The margin of safety is the difference between actual sales and the point at which a business breaks even.
The margin of safety (MOS) ratio equals the difference between budgeted sales and break-even sales divided by budget sales.
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.
Formula for Margin of Safety Calculation
The margin of safety is a measure of business risk. It represents the percentage by which a company’s sales can drop before it starts incurring losses. The higher the margin of safety, the more the company can withstand fluctuations in sales. A drop-in sales greater than the margin of safety will cause a net loss for the period.
There are different ways in which the margin of safety can be expressed: (a) in units of goods sold, (b) in dollars of sales
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 high fixed costs, action is required to either reduce fixed costs or increase sales volume.
The margin of safety represents the gap between the actual sales of a business and the point at which it achieves breakeven. It serves as a crucial indicator for businesses to evaluate their financial stability and risk levels. By understanding the margin of safety, businesses can assess the extent to which their sales can drop before experiencing a financial loss. This knowledge allows them to make informed decisions based on their risk tolerance and objectives in order to safeguard their financial well-being.