Breakeven point is the level of sales at which point, the total cost equals total sales revenue and the relationship between cost, volume and profit is known as breakeven analysis.
Breakeven point is a stage where there is no loss and no profit. During the course of analysis of breakeven point of an entity, initially the sales revenue should meet the variable costs which are also direct costs in nature. The surplus of sales revenue over the variable costs is called as "contribution". The contribution has to meet the fixed costs thereafter. The level of sales at which contribution equals fixed costs is considered as the "breakeven point".
Margin of safety: It indicates the amount by which the volume of sales exceeds the break-even point. A business deals in an uncertain situation and various economic, social and political factors may affect the sales and hence the profit earned by the firm adversely. Normally when a corporate approaches a banker for availing finance, the banker who is taking a calculated risk in sanctioning the credit facilities to the corporate may want to ascertain the business position of the concern, in case the sales volume falls below a certain point.
In other words, the banker attempts to answer the following question:
Whether the concern will be in a position to withstand a fall in sales, and if so, to what extent ?
The margin of safety is a robust tool, by which the banker can estimate the sensitivity of the business to variation in sales. It essentially indicates the operating strength of the business concern.
Normally a banker expects a margin of safety beyond 25% in view of the facts that marketing of the products reaching an adverse position by 20% plus or minus is highly probable. A low margin of safety is a pointer to high overhead costs which requires a higher volume of sales to absorb them.
As such, the banker, therefore, probes into the matter deeply to ascertain as to why the overheads scale high against a low volume of sales.
In situations where increase in sales is found to be difficult, the banker puts on guard in sanctioning the credit proposals, because the working capital finance may probably go towards meeting the overheads only. A realistic plan for reduction of overheads should be made by the company as a pre-requisite towards enabling the banker for considering the credit proposal further.
In case the margin of safety is found to be very small, the possible solutions are:
(1) Increasing the sales price
(2) Reducing the fixed costs
(3) Reduction in variable costs by efficient use of plant, raw materials and stores
(4) Substitution of the existing product line with a more marketable and profitable product
(5) Increasing the volume of sales of the existing products
The margin of safety indicates the shock-absorbing capacity of the business, and hence it is a variable guide to the operating strength of the unit.
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