What is the margin of safety and how do you calculate it?

As a small business owner, approaching your break-even point is a bit like flying towards the sun.

Every now and then, you’ll want to apply the “Icarus” test—to find out just how close your business can get to breaking (without crashing and burning).

This is where the formula for margin of safety comes in.

In this article, we’ll walk you through what the margin of safety is, why it’s important, how to calculate the margin of safety, and how to 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 breaks even—the point where revenues equal costs, so your business doesn’t make a profit or sustain a loss.

There’s an inverse relationship between the margin of safety and insolvency: the higher your margin of safety, the lower your risk of insolvency.

The margin of safety has a number of practical applications to your business.

Firstly, you can use it to assess the risk of your products or services. A higher margin of safety points to a lower risk of incurring losses if your sales take a tumble.

Secondly, the margin of safety enables you to make informed decisions about how to price your products or services. For example, if it is on the lower side, you may want to think about adjusting your prices to boost sales.

Thirdly, it helps you find the production “sweet spot,” where your production levels aren’t set too high (over-production) or too low (under-production).

Fourthly, knowing the margin of safety positions you to make better judgement calls when it comes to investing in new products, services, or existing inventory. A higher margin, for instance, indicates that your investment has less risk attached to it.

Lastly, having an understanding of how far sales can decline before your business becomes unprofitable makes for more accurate budgets and forecasting.

How to calculate margin of safety

To calculate the margin of safety, you’ll need to comb through your bookkeeping records or access your accounting programs to collect 2 sets of figures: actual (or budgeted) sales and break-even sales.

You can then calculate margin of safety in 3 ways: in pounds, as a percentage, or per unit sold.

The formula for margin of safety (in pounds) is as follows:

Actual (or budgeted sales) – break-even sales

To calculate the margin of safety, subtract your company’s break-even sales from its actual (or budgeted) sales.

For example, if your company makes £500,000 in sales with break-even sales of £200,000, its margin of safety is £300,000.

What this means is that your company has a buffer of £300,000, which is the amount of money it can afford to lose before breaking even, which is the last stop before unprofitability.

Margin of safety (as a percentage)

Here’s the formula for margin of safety (as a percentage):

Actual (or budgeted sales) – break-even sales / actual (or budgeted sales) x BY 100

In the above example, the margin of safety is calculated as follows:

Actual (or budgeted) sales: £500,000

Break-even sales: £200,000

Formula: £500,000 – £200,000 = £300,000 / £500,000 = 0.6 x 100 = 60

Margin of safety: 60%

This means the company can lose 60% of its sales before reaching its break-even point.

Margin of safety (per unit sold)

The formula for margin of safety (per unit sold) is:

Actual (or budgeted sales) – break-even point / selling price per unit

Imagine your company sells high-end candles at £100 each, the margin of safety calculation would look like this:

Actual (or budgeted) sales: £200,000

Break-even point: £100,000

Selling price per unit: £100

Per unit sold formula: £200,000 – £100,000 / 100 = 1000

Margin of safety: 1,000

This means your candle business has a cushion of 1,000 units before it becomes unprofitable. In other words, it can afford to lose 1,000 candles and still manage to break-even.

This buffer allows your business to experiment with new candle designs or marketing campaigns without the imminent risk of making a loss.

What is a “good” margin of safety?

The ideal margin of safety varies from one business to another but, generally speaking, the higher your margin of safety, the safer your business is.

Ultimately, the minimum margin of safety to target depends on your cost structure.

If most of your business costs are variable, a margin of safety of 20 to 25% may be reasonable, especially if you can reduce costs during slow periods.

But if your business has mostly fixed costs, it’s preferable to have a higher minimum margin of safety — somewhere along the lines of 50%, but ideally around the 70 to 75% mark.

If your business has a margin of safety of 50%, it’s acceptable assuming there are minimal fixed costs. If your sales decline, you can probably cut back on variable costs.

By contrast, if your business has mostly fixed costs, its margin of safety is relatively low and you may want to consider ways to improve it.

How to improve margin of safety

There are only 2 ways your business 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
  
• Producing more units with the same resources
  
• Buying infrastructure, such as software as-a- service as opposed to buying it outright
  

As for revenue-increasing methods, they include:

• Increasing the price of your goods or services
  
• Introducing a new pricing structure
  
• Growing your marketing campaign
  

Final thoughts

When you’re on the cusp of making an important decision in any business, risk assessment is key.

One way of calculating the level of risk your business has is the formula for margin of safety.

But the margin of safety isn’t a static figure. It’s a constantly moving target when your business is incurring extra operating costs with new break-even points.

For this reason, it’s important to re-calculate the margin of safety regularly, particularly when your business sees a significant uptick in costs.

Any revenue that pushes your business above the point of breaking even contributes to its margin of safety. And equally, any application of the formula for margin of safety can potentially contribute to business longevity.