Despite the years spent in our lives, we do not know whether we are on the right track when it comes to managing our personal finance. We never fail to set goals in terms of wealth but some of us may fail to achieve the goals.
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. That’s 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