Margin of Safety in Accounting: Definition & Formula

Margin of Safety in Accounting: Definition & Formula
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  • 0:05 An Introduction to…
  • 1:00 Further Exploring…
  • 2:25 Example of Margin of Safety
  • 2:58 Calculation
  • 4:49 Lesson Summary
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Lesson Transcript
Instructor: Brianna Whiting
In this lesson, we will explore margin of safety. We will define the term and apply it to some basic examples. Then, we'll calculate margin of safety before concluding with a summary and a quiz.

An Introduction to Margin of Safety

Let's imagine that you own a clothing company. You've always taken pride in the fact that you carry the latest fashions for each season. Your up-and-coming styles have always been very popular among your clientele and, thus, your sales have been remarkable. However, when visiting with one of your suppliers, you notice that the next predicted fashion craze is a bit risky.

You see, your supplier predicted that women would be wearing scarves with dried flowers sewn to them. Not sure if your clientele would be interested in wearing something so different, you hesitated to make an order. Wanting to make a sale, your supplier decided to cut you a deal and sell you the scarves at $10, which is less than the $12 you usually buy scarves for. Since the cost of the goods to you is fairly low, your margin of safety has increased because you need to sell fewer scarves to the dried-flower-crazy public before breaking even on your scarf investment.

Further Exploring Margin of Safety

So what exactly is margin of safety? Well, there are a couple ways to look at this term: from an investor's point of view and from a sales point of view, much like the example from above.

From an investment standpoint, margin of safety is a purchase made when the market price is well below its intrinsic value, or its true worth. The difference between the purchase price and the intrinsic value, is known as the margin of safety. Knowing the difference helps an investor to make a purchase with the least amount of risk. Incorporating margin of safety into their decisions helps investors get the best value on stock purchases.

It's important to note in investing that margin of safety is not always concrete. An investor cannot guarantee success, because knowing the purchase's intrinsic value is very subjective. Everyone has their own way of determining intrinsic value, and so margin of safety is a way to attempt to protect an investor from making any errors in calculating intrinsic value.

From a sales point of view, margin of safety is the lowest reduction in sales that can occur before a company reaches its break-even point. In other words, it's a way for a company to evaluate how close they are to losing money if its sales are lowered, which can happen when a contract is lost or is not renewed, for example. Margin of safety can be expressed as a total monetary amount, a percentage of sales, or a number of units.

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