Does your business use cost accounting? If they don’t, do they know why?
Pricing a product or service for less can improve the bottom line in some situations. Cost accounting has been widely used in manufacturing companies for decades. Many good non-manufacturing businesses use cost accounting in their business strategy. They blend key business revenue drivers along with the marketing loss leader concept. This blending can be especially important during slow business periods.
Periodically, accountants, auditors, and business organizations should reconsider how these concepts are blended. These concepts can be applied to the business portions of government, colleges, and non-profit organizations.
Variable costs are the costs incurred as business activity changes, such as the extra cost incurred when an additional product unit is sold. The variable cost of a product unit includes labor, materials, utilities, etc. See http://en.wikipedia.org/wiki/Variable_cost
A typical bakery will sell doughnuts at full price on the first day. The second day those same doughnuts are a day old so they are sold at a discount (Day Old Doughnuts). It is better to sell the day old product at a discount than to get no revenue. The objective is to maximize the bottom line. The bakeries will usually at least recover their variable cost on the day old doughnuts, and possibly more, so they can contribute to the fixed cost. The bakeries are also likely to get more repeat business.
At off peak almost all of the expenses are fixed costs. Fixed costs are the costs incurred no matter whether a facility is used or not used. See http://en.wikipedia.org/wiki/Fixed_costs
An organization might need a loss leader in order to improve the overall bottom line. Milk and bread are loss leaders for grocery stores. A loss leader is a product that is sold at less than the fixed cost plus the variable cost. See http://en.wikipedia.org/wiki/Loss_leader The reason this is done is because such products are known to draw in more customers than when there is no loss leader. Thus, they pull in more customers but they more than make it up on the other goods normally sold to these customers. Grocers usually place milk and bread in the rear of the store in order to stimulate impulse buying.
Another key concept is contribution margin. The price charged less the variable cost is the contribution margin. The contribution margin is the amount left over that can be used to cover some or all of the fixed costs. Only after all fixed costs and variable costs are covered can one reach a profitable status. See http://en.wikipedia.org/wiki/Contribution_margin
Some travel websites sell the last few hotel rooms available, or the last airline seats available. The price is often below the fixed cost plus variable cost. Any price above the variable cost will provide a contribution to help cover fixed costs. If a hotel room is empty or an airplane seat is empty, the fixed cost is a charge against revenue for that period. If the room can be sold for anything above the variable cost, the amount above the variable cost goes toward the fixed cost and it reduces the charge to the daily revenue on that day. Furthermore, when the hotel sells more rooms, they are nearly certain to generate more food sales, gift shop sales, bar revenue, and other revenue areas do better. Thus, the hotels improve their bottom line by selling via such routes. The hotels are also likely to get more repeat business.
Products or services that are not key revenue drivers can provide a better rate of contribution margin on each dollar of sales. The discounted price on a key revenue driver product often generates additional sales traffic. Thus, by reducing the product unit price on a key revenue driver at off peak, a business can actually improve their overall profitability, or at least greatly reduce their losses.
Drug stores place the pharmacy in the back of the store. 90% of their profit comes from their front end business. The pharmacy area is what draws the customers into a drug store. The store arrangement causes customers to walk through the areas that provide so much profit. A typical drug store makes $2 to $3 dollars on each prescription. The daily labor cost for a pharmacy might barely match the total daily contribution margin on the prescriptions. One might view the pharmacy as a loss leader that enables the drug store to pick up the profitable front end business.
Many organizations improve their financial position for off peak periods by trying to maximize their contribution margin at off peak. This means that they are willing to accept less profit or even a loss at off peak demand. They are trying to minimize their losses at off peak demand. For example, it is better to accept a small loss on a product unit when the shelf life is short rather than to have a total loss when the product unit has to be thrown away.
Movie theatres have several different prices depending upon day of week and time of day. The key objective is to fill most of the seats, rather than get the most from ticket revenue. The reason is that sales at the concessions stand provide most of the profit. Concession sales are driven by the number of tickets sold. Thus, the discounted matinee pricing makes sense because they fill more seats, and make more profit due to concession sales providing more profit. Matinee ticket prices are usually 50% to 75% less than the price at the peak on a Friday or Saturday evening. The matinee ticket prices are just another loss leader type product. The concession profits from the matinee movie exceed the variable cost and help cover the fixed cost. Thus, the overall movie theatre profitability is higher than if no matinee movie is shown.
The smaller the key revenue driver’s percentage of total revenue, the lower the key revenue driver price can be. The key revenue driver price can be as low as a point between the variable cost and the total cost. The objective should be to maximize the contribution margin during each marketing period without doing greater harm to the long term contribution margin.
Some oil change shops offer quick oil changes at a reduced rate for customers who arrive before 10 a.m. on specified days. This discounted pricing is done because they are not as busy before 10 a.m. They are not likely to price the service below their variable cost. They could price the service between the variable cost and the total cost, which is the variable cost plus the fixed cost. The shop is more likely to price the service somewhere between the regularly posted price and the total cost. A key objective might be to maximize the contribution margin that can be achieved before 10 a.m. This means that the price charged is a balance among customer demand, variable cost, the maximum number of customers likely to be served, and the price the customers are willing to pay for arriving before 10 a.m. The maximum contribution margin will provide the most money to help first cover fixed cost and to improve the long term bottom line.
Cruise line companies will sell rooms or cabins at prices approaching variable cost in order to fill up the ship. The reason is that most of the revenue and profit is not from the accommodations. Those other revenue areas are driven by the occupancy level. The more passengers on board the more money they make. Thus, cruise ship accommodations are a loss leader that pays off for the cruise line.
Sunk costs are past costs that have already been incurred and cannot be recovered. See http://en.wikipedia.org/wiki/Sunk_costs In some cases, the contribution margin for some short periods can approach zero. When the sunk costs are high and the contribution margin is very low for short periods, a business might need to consider reducing a product price to improve the contribution margin during the off peak period.
If a cruise ship cabin is empty for a ten day cruise, the cabin would provide no contribution margin for the entire ten days. Since the sunk cost for the cruise cabin is high, the cruise line would have a better contribution margin by charging any price above the variable cost of the cruise cabin. See http://www.definethat.com/define/337.htm for more on sunk costs.
Las Vegas hotels are much like the cruise ships. Most of their revenue and profit is from areas other than lodging. They miss out on the revenue from those other areas if they fail to have overnight guests. At the depths of the recent recession folks could get a nice Las Vegas hotel room for between $12 and $45. The hotels covered their variable room cost and perhaps some fixed costs. They expected to more than make up for the loss leader elsewhere. Their goal is to maximize profits and minimize losses. Thus, the Las Vegas hotel rooms are a loss leader during off peak periods. In essence, they can afford to lose money on the rooms in order to make more money overall.
Pricing a product or service for less can improve the bottom line in some situations. The smaller the key revenue driver’s percentage of total revenue, the lower the key revenue driver price can be. The key revenue driver price can be as low as a point between the variable cost and the total cost. Accepting a lower price on a business segment can generate more overall business and improve the bottom line.
What drives the revenue areas of your business? If you do not have a loss leader, could you improve your bottom line by having a loss leader?
Does your business use cost accounting? Does your business know the various cost factors? If you do not know your costs and margins, you could be missing out on a golden financial opportunity.
Can less be more? Yes, less can be more.
The key editor for this article was
Peter Missen, Principal Auditor
Portsmouth City Council,