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.