Overview of margin of safety percentage
Margin of safety percentage refers to the method by which the margin of safety is calculated. As a result, there needs to be a brief understanding of the break-even analysis and the concept of margin of safety which are as follows:
Break-even point
The break-even level or break-even point (base for margin of safety percentage) depicts the sales (which can be either in terms of revenue or units) required to meet the total costs including both variable and fixed costs of the company. Therefore, it concludes that total profit at break-even level is zero.
A company passes the break-even point when sales are higher than variable costs per unit. This explains that the selling price for the commodity should be greater than what the company paid for its raw material. This overcomes the initial price which leads to profits.
The concept of break-even point(base for margin of safety percentage) is commonly used in financial analysis, which is further used for economic use, accountants, managers, entrepreneurs, financial planners and marketers. It allows the people to find required outputs and work towards them.
The break-even(base for margin of safety percentage) value depends on the type of business and is not generic. The value showcases the units to be sold to cover their variable costs. As a result, each business must calculate individually whether high or low. Moreover, each item sold adds up a contribution to the covering fixed costs as well.
How to improve the working of Break-even analysis?
If a business finds it difficult to sell required units, they consider the following:
1. Reduction in fixed costs. This motive can be achieved by negotiations such as a decrease in rents, better management of costs and bills etc. 2. Reduction in variable costs
This level also provides a rough indicator of the market activity impacts. Being the simplest analytical tool, the analysis provides a view of the relationship between costs, profits and sales. For example, the break-even sales as a percentage of actual sales help managers to know when is the break-even(base of margin of safety percentage) achieved. It provides an idea to the firms whether there is a need to cut costs or restructure for optimum results. This increases the efficiency and helps them to achieve higher returns.
Construction
In the case of cost-volume analysis, ( where MR and MC are constant), the break-even point is calculated with the help of Total Revenue and Total Costs.
TR=TC P x Q= TFC + V x Q Px Q – V x Q= TFC (P-V) x Q = TFC Q= TFC / P-V Here, TFC = Total Fixed Cost P= Unit Sale Price V= Unit Variable Cost
The quantity, (P-V) here is also termed as Unit Contribution Margin(C). This explains the marginal profit per unit or that portion of every sale that contributes to fixed costs. Therefore, the break-even point(base for margin of safety percentage) is defined as the point where Total Contribution= Total Fixed Cost.
Total Contribution= Total Fixed Cost Unit Contribution x Number of units= Total Fixed Cost Break-even point(units) = Total Fixed Cost / Unit Contribution Break-even(sales) = (Fixed costs) / C/sales or Fixed costs / pv ratio Where P/V ratio = Contribution / Sales
The graph explains the areas for loss and profit. Moreover the point indicating the break-even where total revenue is equal to total cost.
Limitations of Breakeven analysis
- The break-even analysis(base for margin of safety percentage) takes into consideration only supply-side analysis, which tells the likely sales for the product that can be at different prices.
- The fixed costs are assumed to be constant. However, this situation is true in the case of the short-run, whereas when the scale of production increases it makes fixed costs rise.
- The average variable costs are assumed constant per unit of output, at least in the range of quantities of sales likely(i.e linearity) in the margin of safety percentage.
- The number of goods sold is assumed equal to the number of goods produced. This explains that there is no change in the number of goods at the end of the period held in inventory and at the beginning of the period.
- For a multi-product company, the relative proportions for each product produced and sold are assumed constant. This explains that mix sale is constant.
Margin of safety
The margin of safety percentage depicts the strength of the business. It helps the business evaluate the amount gained or lost. Moreover, it enables the business to know whether they are below or over the break-even point. By going with the actual definition, the margin of safety in break-even analysis or MOS refers to the extent to which projected or actual sales exceeds break-even sales.
The margin of safety in break-even analysis (units) = Current output – Break-even output MOS(amount//revenue) = Current/Actual Sales – Break-even Sales Margin of safety percentage = {(Current sales – Break-even point) / Current sales} x 100 Margin of safety formula PV ratio: MOS = Fixed costs/ P/V ratio Where, P/V ratio = Contribution / Sales
The margin of safety ratio also allows comparison between different companies. Therefore it can be computed by following separately for units and revenue maximisation:
Margin of safety ratio = (Current/Actual sales – Break-even sales) / current sales
The above graph explains that at point Q1 we have current sales marked. Whereas point Qbep represents the break-even quantity attained. As a result, the difference between the two highlights with MOS or margin of safety.
Features
- There can be a situation of loss i.e margin of safety percentage can be negative as well.
- Results of forecast data will often show a higher value than achieved in reality. The forecasts of estimated cost by production personnel or development will be often low while the figures shared by sales or marketing staff tend to be high.
- The margin of safety percentage has a value concerning sales and production. It acts as a planning tool that depicts risk and included in the decision-making process.
