Verifying the Obviously True May Show …

You likely have seen such signs. It may not be in IKEA parking lot (picture used here only for illustrative purposes) it could be your local grocer. The stores tell us that it is important for us to do our part, because it helps to keep prices low. Seems obvious and sounds true. We could even come up with an explanation on our own – carts left astray in the parking lot cause collision damage that cause liability to the store which flow back to products as higher prices.

We do not stop to question or analyze whether it true, we do our part (mostly) and move on. Which is a civic thing to do, so please continue doing it, I am not recommending otherwise. But I am questioning their not so subtle hint on pricing and the reason we tell ourself.

First let us look at this from pricing angle. How are merchandises priced? They are priced at what the customers are willing to pay such that it maximizes the business’s profit. A  simple explanation of customer willingness to pay  and price elasticity can be found in my book. Here let us look at IKEA’s published FAQ for the explanation:

The IKEA business idea is: “We shall offer a wide range of well-designed, functional home furnishing products at prices so low that as many people as possible will be able to afford them.”

You cannot find a simpler and clearer explanation on pricing. IKEA has chosen to maximize its profit by appealing to as many people as possible. Note that if the prices are any lower than they are now, even more will  shop, so why not do that? Clearly they have to price the merchandises at least above their marginal cost (ignoring loss leaders here) – the cost for the store to acquire, ship and shelf them. Even at prices above marginal cost, after certain point the increase in number of customers by lowering the prices will not deliver incremental profit. So they find a price point at which the profit is maximized.

On the flip side, if they were to increase pricing on certain merchandise then they will find fewer people willing to buy it. They may find that the loss of profit from lost sales is more than incremental profit from price increase.

Back to shopping cart in parking lots. If you followed the pricing for profit maximization argument you can see why. The store cannot simply increase prices to recoup the losses from shopping cart damage liability or any other such costs without affecting the sales/profit. The prices we see now are optimized to the extreme, to their final cent. A moment’s reflection will convince you that if they can indeed raise prices because we are not stowing shopping carts properly without affecting sales/profit they would have already done that – shopping cart or not.

Second let us look at this from cost and execution angle. Each IKEA store sells 10,960 products. Only the marginal cost of the merchandises matter not the fixed cost of operating the building, the interest payments, employee salary or liability insurance premium. Even if the costs were to be allocated to each merchandise, and somehow they have figured out a weighted average method to do so across all 10,960 of them based on their price and sales volume, the increase will likely be very low that we won’t even notice it. Which brings us back to previous point in bolded text, why wait for the damages to go up?

So what we see is a nudge to improve a store’s operational profit by keeping its costs down – be it liabilities or hiring an additional person. None of these can be easily passed on as higher cost without impact on their sales and profit. Do not worry about prices going up.

Next time you see a sign like this, do not take take the pricing reason for granted. Leave the cart in its allocated space because it is the civic thing to do.

Cost Allocation Obfuscation – eBook Pricing

Cost, especially fixed cost allocation, has nothing to do with pricing. Unless you are selling to the Government which allows you to quote only cost plus pricing. Government contractors are more than happy to do so because they not only include the variable cost of making a toilet seat but also add to it its share of all their fixed costs. So when you assign each toilet seat its share of building cost, executive salaries, etc etc you get $2000 as price tag.

Allocating each unit produced, its share of fixed cost is a financial accounting artifact – required by GAAP accounting rules. When convenient, like in obfuscating the true marginal cost to justify higher prices, some businesses are happy to adopt it.

Now publishers are adopting the same obfuscation to justify their eBook prices. Since they  are not selling the value of the book, they are facing challenges from customers expecting lower prices on eBook over hardcover books.

Michael Connelly’s recent legal thriller, “The Fifth Witness,” has more one-star reviews on Amazon than five-star reviews in part because some angry reviewers focused on the e-book’s $14.99 price.

Customers expect publishers to pass on cost savings from paper and printing charges in the form of lower prices. What are publishers resorting to? Obfuscation

Publishers argue it’s impossible to break out a profit per title that includes a percentage of all their costs because all books have unique one-time costs which are broken out over an unknown number of copies. It’s also hard to apply corporate overhead costs against the sales of individual titles.

