Margin of Safety

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on August 26, 2021

Margin of Safety: Definition

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.

Formula to Calculate the Margin of Safety

Margin of safety = Actual sales volume – Break-even sales volume

Formula to Calculate the Margin of Safety Ratio

Margin of safety ratio = (Actual sales – Break-even sales) / Actual sales

Example

Using the data provided below, calculate the margin of safety for five start-up enterprises.

  • Actual sales (4,000 units @ $25/unit) = $100,000
  • Contribution margin per unit = $15
  • Total fixed costs  = $25,000

Solution

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.

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