What the margin of safety is and why you should know it
Your business needs to make money.
That’s pretty straightforward.
But it won’t always do so.
There are ups and downs along every journey.
So there will be times when your business is doing well, and times when things are a little tighter.
As long as your overall trend is upwards, you shouldn’t have much to worry about.
When things aren’t going so smoothly, you may want to keep track of your margin of safety.
This article will look at what the margin of safety is, why it’s important, and how to not just track it but improve it.
Let’s dive in.
What is the margin of safety?
The margin of safety is the buffer your business has between its current sales performance and the break even point. The break even point is the figure at which your revenue matches your expenses, so you aren’t making or losing money.
Hopefully, your business will be running well above this point most of the time, churning out tidy profits. How well it’s doing that will determine your margin of safety.
There are multiple ways to calculate your margin of safety, but they all tell you the same thing: how much of your sales you can afford to lose before reaching the break even point.
Let’s look at an example. If your business makes £200,000 a year and its total expenses are £120,000, then it can afford to lose £80,000 in sales before reaching the break even point. We can simply say that the margin of safety is that £80,000 figure.
We could also look at the margin of safety as a percentage of current sales. Since £80,000 is 40% of £200,000, your margin of safety can also be expressed as 40%. Again, the maths stays the same. If you lost 40% of your sales, you’d have lost £80,000 and reached that break even point.
Finally, you can consider the margin of safety in terms of units. Sticking with the same figures, we break that £80,000 buffer down into an easier amount to visualise. If your business primarily sells £500 office chairs, then you can afford to lose sales of 160 chairs.
Why your margin of safety is important
Understanding the margin of safety for your business allows you to make informed decisions about risks, opportunities, pricing, production, and much more.
A higher margin of safety gives your business the breathing room to experiment with new products, sales tactics, or marketing channels safe in the knowledge that you can afford to take something of a hit, though of course you will hope for success instead.
If your margin of safety is lower, you may want to evaluate how you can increase revenue through higher pricing or generating new business, or decrease expenses through cost-cutting measures or streamlining production.
For instance, you might introduce some lean start-up principles to change your ways of working.
Or you could take the opportunity to look at your utilities expenses and notice that your energy efficiency has room to improve. We have great sustainability tips for educational establishments, healthcare businesses, shipping companies, and restaurants.
Your margin of safety can also factor into budgeting and forecasting, giving you a “worst case” look at sales around your break even point.
How to track the margin of safety
As there are different ways to express the margin of safety, you may find uses for each method. Production might care about the volume of units you have as a buffer, while finance might prefer the actual cash figure or a percentage.
However you choose to use the margin of safety within your business, it helps to keep an up to date and accurate figure. You may want to calculate it on a regular basis, taking revenue and costs each month as they come, or setting up a rolling view that looks back at the last 12 months for instance. You could even set up a simple tracker that automatically works out your margin of safety based on revenue and cost data from a set period.
If you don’t set up a regular way to track your margin of safety, you should at least reassess it in the face of significant changes to your business. These could include steep rises in costs, a new product launch, or additional hires. Understand how these changes affect your margin of safety so all future decisions are made with these factors in consideration.
What you consider a ‘good’ figure will depend on how your business and its costs are set up. If many of your costs are fixed, then it helps to have a higher margin of safety somewhere in the region of 50–75%. This will ensure that you still have the money to pay for these set expenses even with a dramatic decline in sales and revenue.
Conversely, if your cost structure is more flexible, thanks to on-demand production or low overheads, then a lower margin of safety is acceptable. 25% may be totally fine if it is easy enough for you to reduce costs as needed during slower periods.
How can you improve your margin of safety?
Since the margin of safety depends on revenue and costs, you need to improve one or both of these aspects to give yourself a larger buffer. Training your staff to cover additional roles, planning ahead, and researching tax relief options are just some of the ways to reduce your small business expenses, as covered previously on this blog.
Meanwhile, there are a myriad of ways to increase your revenue. You can raise prices, find new customers, introduce new or improve products, source additional funding… There is a lot of flexibility here, so you may want to start with just one or two ideas that you can implement well, rather than trying half a dozen new initiatives at once.
With a firm understanding of what your margin of safety is, you will be better equipped to make informed decisions for your business and guide it towards continued growth and profitability.