Margin of Safety
The margin of safety is the difference between actual sales and the point at which a business breaks even.
The margin of safety indicates how much a company may lose in sales before it starts losing money or before it falls below the break-even threshold. The greater the margin of safety, the lesser the danger of incurring a loss or failing to break even.
In order to calculate the margin of safety, we use the following formula:
We can take this formula one step further to figure the margin of safety percentage
The Margin of Safety percentage = Margin of Safety in Dollars / Total actual (or budgeted) sales in dollars
It is essential that there be a considerable margin of safety; otherwise, a reduction in activity could prove disastrous. The amount of a business’s margin of safety is indicative of its financial health. A narrow margin of safety typically indicates large fixed overheads, meaning that profits cannot be realised until there is sufficient activity to absorb fixed costs.
A high margin of safety indicates that the break-even point is well below actual sales, so that even if sales decline, there will still be a point. With a narrow margin of safety and large fixed costs, action is required to either reduce fixed costs or increase sales volume.