Question

Discuss why a declining margin of safety over a period of time would be an issue of concern to managers?

Answer 1

• We must know that Break Even point is that point where sales revenues is generating neither any profits nor any losses.
• Any level operated and sold below Break Even point will give LOSSES.
• Any level above Break Even point will give INCOMES.
• Margin of Safety is the ‘margin’ OR ‘excess’ of actual Sales over Break Even Sales.
• This means, Margin of Safety = Total Sales – Break Even Sales.
• Now, if Margin of Safety starts to decline, this means:
  --For some reasons, total sales are declining, OR
  --For some reasons, Break Even level is rising (like increase in Fixed cost, decline in contribution margin)
• Hence, when Margin of Safety starts declining, the Sales level starts getting closer and closer to Break Even level.
• As already stated, at Break Even level, there are no incomes or losses. The higher the sales are from Break Even level, the more would be the profits.
• But, when the gap between Total Sales and Break Even sales (ie Margin of Safety) starts getting smaller, it would concern manager because the profitability would be decreasing, and the company would be reaching nearer to Break Even level, OR in worst case scenarios, may be below Break Even level.