Margin of Safety: What it is & how it works?

Margin of Safety


What is Margin of Safety?

The Margin of Safety is the variance amongst the sum of anticipated profitability and break-even point. Margin of safety formula is equivalent to current sales subtracted from the breakeven point divided by present sales. There are two uses to define Margin of Safety:

Budgeting

In break-even and budgeting analysis, 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 management of the possibility 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 enable results in a business cutting down its expenses while a greater spread of margin guarantees a business that it is safeguarded from sales inconsistency

Investing

In the standard of investing, Margin of Safety is the variance between the basic value of a stock as compared to its prevalent market price. Intrinsic or basic value is defined as the actual value of a business’s asset or the current value of an asset when accumulating the entire discounted future income generated. The degree of margin of safety is subjected to an investor’s inclination and the category of investment he/she selects. Certain numerous circumstances, an investor may find interests with extensive margin are ‘deep value investing’ i.e. purchasing a stock in an extremely underestimated trade. The prime objective is to look for noteworthy discrepancies between present stock prices and the basic value of such a stock. This kind of investment will need a huge investment and involves a lot of risk. The other one is ‘growth at reasonable price investing’ – selecting businesses that have optimistic development trading rates which are in some way lower than the intrinsic value.

Margin of Safety

Margin of Safety Example

Byrd and Co. purchased a new machinery to increase the productivity of biscuits manufactured. The new machinery is intended to upsurge the operating expenses by £1,000,000 per annum, and the sales will similarly expand. Post the purchase of machinery, the business attained sales revenue of £4.2 million, with a breakeven point of £3.95 million – generating a Margin of Safety of 5.8%

Margin of Safety in Accounting

A financial ratio, the margin of safety measures the volume of sales that surpass the break-even point. In simpler terms, margin of safety is the income generated post an organisation or company paying all its variable and fixed costs related with manufacturing 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 Margin of Safety as it acts as a kind of buffer of the business – as stated, it is the amount of sales a business or department can forgo before it begins to lose money. As per the definition, till the time there is a buffer, business operations are lucrative. In case the Margin of Safety reaches zero, the business reaches a break-even point for the period and no income is recognised. Similarly, if the Margin of safety becomes negative, the business loses money

Usually, a business computes its Margin of Safety 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. For example, a business with a small margin of safety percentage can manage loss for a period if it experiences a small decrease in sales, whereas, a business with a larger Margin of Safety might be able to manage with sales fluctuations without incurring losses for a specific period in a financial year.

Margin of Safety = Current Sales Level – Breakeven Point

Margin of Safety formula indicates the complete sales above the breakeven figure. Typically, it is beneficial to represent this calculation as a percentage. Hence, the formula will be:

Margin of Safety = (Current Sales Level – Breakeven Point) ÷ Current Sales Level

Managerial accountants also compute margin of safety in units by deducting the breakeven point from the present sales and dividing the variance by the selling price per unit. This equation evaluated the lucrativeness buffer zone in units manufactured and enables the 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, also referred to as Margin of Safety ratio. The ratio can be obtained by dividing the margin of safety by total sales. Let’s understand the below mentioned equation with an example:

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 – at the present sales level and price structure, a decrease in sales by 12.5% or £12,500, would result in losing profits and hitting down to breakeven level. In an organisation, dealing with one product firm, 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, Margin of Safety is 50 units (£12,500 ÷ £250 per unit = 50 units).

Add Your Comments