All firms, regardless of industry, are concerned with revenue and expenses, as these figures determine an organization's profit or loss. This information alone makes evident the importance of recognizing the level of output that's necessary to earn a certain profit.

In turn, information regarding a desired profit level trickles down the organizational structure as different departments plan production runs, hire employees and seek financing to support the specified objective.

In the process, leaders must first decide whether any particular investment is worth its cost in terms of the degree it will contribute to the achievement of the company's top-level objectives. For instance, some might evaluate changes to a production line while others might consider the benefit and cost of a new marketing campaign.

One way a leader answers such questions is to perform a break-even analysis. It tells her, for example, the number of incremental units the company must sell to make the money back that's invested in a new marketing campaign.

During the process, the decision-maker will pay particular note of the "margin of safety."

Break-Even Point Example

Break-even analysis identifies the minimum level of sales necessary for a company to cover the related costs.

At a break-even point, the revenue earned from the sale of a number of items equals the costs incurred to produce and sell them.

For example, assume a break-even volume is 3,200 units. In this case, if a manufacturer sells 3,200 units over the company's lifetime, it will recover the fixed costs invested in production and the sale of those units.

Selling fewer than 3,200 units will result in a loss. (There is no negative break-even point.) Selling more than 3,200 units results in a profit.

Break-Even Analysis 

There is no doubt that the objective of any for-profit organization is to make a profit. Firms attempt to operate in a space that’s to the far right of the break-even quantity. This means the company's intent is to sell as many products as it can produce using current resources.

Once the break-even quantity (BEQ) is known, companyies compare that quantity to the actual quantity they’re producing. If actual production is above the break-even point, they’ll make a profit and their firms will be operating in a safe space.

The risk of backsliding into the danger zone – to the left of the break-even point – depends on how far above the break-even point actual production is. The greater the distance production resides to the right of the break-even point, the greater the margin of safety.

Also, the greater that distance, the greater the company's profitability.

Margin of Safety Formula

Suppose Bravo Boats plans to manufacture and sell 50 boats each month. The company determines that its break-even quantity is 35 boats per month.

The margin of safety equation is 50 - 35 = 15 boats per month.

If Bravo Boats sells fewer than 35 boats per month, the company will incur a loss. In this case, there is no safety margin.

Considerations for BEQ and the Margin of Safety

The BEQ recognizes the number of incremental units beyond current production a company must sell to justify a proposed investment. Because it's difficult to say for sure what sales volume was due to a sale, a coupon offering or even the shutdown of a competitor's production line, it's also difficult to commit to the outcome of a break-even analysis.

The benefit of identifying the margin of safety lies in its use as a practical planning tool, measuring the risks that leaders should consider during the planning process.