margin of safety in cost accounting

margin of safety in cost accounting

Exploring the Importance of Margin of Safety in Cost Accounting

1. Introduction to Margin of Safety

The margin of safety calculates the incremental amount of sales companies make after entering the period of manufacturing to enjoy profit during capacity times. In 1983, John C. Lask outlined the concept and process of computing margins of safety to help businesses understand the importance of the cost before production. As more companies recognize this importance of this concept, the computation of margins of safety becomes a valuable tool in the financial arena. The computation is done to help managers observe safety times for decision-making. The research paper is an exploration of the margin of safety and its impact during the service and item manufacturing times. This research is exploration in the service sector that is more opportunity to investigate this important financial tool. This research will help service companies determine their safety times and how it will help the company earn profit. Research is important in establishing the importance of safety margins during precise times and working those times to have maximum profit.

Margin of Safety (MOS) is a valuable tool in cost accounting that aids managers in making financial decisions. MOS calculates the excess sales over the break-even sales. Incremental sales in excess of the break-even point become profit. At the break-even point, the costs and expenses associated with production are equal to the revenues from the product. It is the calculation of the point at which the costs are equal to the income earned. In other words, it is the position at which a company is even in terms of costs and income. The product or service has paid for itself. If costs exceed revenues, a company will sustain a loss. When revenues exceed costs, the company makes a profit. The break-even point is determined to determine the number of units needed to be sold to ensure that the company covers the complete cost of returns.

2. Calculating and Interpreting Margin of Safety

The calculation of the margin of safety and break-even point is accomplished by using the following equation: Margin of Safety = Total Sales – Break-even Sales. The margin of safety can be expressed in two other equivalent forms. Margin of Safety = Total Sales – Fixed Costs. Margin of Safety % = Margin of Safety/Total Sales x 100. For descriptive purposes, the margin of safety will be analyzed in terms of both dollars and percentages in the following discussion.

The margin of safety in the break-even point is measured in terms of a sales band. It may be expressed in dollars, units, or sales percentages. The margin of safety is the difference between the actual level of sales and the break-even point. It shows how many dollars of sales must be lost before there is a loss from operations. A large margin of safety means that the company can afford to maintain its sales and only a slight decrease in sales will result in a loss. A small margin of safety implies that the company has little leeway in which to move; a reduction of only a small amount in sales will throw the company into a loss position. High relative levels of fixed expenses narrow the margin of safety because a larger amount of sales is needed to cover the fixed costs.

3. Applications of Margin of Safety in Cost Accounting

In general, the margin of safety approach is a poor method for estimating the volume of sales associated with desired profit. Moreover, in the management of profit-oriented entities, the concept, of necessity, is accompanied by a probability of selecting sales, production, or investment volumes that are risky relative to the true absorptive and retaliatory capacities of the business. The margin of safety approach also relies on anticipated per-unit profit; unfortunately, imaginary average operating results for producing until the margin of safety is achieved are a poor substitute for the true operating performance that would accompany such an increase in production.

The margin of safety can be used purely for managerial insights or can be used as an essential ingredient in many cost accounting techniques. In this section, different cost accounting techniques and applications, where the concept of margin of safety is used, are explored. Various techniques using margin of safety offer incremental analysis in cost accounting. These techniques are more useful for short-term decision analysis and can be used in financial and capital budgeting decisions as well. However, our discussion in this section is to highlight the importance of the concept of margin of safety and how it is applied in different cost accounting settings without delving into the total essence of the techniques.

4. Enhancing Profitability through Margin of Safety

A careful review of these various broad strategies for enhancing profitability within the margin of safety reveals that few recommendations for improving efficiency or expertise have been omitted. All should be considered and evaluated in the constant effort to improve competitive positions and financial performance consistent with the primary goal of long-term organizational survival.

Several ways to enhance profitability within the limits of the margin of safety include: a. Change the product mix sold to emphasize products with higher profit margin percentages; thus, the absolute gross profit margin is maintained at a high level despite the sales volume decline. b. Reduce product prices and/or increase gross profit margins to stimulate demand for products with higher profit margins and a balanced product mix. c. Reduce selling and/or administrative expenses through careful control and management, thus raising net income for a given gross profit. d. Operate more efficiently by reducing variable or semi-variable expenses through production control, careful inventory management, closer supervision of labor and factory overhead cost centers, and other cost-reducing actions. e. Secure volume discounts from suppliers by increasing the individual volume of units purchased from each supplier. f. Negotiate with labor or increase labor training to improve employee morale, efficiency, and productivity.

The margin of safety is the extent to which budgeted or actual sales exceed breakeven sales. The margin of safety is customarily expressed in sales or revenue figures – that is, actual, proposed, or budgeted sales volume minus the breakeven volume (fixed costs). The margin of safety is a very important management tool and is widely used in cost-volume-profit analysis. The margin of safety is the best way to answer the following questions: 1. How far can sales drop before any fixed costs become lost? 2. What is the financial cushion in the event of a drop in sales? 3. Why bother with breakeven analysis? The margin of safety is important only because it is an excess of budgeted or actual sales over the breakeven sales. Its value is related directly to the level of profitable operations that can be maintained in the face of adverse business conditions. Alternatively, the value of the margin of safety is equal to the gross profit on sales in excess of breakeven sales.

5. Conclusion and Future Trends

Far from intending to suggest a final and airtight decision-making model for all organizations, we consider the fact that the ideal model may well embody elements advantageously included in the model presented here, whose fundamentals and techniques require special attention to determine freezing points that may favor greater proximity to the truth or, at least, greater flexibility in decision-making models. This work also presents general conditions under which they can be replaced by a violation of the entity’s economic objective, which is to maximize the link between costs and decisions. This situation does not reflect the model we describe.

In any type of organization, the amount of information verified about the costs should be enough to permit supervisory decisions to be made in an environment of doubt, bearing in mind a safety gap suitable to prevent prospective faults in the formation of these decisions. The margin of safety, in the context of cost accounting, may be associated with the flexibility which an organization must present in its decision-making model. Thus, it is clear that when information on costs is compiled for decision formation, it will not always be equal to those desired to avoid distortions in these decisions, even with a fantastic conjugation of information compiled by the best techniques and models from the world of cost accounting. It is logical that flexibility will be reduced as the level of information surpasses the potential levels.