Margin of Safety

An owner can be paid on schedule, by the book, from a business that cannot afford it. The draw arrives on the same date every month. In the good months, profit covers it. In the slow months it comes out of the reserve, or out of the suppliers, who get paid a little later than they should. Nothing about the payment looks wrong. The trouble lies in the distance between the profit and the draw, and in many small businesses nobody measures that distance until it has closed.

Margin of Safety measures it and keeps it open. It builds enough operating profit above breakeven to pay the owner with a cushion, and it identifies which lines produce that profit, so the owner knows how much room the business has and where the room comes from.

The name comes from engineering, by way of investing: a structure built to carry more than its expected load, so that an unexpected one does not bring it down. Here the load is the owner's draw and the structure is the business's operating profit.

Knowing what each line contributes

The work starts with knowing, each month, the contribution margin of every significant product or service line: revenue less the direct and variable costs of that line. Then the lines are ranked, and the ranking that matters is by contribution per unit of whatever the business runs short of first. That order can look very different from the order by contribution per sale.

Every business has a binding constraint, the resource that runs out first when orders rise. It might be crew hours, machine time, seats or delivery slots. Once that resource is full, every hour given to one line is an hour taken from another, so the useful question becomes which line earns the most per hour of the constraint.

In the illustration, installations earn $600 a job against $90 for a maintenance visit, and look like the business's best work. But an installation takes ten crew hours and a maintenance visit takes forty-five minutes. Per crew hour, maintenance earns $120 and installations earn $60. When the crew is full, selling maintenance plans makes the business more money than winning installations does, which reverses the ranking by job.

Producing the ranking takes two pieces of setup. Every expense account in the chart of accounts is tagged once as fixed, variable or direct, so the contribution report comes out of each monthly close without being rebuilt by hand. And the constraint is measured, from the capacity record kept under Demand Engine, so contribution can be divided by the hours each line uses. The ranking then goes on the monthly report and decides where new sales effort goes.

A buyer capitalizes operating profit, so effort spent on the lines that pay least per hour of the constraint is profit the business could have earned and did not. Acting on the ranking takes away the buyer's reason to discount the size of the earnings: the business is presenting the most profit its constraint can produce.

Acting on the ranking

The ranking changes nothing until someone acts on it, and there are only a few things to do. Sales effort moves toward the lines that earn the most per hour of the constraint, so the maintenance plan gets offered on every call and the installation enquiry gets a quote that reflects what it really costs in crew time. The lowest-ranked line can be repriced to earn its share of the constraint, which is often the simplest move. A line that still loses money after its share of the fixed costs can be dropped, which raises margin and frees its capacity for better work in the same quarter.

These moves are valued like any other change in cash flow. If the business in the illustration moves forty crew hours a month from installations to maintenance, it gains $60 on each of those hours: $2,400 a month and $28,800 a year. After an illustrative 25 percent tax rate that is $21,600 a year, and capitalized at a 20 percent cost of capital it adds about $108,000 to the value of the business. All of it comes from deciding where the crew's time goes, with the same customers, staff and capital as before.

Profit that covers the draw with room to spare

The second half of the driver is the cushion itself. Over the latest year, operating profit before any payment to the owner should comfortably exceed the draws paid in the same months, and it should cover the month's draw in nearly every month of that year.

The year and the months test different things. A year can be covered on average while several months are not, and in those months the draw was paid from something other than profit. A buyer looking at the months will see the pattern. A lender looking at the same months will see a business whose earnings only just pay one person.

The cushion has a plain meaning. If operating profit before owner pay is $112,000 and the draws total $84,000, profit could fall by 25 percent before the draw stopped being covered. That 25 percent is the business's protection against a slow season, a lost customer or rising costs. A cushion of a few percent gets used up by an ordinary bad month. With a real one on the record, the buyer can see the owner's pay was earned from profit and has less reason to doubt that it will be again.

Two habits produce it. The first is to report three numbers on one line every month, beside the breakeven revenue on the monthly report: operating profit before owner pay, the draw paid, and the difference. The owner then reads the cushion every month instead of hearing about it from the accountant at year end.

The second is a rule about which comes first, the draw or the cushion. When the cushion falls below the level the business has set and stays there, the draw holds, and the gap is closed by improving contribution: more effort on the highest-ranked lines, a price change through the Pricing driver, or a fixed cost cut through Fixed Cost Discipline. The draw rises only once the cushion has held long enough to show that the good months were not a run of luck. The rule exists because instinct works against the owner here. The natural response to a good quarter is to raise the draw and the natural response to a bad one is to leave it alone, and an owner who follows both ratchets the draw up in good times and pays for it from the reserve in bad ones.

The cushion also enters the valuation directly. One risk a buyer prices at this stage is a cost shock, such as a supplier's price increase, higher wages or an expensive repair. A business with a thin cushion meets the shock by paying its owner from the reserve and then, if the shock lasts, by borrowing. A business with a wide cushion absorbs it out of profit. The chance that a shock pushes the draw onto the reserve is one of the numbers in the valuation, and a cushion that has held above the business's own level for a year is the evidence that lowers it.

What has to be in place first

The driver depends on two pieces of earlier work. The cushion is measured from a breakeven revenue that was calculated under Fixed Cost Discipline, and an owner's sense of where breakeven sits will not do. And contribution by line cannot be computed from costs that sit in one pool, so it needs the direct costs coded by line under Direct Cost Capture. A business that skipped either has no baseline to measure its margin of safety from.

Knowing that it works

Contribution margin by line, monthly, in dollars and as a percentage of the line's revenue, shows where the profit comes from and whether any line is sliding. Operating profit before owner pay as a multiple of the draw, over the trailing year, puts the cushion in a single number to set against the level the business has chosen.

The check that can be put to the owner is to name, without looking, the line that earns the most per hour of the constraint and this month's cushion, and to have both answers match the monthly report. The first tells you whether the owner knows where the business's best work is. The second tells you whether they know how much room they have.

Why it slips, and what holds it

The decay here is operating profit sliding back toward breakeven while the draw stays where it was, until the draw is being paid from the reserve. It usually builds over several months: costs rise a little, prices stay put, and the draw, once raised, is never lowered.

The safeguard is that the draw changes only through the written cushion rule. A draw that can rise only after the cushion has held, and that holds when the cushion falls, cannot outrun the profit that pays it. The rule moves the decision about the owner's pay out of whichever month the owner happens to feel richest or poorest and puts it on the record, where a buyer will later look for it.