Margin of Safety Formula, Definition, Example and Uses

Margin of safety refers to the difference between break even point and expected profitability. It is the revenue earned by a company after it pays fixed and variable costs incurred in the production of goods and services.

This article will explain margin of safety, uses and margin of safety formula in detail. Let us learn more about it.

Table of Contents

• About Safety Margin
• Margin of Safety Formula
• Example
• Application of Safety Margin in Investing
• Application of Safety Margin in Accounting
• Application of Safety Margin in Budgeting
• Determining Profitable Production Amount
• Importance
• Drawbacks
• Understanding good safety margin

What is Margin of Safety?

The margin of safety in cost accounting is referred to as a financial ratio that measures the amount of sales that have exceeded the break-even point. This financial ratio indicates the actual profit of the company once it pays for all fixed and variable costs. You might wonder why it is known as the safety margin ratio. The reason is that it is the threshold amount below which a company will start facing loss. To remain profitable, the company must have a positive margin of safety. Once the company reaches the break-even point, it is in no loss and no profit position.

Margin of Safety Formula

Here, the current sales are estimated. Let us take a look at different safety margin formulas.

1. Margin of safety ratio

Current sales (estimated) – break even point / current sales(estimated) 

2. Margin of safety (in percentage)

[Current sales – break even point / current sales] x 100

3. Margin of safety (in units)

Safety margin (units) = current sales – breakeven point/sales price per unit

4. Margin of safety (in dollars)

Current (estimated) sales – break even point

Components of Margin of Safety Formula

Here are the components of the formula of margin of safety:

1. Intrinsic Value: This is the actual value of company or asset that is based on the underlying perception of its true value. This includes all aspects of business, both tangible and intangible factors. Intrinsic value may or may not be the same as the current market value.
2. Market Price: This represents the current price at which the asset or security is being sold in the market. It is determined by the prevailing demand and supply dynamics in the market.
3. Margin of Safety: This is the difference between the intrinsic value and the market price, expressed as a percentage of the intrinsic value. It represents the buffer or cushion that an investor has against the uncertainties and fluctuations of the market.

What Is a Break-Even Point?

Break-even point (BEP) is the sales amount where the business is neither making a profit or a loss. The business will still be able to cover outgoing costs but without making any profit.

Startups are considered to be an accomplishment if they reach the break-even point. Established companies slowly move beyond the break-even when these companies are in a financial situation to survive sudden market change and any other factors that can impact your bottom line.

Example of Margin of Safety 

Let us understand this concept through the simplest formula of margin of safety:

Margin of safety= Actual sales – Break-Even sales  

For example:

• Actual sales: $500,000
• Break-even sales: $300,000
• Apply formula: 500,000 – 300,000 = 200,000
• Margin of Safety = $200,000

Application of Safety Margin In Investing

The concept of safety margin was popularized by Benjamin Graham who was an American investor. According to him, if he bought a stock priced at $1, there was a possibility that the stock may value less than that in future. This is why he had concluded that buying a stock at a price lesser than its intrinsic value will substantially limit his losses. 

Margin of safety is a principle of investing through which investors purchase securities only when their market price is below their intrinsic value. Any stock that has a current value less than intrinsic value is good to buy. A stock is considered to be a good sale if its current value is higher than its intrinsic value.

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Calculating Intrinsic Value

Now, what is intrinsic value? It measures an asset’s worth. To calculate this value, one has to perform an objective calculation or use financial modelling. Investors also use qualitative and quantitative factors, such as governance, firm management, industry performance, assets and earnings for determining the intrinsic value. Then the market price is used as the point of comparison for calculating the margin of safety. 

Let us understand how intrinsic value (V) is calculated:

EPS= Company’s trailing twelve-month earnings per share

4.4 = the average yield of high-grade corporate bonds as in 1962 

8.5= Price earning ratio of the stock at a 0% growth rate

Y = the current yield on AAA corporate bonds 

g =  expected growth rate for the next 7-10 years.

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Application of Margin of Safety in Accounting

In accounting, the margin of safety is the difference between current/forecasted sales and sales at the break-even point. Experts use this financial ratio for break-even analysis and forecasting to assess the existing cushion in actual or budgeted sales before the firm bears the loss.

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In accounting, the margin of safety formula is:

Safety Margin= Expected or Actual Sales Level – Break even sales Level 

This measure is useful in situations where larger portions of the company’s sales are at risk, such as when the company has a single customer contract that may get cancelled.

Determining Production Amount to Gain Profits Using Safety Margin

The safety margin can help in determining the production level at which the business can become profitable. You will still have to take the break-even point from the current sales figure. Now, you will need to divide its sum by the selling price of each unit.

This formula of margin of safety will be:

Margin of safety = (Actual sales – Break-even sales)/ Per unit selling price

For example:

• Per unit selling price: $100
• Actual sales: $400,000
• Break-even point: $100,000
• Apply formula: 400,000 – 100,000 ÷ 100 = 3,000
• Margin of Safety = 3,000

It indicates that if your business loses 3,000 sales of that unit, your business will reach a break-even point.

Application of Safety Margin in Budgeting

Along with that, margin of safety is also useful in budgeting and breakeven analysis. Here, the safety margin represents the gap between sales output and level by which the sales of a company can decrose before the company goes in losses. Once the company knows about the low percentage of margin of safety, it will start cutting down expenses. In case, the safety margin is high, the company is protected from sales variability.

The Importance of Margin of Safety

• The margin of safety is a buffer amount below which a business will no longer remain profitable. As long as there is a buffer, the business will reap profits.
• It is important as it helps the management in assessing the risk factor that the business might face due to changes in sales.
• According to this financial ratio, management can make changes in their marketing and promotional strategies to increase sales before it falls below the safety margin ratio.
• Companies can also plan out their expenses wisely in order to prevent losses. Overall, it is a risk management strategy.
• The margin of safety is an important factor while investing as this financial ratio prevents most errors in analyst judgement or calculation.
• Businesses use the margin of safety to analyse and expand their inventory. They can also assess if they should move ahead with the existing business strategies or not.

Drawbacks of Margin of Safety

The margin of safety is not suitable for businesses that have inconsistent sales. For example, it is not suitable for businesses having seasonal sales since some months will have significantly low results. For such businesses, annualize the information to integrate seasonal fluctuations into the outcome.

Understanding a Good Margin of Safety Percentage

A higher safety margin is better for the business. The margin of safety represents your buffer against losses, and this varies from one business to another. For example, your margin of safety is $10,000 but the per unit selling price is $5,000. This indicates that your business will suffer from loss after losing sales of only two units. On one hand, $10,000 may be a big buffer for some businesses, but it might not be enough for others.

Conclusion

We hope that through this article, you have been able to understand what is margin of safety, the formula of margin of safety, applications, its importance and drawbacks in detail. Through safety margin, one can learn if the business has actually starting making profit or not. This will in turn, prevent the business from going into losses.