What is margin of safety?
Margin of safety refers to the expected sales that are more than the break-even point. It is an estimate of the sales revenue that can fall short of the budgeted revenue before the business makes a loss.
Margin of safety formula
Management makes a sales budget at the start of a budget period. However, actual sales may not be equal to budgeted sales and variance might arise. To avoid an adverse situation, a business needs to perform a risk assessment to see if the results are or will be different from the budget. Management wants to know how much the sales can fall before the business makes a loss. To calculate the number of units to be sold which is an acceptable decrease, a business can use the margin of safety method. Management uses margin of safety method to compare the break-even sales and budgeted sales/current sales to see the risk of loss. It informs the management about the estimated acceptable downfall of sales.
Note: Break-even point is a point where the sales of a business are enough to cover the total costs only. Thus, a loss occurs below the break-even point.
To understand the concept of margin of safety, let us consider an example of Wonder Watches limited, a watch manufacturing company. Management made a sales budget of 30,000 watches at the start of the year 2022. The selling price of each watch is $20. Thus, the total budgeted sales revenue amounts to $600,000.
Variable costs of $8 are expected per watch. Therefore, the contribution per watch (unit) is $12 ($20 – $8). Total fixed costs of $240,000 have been approximated for the budget period. The Break-even units and margin of Safety are calculated as:
Break-even point (units) = Total fixed costs / Contribution per unit
Break-even point (units) = $240,000 / $12
Break-even point (units) = 20,000 units
Margin of safety in units = Budget sales in units – Break-even sales in units
Margin of safety in units = 30,000 – 20,000
Margin of safety in units = 10,000 units
This shows that if the business can sell 20,000 watches, it will result in a no-profit-no-loss situation for the business. However, the business has estimated that 30,000 watches are to be sold in the budget period. Consequently, even if the business’ sales are decreased by 10,000 watches (30,000 watches- 20,000 watches), it will experience no loss. This figure of 10,000 watches is the margin of safety in the context of sales budget.
Example – How to calculate margin of safety
The management of Pizza Bay Limited, a pizza restaurant, is considering using the margin of safety method as a risk assessment technique. Budgeted sales of 50,000 pizzas were set at the start of the year 2022. Each pizza sells for $30. The variable costs of making the pizza have been approximated as $12 per pizza. Fixed costs of $855,000 are expected to be incurred for the budget period.
Calculate the margin of safety of pizzas and advise the management about the risk of loss (if any).