Margin of Safety

Learning Outcomes

  • Compute the margin of safety

The margin of safety is the difference between actual sales and the break even point. Now that we have calculated break even points, and also done some target profit analysis, let’s discuss the importance of the margin of safety. This amount tells us how much sales can drop before we show a loss. A higher margin of safety is good, as it leaves room for cost increases, downturns in the economy or changes in the competitive landscape.

If you remember back to our example with our friends at Monte Corporation and the widgets, when a new competitor came into the market, it created a crisis!

The formula used to calculate the margin of safety

[latex]\text{Margin of safety}=\text{actual (or budgeted) sales}-\text{sales required to break even}[/latex]

We can take this formula one step further to figure the margin of safety percentage

[latex]\text{Margin of safety percentage}=\dfrac{\text{Margin of safety in dollars}}{\text{total actual (or budgeted) sales in dollars}}[/latex]

Now let’s look at an example:

Let’s go back to our kayaks. Remember our basic information:

Price per kayak $500
variable costs per kayak $225
Contribution margin per kayak $275
Fixed costs/month $7,700

Also, remember, Minnesota Kayak Company needs to sell 28 kayaks at $500 each to break even. So in this example, $14,000 in sales is their break even point.

Let’s assume their current sales of kayaks is 50 kayaks per month at $500 each, so $25,000. Using the formulas above, what is their margin of safety?

[latex]\$25,000-\$14,000=\$11,000[/latex] is their margin of safety.

What is their margin of safety percentage?

[latex]\dfrac{\$11,000}{\$25,000}=44\%[/latex] is their margin of safety percentage.

We can check our calculations, by multiplying the margin of safety percentage of 44% by actual sales of $25,000 and we end up with $11,000.

So the margin of sales percentage tells us that Minnesota Kayak Company can sell 44% fewer dollars worth of kayaks and still break even. The higher the margin of safety percentage, the better!

Practice Questions