All work is good work as long as it contributes to my bottom line!

If you are a student of orthodox financial management theory, which, if you are reading my blog is unlikely, you will be aware of the theory of marginal costing. It goes something like this ….

If a business can be marginally better off by making an incremental sale it should do so. In a competitive market, you will regularly have to decide whether to make a sale at a less than optimal price. For example, a customer tells you that he will only buy from you if you supply him at a low price. You analyse the position, and while the situation isn’t ideal, you conclude that even at the lower price you will still enhance your overall profitability on the proposed supplies to this prospective customer on the basis that your fixed costs will not change. You agree to the deal. But is that right? There are always a number of factors to consider when evaluating new custom including the impact on the business’s working capital, finance and risk but here I am going to focus on profitability. Does it really contribute to your overall profitability?

Assessing the costs to serve a particular customer can be very difficult. You may be able to calculate the gross profit on the customer’s business as many accounting systems can cope with this, but most accounting systems will not allow you to determine the “fixed” costs associated with serving a particular customer. Salaries and central costs are often considered relatively fixed and are therefore ignored at the margin. The logic goes, “If it makes a gross profit, it will enhance the net profit”. Let’s look at an example.

 

000’s Existing business New business opportunity With new business
Sales 1,000 100 1,100
Gross profit 350 10 360
Fixed costs 250 0 250
Profit 100 10 110

 

There are some real problems with this logic. Rarely are fixed costs actually fixed. If you look at the history of any business these so called fixed costs seem to scale with size. It isn’t necessarily a smooth correlation but nonetheless the evidence suggests fixed costs vary as a business grows. Also, marginal costing theory would suggest that if each of the existing customers reduced the price they pay to mirror that of the prospective new customer you should accept that too. This would mean the £1,000 total sales would give a gross profit of £100. After deducting the fixed costs you would make a loss. Successive decisions taken “at the margin” simply don’t work even if each decision can be justified on its own.

The real problem with marginal costing theory is that it ignores opportunity costs. Whilst this incremental business may not drive additional costs at the margin if the business has spare capacity to deal with the additional work, it will consume that capacity. When the next new customer comes along capacity may then need to be enhanced and that will be at an additional cost. These additional costs cannot be allocated to either the first or the second customer in any meaningful way. The need for the additional resource is driven just as much by the first customer as the second. The real cost is the opportunity cost of those resources that make up that spare capacity.

Economic theory teaches us that wealth is determined by the allocation of scarce resources. Allocating resource is never for free. There is always a trade off between the resource’s current use and that of an alternative use. The big question facing many businesses is whether to consume capacity with sub-optimal work or hold back capacity for better quality work.

Both airlines and hotels face this dilemma. They have high fixed costs and a potential customer’s offer to pay a contribution towards their fixed costs may be tempting to accept, however low the price offered, especially at the 11th hour when there seems no reasonable prospect of an alternative customer offering to pay full price. Despite this both airlines and hotel groups have learnt that in the long term they need to resist these temptations and hold back capacity. Airlines have concluded that the cost of not being able to accommodate a full paying passenger is too high and would rather run the risk of flying with empty seats. Hotels too have come to the same conclusion.

If Hotels accept last minute cheap deals then they encourage consumers to look for such deals. There is also a reputational risk. Businesses trying to carve out a meaningful position in a market place can confuse their market message if they compromise their pricing integrity.

This idea of holding back resource and capacity is not a new phenomenon. Over 2000 years ago Mary and Joseph were told that there was no room at the Inn. Maybe there wasn’t; or maybe the Inn keeper was a student and critic of marginal costing theory and was holding back capacity for a better offer. After all, there were some high rollers in town.

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