What is the Margin of Safety? Definition, Formula, and Example

Organizations today are in dire need of calculating the difference between their budgeted sales and breakeven sales. This helps them in scaling their performance. They use this margin of safety formula to calculate and ensure that their budgeted sales are greater than the breakeven sales.

The Margin of Safety is the difference between budgeted sales and breakeven sales. It is applied in two different terms, i.e. investing and budgeting.

Budgeting and investing are the two different applications that define the Margin of Safety.

What is the Margin of Safety?

The Margin of Safety is a figure that helps organizations set prices for their products and scale up their productivity and efficiency.

How Margin of Safety can be Understood?

The margin of safety can be understood in terms of two different applications that are budgeting and investing.

The margin of Safety in terms of Budgeting:

In budget planning and breakeven sales analysis, the Margin of Safety is the area between the approximate sales outcome and the level by which an organization’s actual sales could diminish before the organization becomes non-profitable.

This is a danger signal. It shows the administration the danger of misfortune that might occur as the business faces changes in its sales, mainly when many sales are at risk of being non-profitable.

There are two different levels of margin of Safety. One is the higher margin of Safety, and the other is lower. At a lower margin of Safety, the organization will need to make changes by cutting down some of its expenses.

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However, the high margin safety assures that the organization does not have to make any changes to its sales and budgets because they are protected from a very high sales variance.

The margin of Safety in terms of Investing:

In terms of contributing expenses or investing, the Margin of Safety is the distinction between the actual worth of a stock against its overarching market cost. Actual worth is the genuine worth of an organization’s asset or the current worth of an asset while including the total limited future income created.

When the margin of Safety is applied to investing, it is determined by suppositions. It can be supposed as the investor would possibly purchase securities when the market cost is physically beneath its approximate actual worth.

It is a highly subjective task when an investor decides the security’s actual worth or genuine worth. The cost may be different and inaccurate as every investor uses a different and unique method of calculating the actual value. It can be accurate or not accurate.

FORMULA:

There are three different formulas for calculating the Margin of Safety.

The margin of Safety (when units are required) = budgeted sales units – breakeven sales units.

The margin of Safety (when total revenue is required) = margin of safety units × selling price/unit

The margin of Safety (when percentage % is asked) = (budgeted sales units – breakeven sales units/budgeted sales units) × 100

These formulas are implemented based on the given conditions.

Here’s how these three formulas can be implemented:

Suppose the following data relates to product “P”:

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Selling price = $10/unit

Material cost = $4/unit

Labour cost = $3/unit

Variable overhead cost = $1/unit

Fixed overhead cost = $20000/unit

Calculating the Margin of Safety in units:

Margin of safety in units = 12000 unit – (20,000/3)

Margin of safety in units = 12000 unit – 10,000 unit

The margin of Safety in units = 2000 units

Calculating the Margin of Safety in revenue:

Margin of safety in $/revenue = 2000 units × 100

Margin of safety in $/revenue = $20,000

Calculating the Margin of Safety in percentage %:

Margin of safety in percentage = {(12,000 unit – 10,000 unit)/12,000 unit} × 100

The margin of Safety in percentage = 20%

EXAMPLE:

The basic breakeven model for calculating the margin of Safety can be adapted to multiproduct environments. Calculating the margin of Safety for multiple products is the same as for single products, but we use the standard mix. The easiest way to see how margin of safety calculations are done is to look at an example below:

Murray Ltd produces and sells two types of sports equipment items for children. They are balls (in batches) and miniature racquets.

A batch of balls sells for $8 and has a variable cost of $5. Racquets sell for $4 per unit and have a unit variable cost of $2.60.

For every two batches of balls sold, one racquet is sold. Murray Ltd. budgeted fixed costs are $407,000 per period. Budgeted sales revenue for the next period is $1,250,000 in the standard mix.

To calculate the Margin of Safety, the following six steps must be followed:

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Step 1 – To Calculate contribution per unit:

 BallsRacquets
 $ per batch$ per unit
   Selling price$8$4
 Variable cost$5$2.60
Contribution$3$1.40

Step 2 – To Calculate contribution per mix:

($3 * 2 balls) + ($1.40 * 1 racquet) = $7.40

Step 3 – To Calculate the breakeven point in terms of the number of mixes:

Breakeven point = Fixed costs/Contribution per mix

Breakeven point = $407,000/$7.40 = 55,000 mixes

Step 4 – To Calculate the breakeven point in terms of the units of the products:

55,000 mixes x 2 = 110,000 balls 55,000 mixes x 1 = 55,000 racquets

Step 5 – To Calculate the breakeven point in terms of revenue:

 ($8 * 110,000 balls) + ($4 * 55,000 racquets) = $1,100,000

Step 6 – To Calculate the Margin of Safety:

Budgeted sales – breakeven sales = $1,250,000 – $1,100,000 = $150,000

Or, as a percentage. ($1.250,000 – $1,100,000)/$1,250,000 = 12%

Conclusion:

The Margin of Safety is calculated to ensure that the company does not face any extra loss. It helps the company to scale its productivity and efficiency. Calculation of the margin of Safety is made to assure that the budgeted sales are higher than the breakeven sales as it’s beneficial for the company.

You can calculate the margin of safety in terms of units, revenue, and percentage. So, there are three different formulas for calculating the Margin of Safety. All these formulas vary depending upon the type of margin safety that’s asked.