Reaching break even is a huge accomplishment for a new company, product or service, signalling the moment when your new venture covers its costs and starts making money. But what comes next? After reaching break even point, the revenue your business earns is profit. And the more profit you make, the more your cash reserves grow, which means your business is better prepared to face any unexpected challenges.
That’s why the difference between your break even point and revenue is known as the margin of safety. “Calculating the margin of safety will allow a business to put a number on how close - or how far - it is from being unprofitable,” says James Gribben, Head of Communications for Be the Business, a not-for-profit organisation supporting business owners.
Let’s take a closer look at how to calculate margin of safety and why it’s important to your business.
Why is the margin of safety important?
The margin of safety is the buffer your business has before it becomes unprofitable. The higher the margin of safety, the more money a business has to withstand short-term fluctuations in demand, economic downturns and changes in competition. According to Gribben, it acts as an indicator, indicating when it’s time to implement changes, such as cutting expenses.
John Edwards, CEO of the Institute of Financial Accountants adds that the margin of safety calculation is a useful tool for quickly and effectively monitoring profitability without having to perform in-depth financial reporting. He explains that it can be used to evaluate whether expansion into new markets is viable, based on sales projections. Margin of safety can also be used to support budgeting decisions and by potential investors to understand business risk.
How to calculate margin of safety
The margin of safety formula can be used to either evaluate all your sales, or on a product-by-product basis. It’s best suited to businesses that have consistent sales, rather than those that experience seasonal fluctuations, as some months will have significantly low margins compared to others, says Edwards. For these companies, annualised data will be more accurate.
A margin of safety of zero means your business is at break even point. It is neither losing nor making money. A negative margin of safety shows your business is below break even point, which means it is losing money and not earning enough to cover its own costs. And a positive margin of safety means your business has exceeded break even point and is making a profit.
Let’s look more closely at how to calculate margin of safety.
Margin of safety formula
The margin of safety calculation subtracts your break even point from your actual or forecast sales revenue.
Margin of Safety in Pounds = Current Sales – Break even Sales
Sometimes it’s useful to convert this figure into a margin of safety percentage. This is particularly relevant when comparing different products or services, says Gribben. You can calculate the margin of safety as a percentage as follows:
Margin of Safety Percentage = ((Current Sales - Break even Sales) / Current Sales) x 100)
Current sales
The margin of safety can be calculated using your current sales or forecast sales. You can also use it to compare profitability between departments, product lines or services by using current or forecast revenue from each specific unit.
Break even
Break even point is calculated by taking all the fixed and variable costs associated with the manufacture and delivery of your products, alongside your average sales price per unit, to work out how many units you need to sell or the revenue you need to generate, to break even.
Margin of safety calculation example
Suppose your business has sold £200,000 worth of goods in the first quarter. To break even, you need to sell £20,000 of goods per month, or £60,000 over a quarter. Let’s now apply the formula for margin of safety.
Current sales: £200,000 per quarter
Break even sales: £60,000 per quarter
Margin of safety: £200,000-£60,000 = £140,000
Margin of safety percentage: ((£200,000-£60,000) / £200,000) x 100 = 70%
How to analyse your margin of safety calculation
In general, the higher a margin of safety, the more stable and less risky your business is. But in reality, it’s largely dependent on your business and its cost structure, says Gribben. Let’s look in more detail at how to interpret a margin of safety calculation.
What is a good margin of safety?
Businesses that have a lot of variable costs, such as raw materials, packaging and shipping, generally have more flexibility to cut back on expenses and operate with a lower margin of safety when they need to, such as when sales are slower. For these businesses, a margin of safety of 20 to 25% is considered “acceptable,” says Edwards.
But for businesses with a lot of larger, fixed costs such as premises and equipment that are tough to change at short notice, lowering costs when sales slow is very challenging. These businesses are therefore higher risk as they’re less able to respond to short-term changes in demand, explains Edwards. In this case, a margin of safety of 50% is the “bare minimum”, he says, though financial institutions will likely want to see 70 to 75%.
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Moving beyond costs, your wider business model should also be considered when analysing your margin of safety. Edwards shares an example. “If a business has a margin of safety of £10,000 but its average order value is £5,000, then £10,000 would be considered a low margin because the absence of just two sales will lead to potential losses,” he says. "But if the margin of safety is £10,000 and the average order value is £100, then the business can fluctuate by as many as 100 sales before making a loss."
How much do I need to produce to make a profit?
In addition to working out the margin of safety in pounds and as a percentage, you can also calculate the margin of safety in units.
Margin of Safety in Units Formula = (Actual Sales - Break even Sales) / Sales Price per Unit
Here’s an example:
Selling price per unit: £200
Actual sales: £400,000
Break even point: £150,000
Margin of safety in units: (£400,000-£150,000) / £200 = 1,250 units
This means that you have a buffer of 1,250 units before the business starts losing money. Or in other words, you could lose 1,250 sales and still break even.
The margin of safety gives business owners an indication of how much risk their business can absorb before making losses. This makes it a valuable tool for identifying whether expenses need to be trimmed or whether your business has sufficient cash reserves for growth and expansion.
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