5.5: Margin of safety
The margin of safety looks at how far above the breakeven point a company’s sales are. The greater the difference, the more secure a company can feel about hedging against possible declines in sales. The margin of safety can be expressed as a dollar amount, a percentage, or a number of units.
As an example, a company’s breakeven point of 2,400 units per month is determined as follows:
\(\ \frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\$ 120,000}{\$ 80-\$ 30}=2,400 \text{ units per month to break even}\)
Actual sales for the month were 8,000 units. The contribution margin per unit is $50 ($80 - $30).
|
Margin of safety in units: |
8,000 – 2,400 = 5,600 |
|
Margin of safety in dollars: |
(8,000 x $50) – (2,400 x $50) = $400,000 - $120,000 = $280,000 |
|
Margin of safety percentage: |
($400,000 – 120,000) / $400,000 = 70% |
The margin of safety is 70%, which gives the company a significant cushion over its breakeven point. The higher the margin of safety, and the more it exceeds the breakeven point, the better.