The margin of safety is a financial ratio that measures the amount of sales that exceed the break-even point. In other words, this is the revenue earned after the company or department pays all of its fixed and variable costs associated with producing the goods or services. You can think of it like the amount of sales a company can afford to lose before it stops being profitable.
It’s called the safety margin because it’s kind of like a buffer. This is the amount of sales that the company or department can lose before it starts losing money. As long as there’s a buffer, by definition the operations are profitable. If the safety margin falls to zero, the operations break even for the period and no profit is realized. If the margin becomes negative, the operations lose money.
Management uses this calculation to judge the risk of a department, operation, or product. The smaller the percentage or number of units, the riskier the operation is because there’s less room between profitability and loss. For instance, a department with a small buffer could have a loss for the period if it experienced a slight decrease in sales. Meanwhile a department with a large buffer can absorb slight sales fluctuations without creating losses for the company.
The margin of safety formula is calculated by subtracting the break-even sales from the budgeted or projected sales.
This formula shows the total number of sales above the breakeven point. In other words, the total number of sales dollars that can be lost before the company loses money. Sometimes it’s also helpful to express this calculation in the form of a percentage.
We can do this by subtracting the break-even point from the current sales and dividing by the current sales.
This version of the margin of safety equation expresses the buffer zone in terms of a percentage of sales. Management typically uses this form to analyze sales forecasts and ensure sales will not fall below the safety percentage.
Managerial accountants also tend to calculate the margin of safety in units by subtracting the breakeven point from the current sales and dividing the difference by the selling price per unit.
This equation measures the profitability buffer zone in units produced and allows management to evaluate the production levels needed to achieve a profit. Let’s take a look at an example.