What is Margin of Safety?

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What is Margin of Safety?

“Margin of Safety?” is an important factor to be known by the investors.

So, let’s get into the concept of “Margin of Safety”.

Today, from this article you will learn in brief about “What is Margin of Safety?”

One of the most must read book by Seth Klarman, “Margin of Safety” has been influenced a lot of investors to this concept.

So, let’s get started with the definition first,

Meaning of Margin of Safety

Margin of Safety (MOS) defines as the excess of actual or projected sales over break-even sales that can be indicated in monetary terms or units, or as a percentage of total sales.

The mos works at the sales point over and above the break-even point that results in profits.

Break-even point (BEP), is the point wherein total cost and total revenue are at equilibrium and profit is zero.

It can be calculated as:

Margin of Safety = Total Sales – Break Even Sales

Another method to calculate the margin of safety is to discover out the difference between the budgeted and break-even sales (in units) and then to multiply the result by the contribution per unit.

This is because, at Break-even point, fixed overheads are absorbed and any further contribution, will sum to profit.

It can be computed as:

Margin of Safety = Margin of Safety

The MOS is important to the company, as a reduced activity level, will lead to losses.

The size of the mos is a measure of company’s financial health, i.e. low margin of safety presents high fixed overheads, and profits are not earned, until and unless the activity level so high that it covers fixed costs.

On the other hand, high mos presents that the break-even point is highly less than the actual sales.

Therefore, even if there is a reduction in the sales, the business will be able to earn profits.

So, when there is peak in the margin the greater will be the chances to make profits or responsive to any sudden decline in company’s revenue, thus it reduces the risk of losses in business.

Various Ways to improve M O S

  1. To Increase the contribution per unit: One of the most essential way to improve the margin of safety is to improve the marginal contribution per unit, which is only possible by increasing the selling price (if market conditions are favorable) and lowering the variable cost per unit of the product.
  2. To lower down the Break-even Output: The mos can be improved by lowering the break-even output, and this can only be possible if the fixed overheads are decreased.
  3. Increasing sales volume: The easiest technique is to increase the mos is to sell as much as the company can if there is underutilized capacity.

The MOS replicates the amount by which drop in sales can be tolerated by the company before losses actually start incurring.

When the margin is high there is decrease in sales and this will not influence the business profit, while when it is low there is a slight decline in sales that abruptly affect the entire business.

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