What is a margin of safety?

Definition

The margin of safety is the gap between current sales and the sales level where the period's costs are just covered. On the books, this is a cushion you read from the Income Statement, not a ledger account.

A cafe that sits well above that covering level can lose some quiet weeks and still pay rent and kitchen wages. A thin gap means a quiet Saturday can put the month underwater.

This figure can be stated in dollars, in tickets, or as a percent of current sales. It is not a line on the Balance Sheet.

Accrual books use the period's recorded sales and recorded costs. Cash-basis books can show a different cushion if deposits were collected early or a utility bill is still open.

Where it shows up

P&L: Related to how far current sales sit above break-even.

Balance sheet: Related to the fixed-cost obligations that must still be covered if sales fall.

See also: Break-Even Point · Contribution Margin · Revenue

When you look at your Income Statement, you will not see a printed cushion. You see revenue, the costs that move with each ticket, the bills that stay put, and what is left after those costs.

If that leftover is large, the cafe has room before a slow week hurts. If it is small, a few cancelled shifts can drop the month below the covering level.

The Balance Sheet does not list this cushion. Related amounts show up as current liabilities and prepaid occupancy that still have to be covered if sales fall.

On the Statement of Cash Flows, collecting from customers and paying rent are the cash events. The cushion itself does not move cash; it is a reading of how far sales sit above the covering level.

Food and supply inventory sit in current assets until they are sold. Those dollars join the moving costs only when they leave with a ticketed order.

How it works

The cafe first finds the sales level where the period's costs are just covered. Subtract that covering level from current sales, and the difference is this cushion.

You can state the cushion as:

• Dollars of sales above break-even
• Units (tickets or covers) above break-even
• A percent of current sales

The same gap can be written as a percent of current sales. A $20,000 gap on $80,000 of sales is a 25 percent cushion.

If the leftover on each ticket shrinks, the covering level rises and the cushion shrinks. If rent rises and the leftover holds, the covering level also rises.

Stay with this gap when you read the number. It is not the leftover on one ticket, and it is not the month's profit.

Cost of goods sold is where food cost and supplies usually land. Those moving costs have to be subtracted before you know how far sales can slip.

If you raise the price of a ticket and the number of tickets holds, the covering level in tickets drops and the cushion grows. If you add another salaried desk role, the covering level rises.

A month that is already above the covering level can still feel tight in the bank. Prepaid rent or a late supplier bill can move cash without changing this gap.

Example

Oak Lane Cafe takes in $80,000 in a typical month. Each $20 average ticket leaves $8 after food cost and card fees.

Monthly rent, insurance, and salaried desk pay total $24,000. Those bills do not move with the day's covers.

The covering level in tickets is $24,000 divided by $8, or 3,000 tickets. In dollars that is 3,000 times $20, or $60,000 of sales.

Current sales of $80,000 sit $20,000 above that covering level. The cushion is $20,000, or 1,000 tickets, or 25 percent of sales.

Current sales          $80,000
Break-even sales       $60,000
Margin of safety       $20,000  (25%)

At $70,000 of sales the cafe is still $10,000 above the covering level. At $55,000 of sales the month is short $5,000.

If a street closure cuts weekend traffic and sales fall to $62,000, the remaining cushion is only $2,000. One more quiet Saturday would put the month underwater.

Oak Lane does not post a line that says this cushion. The books post sales, product cost, rent, and wages; the figure is the gap between those sales and the covering level.

Common mix-ups

This cushion is not the same thing as profit. Profit is what is left after all costs; this figure is how far sales can slip before that leftover hits zero.

This cushion is not a ledger account. You do not debit or credit it when a busy night is cancelled.

This cushion is not the leftover on one ticket. That leftover helps you find the covering level; this figure is the room above that level.

Related terms

• Break-Even Point: The sales level at which total revenue exactly covers total costs.
• Contribution Margin: Revenue minus variable costs, showing what is left to cover fixed costs.
• Revenue: The total value of goods and services the business earned in a period.
• Fixed Costs: Costs that stay roughly the same regardless of sales volume.
• Operating Income: Profit from core operations before interest and taxes.
• Scenario Planning: Modeling several plausible futures to see how the numbers hold up.
• Sensitivity Analysis: Testing how much the outcome changes when one assumption moves.
• Forecast: An updated projection of where the numbers are actually heading.