For a small business owner, approaching breakeven is a bit like flying toward the sun.
Every now and then you want to use the “Icarus” test – to find out how close your company can come to collapse (without crashing and burning).
This is where the margin of safety formula comes into play.
In this article we will explain what the margin of safety is, why it is important, how to calculate the margin of safety and how you can improve it.
Why is the margin of safety important?
The margin of safety is a measure of how far your sales can fall before your business reaches breakeven — the point at which revenue equals costs, so your business does not make a profit or incurs a loss.
There is an inverse relationship between the margin of safety and bankruptcy: the higher your margin of safety, the lower your risk of bankruptcy.
The margin of safety has a number of practical applications for your business.
First, it allows you to assess the risk of your products or services. A higher margin of safety indicates a lower risk of losses if your sales plummet.
Second, margin of safety allows you to make informed decisions about pricing your products or services. For example, if the value is in the lower range, you should think about adjusting the price to boost sales.
Third, it helps you find the production “sweet spot” where your production levels are not set too high (overproduction) or too low (underproduction).
Fourth, knowing the margin of safety will enable you to make better decisions when investing in new products, services or existing inventory. For example, a higher margin means there is less risk associated with your investment.
Finally, knowing how far sales can fall before your business becomes unprofitable will help you make your budgets and forecasts more accurate.
How to calculate the safety margin
To calculate the margin of safety, you’ll need to dig through your accounting records or access your accounting programs to record two sets of numbers: actual (or budgeted) sales and break-even sales.
You can then calculate the margin of safety in three ways: in pounds, as a percentage, or per unit sold.
The margin of safety formula (in pounds) is as follows:
Actual (or planned) sales – break-even sales
To calculate the margin of safety, subtract your company’s break-even sales from actual (or budgeted) sales.
For example, if your business has a turnover of £500,000 and a break-even turnover of £200,000, the margin of safety is £300,000.
This means your business has a buffer of £300,000. That’s the amount of money it can afford to lose before it breaks even, which is the final frontier before unprofitability.
Safety margin (in percent)
Here is the formula for the margin of safety (in percent):
Actual (or planned) sales – break-even sales / actual (or planned) sales x BY 100
In the example above, the safety margin is calculated as follows:
Actual (or planned) sales: £500,000
Break-even sales: £200,000
Formula: £500,000 – £200,000 = £300,000 / £500,000 = 0.6 x 100 = 60
Safety margin: 60%
This means the company can lose 60% of its revenue before it breaks even.
Safety margin (per unit sold)
The formula for the margin of safety (per unit sold) is:
Actual (or planned) sales – break-even point/sales price per unit
Imagine your business sells high quality candles at £100 each. The calculation of the safety margin would look like this:
Actual (or planned) sales: £200,000
Break-even point: £100,000
Selling price per unit: £100
Formula per unit sold: £200,000 – £100,000 / 100 = 1000
Safety margin: 1,000
This means your candle business has a 1,000 unit cushion before it becomes unprofitable. In other words, it can afford to lose 1,000 candles and still break even.
This buffer allows your business to experiment with new candle designs or marketing campaigns without the immediate risk of loss.
What is a “good” margin of safety?
The ideal margin of safety varies from company to company, but in general, the higher your margin of safety, the safer your company is.
Ultimately, the minimum safety margin to the target depends on your cost structure.
If most of your business costs are variable, a safety margin of 20 to 25% may be appropriate, especially if you can reduce costs during slow times.
However, if your business has predominantly fixed costs, a higher minimum safety margin is preferable — around 50%, but ideally around 70 to 75%.
If your business has a 50% margin of safety, this is acceptable as long as there are minimal fixed costs. If your sales are declining, you can probably reduce variable costs.
On the other hand, if your business has mostly fixed costs, the margin of safety is relatively small and you should consider ways to improve.
How to improve the safety margin
There are only two ways your company can improve its margin of safety: reduce costs or increase revenue.
You can reduce costs by:
- Removing product lines or services with the lowest profit margins
- Produce more units with the same resources
- Purchase of infrastructure, such as B. Software as a service instead of buying it directly
Methods that increase sales include:
- Increase the price of your goods or services
- Introduction of a new pricing structure
- Expand your marketing campaign
Final thoughts
When you are about to make an important decision in a company, risk assessment is crucial.
One way to calculate your company’s risk level is to use the margin of safety formula.
But the margin of safety is not a static number. It’s an ever-changing target as your business incurs additional operating costs due to new break-even points.
For this reason, it is important to recalculate the margin of safety regularly, especially if your company experiences a significant increase in costs.
Any sales that bring your company above break-even contributes to its margin of safety. And likewise, any application of the margin of safety formula can potentially contribute to the longevity of the business.