They are hiding behind cost argument to say their “margin” per eBook is still low and hence it deserves prices that are comparable to hardcover.

If they are not willfully obfuscating, they are just plain ignorant in their cost allocation. Hard to believe.

All these because publishers are not addressing , “what job is the customer hiring a book for”. There is no attempt to sell the value. If the publishers are not differentiating on the content and the customers are not seeing difference between different titles (not their fault), both sides argue about the cost.

Does the customer get any less information value from a eBook than a hardcover book?

The real disruption of the publishing industry is yet to come. We will start seeing, substitutable, undifferentiated, and copious content sold as commodities for less than 99 cents and high value content sold at prices that capture a fair share of the value created for customers.

Until then, publishers, customers and all the media bloggers will focus on costs.

Necessary and Sufficient Conditions for Choosing GroupOn

Read the book: To Group Coupon Or Not for Small Businesses

Let us say you sold cupcakes at $4 a unit. You sell 1000 a week at that price. You are considering using GroupOn to increase your sales. Here are the necessary and sufficient conditions
Necessary:  The Marginal Cost of each unit must be less than 25% of full price. If this is not true GroupOn recommended 50% off promotions and its 50% cut are not for you.
Sufficient: The incremental profit from serving the GroupOn delivered customers must be more than the incremental cost to serve them. A more restrictive requirement is, this net profit must be more than what is possible through other methods.

For the detailed  factors read on:
  1. Cost Calculation: The stories I read on GroupOn and other Small Business stories from Times indicate they are doing cost accounting wrong. For example, cupcake stores allocate a share of all the costs, from rent, insurance to bathroom cleaners to each unit sold. That is wrong! You need to compute the true marginal cost of SELLING one more cupcake and treat everything else as fixed costs. Let us assume it is $1 for your cupcake.
  2. Contribution Margin: Now that you know the true marginal cost (MC) of each cupcake, Price – MC,  gives its contribution margin (CM). In this case it is $4 – 1 = $3. The sum of CM from all cupcakes, $3000, go towards offsetting your fixed costs. If after covering all such costs you still have some CM left, that is your profit.
  3. Discount: From the vivid news stories described by small businesses and from a survey of GroupOn deals, the most common discount is 50% (or more). So the effective price drops to $2 and CM drops to  $2 -$1 = $1.
  4. GroupOn’s Cut: GroupOn gets 50% of the deal price . This may not look like additional cost but this is the cost to sell each additional unit.
  5. Contribution Margin of GroupOn Customer: After the 50% cut, the contribution margin further drops to  (P/2 – MC – P/4  = P/4  – MC). That is right, the new customer you acquire contribute much less than a regular customer. In the example we are using, the CM of a GroupOn customer is $1 – $1 = $0.
  6. Lifetime Value?: You might think you are getting the customer for life (or at least a few more times ). But there is nothing to support the claim other than hope. Sometimes it might take you years to serve these customers you acquired – either because it will take them time to visit you or because of sheer capacity limitations. If these customers are willing to buy your cupcake only because of its deal, are they likely to pay the full price? They are more likely busy searching other great deals.
  7. Incremental Costs: If you can serve all the new customers from the campaign with no additional investment (equipment, people, space), then it is not too bad. But if you need to hire more people, buy new oven etc, then all these costs be covered fully by the GroupOn customers. One common mistake is to distribute the new costs over all the cupcakes sold. The new costs are a direct result of these new customers and hence the CM from these customers alone must cover the costs.
  8. Opportunity Lost: Suppose the deal drove lots of customers to your stores and that ended up turning away some of your current and new (non GroupOn) high CM, customers.  That is opportunity lost.  Another aspect is, your business may already be growing albeit at very low rate due to previous marketing efforts,WoM and other reasons. These customers pay full price. If you cannot serve these new customers because you are busy handling promotion customers, that is opportunity lost. You need to calculate how many such full-price customers you are losing because of your focus on GroupOn customers.
  9. Opportunity Cost: This is the cost of alternative you did not take because you chose GroupOn – from time and resources you invest. Are there other channels that could have delivered you incremental sales?

