MARGIN OF SAFETY
The margin of safety (MOS) concept is related to the operating leverage concept. The MOS may
be defined as the excess of total sales over the break-even volume of sales. In effect, the MOS defines the
amount that sales can decline before losses will occur for a company. The MOS equation is:
Margin of safety (MOS) = Total sales - Break-even sales
The MOS may be calculated in terms of dollars or as a percentage. The percentage is obtained by dividing
the MOS in dollars by total sales dollars as shown.
MOS percentage = MOS in dollars
Total sales
To illustrate the impact of operating leverage on profit and the concept of MOS, we will use the
following data for two companies, A and B:
Sales revenue (1,000 units)
Less variable costs
Contribution margin
Less fixed costs
Profit
Total
$100,000
50,000
$50,000
30,000
$20,000
Company A
Per Unit
$100
50
$50
Percent
100%
50
50%
Company B
Total
Per Unit
$100,000
$100
20,000
20
$80,000
$80
60,000
$20,000
Using the short-cut formula, break-even sales (fixed costs  contribution margin percentage):
Company A: $30,000  50% = $60,000
Company B: $60,000  80% = $75,000
MOS in dollars (total sales - break-even sales):
Company A: $100,000 - $60,000 = $40,000
Company B: $100,000 - $75,000 = $25,000
MOS percentage (MOS in dollars  total sales):
Company A: $40,000  $100,000 = 40%
Company B: $25,000  $100,000 = 25%
Although Companies A and B have the same profit at sales of 1,000 units, this is the only level of
sales at which their profits will be equal. For every unit sold over 1,000 units, Company A’s profit will
increase by only $50 (the per-unit contribution margin), whereas Company B’s profit will increase by $80.
For sales under 1,000 units, Company A’s profit decreases by only $50 per unit, whereas Company B’s
decreases by $80.
If we now assume that 1,200 units are sold, we can see that Company A’s contribution margin will
be $60,000 ($50 per unit contribution x 1,200 units), and its profit will be $30,000. Company B, on the
other hand, with its higher operating leverage, will generate $36,000 of profit [($80 per unit x 1,200 units)
2 $60,000].
If a company expects sales to increase in the future, management might prefer Company B’s cost
structure, where the higher operating leverage results in higher profit. Conversely, a company expecting
sales to decrease in the future might prefer Company A’s cost structure, where the lower operating leverage
results in higher profit. To illustrate, assume that sales have decreased to 900 units. Company A will
generate a contribution margin of $45,000 ($50 x 900), and $15,000 of profit, whereas Company B will
have a contribution margin of $72,000 ($80 x 900), but profit of only $12,000.
If the declining sales scenario is carried further, to the break-even point, for example, the MOS
concept shows that Company A is in a safer, that is, less risky, position. Sales can decline $40,000 (40%)
before losses will begin for Company A, as compared to $25,000 (25%) for Company B.
Percent
100%
20
80%
What is Company B to do about its low margin of safety? Unfortunately, there is no quick or easy
solution to this problem. If possible, fixed costs may be reduced, which will lower the break-even point and
improve the MOS. Alternatively, total sales may be increased, which will also improve the MOS.
Essentially, the MOS concept helps identify a potential problem, the solution to which is found by
analyzing the company’s cost structure and applying C-V-P analysis, as described in this chapter.
As you can see, there is no simple answer as to which type of cost structure is better. As discussed
in the previous section, operating leverage is neither good nor bad. Every company is different, so several
factors must be considered: whether sales are expected to increase or decrease from the current level, how
stable sales volumes are, and how willing management is to take risks. Certainly, low fixed costs and high
variable costs (Company A’s cost structure) provide a much more conservative cost structure than low
variable costs and high fixed costs (Company B’s cost structure). Thus, if management is reluctant to take
risks, it will want its costs to be variable rather than fixed whenever possible. In our example, Company A
has a higher MOS and will experience much narrower swings in profit than will Company B. Company B
has a lower MOS and will be more profitable in good times, but will have higher losses in bad times.
TO SUMMARIZE
The margin of safety (MOS) for a company is defined as total sales minus the break-even sales. The MOS
shows how much sales can decline before losses will occur for a company. Similar to operating leverage,
MOS is a measure of risk to profits to which a company is exposed as sales volume changes.
COMPUTING CONTRIBUTION MARGIN NOT REALIZED
Thus far in the chapter, we have assumed that each product sells for only one price and have
made no mention of selling the same product at different prices. This is a somewhat unrealistic
assumption; as you know, not all seats on an airplane sell for the same price nor do matinee theater
tickets sell for as much as evening theater tickets. The determination of whether discount airplane or
movie tickets, for example, or other prices should be offered can be made only by looking at
capacity. If a manufacturing firm, airline, or movie theater is not operating at full capacity, it may be
a good decision to increase production (fill more seats) at a lower price.
The decision of whether or not to use excess capacity to offer lower-price products or services can
be aided by computing the contribution margin not realized. To illustrate, assume that a company sells
three products, A, B, and C, at average sales prices of $5.34, $4.23, and $15.00 per unit, respectively.
Assume also that the variable costs per unit are $1.59 for product A, $1.53 for product B, and $7.55 for
product C. Further assume that the company has unused capacity at the current production levels of
100,000 units of product A, 900,000 units of product B, and 100,000 of product C. If the company can sell
all the additional products it can make by discounting the selling price 15%, it would compute its
contribution margin not realized as follows:
Average selling price
Average selling price less 15%
Less variable costs
Contribution margin per unit
Unused capacity
Contribution margin not realized
Product A
$5.34
$4.54
1.59
$2.95
x 100,000
$295,000
Product B
$4.23
$3.60
1.53
$2.07
x 900,000
$1,863,000
Contribution margin not realized measures the extent to which the company effectively manages
its capacity and the effect unutilized capacity is having on the company’s profitability. Calculating
contribution margin not realized helps firms make better decisions regarding sales and profit opportunities,
downsizing, and redeployment of resources.
It is important, however, that capacity decisions be made for the long run rather than on a periodby-period basis. Measurements of optimal capacity, such as those above, can break managers out of routine
year-to-year planning and give companies a stretch target to reach for. If capacity is not being used, it
should be reported for what it is: waste. Unused capacity should also be addressed with the same intensity
that a company would tackle other kinds of waste.
Product C
$15.00
$12.75
7.55
$5.20
x 100,000
$520,000
Like any management tool, decisions concerning contribution margin not realized should be made
carefully. A company may well decide that keeping a supply of unused capacity is beneficial so that it can
respond quickly to surges in customer demand. The job of a management accountant is to provide decision
makers with information (such as contributions lost by not using excess capacity) so they can make
intelligent decisions. Managers then use that information to make decisions. Usually, the better the
information, the better the decisions. In the cases of capacity decisions, efficiently using resources is
critical to the success of most firms and often determines whether some firms will even survive.
TO SUMMARIZE
If an organization is not operating at full capacity with normal selling prices, it may be wise to
produce and sell additional goods (up to capacity) at discounted prices. To determine the extent of lost
profits, the contribution margin not realized can be calculated. Like all management tools, this calculation
of contribution margin not realized should be used carefully and usually should be considered only with a
long-run perspective.