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Explain Margin of Safety.
Margin of Safety is the amount of sales which generates profit. In other words, sales beyond Break Even Point are known as Margin of Safety. It is calculated as the difference between total sales and the break even sales. It can be expressed in monetary terms or number of units. It can be expressed as below:
Margin of Safety = Sales – Break Even Sales
= Sales - {(Fixed Cost) / (P/V Ratio)}
= ((Sales * (P/V) Ratio) - Fixed Cost) / (P/V) Ratio
= (Contribution - Fixed Cost) / (P/V) Ratio
= Profit / (P/V) Ratio
The size of margin of safety is an extremely important guide to the financial strength of a business. If margin of safety is large, which indicates that BEP is much below the actual sales, that means business is in a sound condition and reduction in sales will not affect the profit of the business. On the other hand, if margin of safety is low, any loss of sales may be a serious matter. Thus, efforts need to be made to reduce fixed costs, variable costs or increasing the selling price or sales volume to improve contribution and overall P/V Ratio.
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