Tuesday, February 14, 2012

Margin of Safety

Margin of Safety represents the difference between sales at a given activity nd sales at Break even point (BEP is the point of sale where company makes neither profit nor loss). Consequently it indicates the extent to which a fall in demand could be absorbed before the company begins to sustain losses. The margin of safety is expressed as percentage of sale. The validity of safety always depends on the accuracy of cost estimates. The wide margin of safety is advantageous for the company. Margin of safety depends upon the level of fixed cost, rate of contribution and level of sales.

Sales – Sales at BEP = Margin of safety.

Improvement in Margin of Safety-

The Margin of Safety can be improved by adopting the following steps-

i) Increase in sale volume- It widens the difference between sales at activity level and sales at break even point.

ii) Increase in selling price- If it is not possible to increase sales volume, selling price is increase to increase the margin of safety.

iii) Change in product mix thereby increasing contribution – This will lead to improvement in margin of safety , because it widens the gap of sales specified activity level and sales at break even point.

iv) Lowering fixed cost- It increases the margin of safety , because break even point goes down by lowering fixed cost.

v) Lowering fixed variable cost- It increases margin of safety by improvement in P/V ratio.

Angle of Incidence- The angle which the sales line makes the total cost lines, is known as angle of incidence. This angle gives pictorial relationship between products and sales. This angle indicates the profit earning capacity of a company over the break even point. A large angle of incidence will indicate earning of high margin of profit. Low angle of incidence indicates that variable cost forms a major part of cost of sales. Normally margin of safety and angle of incidence are considered together. For example, a high margin of safety with a large angle of incidence will indicate the most favorable condition of a company. Under such a situation, the company is monopolizing in the market. On the other hand, low margin of safety with low angle of incidence indicates bad financial shape of the company.

Main features of Marginal Costing-

i) Costs are divided in to two categories i.e. Fixed cost and variable cost

ii) Fixed costs are considered as period cost and remains out of consideration for determination of product cost and value of inventories.

iii) Prices are determined with reference to marginal cost and contribution margin.

iv) Profitability of departments and products is determined with reference to their contribution margin.

v) In presentation of cost data, display of contribution assumes dominant role.

vi) Closing stock is valued on marginal cost.


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