Variable Costs, Variable Profits

I just finished reading this post from Seth Godin about how businesses can play with their margin to afford promotions.  Godin writes about a fictional pizzeria:

The marginal profit of one more pizza is high. You’ve already paid for the rent, the oven, the sign, the ad in the Yellow Pages, the hourly wage, the uniforms, all of it. Whether you sell that last pizza of the day or not, all those costs are fixed. So, if your ingredients cost $2, your gross margin is $8…

If someone offers to run a coupon…[offering] a large pizza for $2, is it worth it for you to run it? That’s 80% off! Surely, this is too expensive. You can’t afford 80% off.

On the margin, of course you can. You got a new customer for free. Unless your store is at capacity, with people waiting in line, one more pizza sold at cost is a great way to build your business…

Let’s break down the economics a bit (not that it’s terribly complicated).  There are two general kinds of costs, fixed and variable.  Fixed costs are what Godin lists above – rent, oven, employees.  There’s really nothing that can be done to lower them.  Variable costs change depending upon a few different factors.  If we continue with the pizza example, then the more pizzas you sell, the more tomatoes you need to buy.  You might need more gas for the oven.  And so on.  Also, a rise in variable costs doesn’t necessarily have a linear relationship with sales; by purchasing more, you might be able to obtain the same quality goods for less via wholesale.

Godin is in a way proposing a variable margin, a reverse of variable costs.  The idea is that the more you voluntarily (and temporarily) lower your margin, the more you sell – if not now, then in the future.  The key really is repeat customers, which means a product that is at least somewhat impermanent (think clothes or music, not houses or cars).  By providing potential customers with a reason to initially consume your product, you create the chance for them to become loyal to your brand.  The next time they purchase from you, your margin has been restored.

Of course this is nothing new.  It’s why we have sales, coupons, “special one time offer only” and “buy now while supplies last.”  What I think is new (or at least refreshing) is the approach.  A variable margin means a focus on future profit instead of immediate gain.  It means building trust before building sales.  And it means understanding that loosing unrealized gains now (discounting your product) is often preferable to loosing everything tomorrow (when nobody purchases from you).

You might not have to be as extreme as Godin suggests.  You might not gain more customers from discounting 80% off over 50% off.  We could probably throw together an experiment to see.  But either way, it’s still worth trying, right?