Margin of Safety (MOS) shows how much demand for a product exceeds Break-even Quantity (BEQ). It measures the difference between the business’s actual sales and the number of products needed to be produced and sold in order to break-even.
How useful is Margin of Safety (MOS)?
Margin of Safety (MOS) measures the amount by which sales can fall before the company makes losses from producing and selling a particular product. In other words, how many products the business may afford not to sell and still break-even.
Positive Margin of Safety (MOS)
A positive Margin of Safety (MOS) is when the real amount of sales exceeds Break-Even Quantity (BEQ). A positive Margin of Safety (MOS) means that the firm makes a profit. The greater the positive Margin of Safety (MOS), the safer the firm is in terms of earning profits from producing and selling the product, especially during economic downturn. The higher positive Margin of Safety (MOS), the lower the risk of a loss being made.
Negative Margin of Safety (MOS)?
A negative Margin of Safety (MOS) is when the real amount of sales is lower than Break-Even Quantity (BEQ). A negative Margin of Safety (MOS) means that the firm makes a loss. The greater the negative Margin of Safety (MOS), the more in danger the firm is in terms of earning profits from producing and selling the product, especially during economic downturn. The lower negative Margin of Safety (MOS), the higher the risk of a loss being made.
How to calculate Margin of Safety (MOS)?
Margin of Safety (MOS) can be calculated in terms of numbers and as a percentage.
In terms of a number, Margin of Safety (MOS) is calculated using the following formula:
Margin of Safety (MOS) = Actual Sales (Real Demand) – Break-even Quantity (BEQ)
Margin of Safety (MOS) is not expressed as a monetary value in USD$ or any other currency, but as a number, or percentage. It is because Margin of Safety (MOS) is shown on the x-axis of the Break-even Chart. And the x-axis is labelled as ‘Output (in units)’.
So, the unit of measuring Margin of Safety (MOS) is the volume of output not the value of output.
However, many businesses prefer to express their Margin of Safety (MOS) as a percentage instead of a number. Because it puts Margins of Safety (MOS) for many different products into perspective allowing better comparisons to be made.
In terms of a percentage, Margin of Safety (MOS) is calculated using the following formula:
Margin of Safety (MOS%) = Margin of Safety (MOS) / Break-even Quantity (BEQ)
Or,
Margin of Safety (MOS%) = [Actual Sales (Real Demand) – Break-even Quantity (BEQ)] / Break-even Quantity (BEQ) x 100%
In this way, a percentage of Margin of Safety (MOS) can indicate the degree of risk involved in a business decision whether to develop and sell the product, or not.
Margin of Safety (MOS) in practice
Let’s take a look at a real-life example of calculating Margin of Safety (MOS), and expressing it both as a number and as a percentage.
Example of calculating Margin of Safety (MOS) A hamburger restaurant has Fixed Costs (FC) of USD$3,500 per month. Variable Costs (VC) are USD$10 per hamburger, and the selling price of one chicken hamburger is USD$30. The maximum number of hamburgers the restaurant can produce and sell per month is 500. The restaurant sells out all of its hamburgers, therefore actual sales, or real demand, equal to 500. This hamburger restaurant must sell 175 chicken hamburgers per month in order to break-even. If it sells 174 chicken hamburgers, it will make a loss. If it sells 176 chicken hamburgers, it will make a profit. So, Break-even Quantity (BEQ) equals to 175 which means that at this output, the business will not make a profit, but nor will the business be making a loss. Now that we have the Break-even Quantity, we can use it to calculate Margin of Safety (MOS) for our hamburger restaurant: A. Margin of Safety (MOS) as a number: Margin of Safety (MOS) = Actual Sales (Real Demand) – Break-even Quantity (BEQ) Margin of Safety (MOS) = 500 – 175 Margin of Safety (MOS) = 325 So, if the real demand and actual sales is 500 chicken hamburgers per month, then the Margin of Safety (MOS) is 325 burgers. This means that the business can sell 325 chicken hamburgers less than its current sales level without making any loss. This is not that bad at all. The larger the Margin of Safety (MOS) is, the less vulnerable a business becomes to any negative changes in the market. B. Margin of Safety (MOS) as a percentage: Margin of Safety (MOS%) = Margin of Safety (MOS) / Break-even Quantity (BEQ) x 100% Margin of Safety (MOS%) = 325 / 175 x 100% Margin of Safety (MOS%) = ~186% So, in this case, the MOS is 186% higher than the Break-even Quantity (BEQ). The level of actual demand from the market is 186% higher than what the company needs to produce and sell to break-even. We can say that it is a very safe situation and there is quite little risk when it comes to producing and selling the chicken hamburger as a product. The Break-even Chart will show the Margin of Safety (MOS) on the x-axis.
Overall, Margin of Safety (MOS) is a useful indication of how much actual sales of a particular product could drop without the business falling into making loss on this product.
Once we have the Break-even Chart properly constructed indicating Margin of Safety (MOS), we can see the effect of changes in the business’s Sales Revenue and various costs on Margin of Safety (MOS).
This could be a very useful information to business managers who are considering changing the price of a product, or if they know about any upcoming changes in costs.
