Squeezing the Lemon

On 03/06/2010, in Economics, Entrepreneurship, by Jordan Wilson

Apologies to anyone expecting a post about my favourite beverage, the Caipirinha.

Yes, that would be a good post. But it would require limes, not lemons.

Rather, this follows on from How to Become a Billionaire. In that post, I mentioned how “squeezing the lemon” could reduce costs, thereby improving profitability.

Now I want to provide a simple example of the relationship between cost, revenue, and profitability.

A coffee shop owner sells 10,000 cups of coffee per month at $2.00 per cup. She sells only the one size and no other products. Revenue is therefore $20,000 per month.

Variable and Fixed Costs

Let us say variable costs run $1.00 per cup of coffee sold.

Variable costs are costs that are directly correlated to the level of business activity. Any cost that is directly linked to volume. In a coffee shop that might include coffee grounds, plastic cups, stir sticks, sugar, milk, etc. You sell a coffee, you need a cup to put it in. No coffee sold, no cup used, so no expense incurred.

And let us pretend that fixed costs run $7000 per month.

Fixed costs are costs that do not fluctuate – over the short to possibly mid-term – based on volume sold. They are incurred equally whether you sell 1,000 or 10,000 0r 20,000 cups monthly. In the short run, you need the same amount of building space regardless of volume, so rent would be a fixed cost. The same generally holds true for expenses such as staffing, advertising, insurance, and maintenance.

Note though that while fixed costs are fixed in the short term they can change in the mid to long run. At 10,000 cups per month sold you might need two baristas and 1000 square feet of space. If volume rises to 50,000 cups per month, you may need to higher additional staff or find larger premises.

As a result, over time fixed costs tend to look like steps on a staircase. Flat for a period, then an increase as business volume outgrows current resources. Then flat for another period as those new resources are able to deal with further volume growth. Then another sharp increase as those resources need to be increased to handle the ever growing volume.

For example, one barista can process at peak efficiency 7000 cups per month. So two baristas can handle 14,000 cups each month. If we ignore part-time help, then at 10,000 cups sold per month you require two baristas. And, at that volume, there is about 4000 cups of excess capacity. Excess in the sense that the current resources (the two baristas) could process more units than they do at the present.

As volume increases to 14,000 cups sold per month, they will reach full capacity. At that volume, the coffee shop will not be able to sell more cups without increasing staff (over-time, part-time or new full-time staff). To continue growing the business,  additional staff will need to be hired. This will create new excess capacity, allowing the business to grow into  higher volumes for the future.

Variable costs will look like a diagonal line rising at a constant pace as volume increases. A cup costs $0.20. You sell 1000 coffees, you need to spend $200 on cups. You sell 10,000 coffees, you need to spend $2000 on cups. The relationship stays constant.

Of course, this is a simple example. In the real world, the more volume you buy, the greater the price discounts you can obtain. But we shall keep it simple today.

Converting the fixed costs to a cost per cup basis equals $0.70 per cup. Adding in the variable costs of $1.00 per cup requires the owner to charge at least $1.70 per cup, over the long run, to break even. As she now charges $2.00 per cup, she nets $3000 per month in profit by selling 10,000 cups.

Squeezing the Lemon

A shrewd businesswomen, the shop owner takes steps to reduce her costs. She is able to extend her lease on favourable terms, find less expensive suppliers while still maintaining a high quality product, and hires her retired mother as the barista at a low salary. She tightens cost controls until she cannot save another cent.

In short, she has squeezed the lemon dry. There is no more juice to be wrung. And there are no more cost savings to be found in her business.

Through squeezing, variable costs fall to $0.80 per cup and her fixed costs to $5000 per month, or $0.50 per cup.  Now her combined costs are $1.30 rather than the original $1.70. So each month she now nets $7000 instead of $3000. Not too bad.

Impact of Cost Reduction on Revenue and Profitability

As importantly, if she can lower her cost base, she may be able to reduce her selling price without impairing her original profit margin.

Consider three coffee shops, in close proximity, selling identical coffee. Each shop sells 10,000 cups a month at $2.00 per cup. Our store owner from above has reduced her costs to $1.30 per cup, her competitors are unable to do so.

She decides to pass on some of the savings to her customers and reduces her price to $1.70 per cup. Her competitors, unable to to reduce their cost structure, cannot match this lower price in the short term without cannibalizing profits. She now nets $0.40 per cup, so her monthly profit rises from $3000 to $4000. Less than if she had left the price at $2.00 but an increase of 33% from her original profit margin.

Price Elasticity

But why would she sell her coffee for $1.70 when she could get $2.00 for a cup? That seems to not make any sense.

All else equal, our store owner will steal customers away from the other two shops by reducing her price below the competition. Would you pay $2.00 for the exact same product that costs $1.70 a few steps away? Not likely.

Even if she only takes 15% of her competitors’ clients, her volume will increase to 13,000 cups per month. So, at the new lower price, her overall revenue actually increases to $22,100 per month.

Compare this to originally selling 10,000 cups at $2.00, for revenues of $20,000. It is an increase of 10.5%. Plus her pre-tax profit is now $5200 as opposed to $3000 at 10,000 cups sold. Pretty good return for actually reducing her prices.

This is an example of price elasticity.

As the price of a product changes, the demand will change. If the product is something you need, such as electricity or gasoline, the provider can increase the price with little decrease in demand. You need to run your car. It will take a huge increase to change your buying pattern.

In our example, the exact same coffee was sold at three separate shops. By reducing the price in one shop, demand for the the cheaper coffee will rise. The greater the demand changes based on a price change, the greater the elasticity (think of a rubber band).

In our example, the store owner wins two ways by squeezing the lemon. She increases her per unit profit margins and she also increased her sales volume through the high elasticity of coffee.

The Market is Always Changing

One thing to watch in the real world is the actions of competitors. Business does not operate in a vacuum.

In our example, over the mid to long term, the competitors will need to reduce their costs and adjust their pricing as well or face extinction. If they can match pricing at $1.70 per cup, then the increased volume our shop owner stole may tail away over time and revert back to the other companies.

And if the competitors can cut their costs even more than she did, a price war may ensue that hurts everyone’s profit margins.

When in business, if a competitor is able to reduce his costs and prices more than you have, you will have to react. Not an easy task if you have already squeezed your own lemon dry. So always be on the lookout for ways to improve your business processes and results. Your competitors likely are.

No one ever said business is easy.

I hope this helps understand the relationship between costs, revenues, and profitability.

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