The Margin of Safety is a very useful measure that should be used together with break even point calculations.
The break even point identifies the sales volume or value where a business neither makes a profit or loss in the period.
>>> Why Break Even Point Analysis Is Important
>>> The Cost Volume Profit Relationship
>>> How To Calculate The Break Even Point Of A Business
What Is The Margin Of Safety?
The margin of safety is the extra sales value or volume the business has sold in a period in excess of the break event point.
Here is a quick example.
If the break even point for a business in a year is £0.8 million and the business achieves turnover of £1.2m, then it has a margin of safety of £400k.
Personally, when the business is trading above the break even point, I prefer to look at and track the issue as a percentage where the margin of safety % is the excess over the break even point divided by the break even point.
In the above example, this would be 400/800 = 50%
Why Is The Margin Of Safety Important?
Every business changes every month, either because it tries to improve or because customers, competitors, suppliers and the wider business environment force the business to adapt to changes outside of its borders.
The Break Even Point moves around from month to month and while the business is making a good profit, it can be easy to get complacent about success.
Changes in the Margin Of Safety, and on their own they tend to be bad news, flags a warning to the business owner and managers before any problems have time to get too serious.
There is a bias, left on its own, the Margin of Safety reduces as the Break Even Point increases. that’s because fixed costs creep up and margins creep down from extra sales discounts and price increases from suppliers.
Monitoring The Margin Of Safety
This ratio can be tracked on a monthly basis.
Just as break even point calculations often benefit from smoothing by using rolling data (last 3 months or even moving annual total) to prevent trends being hidden by large fluctuations up and down, so can the margin of safety.
If the ratio reduces, the business is warned that its financial health is suffering and can decide whether this change is permanent (and something needs to be corrected) or temporary (and it will put itself right when, for example, a low price promotion ends).
The Margin Of Danger, The Negative Margin Of Safety Or The Margin To Safety
Is a margin of danger?
This would be the amount a loss making business is below the break even point.
I’ve never heard anyone else use the margin of danger phrase or even negative margin of safety although again it can be useful to track how well a business is closing the gap to break even.
I prefer to think of it as the Margin to Safety if the business is operating below break even.
I find it useful to measure how this gap to the break even point is being closed.
A business that is struggling and in the red needs encouragement to know that it making progress as it makes the difficult decisions to get back above the break even point.
I’ve tended to show this information as:
The sales needed to break even
The % gap to close to reach break even.
If you focus on closing the gap between the sales and the break even point which we’ll still call the margin of safety, it helps you to think about moving both measures:
- Increasing sales
- Reducing the break even point.
The danger is that the most common and easiest way to increase sales revenue is to reduce prices. This unfortunately reduces the contribution margin and often increases the break even point.
A business can have a gap of £30,000 to close to reach break even, increase sales by £20,000 (thinking it was doing the right thing) and finish with an increased margin to safety of £50,000.
It’s counter intuitive but many business turnarounds happen by reducing the sales revenue and returning the business to a profitable core.
This happens because the break even point can be reduced at a faster rate than the sales revenue.
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