The margin of safety is referred to as the difference between the amount of profitability expected and the calculated break-even point where revenue is equal to costs.
The margin of safety is calculated as the current sales less the break-even point, then divided by the current sales volume.
The margin of safety, as its name implies, assists organizations in deciding the level of sales that need to be achieved to guarantee continued profitability while also providing adequate information on the level below which sales must not drop.
Factors Involved in Calculating Margin of Safety
- Sales volume: Every business has to ensure that it makes a reasonable level of sales that would ensure that it covers and caters for the cost of production; hence after production is completed, the onus falls on the marketing department to ensure that sales volume are increased to enable the business to recoup its costs.
- Cost of production: there is no possibility of sales without investment in production; therefore, the amount to be expended in the production of goods would include; cost of material, labor cost, capital investment, etc., to get the best possible production yield. Elements of costs are divided into two, namely, variable: these are costs that vary with production levels (material costs, labor costs, etc.) and fixed cost; these are costs that remain constant and do not vary alongside production level (machinery cost, rental fee, etc.)
- Break-even point: The break-even point is the sales volume of the units where sales revenue equals the production cost. The determination of the break-even point is really important for any business’s survival as it allows it to plans its strategy effectively to make the most profit possible after crossing the break-even point. This point is also very important for decision-making if the company allows for growth in the business through the measurement of performance.
Importance of Margin of Safety:
A business’s ability to deliver results can be measured by the size of its margin of safety; a high margin of safety indicates that a business is performing well.
This implies that the break-even point is much below the actual sales level, indicating that even when there is a fall in sales, there would still be the propensity to make a profit.
However, a small margin is evidence that the business is not high-performing, meaning sales are not allowed to drop below that level lest the business plummets into loss-making.
In a situation where a company experiencing a low margin of safety also suffers the rue of high fixed cost and high contribution margin ratio, The management needs a call for action geared towards reducing the fixed cost or increasing sales volume to the point of profit.
However, if the margin of safety, as well as the contribution ratio, are low, i.e., fixed cost is low or reasonable, at that point, the situation requires that the management commit efforts towards reducing the variable cost through seeking reduced cost of raw materials, or an increase in the selling price should be effected.
The margin of safety further serves as a means for conducting inter-firm comparisons.
Steps to Improve Margin of Safety:
The margin of safety of an organization can be improved by taking the following steps:
- Increasing the selling price.: The selling price of goods that an organization produces sets the tune for the amount of revenue that would accrue to it. The company should ensure that it marks up its cost enough to cover its cost of production, therefore catering to the fixed and variable costs incurred by the organization.
- Increasing the sales volume by increasing the capacity: A company can also successfully better its margin of safety by increasing the sales volume by benefitting from economies of scale, which would ensure that sales volume improve significantly while keeping some elements of cost fixed therefore leading to more profitable results guaranteed to improve a company’s safety margin.
- By improving the contribution margin through reducing the variable cost: Another way to improve the margin of safe is to reduce the variable cost of production by seeking out discount offers that would assist in reducing cost and maximize resources, therefore, improving contribution margin.
- By lowering BEP through reduction of fixed cost: Another way to increase the margin of safety is to lower Breakeven point through reduction of the fixed cost of production; this can be achieved by leasing some assets that are used in production rather than incurring the cost of maintenance internally, and not putting assets to optimum use. Leasing allows you only to use assets that are required for production.
- By adopting a better profitable product mix: The margin of safety could be further improved when a company adopts a better product mix, i.e., selling goods and are complements of one another and that has the best sales level that could help bolster the margin of safety.
Understanding Margin of Safety
The use of the margin of safety can be defined under two applications:
1. Budgeting
When calculating budgeting and break-even analysis, the margin of safety helps to measure the gap between the estimated sales output levels of the company compared to the level by which a company’s sales could dip to before the company ceases to make profit from the sales.
This point helps to inform the management of the possible risk of loss that is likely to happen as the business is subjected to variation in sales volumes, most especially when a significant amount of sales are at risk of decline or unprofitability due to certain quantitative or qualitative factors affecting sales
A company whose margin of safety percentage is low might be forced to cut down on expenses to guarantee business continuity.
It is worthy of note that a high spread of margin assures a company that it is protected from sales variability, and it can continue to build on the business it already has while enhancing its market development through expansion to other geographical locations.
2. Investing
When considering the Margin of Safety from an Investing point of view, it is measure as the intrinsic value of a stock measured against the prevailing market price of the stock.
The intrinsic value of a company’s share is the real worth of the company’s asset or the calculated present value of an asset after adding the total discounted future income generated from the asset.
Applying margin of safety to investment would imply making use of assumptions, as an investor is only inclined to purchase securities when market prices are materially below the estimated intrinsic value of the stock, making it appear that he has made a bargain purchase as an investor expects that the capital gain would help guarantee an improved return on investment.
The determination of the intrinsic value or true worth of market security s highly subjective because there are no agreed metrics for its computation, and investors can adopt different metrics for its computation which may or may not be entirely accurate.
The fair value of security must be known. This would guide the computation using the discounted cash flow analysis method to give an objective, the fair value of a business in which the investor wines to commit funds.
What is the Margin of Safety Formula?
For accounting, the margin of safety is calculated by dividing the budgeted sales by the difference between the actual and the break-even point. The result is then expressed in percentage showing the percentage of sales to the margin.
The margin of Safety = (Actual sales Level – Breakeven Point) / actual sales Level x 100
The margin of safety formula can also be expressed in any currency amounts or number of units:
The margin of Safety in Dollars = Current Sales – Breakeven Sales
The margin of Safety in Units = Current Sales Units – Breakeven Point
Practical Example
Ford Co. A company incorporated just purchased a new piece of machinery to expand the production output of its top-of-the-line car model.
The machine costs are expected to increase the operating expenses to $1,000,000 per year, and the sales output is expected to augment.
In the year of the machine acquisition, the company recorded a sales revenue of $4.2M, with a breakeven point of $3.95M, giving a margin of safety of 5.8%.
This stipulates that the company is not expected to drop its sales level below 5.8% lest it makes a loss.
This safety margin is not so wide; hence the company is expected to find a means to reduce its fixed cost to ensure that its contribution margin improves and results in increased profitability for the business and also a bigger safety margin.
Conclusion
The margin of safety is a tool used by most businesses to determine the sales volume required to keep them afloat.
In business, and to achieve this, the company has to monitor closely its fixed and variable costs to keep the costs within the reasonable threshold while also reviewing its selling price, which might not be entirely feasible due to the competitiveness of most markets.
Therefore a company should pay close attention to its margin of safety, guarantee continuity with improved profit levels, and effectively shore itself against loss.
