What is the Margin of

Safety?
Margin of safety (safety margin) is the
difference between the intrinsic value of a
stock and its market price.
Another definition: In break-even analysis,
from the discipline of accounting, margin
of safety is how much output or sales level
can fall before a business reaches
its break-even point.
For example, if actual sales for the month of December 2015 are $2,500,000 and
the break-even sales are $1,500,000, the difference of $1,000,000 is margin of
safety.

Margin of Safety Formula

Margin of safety =Actual sales - Break-even sales
Actual sales
Importance of Margin of Safety:
The soundness of a business may be gauged by the size of the margin of
safety. A high margin of safety indicates the soundness of business i.e., the
break-even point is much below the actual sales so that even if there is a fall
in sales, there will still be a profit. A small margin, on the other hand,
indicates a not-too-sound position.
If a low margin of safety is accompanied by high fixed cost and high
contribution margin ratio, action is called for reducing the fixed cost or
increasing sales volume. But if the margin of safety as well as the
contribution ratio are low (the fixed cost being reasonable) the situation
requires that efforts should be made towards reducing the variable cost, or
an increase in the selling price should be effected. Margin of safety is also of
immense use in making inter-firm comparisons.
Steps to Improve Margin of Safety:
The margin of safety can be improved by taking the following steps:
(i) Increasing the selling price.
(ii) Increasing the sales volume by increasing the capacity.
(iii) By improving the contribution margin through reducing the variable cost.
(iv) By lowering BEP through reduction of fixed cost.
(v) By adopting a better profitable product mix.