Margin Of Safety Definition
The margin of safety is financial which is used to measure the number of sales which exceed to the break-even point. In simple word Margin of safety is the revenue earned by the company after paying the fixed and variable cost which used to produce the goods or services.
The safety margin is like a buffer. If the safety margin is positive then the operations of the company are profitable. If this ratio is zero then it means that the operation breakeven for the period and profit will be zero for that company.
But if the margin of safety is negative of any company then the company is in lose and not able to create the profit from its operations.
To judge the risk of product, operations, and department management use this ratio.
If the number of units of any company is less then the company is riskier because between the profit and loss of that company there is a small difference. For example, if the company have the small buffer then small fluctuation in the sales make cause for the loss of the company.
But is the buffer of the company is high then due to a small fluctuation in sales there is not the creation of any loss of the company?
The Margin of safety formula can be calculated by the subtracting of the breakeven point from actual sales.
Margin of safety = Actual sales – Breakeven point
It shows the number of sales above the break-even point. This ratio can be express in the percentage form as
Margin of safety = (Actual sales – Breakeven point)/Actual sales
Managerial accountants use this formula for the result of margin safety in the percentage form. This ratio is used to measure the buffer zone profitability. And from this management analyze that what production level required for the profit of the company.
Now we take the example of Jerry machine shop. Jerry produces the Boat propellers and now he is debating that he should invest in new machines or not for making the new parts of the boat. Current sales of Jerry is 100,000 dollars and his breakeven point is 75,000 dollars.
margin of safety = actual sales – breakeven point
= $100,000 – $75,000
So the margin of safety for Jerry is 25,000 dollars. It means that if the sales of Jerry fall to 25,000 dollars then he can also pay his expenses from current revenue.
Now we convert this into a percentage by dividing the result by $100,000. then the percentage will be 25%. It means that Jerry buffer from loss is 25% of sales. If Jerry wants to expand his business’s operations then the buffer will be decreased which makes his business riskier so it is not a good idea to expand the operation.
For more Financial Ratio Check:
Inventory turnover ratio
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