Margin of safety: formula and more info

Margin of safety is a term used in both business and investments. Here, we're focusing on the former: margin of safety for business. When you're assessing your business' performance or deciding on the direction you want to take next, margin of safety tells you how much your revenue can drop before you stop making a profit.

When you know your margin of safety – either on a single product or for your business as a whole – you have a better understanding of risk and opportunity. So here, we're going to explain what margin of safety is, how to calculate it, and when you most need to keep these figures in mind.

What is margin of safety?

Margin of safety is so called because it measures how 'safe' a business is from making a loss.

All businesses have a breakeven point – it's the moment when your total costs and total revenue are equal. When you break even, you've made enough money to cover your expenses, but not enough to be in profit. Everything you make above your breakeven point is your margin of safety – the cushion that protects your business from insolvency because you could afford to lose that amount without going into the red.

While there's a close link between a business' profit margin and its margin of safety, it's important to remember that they're different metrics. Profit margin is how much your  business makes from its sales (usually given as a percentage of your revenue). Margin of safety measures how far you are above your breakeven point. Instead of looking purely at how profitable your business is, it's how far those profits have put you from making a loss.

Where is margin of safety used?

Accountants and business owners use margin of safety to evaluate their revenue and costs and to inform their business decisions.

For example, it's important to have an idea of your margin of safety when:

• You want to add a new product or service to your offering. You can use margin of safety calculations to assess how much of a new product you'd have to sell to make a profit. This can tell you how risky it is to invest in that product. If you'd have to sell more units or win more contracts to reach your breakeven point, your margin of safety will probably be narrower, so there's a higher chance you'll lose money.

• You're evaluating your pricing structure. A low margin of safety can be a sign that you need to either increase your pricing or boost your sales to give your business more of a financial cushion. You'll have to look at your sales projections and other metrics to identify the best strategies.

• You're renewing contracts with your suppliers or service providers. If your business' margin of safety is generally low, or it's noticeably lower on certain products, it can be a sign that you need to make savings. With recent inflation and increases in the costs of raw materials, many businesses have seen their expenses eat into their margin of safety. Renegotiating contracts that have increased in price can be a good starting point in building that cushion again.

How to work out margin of safety

If you're wondering how to calculate a margin of safety, and you have your sales figures in front of you, the maths is quite simple.

The formula for margin of safety is:

(Actual sales – Break-even sales) / Actual sales = Margin of safety

Let's break this down with an example business.

Imagine a company with total sales of £200,000. They break even at £120,000. This means that their margin of safety is £80,000, because their revenue could drop by this amount without dropping below the breakeven point.

Margin of safety is usually expressed as a percentage. To find this, you divide the margin of safety by the total sales and multiply it by 100.

£80,000 / £200,000 x 100 = 40%

Depending on the product or service your business supplies, you can also talk about margin of safety in terms of numbers of units.

For example, you might be weighing the benefits of adding a new product to your range, with projected sales of 1000 units. Based on the cost of purchasing those units, you know you'd have to sell 600 to avoid a loss. In simple terms, you make a profit on the 400 units you sell above the breakeven point, which also represents a 40% margin of safety.

But what does a 40% margin of safety mean? It all depends on your business model.

What's a good margin of safety?

Generally speaking, the bigger the margin of safety, the better, because it gives your business a bigger buffer to keep you in profit.

However, there's no magic number that guarantees your business' financial stability. It depends on the industry you're in, the margins on the different products you sell, and – most of all – whether you use a fixed cost or a variable cost model.

If you have a fixed cost model, your expenses stay the same no matter how much your revenue grows. Whether you sell 100 units or 10, you pay the same price for things like staffing, business insurance, the lease on your office space, and logistics. If your business provides a digital subscription service, like an app, for example, you can probably scale up your number of customers without drastically increasing your costs.

On the other hand, a variable cost model means that as your business grows, your costs increase. Businesses with variable costs (like many trades, food and takeaway businesses, and retail) see their expenses increase as they serve more customers. And this has a knock-on effect on their margin of safety.

If your business has variable costs and your sales drop, you can hypothetically scale down to save money. With a variable cost model, you can often get by with a low margin of safety, because there are more things you can do to protect your business from making a loss.

However, if you have more fixed costs, you need a higher margin of safety. This is because you'll still have to cover the same expenses even if your revenue drops.

While businesses with more variable costs can get by with a 20–25% margin of safety, more fixed costs mean that you need a cushion of 50%, and ideally much higher, to protect your business from economic issues like the cost of living crisis.

If you're looking at your costs and revenue and you notice that your margin of safety is lower than this, you have two options: reduce fixed costs, or increase revenue.

Decreasing costs

When you decrease your business' costs, you lower your breakeven point, which is one way to improve your margin of safety.

You might be able to reduce your costs by:

• Reviewing and renegotiating the contracts you have with your suppliers.
• Switching to a new supplier who can offer raw materials at a lower price (without compromising the quality of your product).
• Optimizing the way you handle your inventory so, for example, you spend less on sourcing and storing your products before you sell them.
• Leasing equipment or office space rather than buying it outright.

Increasing revenue

When you increase your sales, you build up the amount over your breakeven point and give yourself a higher margin of safety to work with.

You might be able to increase revenue by:

• Increasing the sale price, especially if the costs of producing your product or providing your service have grown.
• Implementing a new pricing model, like targeting subscribers or repeat custom, which uses fewer resources than sourcing and converting new leads.
• Marketing your business more widely, or investing in marketing strategies like SEO, paid online ads, or a referral program to attract new customers.

It's important to note that some strategies for increasing revenue can increase your costs in the short term but increase revenue over time, so it's important to weigh all your options.

Quickfire margin of safety recap

Instead of looking at how profitable your business is, margin of safety tells you how close you are to making a loss. This tells you about how concerned you need to be about insolvency, and when you combine margin of safety with sales projections, you can assess how risky certain business decisions are likely to be.

Remember, whether you want to know it in units or in pounds sterling, the margin of safety formula is: (Actual sales – Break-even sales) / Actual sales  = Margin of safety.

And a higher margin of safety is always good news for your business, it’s especially important to work at a high margin of safety of 50–70% if your business has more fixed costs than variable ones.

Read more:

• What business insurance do I need? 
• Beat the January business slowdown
• New legislation impacting your business

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