What Is the Margin of Safety? Formula to Calculate It

The five components of break-even analysis are fixed costs, variable costs, revenue, contribution margin, and break-even point (BEP). As a financial metric, the margin of safety is equal to the difference between current or forecasted sales and sales at the break-even point. The margin of safety is sometimes reported as a ratio, in which the aforementioned formula is divided by current or forecasted sales to yield a percentage value. The figure is used in both break-even analysis and forecasting to inform a firm’s management of the existing cushion in actual sales or budgeted sales before the firm would incur a loss. The margin of safety principle was popularized by famed British-born American investor Benjamin Graham (known as the father of value investing) and his followers, most notably Warren Buffett. Investors utilize both qualitative and quantitative factors, including firm management, governance, industry performance, assets and earnings, to determine a security’s intrinsic value.

1. Subtract the break-even point from the actual or budgeted sales and then divide by the sales.
2. The smaller the percentage or number of units, the riskier the operation is because there’s less room between profitability and loss.
3. Since fair value is difficult to predict accurately, safety margins protect investors from poor decisions and downturns in the market.
4. The margin of safety principle was popularized by famed British-born American investor Benjamin Graham (known as the father of value investing) and his followers, most notably Warren Buffett.
5. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications.

Using this model, he might not be able to purchase XYZ stock anytime in the foreseeable future. However, if the stock price does decline to $130 for reasons other than a collapse of XYZ’s earnings outlook, he could buy it with confidence. This means that his sales could fall $25,000 and he will still have enough revenues to pay for all his expenses and won’t incur a loss for the period. Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs.

The margin of safety in dollars is calculated as current sales minus breakeven sales. Taking into account a margin of safety when investing provides a cushion against errors in analyst judgment or calculation. It does not, however, guarantee a successful investment, largely because determining a company’s “true” worth, or intrinsic value, is highly subjective. Investors and analysts may have a different method for calculating intrinsic value, and rarely are they exactly accurate and precise.

For instance, if the economy slowed down the boating industry would be hit pretty hard. Although he would still be profitable, his safety margin is a lot smaller after the loss and it might not be a good idea to invest in new equipment if Bob thinks there are troubling economic times ahead. This equation measures the profitability buffer zone in units produced and allows management to evaluate the production levels needed to achieve a profit. This is the amount of sales that the company or department can lose before it starts losing money. If the safety margin falls to zero, the operations break even for the period and no profit is realized.

Example of Investing and Margin of Safety

Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. 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.

Who Calculates BEPs?

Break-even analysis looks at fixed costs relative to the profit earned by each additional unit produced and sold. Now you’re freed from all the important, but mundane, bookkeeping jobs, you can apply your time and energy to deeper thinking. This means you can dig into your current figures and tweak your business to improve growth into the future. For example, using your margin of safety formulas to predict the risk of new products. Businesses use this margin of safety calculation to analyse their inventory and consider the security of their products and services. The last step is to calculate the margin of safety by simply deducting the actual sales from break-even sales.

The margin of safety provides useful analysis on the price and volume change effects on the break-even point and hence the profitability analysis. The margin of safety is the difference between the actual sales volume and the break-even sales volume. It shows how much sales can be reduced before a firm starts suffering losses.By comparing the margin of safety with the current sales, we can find out whether a firm is making profits or suffering losses.

The Margin of Safety Formula

The margin of safety formula is calculated the 8 important steps in the accounting cycle by subtracting the break-even sales from the budgeted or projected sales. In the case of the firm with a high margin of safety, it will be able to withstand large reductions in sales volume. After the machine was purchased, the company achieved a sales revenue of $4.2M, with a breakeven point of $3.95M, giving a margin of safety of 5.8%. Ford Co. purchased a new piece of machinery to expand the production output of its top-of-the-line car model.

Although there was no guarantee that the stock’s price would increase, the discount provided the margin of safety he needed to ensure that his losses would be minimal. In other words, the total number of sales dollars that can be lost before the company loses money. Sometimes t account examples it’s also helpful to express this calculation in the form of a percentage. The break-even point (BEP) helps businesses with pricing decisions, sales forecasting, cost management, and growth strategies. A business would not use break-even analysis to measure its repayment of debt or how long that repayment will take.

For example, the same level of safety margin won’t necessarily be as effective for two different companies. It’s better to have as big a cushion as possible between you and unprofitability. The closer you are to your break-even point, the less robust the company is to withstanding the vagaries of the business world. If your sales are further away from your BEP, you’re more able to survive sudden market changes, competitors’ new product release or any of the other factors that can impact your bottom line. Bob produces boat propellers and is currently debating whether or not he should invest in new equipment to make more boat parts.

Now, as noted just above, to calculate the BEP in dollars, divide total fixed costs by the contribution margin ratio. The break-even point formula divides the total fixed production costs by the price per individual unit less the variable cost per unit. Alternatively, in accounting, the margin of safety, or safety margin, refers to the difference between actual sales and break-even sales. Managers can utilize the margin of safety to know how much sales can decrease before the company or a project becomes unprofitable.

You can also use the formula to work out the safety zones of different company departments. It’s useful for evaluating the risk of the different services and products you sell. And it’s another indicator you can apply to new projects you’re considering.

How to Calculate Margin of Safety?

But using your Margin of Safety can certainly give you one picture of the situation and can help you minimise risk to your profitability. Your break-even point (BEP) is the sales volume that means your business isn’t making a profit or a loss. Your outgoing costs are covered by these break-even point sales, but you’re not making any profit. In accounting, the margin of safety is a handy financial ratio that’s based on your break-even point.

The fair market price of the security must be known in order to use the discounted cash flow analysis method then to give an objective, fair value of a business. £20,000 is a comfortable margin of safety for Company 1, but is nowhere near enough of a buffer from loss for Company 2. Company 1 has a selling price per unit of £200 and Company 2’s is £10,000.

We can do this by subtracting the break-even point from the current sales and dividing by the current sales. In this section, we will cover two examples for the calculation of the margin of safely. The first example is for single product while the second example is for multiple products. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications.