To fully grasp the real meaning of marginal revenue, let me start with a great example from one of all types of businesses, a beer company.
Several years back I was reading the financial statements for Anheuser Bush Beer Company. In those days, Anheuser had two major sources of revenue. The first and the one most of us know about is beer sales. The other included their theme parks (Busch Gardens, Sea-World, and Sesame Place). The beer sales were around 18 Billion Dollars whereas the theme parks generated 1.2 Billion Dollars. The interesting comparison wasn’t the sales, but the profit generated from each division. The beer side of business generated about $200 Million in profit, but the theme parks generated $400 Million in profit. Wow, this shocked me. How were they able to generate so much net profit for this division? The answer is marginal revenue.
I have visited these parks and I could tell immediately that it is close to a professionally licensed pick pocketing operation. You see, you pay a flat fee to get in the front door, but boy do they do a great job of getting you to purchase additional items while in the park. If any of you have visited any one of the major theme park systems, you can’t get out of there without spending $60 per person in food, drinks and trinkets. They set this up by first capturing the audience and by making it difficult via a long walk to get back to your car for a picnic lunch to save money. In addition, they are tenacious at creating a warm fuzzy family moment such as selling photos of you enjoying the ride with your family or funneling the traffic through corridors of dessert vendors. The whole goal is to generate marginal sales generating significant marginal revenues that add quickly to the bottom line.
Anheuser has many barriers to achieve this same principle related to beer sales. The primary barrier is competition. Notice the value of a captured audience?
The rest of this article delves deeper into the basic principle of marginal revenue. The best part is illustrating how you as a small business owner can implement this principle in your operation.
Marginal Revenue – Textbook Definition
In the college textbooks, the various authors define marginal revenue in a very simplistic definition. Essentially it is the value of the additional revenue received from the customer for the additional item sold. So what these authors are saying is each item sold or hour of service provided generates marginal revenue.
Well, DUH! To me, it is much more than this simple minded definition. What it really means is the value generated to the organization for a little more effort in getting the customer to purchase one more unit in their visit or to just purchase from you.
There is also a secondary definition related to marginal revenue. This is the revenue generated due to certain attributes acquired by the business. These attributes include sole supplier of the service or goods, emergency responsiveness, and acquired knowledge. What it means is that the business is entitled to charge more because there is very little competition.
As a small business owner, you need to realize that the textbook answer has very little value to you and that you should think of the definition in a more comprehensive understanding. There’s the textbook answer and then there is reality.
Marginal Revenue – Reality in Business
Marginal revenue is more of a tool in business than a simple value of a single unit of sales. It is tool to exercise to increase the overall performance and profitability of the company. This tool should be a part of the thought process in every employee’s mindset. It doesn’t matter what kind of business you run, everybody should be on the lookout to try and generate greater revenue via additional sales. The following are some examples:
- In the auto repair industry, the technician and the counter guy try to up-sell the services and discover additional services needed for the car. The best example is Firestone. When you take your car there, they are constantly alerting you to issues, specifically safety issues for additional work. Another is Jiffy Lube; they try to get you to purchase auxiliary services like radiator flushes or replacing the air filter.
- In fast food, every notice the ‘super-size’ request at the end of the exchange with the cashier. At McDonald’s it’s ‘Would you like to Super Size your order?’ In your sit down restaurants, the question at the end of the meal is ‘Would like to order dessert?’
- The large retail chains now use warranties as an additional revenue generator. I’m not kidding you, I purchased a $19 soldering gun last month, and the Home Depot clerk asked me if I wanted to pay $7 for a two year warranty. I looked at her as if she were crazy. ‘Nope’ I said, ‘when it breaks, I’ll buy new one’.
- In the grocery stores, it is all the candy and magazines along with the refrigerated bottles of soda at the front cash register.
- One of my favorites is the car wash at the gas station. You insert your debit card and the computer prompts you to purchase the car wash for an additional $5, right there on the spot. You have to hit the ‘NO’ button. It is annoying!
The reason businesses do this is to garner additional revenue dollars while you are there. So in your small business, you should use a similar approach. The consumer has pretty much accepted this as a normal function of business.
The real value involves the marginal cost to generate that marginal dollar of revenue. If all variables remain equal, then there are no additional costs to advertise or costs of insurance related to having that customer standing there in front of your sales representative. Even the labor component is already covered. So the additional cost associated with the purchase is minute and the marginal contribution is greater than normal. Therefore, this better contribution margin falls to the bottom line. This drives profits way up just like the Anheuser example I illustrated above.
There are better situations than others that really benefit the business in exercising the profits of generating marginal revenue. These include captured audiences, limited knowledge and timing. The following section illustrates how these three environmental conditions allow for better opportunities to generate marginal revenue.
Environmental Restrictions Create Marginal Revenue
There are three environmental restrictions that create opportunity to generate marginal revenue. The first is a captured audience. We all are victims of this scenario. I used the theme park example above, but this happens in many different venues. These include movie theaters, sporting events, concerts, and with geographical issues. Most of these are self-explanatory, but I’m sure some of you are asking about the geographical scenario.
Well, if you have a business and you are the only one within a particular town or area, you have a captured audience. A good example would be a crane company. In more remote areas, there is only one crane operating business. There is no competition. The marginal revenue opportunity exists in each and every sale; your price should be higher than normal. Where else is the customer going to go?
Another example of an environmental restriction includes businesses that have acquired unique expertise in certain professions or trades. Examples include lawyers that practice environmental law, or practice zoning law. Some trades with unique licenses include professional engineers or surveyors. One of my favorites includes septic tank installers. I had no idea they required a state license. It turns out they have to document the proper installation of the leaching fields and drainage angles when installing a septic tank. In many states, it’s a health occupancy license. It isn’t like an auto mechanic where you can find several in your town.
The final environmental restriction I’ll discuss is timing. The closer to an emergency the situation is, the more likely you can generate marginal revenue. Think of disaster based operations, or even hospitals. This is one of the reasons emergency room fees are so high! I often am force to take my sons to the local first response medical facilities for their various injuries. I pay what they tell me to pay. It isn’t like I have a choice of where to go.
Maximizing Value from Marginal Revenue
So what do you do when your company doesn’t have one of the environmental restrictions available? Well, you have to change the culture of the business to generate additional sales. This involves everyone in the company. If you don’t know how or where to start; then this is an opportunity to let your staff brainstorm to solve the problem. Have a lunch meeting and explain to everyone that you want to modify the culture at the company to sell more. Have everyone pitch ideas and write the ideas down. Writing it down does two things, it shows your staff that you are interested in what they have to offer and it leads to more questions.
The best illustration I ever saw was a total wide company meeting. The owner wrote everyone’s ideas down on a white board in front of the room. Then as the discussion shifted towards some details, many of the ideas were discounted and the employees that offered those ideas learned more about the company and why it wasn’t the best idea.
For you, the goal is to start somewhere. So brainstorming and then following up is a wonderful way to get the ball rolling. From there, research and creation of some policies and procedures will produce the proper atmosphere for all employees. The final step is education and training. Over time, report back to the staff on progress and performance so everyone feels that they contributed to earning marginal revenue. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.