a level of $550,000 (22,000 keyboards). Amazon’s management believes that to attain the sales target in 2018, the company must incur an additional selling expense of $10,000 for advertising in 2018, with all other costs remaining constant. What will be the break‐even point in sales dollars for 2018 if the company spends the additional $10,000?
(e) If the company spends the additional $10,000 for advertising in 2018, what is the sales level in dollars required to equal 2017 operating income?
|Variable costs (20,000 keyboards × $15)||300,000|
|Operating income||$ 65,000|
|Selling price per keyboard||$25|
|Variable cost per keyboard||15|
|Unit contribution margin||$10|
3. (c) Fixed costs÷Unit contribution margin=Break-even point in units: $135,000÷$10=13,500 unitsFixed costs÷Unit contribution margin=Break-even point in units: $135,000÷$10=13,500 units
4. (d) Fixed costs÷Contribution margin ratio=Break-even point in dollars: $145,000∗÷40%**=$362,500Fixed costs÷Contribution margin ratio=Break-even point in dollars: $145,000*÷40%**=$362,500
|Additional advertising expense||10,000|
|Revised fixed costs||$145,000|
|**Contribution margin ratio = Unit contribution margin ÷ Unit selling price: 40% = $10 ÷ $25|
5. (e)Required sales=(Fixed costs+Target net income)÷Contribution margin ratio$525,000=($145,000+$65,000)÷40%(e) Required sales=(Fixed costs+Target net income)÷Contribution margin ratio$525,000=($145,000+$65,000)÷40%