Marginal Costing

You Need to Know How Selling Cheap also Could be Profitable

One plate Dosa at a restaurant costs Rs. 90/- which Uber Eats delivers to us at Rs.40/-   This is a huge bargain for us.

The question struck in our mind is how Uber eats and Swingy can deliver food at a cheaper price than the price we pay at the restaurant?

We believe it as a promotional cost either the delivery company or the restaurant bear.

But the reality is even at the price at which they deliver through food delivery company, they could be making money.

One, the margins are high in the food business but the important is the 2nd aspect which we are going to discuss today.

Cost Structure

Assume the cost of producing a Dosa is Rs. 15/-. This cost includes all the raw materials and fuel required to produce a Dosa.

The restaurant has invested in the restaurant premise, furniture, have to pay salary to the waiter, electricity charges of the air conditioner, etc. All these costs Rs.30/- per Dosa. When they add these costs, the cost of a Dosa becomes Rs. 45/-

This they sell at Rs.80/-. Total profit is Rs. 90/- minus Rs. 45/- = 45/-.

All the costs which they incur after the Dosa was produced are not allocated to the cost of Dosa when the Dosa is home delivered by the delivery company. The customer is not going to use the restaurant infrastructure.

This way even if they sell a Dosa at Rs.40/-, a cheaper rate through the food delivery company they are making a profit of Rs.25/-. (Rs. 40/- minus Variable cost Rs.15/-)

They charge delivery charges over and above Rs. 40/-. This takes care of the delivery cost.

Types of Cost

This brings us to the concepts of Economics i.e. Fixed Cost, Variable Cost, and Marginal Cost.

Fixed Cost:

Fixed Cost is the cost which remains fixed whether a restaurant produces no Dosa or 100 Dosas in a day. This includes all one-time infrastructure cost like rent for the place, furniture and interior cost, staff salary, kitchen equipment, and air conditioner cost.

Suppose a company invests Rs. 15 mn as one-time investments. They think all one-time cost will be useful for 5 years. In 5 years, they will produce 0.5 mn Dosa. So per Dosa plate fixed cost would be Rs. 30/-.

Variable Cost:

Variable cost changes with increase or decrease in the production of Dosa.

The raw material cost will change for 100 Dosa and 101 Dosa.

Variable cost is the cost which a restaurant incurs to produce Dosa which changes with the quantity produced. This also includes other variable cost incurred after production of Dosas like

This is the raw material cost. This will vary according to the number of Dosas produced.

Raw material cost per Dosa is worked out as Rs.10/- and other variable overheads cost per Dosa is Rs.5/-. So the total variable cost for Dosa is Rs.15/-.

Therefore, by adding fixed and the variable cost they arrive at a total cost of Rs.45/- They add a 100% profit so the selling price comes to Rs.90/-.

Marginal Cost:

The restaurant arrives at marginal cost when they know the cost break up of fixed and variable cost. Marginal cost is the cost of producing every additional unit.

Marginal Cost

Though the average cost of each of 2,00,000 Dosa is Rs.95/-, marginal cost is only Rs. 25/-.

This is why knowing marginal very important to arrive at the selling cost.

Marginal Cost Chart
Credit: https://www.tutor2u.net/

Marginal cost is additional production cost while Variable cost is a total additional cost which includes post-production variable overheads.

Usefulness

“The moment you make a mistake in pricing, you’re eating into your reputation or your profits.” Katharine Paine

Knowing the cost structure is very important for product pricing. You might know the total cost of the product but if you do not understand the cost break up, its fixed and variableness, you may flounder in product pricing.  If you can’t price the product strategically, chances are there you might struggle in the market.

In competition, many times a company has to drop prices to retain a customer or to acquire a customer. This dropping of prices is possible when the company is able to recover only variable cost plus some profit.

You can see from the above table that the variable and marginal cost is quite below the average total cost.

As far as the fixed cost is concerned;

  • It is deferred when the market situation is improved
  • It is recovered where the competition and price elasticity is low
  • It is already recovered by now

If none of the above is possible, the company is in a dangerous situation. They are surviving the present at the cost of their future. Some serious action is necessary.

These off-season sales are nothing but selling off old stocks by recovering the variable cost.

When a company fails to recover even a variable cost there is a problem. Because variable cost is incurred regularly, they need money to pay the suppliers. If they are not able to recover variable cost most likely they won’t be able to pay the suppliers on time.

Product Pricing is a very important aspect of any business. It can win or kill any business. If an entrepreneur is not conscious of its costing system, pricing strategy, and its implication, the business bears a huge cost.

In times when companies are selling at an attractively low price and freemium pricing is a new form of marketing, knowing your cost structure is very critical. Though pricing a product/service is not simple, but not knowing the basics will make it more difficult.

Companies which know the mechanism and economics of product cost, for them selling cheap also could be profitable. Many startups are using this smart pricing model to penetrate the market.

Next time remember when you take a home delivery parcel of food from a restaurant, ask for the discount. You are not using the restaurant infrastructure, so menu price (which includes all fixed infrastructure cost) should not be applicable for the home delivery parcels.

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