The safety margin, an essential financial ratio for the company
The life of a company is not a long quiet river, it is punctuated by pitfalls that can affect its profitability, even its sustainability.
Indeed, there are many reasons to see its turnover fluctuate: competition, context (especially in these troubled and uncertain times with the health crisis related to Covid-19), strategic factors (such as the weather for some sectors of activity) or the evolution of consumer habits, as it is the case in recent years with the explosion of online sales.
These fluctuations represent a risk for the financial health of companies, commonly referred to as “operational risks”.
“How to improve sales forecasts to deal with these risks” is therefore one of the questions we naturally ask ourselves. One of the possible answers is to take into account the company’s financial ratios in the elaboration of the sales forecast, in particular the margin of safety: zoom on the definition of this profitability indicator.
What is the safety margin?
The safety margin represents the difference between the turnover and the break-even point. These two indicators, the safety margin and the break-even point, are part of the essential financial ratios for the sustainability of a company.
The break-even point determines the minimum turnover to be achieved over a given period in order to cover all the company’s expenses. This is the break-even point (or financial balance). We include in this notion of expenses both fixed expenses (rent, salaries, depreciation, etc.) and variable expenses directly linked to the activity of the operating cycle (purchases of goods or raw materials, subcontracting, etc.).
When the turnover exceeds the break-even point, the company makes a profit, below which there is a loss. What about the safety margin?
The break-even point provides information on the critical sales figure, while the margin of safety indicates the drop in sales that a company can bear without incurring a loss. In addition, the safety margin is used to calculate the safety index. The higher the security index, the less risk the company faces. For example, a company with a safety index of 0.255 means that it can suffer a 25% loss in sales before there is any impact other than a loss of profits.
The safety margin is therefore an indispensable financial indicator in that it allows strategic decisions to be made before the risk is realized. As the name suggests, it is a margin of maneuver that allows you to anticipate fluctuations and take the necessary actions. Taking into account the safety margin in its sales forecast allows a company to be more reactive in its choices.
Thus, integrated in the sales forecast, the margin of safety is a useful indicator for the elaboration of the company’s strategy on the short, medium or long term, as:
- the implementation of marketing actions to reduce excess inventory (costly for the company) or to increase sales on a product that will soon be obsolete or outdated and thus reduce losses and unsold products;
- the development of a dynamic pricing strategy, such as increasing the prices of the best-selling products over a given period of time;
- optimization of logistics costs, as it allows for the analysis of variable costs (we will come back to this in the following);
- the determination of the company’s capacity for investment and innovation, since the safety margin indicates the profits made;
- etc.
Finally, thanks to artificial intelligence, and in particular machine learning, integrating the margin of safety into sales forecasting models makes it possible to simulate several scenarios in order to choose the most effective strategy adapted to the company’s objectives. Thus, in addition to being able to identify and anticipate customer behaviors in the implementation of a marketing action for example, it is now easy with these new solutions to see the direct and real-time impact on the safety margin.
How to calculate your safety margin?
The calculation of the safety margin is, on paper, very simple. All you have to do is subtract the break-even point from the sales figure. But you still have to calculate the break-even point first. This is where things get a little tricky, as several intermediate calculations are required.
Here is the break-even formula: break-even = fixed costs/variable cost margin.
Unless you already have the contribution margin, you will have to calculate it. To do this, we will need to know the company’s variable costs, which are indicated in several accounting documents, such as the income statement, the intermediate management balances table or the balance sheet.
The first step in calculating the contribution margin is to calculate the contribution margin, i.e.: sales revenue – variable costs.
Note that the contribution margin can be calculated globally for the company’s activity, but also according to certain selection criteria (by product or service, by product family, by sub-activity within the company, etc.). The point of this clarification is certainly not to lose you in the intricacies of accounting, but to emphasize the advantages of the segmentation of the calculation, such as the analysis of the performance and profitability of each product or sub-activity in order to abandon or optimize the one that is not profitable enough.
Once the margin on variable costs has been obtained, it is divided by the turnover to obtain the margin rate on variable costs.
All that remains is to calculate the break-even point and the safety margin.
To summarize, the calculation of the safety margin involves 4 steps:
- calculation of the contribution margin, i.e., sales – variable expenses;
- the calculation of the contribution margin, i.e. the contribution margin/realised sales;
- the calculation of the break-even point, i.e. the fixed charges/variable cost margin rate;
- the calculation of the safety margin, i.e. the turnover achieved – the break-even point.
To go further, it is also interesting to calculate the security index to know the percentage of loss of turnover that the company can bear. This calculation is, this time, very simple: the security index = the security margin / the realized turnover. To obtain the rate, simply multiply the result obtained by 100.
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Quantitative methods for forecasting product sales
While qualitative forecasting is subjective, quantitative forecasting is based on objective and precise calculations. These methods are used when the analysis of historical data gives enough information to build a successful sales forecasting model. Quantitative models consist of reproducing the structure of the past to forecast the future, by extrapolating past data.
Simple quantitative methods
Simple quantitative methods are based on the use of relatively simple mathematical formulas. Although they do not take into account the demand variables that can affect the data, they still allow for the first approximate forecasts to be made of possible variations in demand.
To do this, the company can use a mathematical formula specific to one of these three calculation methods:
- the extreme points method;
- the double mean method, known as Mayer’s method;
- the least squares method.
The moving average method
The moving average method eliminates fluctuations in sales data due to seasonal and random variations. Moving averaging involves dividing a given period (year, quarters, months, etc.) into several periods and calculating each average. For example, sales can be averaged for each three-month period in a year. To forecast the next year’s sales, simply average the averages for the same periods and so on. This forecasting model is best suited for a company that is already well established in its market and has a large data history.
Exponential smoothing methods
Exponential smoothing of a data set is based on the idea that the future depends more on the recent past than on the more distant past. In this sense, the smoothing method gives more weight to the most recent sales data. This model is most suitable for growing companies. Exponential smoothing methods include:
- simple exponential smoothing, only suitable for data series with no trend or seasonality;
- double exponential smoothing, suitable for data series with a trend;
- Holt’s method, an improved version of double smoothing;
- Winters’ method, adapted to data series with seasonality and trend.
Regression and correlation methods
The regression method consists of showing the evolution of a variable in relation to another variable (simple regression) or to several other variables (multiple regression). For example, the regression model can analyze the relationship between sales revenue (dependent variable) and advertising expenditure (independent variable).
The correlation expresses the strength of the relationship between the variables under study. The calculation of the correlation coefficient allows to measure the degree of correlation: if the correlation is strong, the sales forecast will be all the more precise and reliable.
All these qualitative and quantitative forecasting methods are not exclusive. By combining the methods, the company can limit the uncertainties and maximize the reliability of the forecast.
Interested in learning more? Schedule a meeting today and see what Bamboo Rose Decision Intelligence can do for your brand!