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Keeping an eye on outgoings and profit margins is an everyday occurrence for businesses, but it’s important for company accountants to keep a close eye on the margin of safety, too.
What is the margin of safety?
Margin of safety, also known as MOS, is the difference between your breakeven point and actual sales that have been made. Any revenue that takes your business above break even can be considered the margin of safety, this is once you have considered all the fixed and variable costs that the company must pay. So, the margin of safety definition is the quantifiable distance you are from being unprofitable. It’s essentially a cushion that allows your business to experience some losses, as most companies do from time to time, and not suffer too much negative impact. The bigger the margin is, the lower the risk of insolvency.
How to calculate margin of safety
The margin of safety is the difference between two figures, so it is a simple matter of subtraction. For example, if Company A made $200,000 in sales with a breakeven point of $100,000, they would have following margin of safety:
Margin of safety
However, the margin of safety can also be represented as a percentage. Knowing how to calculate the margin of safety depends on how you wish to present it.
Margin of safety formula
You can use the below margin of safety formula to find your MOS percentage:
The margin of safety percentage can also be worked out using forecasted sales, for businesses strategizing for the future. The margin of safety formula can also be applied to different departments within a single company to define how risky they may be. The same goes for individual services or products. Depending on the situation, a low margin of safety may be a risk a company is willing to take if they also predict future improvement for the selected product or department.
What is a good margin of safety percentage?
Generally speaking, the higher your margin of safety, the better. The value represented by your margin of safety is your buffer against becoming unprofitable, which will vary depending on your business.
For example, if your margin of safety is around $10,000 but your selling price per unit is $5,000, that means you can only lose a sale of two units before your business is in serious trouble. So, while $10,000 may be a big buffer to some businesses, it may barely be enough for others.
In the case of units, the following margin of safety formula can be used:
This means if Company A is selling a unit at $100 each, the formula might look like this:
That gives a buffer of 1000 units before the business becomes unprofitable, i.e., Company A could lose 1000 sales and still break even, and those 1000 sales above break even directly translate into profit. Businesses can use this information to decide if they want to expand or reevaluate their inventory, it can also help them decide how secure they are moving forwards. Seasonal goods, for example, may need to keep any eye on this margin to guide them through off-peak sales periods.
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