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:
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!
1. Introducing Yourself
Your introductory email needs to pack a lot of information into a small package. Try something like this:
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Hello Jane,
My name is John Doe and I work for ABC Agency, where we provide business insurance policies to many of Dallas' rockstar small businesses.
Congratulations on your new business, Jane's Bakery. Are you wondering if you have all the insurance you need? Or if your policies will really cover you in a pinch?
At ABC Agency, we pride ourselves on providing robust, comprehensive coverage options to companies like yours with flexible, pay-as-you-go plans.
Are you available this week to talk more about how we can help? I can help you find the most affordable rates and the best policies out there.
I look forward to speaking with you soon.
Cheers,
John Doe
2. Presenting a Quote
Once you've met with your potential client, a quick reply with their quote will get the ball rolling.
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Hi Jane,
Thanks so much for meeting with me this morning. I loved touring Jane's Bakery–I can still smell those delicious chocolate chip cookies baking! You have a great location, and I'm sure you're going to do great on Front St.
After reviewing my notes, I've pulled together an insurance quote for you (attached). I recommend a business owner's policy. A BOP includes several insurance products in one: liability, property insurance, and business interruption insurance. It offers robust coverage at a competitive price.
I'll call you in a few days to see what you think about this insurance plan. In the meantime, if you have any questions, don't hesitate to email me or call me at [phone number].
Again, thank you for your time today. I look forward to working with you in the future.
Cheers,
John Doe
3. Thanks for Purchasing a Policy
Gratitude is important! It's never a bad idea to thank your clients for their business.
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Hi Jane,
Thank you for choosing a business owner's policy with ABC Agency. We know it's so important to get the right coverage for your business, and we are honoured you've placed your trust in us.
We're excited to work closely with you, and our no. 1 goal is to make sure you're business is always protected.
Do you have any questions? We are here to help. Reach out whenever something comes to mind.
Thank you again for choosing ABC Agency to insure Jane's Bakery.
Cheers,
John Doe
4. Welcome Email
A welcome email helps clients feel like you're there to help–and can softly pitch other insurance products you offer.
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Dear Jane,
Welcome to the ABC family! We are thrilled to have you as a new customer and can't wait to meet all of your insurance needs.
As an independent insurance agency, we work with multiple insurance providers to find the best coverage options for all our customers. If you need any other type of insurance–like [include additional offerings unique to your agency, like life insurance, health insurance, home insurance or anything else]–we can help you too.
Do you want to discuss any of these policies?
Cheers,
John Doe
5. Introducing a New Product
A happy client may want to expand their business with you.
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Hello Jane,
I hope all is well with you and Jane's Bakery. I stopped in yesterday for a blueberry muffin and coffee, and they were delicious. I loved the hint of cinnamon in the muffin! Was that your idea?
I wanted you to be the first to know we are now offering commercial vehicle insurance to our policyholders. Auto insurance for your catering vans is super important since your personal car insurance won't cover them.
We're offering this insurance coverage solely to our current business clients at the moment and have some very competitive rates.
Would you like me to work up a quote for you?
As always, thanks so much for being a part of the ABC family.
Cheers,
John Doe
6. Asking For Referrals
Once your relationship is established and comfortable, let your clients help you grow.
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Hi Jane,
You've been a valuable member of the ABC family for two years now, and we so appreciate your business–not to mention the muffins you supply for our monthly meetings!
Because you are a valued policyholder, I wanted to ask a quick favour. I know you are active in the local Chamber of Commerce, and I'm hoping you might know some colleagues who would benefit from working with our insurance company.
Referrals are one of the most effective ways to connect with our community since people really trust their friends, family and colleagues. Is there anyone you'd recommend I speak with?
Remember that in addition to business insurance products, we offer everything from life insurance policies to pet insurance.
As a thank you for your help, we will send you an Amazon gift card of $100 when your referrals buy insurance from us.
Thanks so much for your help!
Cheers,
John Doe
7. Policy Renewal
If your client needs to renew their policy with you, send an email like this:
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Hi Jane,
I hope you're doing well! What a year it's been—from being listed as one of the top 5 bakeries in Dallas to being an official vendor for the city—you have so much to be proud of.
Just a heads up that your business owner's policy is up for renewal soon and will expire on June 15, 2023.
If you're still happy with the coverage, we can easily renew it for you.
Do you have some time to chat this week?
Looking forward to serving you again!
Cheers,
John Doe