Marginal Cost + Sales cost v Revenue
Anyone who has been subjected to sit through one of my lectures, will know that I love Economics. I am so grateful to Mr. Shellard at my college for encouraging me to pursue this subject.
Economic concepts are so highly relevant to understanding business models and profits and I think more entrepreneurs need to understand concepts such as marginal cost and marginal revenue. But I think an important piece in this equation often gets missed which I hope to illustrate in this blog; the cost of acquiring and keeping a customer.
Marginal cost is simply the cost of producing the last unit. Some businesses have zero or very little marginal cost. So a cinema for example will have a zero marginal cost (the cost of allowing one more person to ‘consume’ a film). Equally, the transport industry has zero or virtually zero marginal costs. How much extra would it cost to sit one more person on an otherwise full flight from London to New York? Perhaps $50?
Economic theory states that providing you can cover the marginal cost (and do not confuse marginal cost with average cost) you are always better off making that trade. Profit is maximised where Marginal Cost is equal to Marginal Revenue. This is very much the pricing model that airlines and hotels adopt.
But, you can still be making big losses as a business even if you are covering marginal costs (because you may not be covering average costs). Again an airline may have a very expensive average cost of a flight – and the breakeven may be to get the flight 70% full. But given that most of the costs are going to be incurred anyway, providing they can get marginal costs covered, it is always a better decision to accept that additional ‘contribution’ to the average cost.
Digital businesses often assume that they have zero marginal costs. This is true to a certain extent. But what is often missed by a lot of businesses I deal with is the cost of selling to a customer and then keeping that customer.
It is easy to think of your cost of production – and thats it. But what about the time, effort and SEO cost that goes into acquiring that customer?
And many people will want customer service – that can be thought of as a marginal cost (if x% of people will phone and take up y% of time, you can add that to the cost). Often businesses fail to make a profit because they confuse this element as a fixed rather than a variable cost. The business plan assumes that this overhead is fixed and not related to sales volume. This is not true.
One of the companies I spent some time with recently, wanted to employ some account managers and I had to show them that there simply was not enough margin in their pricing for them to afford to do this (even though it would grow revenue).
Entrepreneurs have to remember the old adage from Economics “Sales is vanity, profit is sanity, but only cash is reality”.
Have you worked out the true cost of each sale?
