Understanding Costs, Prices and Value is Critical to Success

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Most intelligent businessmen would agree that high profits or perhaps more usefully, a high return on total assets employed, is the result of being successful in business. The implication, as UK Economist John Kay so eloquently writes in his book ‘Obliquity’, is that businesses should focus primarily on what makes them successful in business and not on the results. But that doesn’t mean that we should ignore the components that make up the results, far from it. Costs are one of those components.

In a recent blog post on ‘A Matter Of Who And What To Value’, Dutch financial services expert Wim Rampen asked the question, “to what extent are costs (variable or fixed) relevant?”. This is on the surface quite a simple question, but answering it undercovers a myriad of different options available to companies to manage their costs and their business success.

A simple case illustrates why understanding and managing both fixed and variable costs are not only relevant, but critical to business success. Let’s assume we are a hypothetical company Champion Barbeques. We have two customers Mr A and Mrs B. Mr A is long-time customer who buys our flagship product – a polished steel, multi-burner, gas barbeque – from us each year at a price of GBP 100. We have fixed costs of GBP 50 for each barbeque and as Mr A always buys the same barbeque, low variable sales costs of GBP 20. That yields a profit of GBP 30 for each barbeque sold. Mr A is happy and doesn’t ask us for any support with the barbeque, in fact he probably could teach us a few things about cooking steaks to perfection with it! Maybe we should invite him round for a steak and a beer. We are happy too and so is our accountant.

Mrs B is a different kettle of fish. She is a new customer who has only bought our flagship barbeque from us once so far, at a price of GBP 100. We have the same fixed costs of GBP 50 and as Mrs B needed a lot more support during the initial sale we have a higher variable sales cost of GBP 30. That yields a profit of GBP 20 for each barbeque sold. Not as good as Mr A but still positive. But the story doesn’t end there. Mrs B called us two times for support with the barbeque at a cost of GBP 10 per service call and we sent out a technician to help her at a cost of GBP 20. The technician showed her how to use the barbeque but she struggled with the side-burner for keeping sauces hot. All of a sudden our GBP 10 profit has evaporated and we are left with an operating loss of minus GBP 30 once you add the cost of service. Mrs B still isn’t happy with our barbeque – our technician said he saw her surreptitiously ordering a Big Mac with extra fries from McDonalds the other day – and we are not happy either. Our accountant is just shaking his head in despair; our net net profit from Mr A and Mrs B together is now GBP 0. We have become a ‘zombie company’!

If Mr A comes back to us next year we will welcome him with open arms. Our accountant might even treat him to a glass of sherry. If Mrs B comes back next year we have a much more difficult choice to make. In fact we have a whole range of choices. Option A is to sell her another barbeque and hope that she will require less service. Assuming the variable sales costs go down to GBP 30 and she makes one service call at a cost of GBP 10 we will make a small profit of GBP 10. That would leave us a net net profit of GBP 40 from Mr A and Mrs B together. But hope is rarely a good strategy unless you are a politician.

Option B is to decline to do business with Mrs B on the grounds that the fit between her needs and our barbeque doesn’t allow us to meet our needs (for a profit). That is quite an extreme step to take. It would leave us a net net profit of GBP 30 from Mr A. But we might have excess barbeque inventory to sell off at a loss at the end of the barbeque season and Mrs B might tell everyone in the queue at McDonalds what a beastly company we are.

After this the choices get more creative and more difficult. Option C is to charge Mrs B for the cost of all the post-sale services she uses. We have the same fixed costs of GBP 50 and higher variable sales cost of GBP 30. That yields the same profit of GBP 20 for each barbeque sold. But the service story changes things significantly. Mrs B called us two times for support with the barbeque at a cost of GBP 10 per service call and we sent out a technician to help her at a cost of GBP 20. All of these were charged to her at cost. All of a sudden the company’s original minus GBP 30 of operating loss has tuned into a profit of GBP 20 once it adds on all the service charges. That would produce a net net profit of GBP 60 from Mr A and Mrs B together. But Mrs B is far from happy. She complained to the company and after we threatened to charge her an additional GBP 10 to respond to her complaint she complained to the Barbeque Ombudsman who is looking into the matter. In fact there have been so many complaints about Champion Barbeques’ misleading small print, unfair service charges and generally bullying behaviour that the Govt appointed regulator, the Barbeque Conduct Authority is starting a formal investigation. This has already cost us millions in the court of public opinion and could cost us many more millions more in the law courts.