So when should you consider with GroupOn?

  1. When   MC < 25% of current price (you are selling at high price premium)
  2. When there are low-value customers who are not willing to pay the current price but can be served at a price P1 > MC  (note P1 = P/2 according to GroupOn)
  3. When these customers are not easy to identify and reach
  4. When the incremental profit from these customers is more than the costs they incur you

Knowing Your True Marginal Cost

From big businesses to home based businesses there is an uncontrollable desire to allocate a share of the total cost to every unit of product sold. It is actually surprising that some of the small businesses do elaborate calculations just so they can allocate a share of the mortgage, insurance, delivery vehicle etc. This is from the NYTimes story on the new entrepreneurial craze – Cupcake stores:

For each cupcake she sells, Ms. Lovely figures she spends 60 cents on ingredients, 57 cents on mortgage payments and utilities, 48 cents on labor, 18 cents on packaging and merchant fees, 16 cents on loan repayment, 24 cents for marketing, 18 cents for miscellaneous expenses and 4 cents for insurance. That totals $2.45, leaving a potential profit of 55 cents on each $3 cupcake.

It is not difficult to see that Ms.Lovely’s elaborate calculations are based on volume sold, so any changes in number of cupcakes sold will affect her cost allocations.  Only the ingredients and labor costs are true marginal costs (you could argue even those don’t count as MC).  For a cupcake priced at $3, that gives a contribution margin of  $1.92 which all add up to defray the fixed costs of mortgage, insurance taxes etc.

So when volume drops and the margin drops below 55 cents will Ms.Lovely increase price of her cupcakes? Will the market pay for it? The problem with cost driven decision making is it ignores the customers.

Padding marginal costs with cost allocation combined with the percentage margin obsession will lead to incorrect pricing that is unrelated to what the market is willing to pay and lost profits or even the end of your business.

Here is five step process for cupcake cost economics:

  1. First find out how many cupcakes you can sell different prices, then find the price that maximizes your profit given the true marginal cost for a cupcake.
  2. The difference between price and the marginal cost is what each cupcake contributes to defray your fixed cost and eventually contributes to your profit. This is called the contribution margin.
  3. The number of cupcakes you need to sell so that the total contribution margin can cover fixed costs is your breakeven volume.
  4. Don’t look at % margin on each cupcake, this is irrelevant to your business decision. Not every cupcake you sell needs to contribute to profit, only those that you sell beyond the break even point contribute to profit. Trying to allocate fixed cost and profit to every cupcake leads to bad decisions.
  5. If you cannot sell the cupcake for more than its marginal cost, there is no business case. If the total contribution margin   cannot cover the fixed costs, there is no business case.

Cost Allocation Confusion

[tweetmeme source=”pricingright”] I heard on NPR a story on the cost to send a soldier to Afghanistan. The price tag is $1 million. So to send the 40,000 soldiers the total cost will be $40 Billion.  Correct?

Not quite. The actual total cost could be way more or less this number. The mistake lies in computing the true marginal cost – that is the incremental cost in sending one additional soldier.  The $1 million number is misleading because it includes a fraction of the fixed costs allocated to each soldier:

“So, it’s the cost of some allocation of the cost of the plane, some allocation of the cost of the fuel, some allocation of the cost of the pilots, the maintenance folks,” Zakheim explains. “If you focus just on the soldier, it seems outrageous. But if you focus on the support for the soldier — that’s not all that outrageous at all.”

But what if planes are already flying to Afghanistan and have spare capacity? What if the infrastructure is already there? What if the army already have soldiers on the payroll?  What if the army has to build new infrastructure for housing 40,000 soldiers at a new cost of $20 billion?

A moment’s reflection on these questions will convince you that the true marginal cost does not include fixed cost allocation and the total cost could be less or more than the $40 billion number.

Do you know your marginal costs?