Question

If variable costs​ increase, and all other factors remain the​ same, the margin of safety will become smaller. True False

Answer 1

To answer this question we need to take an example:

Example:

Lets,

Variable Cost Per Unit = $10

Selling Price Per Unit = $20

Unit Sold = 5000 Units

Fixed Costs = $20,000

So, the Margin of Safety = Total Sales - Break Even Sales

So here total sales = 5000 Units x $20 = $100,000

Break Even sales = Total Fixed Costs / Contibution Margin Ratio

CM Ratio = Contribution Margin (Sale 20 - Variable Cost 10) / Sales 20 x 100 = 50%

Break Even Sales = Total Fixed Costs $20,000 / 50% = $40,000

So, the Margin of Safety = Total Sales 100,000 - Break Even Sales 40,000 = $60,000

Now, if the Variable Cost per Unit Increase let assume Variable Cost Per unit will become $15 per unit

Now, The Contribution Margin Ratio = Contribution Margin (20 - 15) / 20 x 100 = 25%

Break Even Sales = Fixed Costs 20,000 / CM Ratio 25% = $80,000

Margin of Safety = Total Sales 100,000 - Break Even Sales 80,000 = $20,000

It means when the variable cost was $10 per unit and all other factors remain same the margin of safety was $60,000

Now, when the variable costs increase to $15 per unit, the margin of safety is reduced to $20,000

Hence, the Statement is TRUE