Last week I shared some thoughts on marginal unit economics. It is THE fundamental thinking needed to do effective marketing. In order to understand what your marginal unit costs are you need to understand what part of your costs are fixed and what parts are variable.

It’s a tougher problem than the textbooks make out to be.

Let’s use a restaurant as the example.

Some restaurant costs are obviously fixed:

• Rent
• Owners’ time
• Manager cost
• Furniture leasing costs
• Menu costs

The most obvious variable cost is the cost of goods for the food eaten by the marginal customer. That cost could become fixed if the food was about to go bad, but let’s assume the restaurant is better managed than that.

The biggest question is the cost of the servers and cooks. The first server and cook are pretty fixed. You need someone there to make and serve the food even if no customer walks in the door (unless you have the manager or owner do it). In theory any staff beyond the first (for a specific role) is variable depending on how many customers you expect to have.

Basically you have a step-change function. The first two staff can handle x number of customers, but once you get to a specific point you need more staff. There is a fuzzy zone where you  could have one server who is scrambling or you could have two servers who are relaxing. That fuzzy zone decreases in size the bigger the restaurant but likely never really goes away.

After you have staffed your night, then the marginal staff cost for any given customer is zero.

So are staff costs fixed or variable?

It depends.

If you are talking about bringing in one additional table of customers it is almost definitely fixed. If you are talking about bringing in 1000 additional tables of customers they are definitely variable.

“In the short term all costs are fixed. In the long term all costs are variable.”

We saw a similar dynamic at A Place For Mom. We would source leads for our senior living advisors (SLAs) who would work with families to help them find senior housing. Overall we knew that SLAs could handle about xx leads per week. If they got more than that on a consistent basis then we saw our overall conversion rate start to slowly decrease. However, we also knew that the SLAs could handle almost twice the normal volume in a given week without any loss of overall performance.

So on a given week we had no marginal operations costs from sending an additional lead. But for planning purposes, the operations costs of handling leads were fully variable.

I believe staffing at restaurants is similar.

It was a complicated problem for a bunch of Harvard/Wharton/Stanford/McKinsey/Bain/BCG MBAs to solve at A Place For Mom. One can’t expect an owner-chef at a restaurant to figure out the math.

But without the math it is impossible to make rational marketing decisions.

What are your marginal costs?

Simplify it.

You know your costs that are definitely variable (COGS). You have a bunch more costs that are short-term fixed, long-term variable. Figure out their marginal cost to serve an additional customer. Add those two numbers together. You now have a range on what your marginal costs are.

For restaurants I have spoken to this works out to 30-60% of their revenue (30% is the cost of the food +30% for the cost of the staff if the staff cost were 100% variable). It means that if the restaurant rebates more than 70% they will be losing money no matter what they do (with some exceptions coming later). If the restaurant rebates 40-70% they may or may not be in trouble depending on how many customers they give that big a rebate to.

Less than 30% they will be making money on the margin – even if the total margin of the company is only 5%.

And that is the key insight.

I have spoken to many businesses who say, “My total margin at the end of the year is only 10%, so if I give a 10% discount I make nothing.”

That is true if you gave a 10% discount to every single customer. But it is not true at all if you give a 10% discount to incremental customers.

Let’s see it in a chart:

Now what happens if he gets an additional 1000 customers at a 10% discount:

See what happened there? Even though we gave a 10% discount (our ENTIRE MARGIN!) to these new customers, we ended up growing our total margin from 10% to 12.8%. It’s magic.

As long as you can acquire customers for less than the cost to service those customers your business’s margin dollars will increase, regardless of the percentages. If you acquire customers at a higher marginal margin your overall margin percent will increase – even if those marginal customers have a lower total margin than your existing customers (in the above example, you could discount 45% on those incremental customers and your 10%

It’s a little mind-warping, but there is no more important concept to understand in marketing a business. And it’s a way of thinking that even many Fortune 500 CMOs don’t seem to fully internalize (in fact CFOs tend to get it more often than CMOs in my experience)

One (very very important) caveat: This only works if those new customers are truly incremental. If they aren’t it’s called cannibalization and the whole house of cards can come tumbling down.

Up next: Cannibals!