The margin of safety is a financial ratio that will tell you the percentage of sales you can afford to lose before you cannot cover your overhead. It can be calculated on a yearly basis by reviewing the annual accounts or monthly if you generate your own monthly profit and loss statement.
The calculation is Net Profit divided by Gross Profit x 100.
Gross profit for a pizza shop is simply Sales minus Cost of Sales. What is the cost of sales? The direct costs incurred in the preparation of the pizza are the cost of the ingredients.
For example, if a pizza shop business generates a net profit of $10,000 after owner’s salary and overheads (eg: rent, power, staff wages, etc.), its gross profit result is $140,000. Thus the margin of safety is just over 7 percent.
This means that this operation can afford to lose only 7 percent of its sales before it cannot cover expenses.
The margin of safety is a ratio that can be used to quickly compare businesses and provides a quick health check result. Obviously, the higher the percentage the better.
The margin of safety is also important when new pizza shops open in your locality. What happens when you have new competition? Well, put yourself in their shoes. What do you have that they do not have? Customers. How do they endeavor to get your customers? Easy–they will probably use price discounting as the weapon.
Therefore, what do we do to combat this new threat? We battle them at their own game. We start discounting and letterbox drops with 2-for-1 offers and other great deals. The winner is the consumer, the loser is the pizza shop with the lowest margin of safety in the area. When you cut your price and start giving product away, you are cutting your gross profit and there is only one direction your safety factor is going. South.
The pizza shop that gets to zero first loses!
In one of my next articles, I will examine how we can increase our margin while still discounting and doing deals. Did you know there are over 50 factors that affect your margin in a pizza shop and price is only one of them?