Importance of Margin of Safety
An investor can purchase a stock at a discount which turns into a good opportunity to bag a stock at a reasonable price and helps in acting as a cushion if the judgement goes wrong. Therefore, it enables maximum benefit and limit losses from the investment made. As a result, few reasons why one can consider the importance of margin of safety percentage are as below:
- Let’s say in balancing assets, a sudden trade war occurs between two countries causing the markets to fall. Here the margin of safety in break-even analysis provides security where the investor enjoys the safety of capital even when prices fall.
- The intrinsic price figures out by using different financial factors. Therefore, just like operations, management etc, the margin of safety formula PV ratio helps to insulate the investor against any probable losses if the verdict is wrong.
- The importance of margin of safety percentage acts as a defence against human factors’ ups and downs, that are inseparable from the market. For example, herd behaviour. It explains to the investor the way he has to look at returns and the type of risk he is preparing for.
Applications
There are two applications to explain the usage of margin of safety percentage:
Budgeting
In terms of budgeting included in accounting or break-even analysis as discussed above, the importance of margin of safety percentage describes the difference of estimated sales output and the level through which a company can decrease sales before it will become unprofitable. It works as a signal for the management sector to look after the risk of loss that can happen due to a change in sales in the business. A low margin of safety percentage causes a company to cut expenses whereas a high margin of safety percentage ensures that the company secures from the variability of sales.
Note: In the case of budgets, the current output gets replaced by budgeted output. For the P/V ratio if given, then the margin of safety formula PV ratio becomes (PROFIT) / P/V ratio.
Investing
In the case of investing, the importance of margin of safety percentage depicts the gap between the intrinsic value of a stock with its prevailing market price. The term intrinsic value explains the actual worth/present value of a company’s asset when counting or adding the total discounted future income calculated.
Investing involves assumptions when it comes to the margin of safety percentage. This explains that an individual purchases securities only when their market price materially below its intrinsic value. It happens because the investors can set a margin according to their risk preferences, resulting in buying of securities when the gap is present and investment can be made with minimum risk. However, finding the true worth of security is subjective since each investor calculates the intrinsic value in a different way which can probably be accurate.
Ideal Margin of safety for Investing
The extent depends upon the type of investment or preference chosen by the investor. However, some scenarios in which investor find interest with widespread margin are:
1. Growth at a reasonable price investing: the investor can choose companies with positive growth trading rates ( below the intrinsic value).
2. Deep value investing: Buying stocks in the undervalued business. The main idea lies in finding mismatches between current stocks and intrinsic value. However, this kind of investment needs a large amount of margin to invest with and involves higher risk.
Example for Margin of Safety Calculation
Let’s say a stock is trading with a price of Rs. 40. But the stock undervalues and can perform better in the future. The assumption is made that its intrinsic value is Rs. 90. Now, Mr X invests when the price was 50 while Y invests when it was 100. For example, the markets face a tough time with high volatility, therefore prices fell to Rs. 80. As a result, X is safer than Y with Rs. 40 as a safety line. The margin of safety in break-even analysis computes as:
Margin of Safety = 1 – ( Current trading price/ intrinsic value)
Although the formula gives a conclusion, the importance of margin of safety differs from person to person since risk profiles are different. An aggressive person can take up the risk by reducing its margin of safety percentage. Whereas a retired man or conservative person requires a wider margin. However, a higher margin of safety percentage ensures a lower chance of losing capital and provides better profits.
The main idea lies in selecting the right stock and investing at the right price. If a stock is at a low price, it does not make it a good stock. The smartness lies in choosing an undervalued stock which adds up to the fortune. Metrics like low P/B ratio, P/E ratio, high dividend yield etc helps to determine whether a stock undervalues.
Points to Remember
- The importance of margin of safety percentage refers to built-in that allows incurring some losses without negative effect majorly.
- In accounting margin of safety regards as break-even forecasts which allow leeway for estimates.
- In terms of investing, the Margin of safety percentage counts qualitative and quantitative considerations ( including governance, assets, management, industry performance etc) to find a price target and a safety margin that discounts that target.
- The investor purchases stocks below their target prices. Where the discounted price builds into a margin of safety formula PV ratio in case these estimates turn biased or incorrect.
Margin of Safety Percentage example
Company Ford planned to expand its production output by purchasing a new piece of machinery for its top of the line car model. The machine will increase the operating expenses to $1000000 annually. Therefore, the company received revenue worth $4.2 million while break-even $3.95 million, attaining 5.8% of the margin of safety percentage.
Let’s hypothetically take a situation, in which a person is a good climber and chances for falling are slim. But for security purposes, the person attached himself to safety gear if he falls. Unfortunately, the winds went strong and the person was pushed down.
Similarly, the stock markets are known for such incidents. Even after calculating all steps and measured steps, the investor can still fall if situations are under control. As a result, an investor wishes to save his head from all possibilities that can occur.
As a result, the investor buys the stock at a discount price lower than its intrinsic value. This is done to offset the unforeseen losses calculated due to the mistakes of oneself or factors that are out of control.