How to calculate margin of safety

Keeping an eye on outgoings and profit margins is an everyday occurrence for businesses. It’s also important for company accountants to keep a close eye on the margin of safety.

What is the definition of "margin of safety"?

The margin of safety (MOS) is the difference between your gross revenue and your break-even point. Your break-even point is where your revenue covers your costs but nothing more. In other words, your business does not make a loss but it doesn’t make a profit either.

Any revenue that takes your business above the break-even point contributes to the margin of safety. You do still need to allow for any additional costs that your company must pay. 

Generating additional revenue should not make a difference to your fixed costs. As their name suggests, fixed costs (also known as overheads) remain the same from one billing cycle to the next. They may, however, increase your variable costs. Variable costs are calculated each billing period. This is because they generally reflect usage. They may also directly reflect your own costs.

So, the margin of safety is the quantifiable distance you are from being unprofitable. It’s essentially a cushion that allows your business to experience some losses without suffering too much negative impact. The bigger the margin of safety, the lower your risk of insolvency.

How to calculate margin of safety

To calculate the margin of safety, subtract your break-even point from your revenue. For example, if Company A made £200,000 in sales with a break-even point of £100,000, they have following margin of safety:

The margin of safety can also be represented as a percentage using the margin of safety formula.

Margin of safety formula

Use the margin of safety formula below to find your MOS percentage:

The margin of safety percentage can also be worked out using forecasted sales. This is useful for businesses making plans for the future. 

The margin of safety formula can be applied to different company departments or even to individual products or services. This gives an idea of how risk is spread throughout a single company. 

In some cases, having a low margin of safety may be a risk you are willing to take. For example, the management team may see it as a temporary issue that will be resolved by future improvements.

What is a good margin of safety percentage?

Generally speaking, the higher your margin of safety, the safer your company. The value represented by your margin of safety is your buffer against becoming unprofitable. In the real world, the minimum margin of safety percentage to aim for generally depends on your cost structure.

If your costs are largely variable, then a margin of safety percentage of 20%–25% may be acceptable. This is because you are probably more able to scale down costs in slow periods. If you have many fixed costs, then it’s advisable to have a much higher minimum margin of safety percentage. In this instance, 50% is probably a bare minimum. Ideally, aim for at least 70%–75%.

For example, Company A has a margin of safety of 50%. This is calculated as follows.

This is a comfortable figure if Company A has minimal fixed costs. If its sales decrease, it can probably take steps to scale back its variable costs. If, by contrast, Company A has many fixed costs, its margin of safety is relatively low. Ideally, it would look for ways to improve it.

Margin of safety calculation per unit

Use the margin of safety formula to calculate your margin of safety in units sold. To do this,  adapt the formula as follows.

Margin of Safety = (Actual Sales – Break-even Point) / Selling Price per Unit

This means if Company A is selling units at £100 each, the margin of safety calculation might look like this:

This gives a buffer of 1,000 units before the business becomes unprofitable. In other words, Company A could lose 1,000 sales and still break even. The 1,000 sales above the break-even point therefore contribute to the margin of safety. They may also have higher profit margins as they will not increase fixed costs (only variable ones). Use this information to decide if you want to expand or reevaluate your inventory. It can also help you decide how secure you are moving forwards. If you focus on seasonal goods, keep an eye on this margin to guide you through off-peak sales periods.

How to improve the margin of safety

There are essentially only two ways to improve the margin of safety. The first is to reduce costs, particularly fixed costs. The second is to increase revenue. Options for decreasing costs include:

• Purchasing infrastructure ‘as a service’ instead of buying it outright.

• Improving productivity to create more units for the same resources.

• Removing the products/services with the lowest profit margins.

• Updating your payment infrastructure.

Options for increasing revenue include:

• Increasing the sales price.

• Implementing a new pricing model.

• Expanding your marketing.

• Updating your payment infrastructure.

Importance of your payment infrastructure

The fact that updating your payment infrastructure can both reduce costs and increase revenue justifies making it a top priority. Using a modern payment gateway such as GoCardless substantially cuts down on your administration. This means it cuts down on your administrative costs.

For example, with GoCardless, set up both recurring and one-off payments in advance. They are collected either as soon as possible or on your specified date. If you use GoCardless with a partner integration (e.g. Xero, Quickbooks or Sage), transactions are created, charged and reconciled automatically. This vastly reduces issues with late payment and hence can vastly improve your cash flow.

Using the right payment gateway also helps to increase your revenue. One of the most fundamental concepts in sales is to make it as easy as possible for people to do what you want them to do. From a customer’s perspective, there is really nothing easier than Direct Debit. They just need to set up a one-time authorisation and you take care of the rest. They are still fully protected under the Direct Debit Guarantee.

Benefits of paylinks

With GoCardless, leverage Instant Bank Pay to improve both your revenue and cash flow. With Instant Bank Pay, send your customers paylinks for them to approve payment. Once approval is granted, funds can be confirmed immediately. They are usually paid out to you on the next working day.

Paylinks resolve the security issues long associated with traditional Faster Payments. They are still very simple for customers to use. In particular, they’re explicitly designed to be mobile-friendly. 

Using paylinks can open up new options for you. These can increase overall revenue and hence the margin of safety. For example, run highly time-limited special offers to encourage customers to act quickly. They can provide the goods or services immediately because they know their payment is confirmed.

We can help

GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.