Page 107 - DMGT202_COST_AND_MANAGEMENT_ACCOUNTING

Cost and Management Accounting

Notes It is important that there should be reasonable margin of safety, otherwise, a reduced level of
activity may prove disastrous. The soundness of a business is gauged by the size of the margin of

safety. A low margin of safety usually indicates high fixed overheads so that profits are not made
until there is a high level of activity to absorb fi xed costs.
!
Caution A high margin of safety shows that break-even point is much below the actual
sales, so that even if there is a fall in sales, there will still be a point. A low margin of

safety is accompanied by high fixed costs, so action is called for reducing the fixed costs or

increasing sales volume.
The margin of safety may be improved by taking the following steps:
1. Lowering fi xed costs.
2. Lowering variable costs so as to improve marginal contribution.

3. Increasing volume of sales, if there is unused capacity.
4. Increasing the selling price, if market conditions permit.
5. Changing the product mix as to improve contribution.

Example: KSBS Ltd. furnishes the following information of its Product M.

(`)
Production (units) Present 10,000 Proposed 10,000
Selling price p.u. 50 40
Variable cost p.u. 30 30
Fixed cost p.a. 60,000 60,000
Calculate the P.V. ratio, break-even point and margin of safety.
Solution:

Particulars Present Proposed
Contribution p.u. ` ` 20 ` 10
P.V. ratio (contribution p.u./selling price p.u.) × 100 40% 25%

Break-even point (units) (fixed cost/contribution p.u.) 3,000 6,000
Margin of safety (units) (actual sales - break-even units) 7,000 4,000
Break-even units as % to total production 30% 60%
Margin of safety as % to total production 70% 40%

Interpretation: The reduction in selling price from ` 50 to ` 40 per unit maintaining the same level
of production, variable cost and fixed cost results in the following:

1. The reduction selling price has reduced the contribution per unit and since the P.V. ratio is
the function of contribution to sales, it also has decreased from 40% to 25%.
2. The break-even units have increased from 3,000 to 6,000 units due to lower contribution
per unit available to meet the total fi xed costs.

3. The higher the break-even point means the lower the margin of safety and lower
profi tability.
Thus, the lowering of selling price has resulted in increase of break-even point and lowering the
margin of safety and P/V ratio. The fixed cost, variable cost and selling price have a direct impact

on profit. Change in any of these variables means a change in profi t.

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