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How to Use the Margin of Safety Formula

6
August 21, 2023

On paper, staying profitable is simple. All you have to do is bring in more money than you spend. But the reality of running a business isn’t so straightforward. You may have surprise expenses or unexpected revenue drops.

As a business owner, it’s important to know that your business can weather some ups and downs in sales before you stop being profitable. The good news is, there’s a tool you can use to help you figure out how much revenue you can lose before you’re in the red–and it’s known as the margin of safety.

Keep reading to learn when and how to use the margin of safety formula.

What Is the Margin of Safety?

The margin of safety is the difference between your breakeven point and your sales or projected revenue. Your breakeven point is the point at which you start making a profit after accounting for all expenses.

So, your margin of safety tells you how much revenue you can lose before your business isn’t making a profit anymore. It’s, essentially, your wiggle room.

Let’s take a look at how to calculate it.

The Margin of Safety Formula

The margin of safety is usually calculated for a period of time, such as daily, weekly, or monthly. For instance, your monthly margin of safety would be based on monthly sales or your monthly breakeven point.

You can also calculate a margin of safety for future sales. In that case, you would use projected revenue instead of actual sales numbers. So, the formula for a projection would be based on monthly projected revenue.

The basic formula looks like this:

Margin of Safety = Current Sales (or Projected Sales) – Breakeven Sales

Variations on the Formula

There are a couple variations you can use that may help you figure out just how much of a buffer you have in your sales.

Percentage

The first variation is the percentage formula, which is typically used for accounting or reporting purposes. It shows how much of a percentage drop in sales the company can take. So, if you want to figure that out, use this formula:

Margin of Safety (percent) = ((Current Sales – Breakeven Point) / Current Sales) x 100

Number of Units

Alternatively, you can look at your margin of safety in terms of units sold. This will tell you the production level you need to maintain to stay profitable

Margin of Safety (in units) = Current Sales Units – Breakeven Point

Margin of Safety Sample Calculations

Let’s say Jordan owns a coffee shop called Early Bird that brought in \$18,000 of revenue. Her breakeven point is \$12,000. To make it simple, assume she only sells one type of coffee with a selling price of \$2.50, so she needs to sell 4,800 cups of coffee each month (12,000 / 2.50) to break even.

Here are the three different ways she could calculate her margin of safety.

Monetary Value

First, there's the traditional method that'll give Jordan a monetary value for how much wiggle room she has:

Margin of Safety = Current Sales (or Projected Sales) – Breakeven Sales

Margin of Safety = \$18,000 – \$12,000 = \$6,000

Jordan’s total margin of safety for the month is \$6,000, which means she can lose up to \$6,000 in revenue before hitting a negative net income, or a net loss.

Percentage

If she calculates her margin as a percent of sales, she’ll get:

Margin of Safety (percent) = ((Current Sales – Breakeven Point) / Current Sales) x 100

Margin of Safety (percent) = ((\$18,000 – \$12,000) / \$18,000) x 100 = 33

Jordan’s \$6,000 margin of safety translates into 33% of her revenue. In other words, her sales level can drop by 33% before failing to break even.

Number of Units

Finally, Jordan can look at her margin by the number of units, which she’ll calculate as:

Margin of Safety (in units)  = (Current Sales Units – Breakeven Units)

Margin of Safety (in units) = (7,200 – 4,800) = 2,400

Jordan can sell 2,400 fewer cups of coffee in a month before she hits her breakeven point.

How To Use the Margin of Safety

The margin of safety has two main applications. Business owners and managers can use it for accounting and business analysis. And investors use the margin of safety concept when evaluating stocks to buy.

Accounting and Sales Forecasting

Business owners and sales managers use the margin of safety to understand how much wiggle room they have before a revenue decrease turns into a profit loss.

If you have a high margin of safety in your sales, your business has a good protective buffer. You'll likely stay profitable even if sales dip a little bit from month to month. When you have a high margin of safety, you can invest more resources into growing without risking profitability.

On the other hand, a low margin of safety tells you that you don’t have much room for error when it comes to sales, and you should focus on cutting costs if the sales drop.

Investments

You may also hear the term margin of safety if someone is talking about investing. The term was actually coined by value investors Benjamin Graham and David Dodd in the book Security Analysis. Since then, the concept has been applied to accounting and sales.

The margin of safety investors use has a different formula, which calculates the difference between a stock’s market price and its actual value (also known as intrinsic value). When an investor calculates the margin of safety, it tells them how much a stock’s price can drop before they lose money on their investment.

Since it’s not directly related to running your business and staying profitable, we won’t cover it here.

Margin of Safety and P/V Ratio

In business, the margin of safety gives you information on how profitable you are. Another metric you might find handy is the profit/volume ratio, also known as the P/V ratio

The P/V ratio is a financial ratio that tells you how profitable you are based on your sales volume. In other words, the P/V ratio can tell you if you’re more profitable when you have \$10,000 worth of sales or when you have \$20,000 worth of sales.

At this point, you might be wondering, don’t you have a higher profit if you sell more?

Not necessarily.

That’s because your costs can change depending on how much you produce. Sometimes if you sell more, you’ll end up spending more to make that product–so you’ll see less of a profit. That may mean you need to make some changes, like raising prices or getting better deals from suppliers.

You can calculate your P/V ratio with this formula:

P/V Ratio = (Fixed Costs + Profit) / Sales

This all makes sense, but how do you actually use this formula? We’ll dive into an example below to make it crystal clear.

P/V Ratio Sample Calculation

Let’s look at Jordan’s coffee shop again and see what her P/V ratio looks with fixed costs of \$7,000 per month at two different revenue levels:

Jordan's Coffee Shop
Revenue Profit
\$10,000 \$700
\$20,000 \$1,700

At \$10,000 revenue, her P/V ratio is:

P/V Ratio = (Fixed Costs + Profit) / Sales

P/V Ratio = (\$7,000 + \$700) / \$10,000 = .77

At \$20,000 revenue, her P/V ratio is:

P/V Ratio = (\$7,000 + \$1,700) / \$20,000 = .435

Interpreting P/V Ratio

A higher P/V ratio indicates a higher profit margin. So Jordan has a higher profit margin when she sells \$10,000 worth of goods than when she sells \$20,000. This indicates that Jordan has more variable costs associated with her sales. The more she sells, the more her costs increase.

If you want to increase your P/V ratio and get a higher profit margin, you can increase your sales price or reduce variable costs, like packaging or sales commissions.

Understanding Profitability with Margin of Safety

You don’t need to be an accounting genius to run a business, but you need to understand profitability and be prepared for sales to change unexpectedly. The margin of safety formula can help you figure out how much room you have before your business stops being profitable. From there, you’ll have the information you need to decide if you should invest in new growth or focus on controlling costs.

Now that you know all there is about the margin of safety—all that’s left to do? Start plugging in those numbers!