For instance, Archan, a management trainee working for a multi-national company would like to have an accumulated saving of R5 lakh in two years. He would like to save 50% of his annual earnings of R5 lakh. He plans to do this by parking the surplus of his earnings in a savings bank account of a public sector bank on a monthly basis (opened exclusively for the goal of accumulating R5 lakh in two years). But let us assume that on completion of the 24th month, his balance in the saving account is just R1.5 lakh (interest on savings is excluded). When he tries to figure out the reasons for missing the targets in wealth creation, he is clueless on how to avoid such failures. Thats where the concept of margin of safety holds light.
Margin of safety
Margin of safety (MoS) is the extent to which an individual or entity can withstand the drop in revenue. In other words what per cent of safety margin an individual has in terms of meeting his variable and fixed expenses It is the excess or shortage over the break-even revenue. In this example, Archan estimates his annual expenses to be R2.5 lakh and aims to have a surplus of R2.5 lakh ie 50% of his annual earnings. But he could accumulate only R1.5 lakh at the end of two years. Assuming that he saved only R75,000 every year, and then his actual MoS is 15% of his revenue/earnings ie R75,000 divided by R5, 00,000. Now the question is what may be the reasons behind the 35% variance in MOS
Margin of safety is calculated by subtracting the total expenses from the total revenues or earnings of an individual or entity. MoS increases for every increase in earning or for every decrease in expenses or combination of increases in earnings and decrease in expenses. The expenses of an individual consists of fixed and variable items. For instance, house rent, food expenses and other necessities are fixed in nature. On the other hand, an individual may spend on vacation/picnics, buying books and other items that are not necessities by spending as a per cent of revenues. These are variable expenses. Fixed expenses do not change for a change in revenue in a normal phase of life. But variable expenses in the case of an individual are dependent on the quantum of his earnings.
Staying in safety zone
Safety zone refers to the excess of earnings over expenses and danger zone refers to the excess of expenses over earnings. The objective in personal finance is to cross the break-even point and stay in the safety zone on a sustainable basis. This can be achieved by the following:
a) Proper estimate of earnings and expenses: It would be better if Archan forecasts his earnings and expenses under the optimistic, pessimistic and most likely scenarios and set his wealth creation goal using the most-likely scenario. For instance, in optimistic scenario, he may foresee 15% hike in salary and it may be 5% hike under pessimistic one. Similarly, in pessimistic scenario, he can estimate medical expenses as 20% of revenue while under optimistic, he may estimate the expense head as 10% of the revenue. It is difficult to predict the earnings and expenses in an accurate manner. But one can estimate the near about numbers to actuals based on the most likely scenario which is in-between the optimistic and pessimistic numbers.
b) Avoiding the temptation to spend on discretionary expenses: Archan should make sure that he has a control on his spending especially on the discretionary expenses that can be completely avoided.
For instance, he can opt to travel by train rather than air if time is not a constraint. He can avoid frequent picnic breaks and so on.
Increasing earnings: This can be done by re-investing the surplus amount in the most profitable avenues. For instance, instead of keeping the entire surplus amount in the savings account of a commercial bank, he can open a recurring deposit account in the same bank for two years such that his return on the savings is higher compared to that of the savings account. But the recurring deposit amount has to be planned in a manner that he has enough cushions to meet the emergent cash requirements.
The happiness that we feel while when our earnings exceed our expenses can be sustained when we understand the behaviour of our expenses and earnings. Such an understanding enables us to plan our future in a successful manner besides providing us a permanent parking space in the safety zone.
The author teaches accounting and finance courses at IIM Ranchi