When I taught my first MBA course I knew that the students would not remember everything I taught them. I also knew that whatever I taught first (and returned to throughout the course) would be internalized more than anything else. So I thought long and hard about what the first thing should be.
I landed on Marginal Value.
It’s a relatively simple concept: Instead of looking at averages, you look at the costs and benefits of an incremental decision. If the benefits outweigh the costs then that action is worth taking. If they don’t then you should not take that action.
As simple as it is, it is ignored by many many marketers.
Consider two very different businesses:
A retailer sells physical goods. Say they sell only one product: Product A. They sell it for $100 and it costs them $70 to buy it. Their margin is $30. If they discount Product A more than $30 (30%) they will be losing money on each sale. Now $30/sale may not be enough to keep them in business (they need to pay for their staff, the real estate rent, marketing, overhead like accounting, etc.), but if they sell enough they will be fine. But no amount of sales at $69 will keep them in business. In fact, the more they sell the more they lose. It’s the classic joke of “Sure we lose money on every sale, but we will make it up in volume.” More volume only works if your marginal benefits are higher than your marginal costs.
But a discount less than $30 could work.
If they sell 1000 units at $100, that’s the same profit as selling 2000 units at $85. If a 15% discount more than doubles their sales, then they should absolutely do that. But if they discount 29%, then they need to sell 30,000 units. That seems unlikely…
A lot of retail is like this – or worse. The marginal margin on products after their cost is very low. It doesn’t leave much room for discounting. And when you do discount, the lift you need to see if so high that it is unlikely to be the right choice. Do we really thing they will double their sales with a 15% discount? (and many products have much lower margins than 30%).
The second extreme example is an airline.
Airlines have huge fixed costs. They need to pay fees to the airports; they need to pay for their planes; they need to pay for the maintenance on their planes. In theory each flight is a variable cost: If they don’t make the flight, they don’t pay for the pilot or the stewards or the fuel (and likely a lot of maintenance as well). In practice they are committed to a certain flight schedule (and given the huge fixed costs of owning the planes it makes a ton of sense to keep them in the air as much as possible).
Now that we assume the flight is taking off, the marginal costs of seating a passenger is really really low. A little more fuel required to lift the passenger and their luggage. The free soda or peanuts provided. It takes a little longer to board which may increase the costs for the gate staff? (That last one is really reaching). I would be surprised if the marginal cost of an additional traveler is more than $20 on a $200 flight.
This means that an airline could give much larger discounts than a retailer and still make the business work. Let’s say a flight is half-full with 100 people at $200/seat. If the airline were to discount the seats by 15% to double the sales (same effect as we showed for the retailer) they would go from making $18,000 after marginal costs ($200 x 100 seats = $20,000 revenue – $2000 costs) to $30,000 ($170 x 200 seats = $34,000 – $4000 costs). That’s a lot better than the break even scenario of the retailer for the same discount.
Airlines obviously know this, which is why their pricing schemes are so much more complicated than retailers (imagine if Old Navy T-shirt prices changes as often as airline tickets?).
Airlines and retailers are an extreme examples. Most businesses sit in-between the two. But most businesses don’t automatically think about marginal economics and so make lots of mistakes.
Retailers discount far more than they should.
Restaurants don’t discount nearly as much as they should.
Next: Fixed and Variable Costs