Option D is to radically simplify the business to remove fixed and variable costs as Siegel & Etzkorn describe in their new book ‘Simple’. If the company invests GBP 20 we could probably reduce the fixed costs to GBP 40, and the variable costs of each sale to GBP 10, of each service call to GBP 5 and of each technician visit to GBP 10. In the original scenario that would leave the margin from Mr A at GBP 30 but increase the margin of Mrs B to GBP 10 for a net net profit of GBP 40 from Mr A and Mrs B together. But radical simplification has a track record of being difficult to implement and we can’t be sure of achieving all of the savings from the investment. That could leave us with all the costs and not many of the savings. A reduction of savings by 50% would reduce Mr A’s profitability to GBP 20 and Mrs B’s to minus GBP 10 for a net net profit of GBP 10 from Mr A and Mrs B together. That is better than being a zombie company, but a lot worse than from firing Mrs B or from charging her for the services used.

Option E is to dispense with the simplification and to provide our ‘Barbeque Like a Champion’ home training for every new customer at a cost to us of GBP 20 per new customer. The training would naturally include a branded recipe book, apron and barbeque utensils. In the original scenario that would leave the margin from long-time customer Mr A at GBP 30, but increase the margin of new customer Mrs B to GBP 10 (as we have solved the problem that created the original calls and technician visit) for a net net profit of GBP 40 from Mr A and Mrs B together. In the process we have changed from a company selling a product (barbeques) to become one selling a service (champion barbeque food cooked by customers).

But there’s more! Option F is to recognise that many customers aren’t really buying barbeques at all, but buying barbeque-based social occasions. Selling barbeques is a goods-dominant logic business model. Customers exchange their money for a barbeque at the point of sale and are left to get on with the barbequing themselves. It is their fault if their friends don’t like steak that only comes in two flavours: ‘well done’ and ‘carbonara’! By servitising the whole thing and offering an ‘Enjoy a Champion Barbeque, Prepared in Your Own Home by our Champion Chefs!’ experience, the company has reinvented itself and entered Pine and Gilmore’s Experience Economy. Selling tasty, freshly prepared, cooked in your own home barbeque food outcomes is a service-dominant logic business model. But this doesn’t apply to all customers. Mr A lives by himself and tends to barbeque with a few mates with a plentiful supply of beers. He is unlikely to buy the barbeque experience. The company will never make more than the GBP 30 profit from Mr A. Mrs B is entirely different. She is an wannabe socialite and would prefer to hire the whole barbeque experience to owning a dirty, greasy, smelly barbeque! Ugh, how common! In fact she will probably hire the experience four times each summer. Mrs B would happily pay GBP 100 for each barbeque experience, or GBP 400 over the whole season. With fixed costs of GBP 50 for the barbeque, and variable costs of GBP 50 for the more complicated experiential sale, GBP 50 for transport, GBP 100 for starters, steaks and spritzers, and GBP 100 for the Chef, Mrs B’s operating loss of minus GBP 30 for selling her a barbeque turns into an profit of GBP 50 for guaranteeing her an outcome. A win:win:win situation. The customer is happy as her social status rises, the company is happy as it rakes in the money and the technician is happy as he is now a Champion Barbeque Chef. Gordon Ramsey look out!

A lot of things go into being successful in business, but as Investment Analyst Michael Mauboussin points out in his article on ‘Death, Mean-Reversion and Taxes’, we are not entirely sure what those things are. Management books like ‘In Search of Excellence’, ‘From Good to Great’ and so on all purport to shine a light on the things that make businesses successful, unfortunately, the vast majority of them have not stood the test of time. Yesterday’s case study paragons are so often today’s junk status pariahs.

This simple example of barbeque business models show how even a simple understanding of costs, prices and value can lead to a whole host of different options: from hoping for the best, through firing unprofitable customers, charging for customer service, radical simplification, customer education, all the way to outcome servitisation. All of the options have parallels in how some industries operate today. I will leave it to the reader to insert their favourite examples. Simply eating the costs incurred when a customer is sold an inappropriate product is not a viable long-term option. And Kant’s Categorical Imperative shows clearly that is morally and ethically wrong to expect other customers, or shareholders come to that, to have to carry those other customers’ costs. Without a thorough understanding of operating costs, market prices and what different actors in the business ecosystem value, the likelihood of choosing a workable business option, let alone a winning one, is significantly reduced.

Graham Hill
@grahamhill

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