If your company's sales fall below a certain point, you break even instead of turning a profit. Below the break-even point, you lose money. The margin of safety measures how much your sales exceed breaking even. If sales start to slip, the margin tells you how bad it can get before you start running in the red. It's a useful concept in managerial accounting, the financial analyses managers use to plan business strategies and budgets. There are several ways to measure the margin.
Measuring the Margin
To calculate your company's safety margin, first calculate the sales needed to break even. Subtract that from the actual or budgeted sales for the period you're looking at. If budgeted sales for next quarter are $15,000 and the break-even point is $12,000, you have a $3,000 margin of safety. If you divide the budgeted sales into the margin, you get a margin ratio of 0.2. If you're interested in unit sales, dividing the margin by the sales price per unit will give you the margin in terms of units sold.
What It Tells You
Suppose one of your largest customers is considering another supplier. If you calculate the margin of safety for the next period without including any sales to that customer, you can see whether you'll still break even without the contract. You can calculate either the volume of new sales you'll need to stay afloat or the number of items you have to sell. If it turns out you're still well above the break-even point, the loss of the customer is less of an issue.
You can also use the margin of safety to see the effect of changes inside your operation. Suppose you're considering buying new equipment that raises your break-even point from $100,000 to $150,000. When the break-even figure goes up, your margin of safety shrinks. If you want to keep the margin of safety, you need to increase sales or cut costs elsewhere to bring the break-even point back down. Cutting costs lowers the break-even point, giving you a bigger margin of safety.
Factors to Consider
If your sales are heavily seasonal, you have to consider that when figuring the margin of safety. The margin will look insanely low during the slump season. Calculating the margin on an annual basis will give you a more realistic look at your company's prospects. If, like a lot of companies, you sell a variety of goods at assorted prices, pushing the higher-priced lines can increase your margin of safety.
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