‘Margin’ of safety

Margin of safety is typically associated with investing. It is a term introduced by Benjamin Graham and later popularised by Warren Buffett. What it means is to buy a business well below its intrinsic value so that the risk of investment loss is mitigated.

This article is about a different margin of safety — the operating margin of a business.

After all my years in consulting I have come to realise that businesses with high operating margin are easier to run — not to mention ‘more fun’ — compared to their low margin cousins.

When the times are bad, these businesses can afford to reduce margins without bleeding red and when the times are good, they can indulge in a few extra pounds of weight without undergoing guilt pangs about losing competitive edge.

High-margin business

High operating margins are possible when there is a huge positive gap between a) value perceived by the customer and price of product/service and b) price of product/service and cost of providing it.

What this means is that the customer sees a lot more value from the product/service than the price that he pays for it and the cost of providing it is significantly lower than the price.

Low-margin business

As a result there is ample room for setting the price and incurring costs, depending on what delivers the required returns to shareholders and what is sustainable.

Low operating margins, on the other hand, occur when there is narrow gap between the customer’s perception of value from the product/service and the price that he pays for it.

Also, in such cases, the cost of providing the product/service is only slightly lower than the price.

Changing the customer’s perception of value is usually very difficult and something that’s intrinsic to the nature of the industry in which the business operates in.

So, the only variable that can be controlled by such businesses from a margin perspective is costs.

Improving efficiency

When low-margin businesses face a downturn, they are forced to run helter-skelter trying to save every penny to avoid swinging into a loss.

Such companies typically try to reduce costs by launching efficiency improvement initiatives that address strategic, structural, process-oriented, people-related or technological issues.

Popular frameworks used in this context are Lean, Six Sigma, TPM, and so on.

The problem though is that, while all these initiatives are good in identifying ‘waste’, it is very difficult to eliminate it in its entirety.

A lot of times it is just not practical or feasible to do so despite the best intents.

Secondly, efficiency improvement initiatives are good at producing one-time savings, but they fail to sustain the savings over time. You can always put the blame on lack of continuous improvement ‘culture’. But we are humans and not robots. So, inevitably ‘waste’ starts gathering surreptitiously and starts impacting the already sensitive margins.

Cyclical nature

While the economy is booming and the business is clocking healthy growth, ‘waste’ is easy to overlook and can be justified in the name of growth.

Gradually, overheads accumulate and reach their peak, funnily, just before the next turn in businesses cycle.

The business now has to go back to square one and begin ‘cleaning the house’ for efficiency all over again.

This cyclical nature of efficiency improvement prevents low-margin businesses from breaking out into a high-margin businesses purely through cost savings.

The exception to this rule is efficiency improvement brought in through fundamental change in paradigm.

For example, GEICO has become the most efficient auto-insurance provider in the US by focusing on selling policies online directly to customers, cutting out the middlemen in the process.

(The author is a business consultant. The views are personal. Feedback can be sent to perspective@thehindu.co.in )

COMMENT NOW