Home >> Metrics Summary
Margin of Safety
Description: The margin of safety is the amount by which sales can drop before a company’s breakeven point is reached, expressed as a percentage. It is particularly useful in situations where large portions of a company’s sales are at risk, such as when they are tied up in a single customer contract that can be cancelled. Knowing the margin of safety gives an analyst a good idea of the probability that a company may find itself in difficult financial circumstances caused by sales fluctuations. Conversely, if the margin of safety is a large percentage, then a company can likely weather a substantial sales decline.
Podcast: A discussion of the margin of safety is available on Episode 70 of the Accounting Best Practices podcast. Listen Now.
Formula: To calculate the margin of safety, subtract the breakeven point from the current sales level, and then divide the result by the current sales level. To calculate the breakeven point, divide the gross margin percentage into total fixed costs. This formula can be broken down into individual product lines for a better view of risk levels within business units. The formula is as follows:
Current Sales Level – Breakeven Point
Current Sales Level
Here are two alternative versions of the margin of safety:
- Budget based. A company may want to project its margin of safety under a budget for a future period. If so, replace the current sales level in the formula with the budgeted sales level.
- Unit based. If you want to translate the margin of safety into the number of units sold, then use the following formula instead (though note that this version works best if a company only sells one product):
Current Sales Level - Breakeven Point
Selling Price Per Unit
Example: The Fat Tire Publishing House, Inc. is contemplating the purchase of several delivery trucks to assist in the delivery of its Fat Tire Weekly mountain biking magazine to a new sales region. The addition of these trucks will add $200,000 to the operating costs of the company. Key information related to this decision is noted in the following table:
|
|
Before Truck Purchase |
After Truck Purchase |
|
Sales |
$2,300,000 |
$2,700,000 |
|
Gross margin percentage |
55% |
55% |
|
Fixed expenses |
$1,000,000 |
$1,200,000 |
|
Breakeven point |
$1,818,000 |
$2,182,000 |
|
Profits |
$265,000 |
$285,000 |
|
Margin of safety |
21% |
19% |
The table shows that the margin of safety is reduced from 21% to 19% as a result of the truck acquisition. However, profits are expected to increase by $20,000, so the management team must weigh the risk of adding expenses to the benefit of increased profitability.
Cautions: The margin of safety calculation is not of much use in cases where strong seasonal swings in sales will send the margin soaring far above and plummeting well below the breakeven point on a monthly basis.