Margin of safety formula: definition, importance, calculation

By Indeed Editorial Team

Published 3 May 2022

Risk assessment is a very important business practice within companies that want to minimise their risk and maximise their profits. One method of calculating risk that you can use is the margin of safety formula, which can help you to identify and value risk levels. Learning about this formula can help you manage risk within your own workplace and expand your knowledge of risk assessment. In this article, we look at what the margin of safety formula is, how you can calculate it, why it's such an important formula and what situations you can use it in.

What is the margin of safety formula?

If you want to learn the answer to the question 'What is the margin of safety formula?' learning about the situations you can use it in and how you can calculate it is a great way to start. In business, a margin of safety is the difference between how much your company can expect to profit and your 'break-even' point, which is the point you can reach where there is neither any profit nor any loss. You can determine this point by using the margin of safety formula, which includes subtracting your business's break-even point from your current sales.

Then, divide that by your current sales and finally multiply your answer by 100. Adjust your margin of safety if you want to calculate for other values, such as euros or units. It's important you know your margin of safety so that you don't lose money, which can happen if you aren't paying careful attention to your margins at all times. If you aren't periodically conducting this margin of safety formula, you may not even notice when you cross the break-even point. All of this can help to make sure your business stays on the right side of this point.

Why is this formula so important?

There are many important reasons for calculating the margin of safety. These are reasons that can still apply across almost any industry and business. Knowing your margin of safety formula is a great way to minimise risk and gives you the opportunity to increase your profits through cost-cutting and increased sales. Here are some reasons this formula is so important:

Gives you valuable information

When you calculate your margin of safety, you're finding valuable information that you can use to create strategies and determine the very profitability of your business. You can use this margin to help inform you of how certain changes you have made are benefiting the company in terms of profit and sales. There are a huge amount of variables that you can change to affect your margin of safety, so finding the right combination of sales, material, production costs and distribution costs can really help you to increase your margin of safety to better or more acceptable levels.

For example, if you use this formula and find that you have a low margin of safety, you can use this information to reduce your operating costs, increase your sales price or find cheaper materials to make your goods with. If you use this formula and find that you have a high margin of safety, then you can use this information to make riskier business decisions that may have potentially greater and long-term benefits than other 'safer' decisions. Your margin of safety can directly impact how you decide to manage your company and its goods and services.

Related: What does an accountant do? Role and responsibilities

Determines reinvestment

Knowing your margin of safety can help you to determine whether a specific cost or fund is worth you reinvesting in it or not. Not every business decision that you make is going to positively affect your business and your margin of error, but by conducting this formula and studying the answer, you can see how your decision is directly impacting your margins. You can then decide to reinvest in that specific area or increase funding into a totally new area to help reach the position that you want to reach in your margin of safety.

For example, you may decide to upgrade all of the information technology and computer equipment within your business. This decision is costing you a significant amount of money, but you believe that the long-term impact of this decision can greatly improve your business and increase your profits overall, which means that you're eventually getting the cost of this improvement back into your business. If you want to determine whether the upfront cost is actually worth the risk, you can use the margin of safety formula to find out.

Protects your investments

A margin of safety can give your investors a safety net on which they can base their decisions to invest in your company. When you determine your company's margin of safety, you outline just how risky the situation is working with your investors' money. Depending on the type of investors that your company has, such as whether they are risk-averse or aggressive investors, this can affect the flow of funding and investment into your company. This can be a great way for you to attract new investors and money if you can do this successfully and demonstrably.

Related: What are fixed costs? Definition, importance and examples

Places a value on risk

While you can expect some sort of risk during the operation of your business, it's a good idea to keep your risk as low as you can. Exceeding your risk limitations can have serious implications for your business and can directly affect how you choose to manage your company. By calculating the margin of safety within your business, you can assign a risk value to each decision that you choose to make. This value can act as a safety buffer and can help you see the specific level of risk you might have when making similar decisions.

You can use these buffers whenever you're thinking of implementing a potentially risky policy, product or investment. These risk evaluations can help you to make the best decision for your company.

Related: Gross vs net Income (with definitions and examples)

How to calculate the margin of safety formula

Learning how to calculate the margin of safety formula is essential for conducting a thorough risk assessment. This formula can help you avoid making potentially risky decisions and is a great way to see exactly how your company is doing in terms of profitability. Here are the steps that you can follow to calculate this formula:

1. Complete the margin of safety formula

You can start calculating your margin of safety by subtracting the break-even point of your investment from your current sales. You can usually find this information by looking through your ledgers or bookkeeping records, although you can also use an accounting program depending on which you use most frequently. After you find this information, you divide your last calculation by your current sales and then multiply this number by 100. You can then convert this to a percentage to find your margin of safety. Here's how this formula looks:

Margin of safety = [current sales level - break-even point] / current sales level x 100

2. Analyse your margin

Once you have found your margin of safety, you can start to compare it to your baseline or the point that you want your risk to stay at. This is essentially how much of a safety margin you and your company are willing to maintain. The exact baseline of each company can vary and can depend in large part on its company goals and overall finances. People usually consider a higher margin of safety more beneficial, as it means you have a larger buffer in which to correct any mistakes or absorb missed costs.

If you have a lower margin of safety, then you may want to start considering ways to increase this. You can do this in numerous different ways, such as cutting production costs, raising the price of your products or finding cheaper ways to distribute your products. This is all dependent on what exactly your product or investment is and changing one factor may not always have the desired result. Only by carefully researching your problem can you find a solution to raise your margin of safety and make your investments as profitable as possible.

3. Recalculate as needed

You can use this formula as many times as you want when assessing new investments. This is a great way to ensure minimal risk. You can even use this to track changes in your investments over time, allowing you to see their progress.