What is the ‘margin of safety’?

The margin of safety is the difference between your anticipated profitability and your ‘break-even point’. A margin of safety formula is equivalent to current sales minus the break-even point, divided by present sales.

The margin of safety is defined as the difference between projected sales productivity and the percentage by which an organisation’s sales could reduce prior to a business becoming loss-making.

This indicates to management the ‘likelihood’ of loss that may occur as the organisation is exposed to fluctuations in sales; particularly when a substantial amount of sales are at threat of decline.

A reduced percentage of margin of safety might drive the business to make other decisions, such as cutting its expenses. A greater spread of margin comforts a business that it is more ‘safeguarded’ from sales inconsistency.

A margin of safety example

‘Bloggs and Co’ purchases new machinery to increase the productivity of biscuits manufactured. The new machinery is intended to increase operating expenses by £1mannually,while sales will similarly increase. After the purchase of machinery, the business saw sales revenue of £4.2m, with a break-even point of £3.95m, – generating a margin of safety of 5.8%.

Margin of safety in accounting

As a financial ratio, the margin of safety measures the volume of sales that surpass the break-even point. In simpler terms, the margin of safety is the income generated post an organisation paying all its variable and fixed costs related to manufacture of goods.

It can also be termed as the amount of sales a business can pay for before it stops earning profit. It is referred to as the margin of safety and it acts as a ‘buffer’; the amount of sales a business or unit can forgo before it begins to lose money. As per the definition, up until the point there is no buffer, business operations are lucrative.

A business usually checks its margin periodically to assess the risk of operations, department, or product. The smaller the margin percentage, the riskier the process as there will be less room between productivity and loss.

Margin of safety = Current sales level – Break-even point

The margin of safety formula indicates the complete sales above the break-even figure. Typically, it is beneficial to represent this calculation as a percentage. Hence, the formula will be:

Margin of safety = (Current sales level – Break-even point) ÷ Current sales level

Management accountants typically compute the margin of safety in units by deducting the break-even point from the present sales and dividing the variance by the selling price per unit. This equation enables management to assess the production levels necessary to attain profit. The equation is as follows:

Margin of safety = (Current sales level - Breakeven point) ÷ Selling price per unit

Margin of safety ratio

The margin of safety can also be expressed in fraction form. The ratio can be obtained by dividing the margin of safety by total sales:

Margin of safety = Margin of safety (£ value) ÷ Total forecasted or actual sales

Example:

Sales (for 400 units at the price of £250 per piece) £100,000
Break-even sales £87,500
Calculation:
Sales (for 400 units at the price of £250 per piece) £100,000
Break-even sales £87,500
Margin of safety in £ £12,500
Margin of safety as a fraction of sales 12,500 / 100,000 = 12.5%

This means that a decrease in sales by 12.5% - or £12,500 - would result in coming down to break-even level. In an organisation dealing with one product, the margin of safety can be stated in terms of the quantity of units sold by dividing the margin of safety by the selling price for each unit. In the above stated scenario, the margin of safety is 50 units (£12,500 ÷ £250 per unit = 50 units).