Every business primarily operates for profit maximization. Profit is essentially the excess revenue earned by an entity over and above its costs. Since revenue is predominantly comprised of sales, the determination of selling price of an entity’s products is key in the objective of profit maximization. It is the cost accounting function which helps in analysis of costs and determination of selling prices. Two terms which are key in sales analysis function of cost accounting are break-even point and margin of safety.
This article looks at meaning of and differences between these two terms– break-even point and margin of safety.
Definitions and meanings
The break-even point is a key costing term related to sales volume of an entity. The break-even point is the level of sales at which the entity would earn no profit and no loss. Essentially this means that the sales volume at which the total monetary quantum of sales equals the total of fixed costs and variables costs incurred by the entity, is the break-even point.
The formula for break-even point is as follows:
BEP sales volume = Fixed costs/(Selling price per unit – variable cost per unit)
Example – M/s ABC Inc. trades in imported mobile phones. Its fixed costs such as rent, depreciation etc. for the year amounts to $10,000. It sells each mobile phone for $150 and its variable costs per mobile phone amounts to $100 per unit. The break even point for M/s ABC Inc will be calculated as follows:
BEP sales volume = 10,000/(150-100)
= 200 units
In this example, over and above its variable cost, the company earns $50 per unit sold. This amount goes towards recouping the fixed cost – it is termed as contribution. Since the fixed cost is $10,000 the company will have to sell 200 units which would each contribute $50 towards recouping the fixed cost. At this sales volume of 200 units, the company would have covered both its fixed and variable costs and thus this is the BEP sales volume.
If sales of an entity exceeds the break even point it will earn a profit and if it falls below the break even point it will incur a loss.
Break even point is used in break even or cost-volume-profit analysis. It helps in:
- Determination of selling price required to achieve certain profit levels
- Identification of sales volume required to achieve required return on investment
- Aids management decision making on several aspects related to product mix, profitability analysis, inter-division profitability comparison etc.
Margin of safety:
Margin of safety is the percentage buffer by which the sales of an entity can decrease before it starts incurring losses. It essentially indicates the level of safety that the entity enjoys at current or estimated sales levels.
Margin of safety is calculated by applying the following formula:
Margin of safety = [(Current or estimated sales volume – BEP sales volume)/Current or estimated sales volume] × 100
Continuing the above example, if M/s ABC Inc estimates that it will be able to sell 250 mobile phone units in the coming year, it will enjoy a 20% margin of safety as computed below:
[(250-200)/250] × 100
Business entities keep a track on their margin of safety and seek to achieve higher %. A higher margin of safety % indicates the strength of the business to absorb volatility in sales levels. Whereas a low margin of safety % indicates that the business has a higher risk of incurring a loss in case of sales volatility. In such cases, management may look at steps to reduce costs so as to increase the margin of safety percentage.
Difference between break-even point and margin of safety
The difference between break even point and margin of safety has been detailed below:
- Break even point is the sales volume at which the entity covers all it costs i.e.: earns no profit and incurs no loss.
- Margin of safety is a percentage by which the entity’s actual or estimated sales volume exceeds the break even point sales volume.
- Break even point represents the minimum sales that the entity must achieve to keep it from incurring losses.
- Margin of safety represents the level of safety (from incurring losses) that an entity enjoys at particular sales level. It is a measure of risk and indicates the level of risk the entity faces of earning losses with a change in demand for the sale of its products.
3. Expressed as
- Break even point is expressed in absolute terms i.e., number of units, as it indicates a specific sales volume.
- Margin of safety is expressed as a percentage of actual/estimated sales volume.
4. Derived from
- The formula to calculate break even point is derived from costs i.e., selling price and costs.
- The formula to derive margin of safety is derived from volumes i.e., actual sales volume and BEP sales volume.
- Break even point must be determined first before margin of safety can be determined.
- Margin of safety is calculated subsequently as it is dependent on break even point.
6. Interpretation of quantum
- In analysis of break even point, the lower the level the better, as it would mean that the company can cover its costs at lower sales levels.
- In analysis of margin of safety, the higher the percentage the better, as it indicates a higher safety to withstand sales volatility.
- Analysis of break even point primarily assists management in taking sales related decisions such as determination of selling price, focusing on requires sales volume etc.
- Analysis of margin of safety primarily assists management in taking cost related decisions – such as focusing on controlling/reducing costs in case of inadequate margin of safety.
Conclusion – break-even point vs margin of safety
Both break-even point and margin of safety are important tools in cost accounting analysis and cost management function. When a business wishes to introduce a new product line or make changes to its existing product mix, the analysis of break even point and margin of safety give important insight into the viability and profitability of the entity’s different products. This aids management decision making with respect to the costs and selling prices associated with each of its products.