The margin of safety measures the extent to which a company's anticipated sales exceed the amount of sales the company must generate to avoid a loss. Every company has fixed costs, such as rent and insurance, that remain the same no matter how many items the company makes. Companies also have variable costs, such as raw materials, that will change from period to period. At the breakeven point, the company's revenues equal the costs. The more the company's sales exceed the breakeven point, the higher the company's margin of safety.
1. Estimate the sales of the company for the year. You can base the sales on prior years, and if necessary adjust for any changes discovered. For example, if each year for the past five years the company's sales increased by 5 percent, and the sales the past year equaled $21 million, you might anticipate $22.05 million in sales.
2. Estimate the amount of sales the company needs to break even for the year. For example, if you expect that you would need to sell $13 million just to break even, $13 million would be the breakeven point.
3. Subtract the breakeven point from the anticipated sales to calculate the margin of safety in dollars. In this example, subtract $13 million from $22.05 million to find the company has a margin of safety of $9.05 million.
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