Everybody needs to break even, so this ratio will give you the insight of what goes too much or too little. In other words, the calculation is basically a subtraction that indicates how much you need to produce to be above the break-even point and get profit. At the same time, the calculation will also offer you the opposite: it will reveal how much you will need to produce to break even. It’s just basic mathematics and without this ratio, you can lose everything.
Also, this acts as a buffer. There is always an amount of money that the company or department can lose before it starts winning money. With this buffer active, you can say that the company wins money. With the margin falling to zero, the department hits the break-even point. If the margin becomes negative, then the company will start losing money.
Below, you can see the formula, as well as the main things you should care about.
The Margin of Safety Formula
The formula is a simple one. Basically, what you need to do is to subtract the break-even sales from the actual sales. And there you will have the margin of safety. The result is the number of sales above the break-even point or the amount that the company can lose to break even.
But as we are speaking in business terms, you will need a ratio to get a better view of what’s going on. In order to do so, you will need to subtract the break-even from the actual sales and then divide the result to the actual sales. This ratio will show you exactly what percentage you will need to get profit.
More Info on this Ratio
If you want to get a better view of what value has the units produced, you can subtract the break-even point from the actual sales and divide by the selling price per unit.
These calculations will easily get you above the break-even point and will ensure that you will win. However, if you have seasonal selling and the ratio fluctuates from season to season, these calculations will need to be done once a season. It means that every three months, you will need to see if you lose, break-even or win. If you fail to do this, you will get some incorrect results that may or may not put you on a loss eventually.
These formulas will be helpful before and after some machinery is bought to speed up the production. Every investor will obviously need to see some results after automation is bought. This will ensure that the stocks purchased, and the raw material are directly proportional with the earnings.
To conclude the above statements, these formulas will give you the edge to know how much to produce and what to sell and in what amount. Also, beware of the season sales as they may vary. It’s better to divide the sales into smaller ones and then calculate the corresponding values. Otherwise, some inexact calculations will turn up and they will cause nothing but frustration and chaos.