A company’s “margin of safety” is the overall level of sales needed to maintain profitability. True False
The correct answer and explanation is:
The correct answer is False.
The margin of safety refers to the difference between actual sales and the break-even sales level. It is essentially the cushion that shows how much sales can drop before the company starts incurring losses. It is not the level of sales needed to maintain profitability, but rather how far sales can decline without the company going into a loss.
The margin of safety can be expressed in units, dollars, or percentage. For example, if a company’s break-even point is \$100,000 in sales, and it is currently generating \$150,000 in sales, then the margin of safety is \$50,000. In percentage terms, this would be calculated as (\$50,000 / \$150,000) × 100 = 33.33%. This means that sales could decline by up to 33.33% before the company would begin to experience losses.
The margin of safety is an important concept because it helps a company assess its risk of not covering its fixed and variable costs, especially during periods of market downturns or other challenges. A higher margin of safety indicates a lower risk, as there is a greater cushion between current sales and the break-even point. A lower margin of safety, on the other hand, indicates higher risk, as a smaller drop in sales could lead to losses.
In summary, the margin of safety is the difference between actual sales and the break-even point, not the level of sales needed to maintain profitability. It provides insight into how much sales can fall before a company starts losing money.