Accounting Cost-Volume-Profit Analysis
6. Margin of safety in CVP analysis
If we want to assess how close our business is to incurring losses, we may calculate the margin of safety.
Margin of safety is the amount by which target (budgeted) or existing sales volume exceeds (or falls short of) the break-even point.
Once the break-even sales amount is determined, the margin of safety can be calculated in units or dollars as follows:
Margin of Safety = Target Sales - Break-even Sales |
We can also calculate the margin of safety as the percentage of target sales by using the following formula:
Margin of Safety = |
Target Sales - Break-even Sales |
x 100% |
Target Sales |
Let's return to our example of Friends Company. Assume that the current sales amount to 25,000 units (or $125,000 = 25,000 x $5). The break-even point equals 5,000 valves (or $25,000 = 5,000 x $5). Friends Company is evaluating a lower level of sales (target sales) of 15,000 units (or $75,000 = 15,000 x $5). The margin of safety is calculated as presented below:
Margin of Safety = 25,000 - 15,000 = 10,000 (in units)
Margin of Safety = $125,000 - $75,000 = $50,000 (in dollars)
Margin of Safety = |
$75,000 - $25,000 |
x 100% = 66.7% |
$75,000 |
Such a large margin of safety indicates the soundness and financial strength of Friends Company.
The margin of safety size is an important indicator of the business vitality. If it is large enough, there can be significant falling of sales and the company will still be able to generate profits. On the other hand, if the margin is small, then any decrease in sales volume may cause a loss to the company.
In order to improve the margin of safety the following steps may be undertaken:
- Increase the selling price
- Reduce variable costs
- Reduce fixed costs
- Change the product mix
- Improve efficiency and productivity
7. Limitations of CVP analysis
Now that we have reviewed CVP analysis, you can probably note that it is an extremely simple and useful managerial tool. However, it has certain limitations because several simplifying assumptions are made in CVP analysis. Such assumptions include the following:
- Selling prices and variable costs per unit do not change with volume (while in real life they might change due to the economy of scale).
- Total fixed costs do not change (which is often true only in the short run).
- Sales volume approximates production volume and there are no significant inventory balance fluctuations (which sometimes is not the case).
- A company produces either a single product or a constant product mix (while in real life companies can react to market conditions and change their product mix often).
- Productivity is constant (while in fact it might change due to the economy of scale or changes in technology).
In real-life situations, these assumptions should be considered and analyzed to ensure that CVP analysis provides accurate results.