What is the margin of safety?

The margin of safety is the change in revenues necessary to reach the break-even.

The margin of safety is thus a difference between actual (or budgeted) revenues and break-even revenues. If the margin of safety is positive, it is the amount of revenues the company can lose before reaching break-even and starting making a loss. If the margin of safety is negative, it is the amount of additional revenues the company must earn to reach break-even and start making a profit.

\[ MS_p = R_p - R_{be} \\ \]

On the CVP following graph, the margin of safety assuming the company is at target profit is displayed in purple:

CVP graph

Figure 1: CVP graph

An absolute amount is however not very informative: a margin of safety of 1,000 does not mean the same thing when revenues are 2,000 and when revenues are 100,000. In the former case, the company can lose 50% of its revenues before making a loss; this risk is extremely unlikely. In the latter case, a drop of 1% is enough, and it is a lot more likely. This is why in practice we usually rather comment the margin of safety ratio (\(MSR_p\)), which is the percentage of revenues a company can lose (must earn) to reach break-even:

\[ MSR_p = \frac{MS_p}{R_p} \]

This ratio has another advantage: it is directly tied to the operating leverage, THE measure of operating risk.

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