Margin of Safety

The margin of safety is a tool to help management understand how far sales could change before the company would have a net loss. It is computed by subtracting break‐even sales from budgeted or forecasted sales. To state the margin of safety as a percent, the difference is divided by budgeted sales. If the Three M's, Inc., has budgeted sales of $800,000, its margin of safety is $50,000 ($800,000 budgeted sales – $750,000 break‐even sales) or 6.7% ($50,000 ÷ $750,000), a rather low margin of safety. If, however, its budgeted sales are $900,000, its margin of safety is $150,000 ($900,000 budgeted sales – $750,000 break‐even sales) or 20% ($150,000 ÷ $750,000). The competition, economy, and assumptions in the sales budget must be reviewed by management to assess whether 20% is a comfortable margin of safety.