# 3 5 Calculate and Interpret a Companys Margin of Safety and Operating Leverage Principles of Accounting, Volume 2: Managerial Accounting

As we sell items, we have learned that the contribution margin first goes to meeting fixed costs and then to profits. The term ‘margin of safety’ is used in accounting and investing in referring to the extent to which business, project, or an investment is safe from losses. This article provides a detailed description of how to calculate the margin of safety and arrive at the margin of safety ratio, the margin of safety percentage, and margin of safety sales in dollars and units. Investors working with a margin of safety will utilize factors such as company management, market performance, governance, earnings, and assets to determine the stock’s intrinsic value. The actual market price is then used as a comparison point to calculate the margin safety. During periods of sales downturns, there are many examples of companies working to shift costs away from fixed costs.

This Yahoo Finance article reports that many airlines are changing their cost structure to move away from fixed costs and toward variable costs such as Delta Airlines. Although they are decreasing their operating leverage, the decreased risk of insolvency more than makes up for it. As you can see from this example, moving variable costs to fixed costs, such as making hourly employees salaried, is riskier in that fixed costs are higher. However, the payoff, or resulting net income, is higher as sales volume increases. Now, look at the effect on net income of changing fixed to variable costs or variable costs to fixed costs as sales volume increases.

Using margin of safety, one should buy a stock when it is worth more than its price in the market. This is the central thesis of value investing philosophy which espouses preservation of capital as its first rule of investing. Benjamin Graham suggested to look at unpopular or neglected companies with low P/E and P/B ratios. One should also analyze financial statements and footnotes to understand whether companies have hidden assets (e.g., investments in other companies) that are potentially unnoticed by the market.

## What is the Margin of Safety Formula?

Although there was no guarantee that the stock’s price would increase, the discount provided the margin of safety he needed to ensure that his losses would be minimal. You might wonder why the grocery industry is not comparable to other big-box retailers such as hardware or large sporting goods stores. Just like other big-box retailers, the grocery industry has a similar product mix, carrying a vast of number of name brands as well as house brands.

Fine Distributors, a trading firm, generated a total sales revenue of \$75,000 during the first six months of the year 2022. If its MOS was \$15,000 for this period, find out the break-even sales in dollars. In CVP graph presented above, red dot represents break even point at a sales volume of 1,250 units or \$25,000.

## Margin of Safety Formula

Operating leverage is a measurement of how sensitive net operating income is to a percentage change in sales dollars. Typically, the higher the level of fixed costs, the higher the level of risk. However, as sales volumes increase, the payoff is typically greater with higher fixed costs than with higher variable costs. Operating leverage is a function of cost structure, and companies that have a high proportion of fixed costs in their cost structure have higher operating leverage. In fact, many large companies are making the decision to shift costs away from fixed costs to protect them from this very problem. Operating leverage fluctuations result from changes in a company’s cost structure.

A stock with a 50% margin of safety will theoretically fall less than a stock with a slim margin of safety or none at all. A stock that is undervalued has most potential bad news priced in already. After the machine was purchased, the company achieved a sales revenue of \$4.2M, with a breakeven point of \$3.95M, giving a margin of safety of 5.8%. The margin of safety is the difference between the amount of expected profitability and the break-even point. The margin of safety formula is equal to current sales minus the breakeven point, divided by current sales.

1. During periods of sales downturns, there are many examples of companies working to shift costs away from fixed costs.
2. This example also shows why, during periods of decline, companies look for ways to reduce their fixed costs to avoid large percentage reductions in net operating income.
3. If Netflix is destined to evolve into a no-growth company, a P/E of less than 18 may be realistic when you calculate its intrinsic value.

These companies pay their shareholders regularly, making them good sources of income. Coupled with a longer holding period, the investor can better withstand any volatility in market pricing. Take your learning and productivity to the next level with our Premium Templates. Access and download collection of free Templates to help power your productivity and performance.

However, it has value in the decision-making process, where it is being used as a tool for averting risk. But that may not be sufficient, particularly for value investors or those with a low risk tolerance. That means that either the stock’s price must fall to \$75 or its intrinsic value would need to increase to \$120 before you’d be willing to invest. A margin of safety (or safety margin) is the difference between the intrinsic value of a stock and its market price.

## Related Investing Topics

The figure is used in both break-even analysis and forecasting to inform a firm’s management of the existing cushion in actual sales or budgeted sales before the firm would incur a loss. Companies have many types of fixed costs including salaries, insurance, and depreciation. This makes fixed costs riskier than variable costs, which only occur if we produce and sell items or services.

## Formula

The blue dot represents the total sales volume of 3,500 units or \$70,000. It has been show as the difference between total sales volume (the blue dot) and the sales volume needed to break even (the red dot). Conceptually, the margin of safety is the difference between the estimated intrinsic value per share and the current stock price. Managers use it to determine how much budgeted security they have before the company would lose money. Our discussion of CVP analysis has focused on the sales necessary to break even or to reach a desired profit, but two other concepts are useful regarding our break-even sales. A low margin of safety signals a high risk of loss, while a high margin of safety means that the business or investment can withstand crises.

The growth at a reasonable price investment method applies a more balanced investment approach. The investor picks companies with positive growth trends and those trading below intrinsic fair value. The investor needs to have at least a 10% margin of safety before trading with the GARP approach. The results projected through forecasting may often be higher than the current results. The margin of safety will have little value regarding production and sales since the company already knows whether or not it is generating profits.