Finding the margin of safety on a chart
Definition
Margin of safety: the amount by which a business's actual or planned output exceeds its break-even output, so how far sales could fall before it starts making a loss.
- Start with the break-even output, found where the total revenue line and the total cost line cross, then find the output the business actually reaches, which sits further along the same horizontal axis.
- The margin of safety is the horizontal distance between those two outputs, so it is measured in units of output and both readings come off the output axis.
Example
- Ridgeway Cycles assembles bikes in Bristol, and its chart shows the two lines crossing above 40 bikes.
- The workshop is currently turning out 65 bikes a month.
- So Ridgeway could lose the sale of 25 bikes a month, close to two in every five it currently makes, and still cover all of its costs.
- Anything worse than that and the workshop slips below 40 bikes and starts losing money.
Common Mistake
- The margin of safety is a number of units, not an amount of money, so a margin of 25 bikes is not £25 and not £25 of profit.
- Take both figures from the output axis, because reading one of them off the £ axis by mistake produces an answer that means nothing.
What a large or small margin tells the owner
- A large margin of safety means the business can absorb a fall in demand without tipping into a loss, whether that is a wet summer, a rival opening nearby, or losing one large customer.
- A small margin means even a modest dip in sales pushes the business below break-even, which is a risky place to trade, so the owner needs to cut fixed costs, lift the price, or push sales up.
- Banks and investors read it the same way, because a lender deciding on a loan for Ridgeway wants to see output sitting well clear of break-even before it hands over the money.
- Tracking the margin month by month shows whether a business is drifting towards break-even, which is how a seasonal firm spots trouble coming before the quiet months arrive.
Example
- Aldi sells in enormous volumes far above the output at which a store covers its costs, so its margin of safety is wide and a slow week barely registers.
- A single restaurant that fills only half its tables has a narrow margin, so one quiet fortnight can wipe out the month.
How the margin of safety changes
- When fixed costs rise: Ridgeway's landlord raises the workshop rent, so the whole total cost line on the chart sits higher, and it now meets the total revenue line further along the output axis, at 50 bikes instead of 40.
- When the selling price rises: a higher price on each bike makes the total revenue line steeper, so it climbs to meet the total cost line sooner, and the crossing point moves back to 30 bikes.
Example
- After the rent rise Ridgeway breaks even at 50 bikes, while output stays at 65 bikes a month.
- The same 65 bikes now leaves only 15 bikes of room instead of 25, so a rent increase on its own has left Ridgeway trading much nearer to a loss, which is why higher fixed costs make a business more fragile.
- A price rise instead pulls break-even output back to 30 bikes, with output still at 65.
- The margin widens from 25 bikes to 35, so the price rise makes Ridgeway safer on paper.
- The owner still has to check whether customers will buy 65 bikes at the new price, because a price rise that drives sales down eats the margin away from the other end.
Note
A discount works the other way, flattening the total revenue line so that the crossing point moves further along the output axis, which raises break-even output and narrows the margin of safety.
Where break-even analysis earns its place
- It is quick and cheap. A handful of figures produces a clear sales target, which suits a small firm like Ridgeway that has no finance department and no time to spare.
- It supports real decisions. Before signing a lease, taking on a mechanic, or launching a second model of bike, the owner can see how many extra units those higher costs would have to sell.
- It helps raise finance. A bank reading a business plan can see the output needed before the business covers its costs, and the margin of safety tells it how much slack there is protecting the loan.
The assumptions that weaken it
- It assumes everything made is sold. Ridgeway might assemble 65 bikes and sell only 58, leaving the rest as unsold stock, so the real position is worse than the chart suggests.
- It assumes one selling price. In practice the workshop discounts last season's frames and gives trade customers a better rate, so total revenue is not really the single straight line the chart shows.
- It rests on forecast costs. Rent reviews, energy prices and supplier increases all move the total cost line after the figures were put together, which is exactly what the rent rise did to Ridgeway's margin.
- Break-even analysis is therefore worth most as a first check rather than a final answer, and it is at its most reliable over a short period for a business with steady costs and one main product. Ridgeway should redo it whenever the rent or the trade price of frames moves, and read it next to market research on whether 65 bikes a month will genuinely sell.
Note
Break-even analysis shows the output a business needs, never the output customers will actually buy, so a low break-even output is no comfort at all if demand is lower still.
Exam technique
When a question says evaluate the value of break-even analysis to this business, do not simply list the assumptions: pick the one that matters most for that particular firm and say why it does.
Self review
- Which two outputs do you subtract to find the margin of safety, and where do you read them from?
- A chart shows break-even at 40 bikes and actual output of 65 bikes: what is the margin of safety?
- What happens to the margin of safety when fixed costs rise, and why?
- Why does a bank want to see a wide margin of safety before lending?
- Name two assumptions behind break-even analysis that may not hold in reality.
