The difference between the actual sales volume and the break-even sales volume is called the margin of safety. It shows the proportion of the current sales that determine the firm's profit. Margin of safety = Actual sales volume - Break-even sales volume Margin of safety ratio = (Actual sales - Break-even sales) / Actual sales Using the data provided below, calculate the margin of safety for five start-up enterprises. First of all, we know the following formula to calculate the margin of safety: Margin of safety = Actual sales volume - Break-even sales volume Therefore, as an initial step, we need to calculate the break-even sales volume. This is done as follows: Break-even sales = Fixed costs / Contribution margin per unit = 25,000 / 15 = 1,667 units = 1,667 x 25 = $41,675 Now we can calculate the margin of safety: = 100,000 - 41,675 = $58,325 We can also calculate the margin of safety in percentage terms: = 58,325 / 100,000 = 0.5832 = 58.32 % As shown above, the margin of safety can be expressed as an absolute amount (e.g., $58,325) or as a percentage of sales (e.g., 58.32%). The margin of safety ratio is an ideal index that can be used to rank firms within an industry. To show this, let's consider the example of two firms with the same net income shown in their income statement but with a different margin of safety ratio. In the case of the firm with a high margin of safety, it will be able to withstand large reductions in sales volume. By contrast, the firm with a low margin of safety will start showing losses even after a small reduction in sales volume.Margin of Safety: Definition
Formula to Calculate the Margin of Safety
Formula to Calculate the Margin of Safety Ratio
Example
Solution
Margin of Safety FAQs
The margin of safety is the difference between the actual sales volume and the break-even sales volume. It shows how much sales can be reduced before a firm starts suffering losses. By comparing the margin of safety with the current sales, we can find out whether a firm is making profits or suffering losses.
An increase in fixed costs reduces the margin of safety. This is because it would result in a higher break-even sales volume and thus a lower profit or loss at any given level of sales.
The margin of safety can be calculated as follows: margin of safety = actual sales volume – break-even sales volume therefore, to calculate the margin of safety ratio, we divide the difference between actual sales and break-even sales by actual sales.
The margin of safety can be used to compare the financial strength of different companies. This is because it will allow us to predict how much sales volume has to be reduced before a firm starts suffering losses.
The margin of safety ratio shows up the difference between actual and break-even sales and can be used to evaluate a company's financial strength. When the margin of safety is high, it suggests that the company enjoys a strong financial position and most likely has more stable Cash Flows.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
