Margin of safety

What it means

The margin of safety shows how far sales can fall below the planned or actual level before a company reaches break-even and starts making a loss. It is expressed in euros as the difference between sales and break-even sales, or as a percentage of sales.

If a company expects sales of 500,000 euros and break-even is at 400,000 euros, the margin of safety is 100,000 euros, or 20 %. Sales can drop by a fifth before the company slips into loss.

The measure relies on splitting costs into fixed and variable and on the contribution margin. The higher the fixed costs, the higher the break-even point and the thinner the margin of safety.

How it works in practice

The margin of safety is useful in planning, for example before hiring a new employee, renting larger premises or buying a machine. Every new fixed cost pushes break-even up and shrinks the cushion.

Banks and investors look at it when judging how a company would cope with harder times. Together with sensitivity analysis it shows what changes in sales or prices the company can absorb.

In a seasonal business it is worth calculating the margin month by month. The annual average may look healthy while the company survives the weak months only on reserves from better ones.

What to watch out for

A company with high operating leverage sees profit rise quickly when sales grow but falls into loss quickly when they drop. A small margin of safety warns that the plan has to come in almost exactly.

The calculation is only as good as the cost split. If some costs are treated as variable when they are really fixed, the margin of safety looks better than it is.