Definition
Margin of Safety is the level of sales exceeding the break-even point.
Formula
Margin of Safety (Units) = Actual or Budgeted Sales Units – Break-Even Sales Units
Margin of Safety (%) =
((Actual or Budgeted Sales Units – Break-Even Sales Units) ÷ Actual or Budgeted Sales Units)) x 100%
Explanation
How much decrease in the level of sales can be tolerated before a business stops making profit? Margin of Safety answers this very question.
Margin of Safety is the number of units or the percentage of sales exceeding the break-even point. It is a safety cushion that protects a business against a loss. Higher the Margin of Safety, lower the risk of making loss whereas lower the Margin of Safety, greater the risk of doing business.
Margin of Safety provides a measure of the sensitivity of profitability of a business to a change in the level of sales.
Margin of Safety may be calculated on the level of actual or budgeted sales.
Example
Sara sold 100 cars in the first year of her car showroom business. If Sara had sold only 60 cars, she would have made no profit or loss.
Calculate Sara’s margin of safety.
Margin of Safety (Units):
= 100 (Actual Sales Units) – 60 (Break-even Units)
= 40 Cars
Margin of Safety (%):
= [(100 (Actual Sales Units) – 60 (Break-even Units)) ÷ 100 (Actual Sales Units)] x 100%
= 40%
If Sara’s sales in the first year had been lower by 40 cars or 40% then she would have made no profit.