If we want to assess how far our business is from 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 percentage of target sales using the following formula:

Let's return to our example of Friends Corporation. 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 Corporation 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)

Such a large margin of safety indicates the soundness and financial strength of the business.

The size of margin of safety 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 profit. 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:

1. Increase the selling price
2. Reduce variable costs
3. Reduce fixed costs
4. Change the product mix
5. Improve efficiency and productivity

We have reviewed the CVP analysis and 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:

• Sales price and variable cost per unit do not change with volume (while in real life they might change due to 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, the company can react to market conditions and change product mix often).
• Productivity is constant (while in fact it might change due to economy of scale or changes in technology).

In real life situations the above assumptions should be considered and analyzed to ensure that the CVP analysis provides accurate results.