What Is the Margin of Safety?
Margin of safety is a financial ratio that estimates the value of sales above the break-even point. It is the revenue a business or company receives after deducting the fixed and variable costs associated with producing its products and services.
This value reveals a company’s capabilities as well as its position in the market. It can help the business make crucial decisions on budgeting and investments. This allows them to assess the risks and whether they are rewarding. They also help in the optimized allocation of resources and cut wasteful costs.
Table of contents
- The “margin of safety” (MOS) is the difference in values between the revenue earned (profit) and the break-even point.
- The corporation needs to maintain a positive MOS to continue being profitable.
- The MOS is a risk management strategy that allows businesses to plan for the future and make necessary corrections.
- The margin of safety is a different concept in the field of investments. It is an investment theory that suggests securities should only be purchased when their market price is below their intrinsic or inherent value.
The Margin Of Safety Explained
The margin of safety ratio reveals the difference in values between the revenue earned (profit) and the break-even point. The break-even point is the point of zero profit and zero loss. In other words, the company makes no profit but incurs no loss simultaneously. Any point beyond the break-even point is profit and contributes to the margin of safety (MOS). The corporation needs to maintain a positive MOS to continue being profitable.
The MOS is a risk management strategy where businesses can think about their future and make necessary corrections. The change in sales volume or output volume (also includes increasing the selling price) could tip the MOS into a loss or profit. It aids in determining whether current business strategies are rewarding or require modification, and if so, when and how.
This also helps them decide on changes to the inventory and end production of unprofitable products. Careful budgeting and making necessary investments would invariably contribute to the betterment of the business. Adopting new marketing and promotional strategies to increase sales and revenue would also help prevent the MOS from falling below the break-even point. In this case, they should cut waste and unnecessary costs (reduce fixed and variable costs, if necessary) to prevent further losses.
When applied to investments, the margin of safety is a concept that suggests securities should be purchased only when their market price is significantly below their intrinsic value. In essence, investors seek opportunities where the market price provides a comfortable cushion or margin of safety compared to the true worth of the security. When a stock’s market value substantially exceeds its intrinsic value, it may be considered overvalued, and prudent investors might consider it a good time to sell. This principle helps investors make more informed decisions about buying and selling securities, aiming to protect their investments and potentially achieve better returns.
Calculating MOS is easy without using a margin of safety calculator. The break-even sales are subtracted from the budgeted or forecasted sales to determine the MOS calculation. The total number of sales above the break-even point is displayed using this formula.
Margin of safety = Actual sales volume – Break-even sales
Margin of safety percentage = (Actual sales volume – Break-even sales) / Actual sales volume *100
The doll house is a small toy manufacturing company with sales revenue of $500,000 for 2022. They had a break-even point of $450,000. They substituted these values into the formula without using a margin of safety calculator.
The margin of safety percentage formula
= ((actual sales volume – break-even sales) / actual sales volume) *100
Doll house’s MOS% is, therefore, 10.
Advantages And Disadvantages
Some of the advantages and disadvantages of calculating MOS are:
- Improves business strategy: The margin of safety ratio reveals the current position of the sales of the company and whether or not there is profit. Depending on the general state of the economy, inferences can be drawn on how the company is performing. With this data, a plan can be preparable to be on par with its competitors. As a result, it aids in evaluating current strategies and making necessary adjustments.
- Risk management: With the available data, the management will take corrective actions that improve the situation. Even a small decline in sales might push the company into a loss; therefore, unyielding business strategies pose a big risk. Hence, it helps to mitigate anything that exacerbates the risk.
- Smart investments: There are already existing data on the projects that worked and those that resulted in profit. Smart investment decisions are possible by avoiding those not producing returns and putting money into those that do.
- Errors: Errors are a challenge that can come with any calculation or data compilation. It may happen in the collection stage or the computation stage. Misinterpretations of data lead to incorrect conclusions.
- Inconsistent sales: It may be difficult to compute MOS when the business has inconsistent sales. A winter clothing company, for example, has lower sales in non-cold months. In other words, their sales revenue may be different in different periods.
Difference Between The Margin Of Safety And Profit
Here are the main differences between the two:
|Margin of safety
|MOS is a measure that shows the value of sales that is above the break-even point.
|Profit is the financial gain attained by a company for its operational abilities.
|MOS shows where the sales volume break’s the limit and goes beyond the break-even point to result either in profit or loss.
|Profit shows how much a business has managed to earn as income.
|Point in time
|MOS is seen as futuristic as the data is collected from actual sales and is often looked at to improve operational capacities and make investment decisions.
|Profit is calculated using sales data from the past.
|Management frequently looks into MOS to make investment decisions and increase operational capacity.
|Profit attracts the attention of management, investors, creditors, financial institutions, and so on.
|MOS is arrived at by deducting break-even point sales from total sales.
|Profit is arrived at by deducting costs incurred from sale proceeds.
Frequently Asked Questions (FAQs)
A margin of safety between 20% and 25% may be appropriate if most of the company’s costs are variable; however, if the company has high fixed costs, a minimum safety margin percentage of 50% or higher is favorable, with the company aiming for around 70%.
The margin of safety is negative when it falls below the break-even point. In such cases, it implies that the company is operating at a loss. Furthermore, it is not making enough money to cover its current production costs.
The margin of safety can be improved by adopting various strategies, including optimizing the product mix for profitability, implementing effective marketing strategies, reducing unnecessary costs, and incorporating customer feedback into business decisions. Since each business is unique, there is no one-size-fits-all approach. Moreover, companies must assess their current positions and adapt accordingly.
This article has been a guide to what is Margin Of Safety. We explain its formula, calculation, examples, advantages, disadvantages, and differences with profit. You may also find some useful articles here –