While accountants are trained to provide a full view of what happened to the finances of a business, an economist or business analyst will speak of “thinking at the margin”. To “think at the margin” is to examine how the costs and benefits of a business will change with a shift in activity.
This process starts by acknowledging that parts of your costs are effectively fixed: if you signed a $5000 per month lease for a shop, you’re going to pay $5000 regardless of how many customers you actually service. Your variable costs can also change with shifts in volume: maybe you can buy larger orders from a supplier at a higher discount. Economics looks at how these costs change.
The same logic applies to marginal revenue, especially in businesses with long lead times, contracts, and big differences in order sizes. Consider a catering business. Given that many events are planned in advance, they can “lock in” slices of their revenue in advance of a weekend. This works in reverse as well: if they don’t have an event booked, they may have trouble finding customers on short notice to fill the revenue gap. This is especially painful if they have to spend money and hire staff before payment is assured. The marginal impact of small changes in demand can be huge in a business like this, which has a high opportunity cost from cancelled events or an empty calendar.
With that in mind, here are five practical examples of where thinking at the margin affects business decisions.
Example 1: Sunk Cost of Running the Machine
Our manufacturing business has a huge machine, financed using an equally huge equipment lease. We need to make a large lease payment every month if we’re going to stay in business.
From a pricing perspective, we look at this as a sunk cost or fixed cost. The lease payment is due regardless of volume; make 0 widgets, make 1000 widgets… same lease payment. So we need to disregard it from our pricing calculations.
If the market is weak, I may approve business just above my variable labor & materials cost to get a little bit of money back. Rather than setting my price to cover the lease payment as well….
It’s a rational decision. The marginal benefit of the additional orders shaves a little bit off my loss. Hopefully next month will be better.
Now, this thinking changes for decisions where I can decide not to buy a machine. If we’re doing a business case on expanding that production line, we’re absolutely going to include the cost of the equipment lease as part of our pricing decision. Because in that situation, we can avoid it… by not buying another machine…
Example 2: Big Orders Reduce Marginal Cost
Another manufacturing example: what happens if we suddenly have the ability to make a lot more of a particular product? Our marginal cost drops.
First, there’s setup time. The same machine setup effort can be leveraged across a much larger number of units. This reduces unit cost.
Second, my suppliers may give me a better price. I’m able to order in larger quantities, which often reduces shipping expense. They certainly aren’t investing additional time in selling me the larger order. They may also be able to make things in larger quantities. All of this enables me to ask for additional discounts.
Example 3: Short Lead Times Increase Marginal Cost
What if a big order needs to be shipped tomorrow?
Believe it or not, this can actually increase the marginal cost of handling the business. First, the short lead time may create a scarcity of materials relative to my existing plan for the business. I’m forced to buy what is available on the market rather than waiting for the lowest cost supplier.
I may also struggle with finding enough labor and freight carriers. If that occurs, I’ll need to increase my rates (pay overtime wages for an extra hour or a rush charge) to offer with an incentive not to serve other customers before me. That additional hour of activity comes at a high marginal cost.
So while that big order may be cheaper to serve in some ways, this additional cost from the rush business can offset those savings. The marginal impact of this order may be negative. This type of marginal analysis should drive pricing decisions around larger rush orders.
Example 4 – Marginal Change for Unprofitable Customers
Switching to logistics and product distribution, many companies learn that they are making unprofitable deliveries when they run the math. Unfortunately, this is another situations where you need to use careful marginal thinking to get to the right answer.
Suppose, for example, we send a truck into the mountains to deliver product to a big account. They may stop at a few small customers along the way to make smaller deliveries.
The accounting team looks at the situation: three deliveries, one truck ride, split the bill three ways. Reality isn’t that simple. A rational person wouldn’t have pursued the smaller accounts if they weren’t already along the way. That small incremental adjustment loaded too much cost on the little customers and not enough on the big account that justified the trip to begin with.
The simple answer (stop shipping small accounts) actually works against you. The marginal utility of those customers is actually positive. With them gone, the total cost of the trip gets allocated against the big account. Without the additional benefits you banked from the small deliveries. So now that account looks worse as well.
Worse, the truck itself can be a fixed cost. Suppose you’ve only got one truck and one driver. The marginal return from cutting out the trip is negative, since you can’t remove the cost without shutting down all customer deliveries.
Play this out over a couple of rounds of marginal decisions around cost cutting and you’ll see how these policies can make a business worse off. A broader view of marginal change and alternative strategies can lead to better decisions.
Example 5 – Extra Passenger Pricing
A common marginal decision for services and logistics businesses. What should you do about extra passengers or guests, particularly children and family members of the decision maker?
Consider a taxi service. It costs you almost the same amount to drive two people to a single destination that it does to drive one. So should you charge for the extra passenger?
On one hand, the additional unit of work doesn’t add cost. Scarce resources aren’t consumed. You are unlikely to get incremental revenue from the other passenger by making them wait for a second trip – someone else would take them.
On the other hand, we’re delivering double the value. A rational decision maker shouldn’t object to claiming a piece of this. And it would potentially double our income.
Two valid claims to the value creating by serving the extra passenger. In the real world, this choice are often resolved by looking at other marginal decision making criteria for the buyer. You see this on cruise ships: once you’ve rented a cabin, there’s not much marginal cost of bringing another passenger. In fact, they’ll help run up the bill at the bar, which is more marginal revenue.
The same applies to young kids eating free at a motel buffet. There isn’t much marginal cost to feeding a three year old… and if it helps convince mom and dad to stop at that particular motel, the marginal benefit of the offer carries the day.