What is margin of safety and how is it calculated?
Margin of safety is a concept related to breakeven analysis. Basically, it helps a company and its management team understand the difference between total sales and breakeven sales. Breakeven sales is essentially the amount of sales needed to generate enough gross profit to cover the company’s fixed costs.
A low margin of safety means that total sales barely exceeds breakeven sales. This is a big risk for the company because if total sales fall to the breakeven level or even below breakeven, that may result in the company have a hard time covering their fixed costs.
Margin of safety can be expressed in dollar or in percentage form:
Margin of Safety Example:
Below is an example calculation for the margin of safety in both dollars and as a percentage. It is important to be able to interpret why a company would calculate margin of safety and how they can interpret the results of the calculation.
In step 1), we determined that the margin of safety was $20,000 by taking total sales of $100,000 and subtracting breakeven sales of $80,000. Then in step 2), we took the margin of safety of $20,000 and divided that into total sales of $100,000, and that tells us the margin of safety is 20%. That means that if the company’s sales decrease by more than 20%, the company will be unprofitable.
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