The margin of safety is a very useful measure that goes hand in hand 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.
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.
If the break even point for a business in a year is £1.25 million and the business achieves turnover of £1.6m, then it has a margin of safety of £350k.
Personally, when the business is trading above the break even point, I prefer to look at 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 350/1250 = 28%
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
Perhaps you are wondering if there is a margin of danger, the amount a loss making business is below the break even point.
To be honest I've never heard anyone else use the margin of danger phrase or a negative margin of safety although again it can be useful to track how well a business is closing the gap to break even.
You could think of it as the margin to safety if the business is operating below break even.
I've just Googled
"what do you call the amount a business is below the break even point"
and I didn't find any relevant links other than general break even analysis pages.
I have found 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.
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