Lessons · Accounting · the margin of safety
The margin of safety
How far sales can fall before the business stops making a profit: current sales minus break-even sales, often given as a percentage of current sales.
Hone is a place to practise a career, one idea a day. This is one of its lessons, written out in full and free to read without an account.
In beta. This lesson was written for Hone and has not yet been checked by a qualified accountant. Practice material, not professional advice. What that means.
What it is for
It turns two numbers a board already has into a statement about risk. Two businesses can make the same profit while one of them is 5% away from a loss and the other is 40% away, and the profit figure alone will never say which is which.
How to think about it
Work out break-even in the same units as your sales figure. Subtract it from current sales. Divide by current sales for the percentage.
Worked example
Break-even 3,000 units at 25.00 = 75,000 of salesBreak-even expressed in money, to match.
Current sales 100,000Where the business is now.
Margin of safety = 100,000 − 75,000 = 25,000The room before a loss.
As a percentage = 25,000 / 100,000 = 25%A quarter of revenue could go before profit does.
Your turn
Sales 100,000 and break-even 75,000. Write the line that gives the percentage.
Margin of safety = 25,000 / = 25%
Solve one, graded on the server
The trap
Dividing by break-even sales instead of current sales. It gives 33% here rather than 25%, and it flatters the business at exactly the moment somebody is relying on the figure to judge risk.