Margin of Safety Formula

The margin of safety is the level of sales above the breakeven point

The margin of safety (MoS), also called safety margin, is an accounting metric and a financial ratio. 

Margin of Safety Formula

In accounting, it is used to calculate the difference between actual sales and the break-even point. A company reaches the breakeven point when its sales cover all its overhead costs. 

In investing, the safety margin is the difference between the intrinsic value of a company's stock and its market price. It is a concept made popular by value investors such as Benjamin Graham and Warren Buffett.

As per Warren Buffett's letter to his shareholders, Chapter 20 of the book "The Intelligent Investor by Benjamin Graham (goodreads.com)" which deals with margin of safety, is the most important chapter that any value investor must read.

Margin of Safety in Budgeting

The margin of safety in break-even analysis and budgeting is an important risk management technique that flags potential profitability concerns. It helps to understand sales that a business should generate to cover its fixed cost. 

In case the sales are below the breakeven point, the gross profit from it won't be enough to cover the fixed expenses, which would mean that the company would be incurring losses.

Profitable companies have actual or real sales that exceed break-even sales. The margin of safety can also be applied to unit sales or dollars. In this case, it expresses the ratio between actual unit or dollar sales and unit/dollar break-even sales. 

Hence, MOS is a very important tool in corporate finance that helps to set targets for the company in terms of sales and overall performance.

Margin of Safety Calculation

The margin of safety can be expressed in three ways: 

  • As a percentage or a ratio
  • As units sold
  • As dollars of sale

Expressed as a ratio, the margin of safety is as follows: 

Margin of Safety = (Current Sales - Break-even Sales) / Current Sales x 100 

Expressed in terms of sale of units, the safety margin is: 

Margin of Safety in units = Current Units Sales - Break-even Units Sales

The breakeven unit sale can be calculated by dividing fixed costs by contribution margin per unit.

Contribution margin per unit = Sale price per unit - Variable cost per unit

The safety margin expressed in dollars can be calculated in two ways: 

Margin of Safety in dollars = Current Dollar Sales - Break-even Dollar Sales

where,
Break-even Dollar Sales = Fixed Cost / Contribution margin

or

Margin of Safety in dollars = Margin of Safety in Units x Price per Unit

A positive safety margin is what all businesses should aim for. Although there isn't a set range for a good MOS, the higher the margin, the better.

Different companies and industries will have different safety margins. High safety margins allow companies to weather a drop in sales or negative market conditions such as supply chain issues. Higher margins of safety also signal that a business has the ability to invest in projects, which can boost future growth and revenue.

Conversely, a low margin of safety is a reason for concern as the company may not be able to generate the required profit and might be on the road to insolvency. The low margin sends a clear message to managers and executives that the company has to reduce its costs or make other changes to its operations (such as changing products in case the supply for the current product far exceeds its demand).

Budget

Example Usage of the Margin of Safety Formula

The margin of safety formula is most commonly used in manufacturing and retail businesses.

It is the difference between sales volume and the breakeven point. The goal of calculating the margin of safety is to quantify the number of sales required to cover the fixed costs and thereby generate a profit. 

For example, you are selling ten widgets for $20 per widget, with the desired profit of $5 per widget. The breakeven point would be $150 = (10 * $20) - (10 * $5). The breakeven in units will be 7.5 = $150/$20. 

The margin of safety stands at 2.5 (10 - 7.5) widgets, or $50 (2.5 * $20).

Margin of Safety In Investing

The margin of safety in investing is the difference between the intrinsic value of a company's stock and its current stock price. Intrinsic value simply means what a company or an asset is worth.

The intrinsic value of a stock can be higher or lower than its current trading price. 

A lower intrinsic value signals that the security is trading at a premium. A higher intrinsic value means that it trades at a discount.

When the intrinsic value of a stock is higher than its current price, it means that the stock is undervalued, which is a good buying opportunity. It is associated with value investing, which is endorsed by some very successful investors like Benjamin Graham and Warren Buffet.

Planning for MOS

The margin of safety in investing represents buying a security at a discount relative to its intrinsic value. Even if the margin of safety might cushion downside risk, there is always a risk with investing. However, this metric is less useful in some investments, as one WSO forum user has remarked.

RLC1:

Margin of safety is subjective and dependent upon the investment. Almost all LBOs are intermediated, and as such, you are rarely able to acquire a profitable company at a meaningful discount to intrinsic value. In a more distressed situation, you might derive a margin of safety based on liquidation value or a low multiple of the profitability from, for example, a particular business segment that is obscured by other unprofitable operations. But those aren't really "LBOs."

The discounted cash flow (DCF) method helps calculate the intrinsic value. Using this model, the intrinsic value of a stock is achieved when estimated future cash flows are discounted by the appropriate discount rate to obtain their present value. The sum of the present value of cash flows is then compared to the current stock price.

Benefits of Margin of Safety

The key benefits of using this metric are:

  • It alerts company management about potential areas of concern, especially when there is a decline in sales. Managers will have to take appropriate actions, including but not limited to cutting costs, identifying underperforming product lines, or reviewing prices.
  • It helps to set sales targets that the sales department is expected to achieve, thereby providing them guidance. It also helps set a bonus structure that rewards them for meeting these targets.
  • It helps identify the major cost components for cost accountants who can then figure out which areas need more attention to reduce costs and increase contribution per unit.
  • It provides guidance to managers who are required to choose between reducing fixed costs while increasing variable costs and vice versa. For example, a factory could choose to automate the production process and let go of employees or hire employees while reducing the amount of automation. While the former is usually preferable, the decision is never straightforward.
  • It helps investors to account for risk in their investments. For example, a stock of a company that has an MOS of 20% is less risky than one with an MOS of 5%. 
DCF Modeling Course

Everything You Need To Master DCF Modeling

To Help you Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: