Margin of safety is a performance indicator used in managerial accounting to estimate the extent by which actual sales or expected sales overcome break-even sales. This metric is used in CVP analysis and can be expressed in units, dollars, as a ratio, or as a percentage. It is very useful for companies having a highly volatile sales volume; thus, they can set a minimum margin of safety level. When actual sales drop below this level, it is time to cut costs.
The dollar amount of margin of safety can be calculated as the difference between current sales and break-even sales. In budgeting, projected sales are used instead of current sales.
Margin of Safety in Dollars = Current Sales - Break-even Sales
The number of units can be computed in two ways.
|Margin of Safety in Units =||Current Sales - Break-even Sales|
|Sales Price per Unit|
Margin of Safety in Units = Current Sales in Units - Break-even Sales in Units
If it is necessary to compare several companies, the margin of safety ratio should be used.
|Margin of Safety Ratio =||Current Sales - Break-even Sales|
It can also be expressed as a percentage.
Margin of Safety Percentage = Margin of Safety Ratio × 100%
The margin of safety ratio (percentage) is a measure of risk. The lower it is, the higher the risk and vice versa.
Retail-X Ltd is a company selling one product at a price of $40 per unit. Budgeted sales for the next quarter are $3,600 units, the variable cost per unit is $25, and fixed costs are $33,000.
To compute the margin of safety, we have to calculate the break-even point both in units and in dollars.
|BEP in Units =||Fixed Costs||=||$33,000||= 2,200 Units|
|Sales Price per Units - Variable Cost per Units||$40 - $25|
BEP in Dollars = 2,200 × $40 = $88,000
Budget Sales = 3,600 × $40 = $144,000
Knowing the budgeted sales and break-even point, we can calculate the margin of safety both in units and in dollars.
Margin of Safety in Dollars = $144,000 - $88,000 = $56,000
Margin of Safety in Units = 3,600 – 2,200 = 1,400 Units
The margin of safety ratio and percentage are as follows:
|Margin of Safety Ratio =||$144,000 - $88,000||= 0.389|
Margin of Safety Percentage = 0.389 × 100% = 38.9%
The ratio of 0.389 indicates that Retail-X Ltd may lose 38.9% of sales before it has net losses.
The graph below represents the margin of safety concept discussed in the example above.