Let’s take a closer look at the margin of safety formula in action and calculate it for two businesses.
The Wooden Spoon Company: Q4 Review
The Wooden Spoon Company makes the best wooden spoons in Indiana. They sold 6,000 wooden spoons in Q4 and spent $17 producing each spoon, making their breakeven point $102,000. They price their product at $24 a spoon, which means their current sales are $144,000.
Their margin of safety in dollars is $42,000
$42,000 = $144,000 – $102,000
Their margin of safety as a ratio is 0.29:
0.29 = ($144,000 – $102,000) / $144,000
And their margin of safety as a percentage is 29%:
29% = [($144,000 – $102,000) / $144,000] x 100
So the Wooden Spoon Company had a healthy margin of safety during Q4 and can rest assured that sales were well managed during this period.
The Wooden Spoon Company: Q1 Forecasting
Now the Wooden Spoon Company is projecting profits for Q1. The cost of materials has fluctuated recently, and they expect utility costs to rise during the winter months. They project that the total cost to produce each spoon will now be $19.50. They also anticipate selling only 4,500 spoons this quarter, making their new breakeven point $87,750. If they keep their price the same, their estimated sales are $108,000.
Their margin of safety in dollars is $20,250
$20,250 = $108,000 – $87,750
Their margin of safety as a ratio is 0.19:
0.19 = ($108,000 – $87,750) / $108,000
And their margin of safety as a percentage is 19%:
19% = [($108,000 – $87,750) / $108,000] x 100
The Wooden Spoon Company can see they’re headed toward rocky ground. Leadership must now decide how to resolve this issue, and they have many options. They could choose to use less expensive materials, change their product pricing, or introduce a more profitable product line to offset the lower profitability of their current product line. They could come up with a different strategy to grow their profitability. The main point is that, by making sales projections, they can identify a rough patch before it occurs and take action early.