 # Margin of Safety By Yuriy Smirnov Ph.D.

## Definition

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.

## Formula

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

or

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 Current 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.

## Examples

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 \$144,000

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.

### Graph

The graph below represents the margin of safety concept discussed in the example above. 