The margin of safety (MOS) measures the gap between the actual revenue and the break even revenue. Consequently, as a business will break even at the break even revenue, the margin of safety indicates by how much the revenue must fall before the business starts to make a loss.
The margin of safety formula is as follows:
In the formula the terms have the following meanings.
- Firstly actual revenue is the amount of revenue that the business generates from its sales or operations in a given period. If dealing with budgets, then the actual revenue can be replaced with budgeted revenue.
- In contrast break even revenue is the level of revenue the business needs to cover its expenses and make neither profit or loss for the period.
The Margin of Safety Percentage
The margin can also be expressed as a percentage of the actual revenue giving the MOS percentage formula.
Margin of safety percentage = Margin of safety / Actual revenue
The percentage is sometimes referred to as the margin of safety ratio or MOS ratio.
Calculate MOS
To illustrate suppose a business has revenue of 100,000 and the break even revenue is calculated to be 90,000. In this case using the formula, the safety margin is calculated as follows.
Margin of safety = Actual revenue - Break even revenue Margin of safety = 100,000 - 90,000 = 10,000
Alternatively this can be expressed as a percentage of the actual revenue giving the MOS percentage as follows.
MOS % = MOS / Actual revenue MOS % = 10,000 / 100,000 = 10%
It is important to realize that above the break even revenue the business will make a profit. In this case the revenue can fall by 10,000 or 10% before the business starts to make a loss.
Additionally the same process can be applied using units instead of revenue. To illustrate, suppose in the above example the unit selling price was 50.00. In this case the actual units are 100,000/50 = 2,000 and the beak even units are 90,000 / 50 = 1,800. The safety margin in units is then 2,000-1,800 = 200 units or expressed as a MOS percentage 200 / 2,000 = 10%.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.