The "Because I Can" Surcharge
I'm ticked off reading about “fuel surcharges” that many companies are tacking on to their prices these days. Let me explain why.
One thing I find fascinating about lean is that it isn't just a factory improvement strategy. It really is a comprehensive business mindset. The one business idea that I am fond of writing about here is the difference in thinking about costs and the price your customer will pay.
Old Non-Lean Model:
PRICE = COST + PROFIT or…
PRICE (I set it) = COSTS (as incurred by me) PROFIT (that I am entitled to)
This model is wrong because it assumes 1) you can set the price of your product and 2) you are entitled to a given profit margin or profit percentage.
The Lean Model, as popularized by Toyota:
PROFIT = PRICE – COST or….
PROFIT (that I earn) = PRICE (as set by the market) – COST (as incurred by me)
Under the old model, you set a goal, say “I want (or Wall St. requires) a 10% margin or my stock price will go down or I will get fired or my wife will make me close up my business and get a regular job”. If your costs go up $5 per item and you “need” to or “deserve” to maintain your profit goal, the logical response is to raise your price to your customers by $5.
The problem with this thinking is that it goes against basic microeconomics. You've probably heard of the idea of the supply and demand curve? The idea is simple…. for most products (let's ignore special cases like cigarettes or Microsoft Windows), when you raise prices, the amount you sell will decrease.
Another problem: look at airlines. Planes are always full these days. People want to travel. But, they are willing to travel at market-rate prices. The airlines, such as American, are losing money because their costs are too high (there are many reasons for this). If American was truly entitled to a profit (management, Wall St., employees all think they should make a profit), they would just raise prices so they were higher than their costs. But, travel would dry up. Companies would look at video conferencing, consumers would drive instead (oops, those high fuel prices) or stay home. The only price increase the airlines can get away with is a modest, you guessed it, fuel surcharge. Airlines need to focus on reducing costs, not just looking at ways to increase prices. One way to reduce costs is to get rid of their overpaid executives, but that's a different blog posting altogether.
So let's say you have 1000 customers for a lawn maintenance business (one type of company that is charging fuel surcharges) and each customer pays you $50 a month. You inevitably have some fixed cost to your business (trucks, mowers, your salary, etc.) and some variable cost that you incur each time you service a customer (truck fuel, mower fuel, wages to workers, etc.).
Your equation might have been:
- PROFIT = PRICE * CUSTOMERS – FIXED COST – VARIABLE COST * CUSTOMERS
- PROFIT = 50 * 1000 – 20000 – 20 * 1000 = 10000
Now gas prices have been rising and that's a significant part of your cost. Let's say your variable cost has now increased to $30 per customer. This would knock your profit down to ZERO. If you say “well, I must make a profit, I will just add a $10 fuel surcharge” and you send a letter to your customers saying you must raise your price to $60. You might even say you're really sorry and wish you didn't have to do this, but you all know, gas prices have gone up.
The problem with this approach is that some of your customers will go away. Let me repeat this. Some customers will leave. They might never come back, even if you reduce your “fuel surcharge” when, and if, gas prices fall.
I'll leave out the more technical economic terms…. but the question is “how many” customers will go away? If you sell something like cigarettes you have customers who are addicted and will continue buying, almost no matter what. But, with lawn service, if it gets too expensive, I might think it's now better for me to just quit being lazy and mow my own lawn.
If you lost 20% of the customers in this lawn business, you are still ahead with the “fuel surcharge” price increase.
- PROFIT = $60 * 800 – 20,000 – $30 * 800 = $4000
That's less profit than before the cost and price increase, but it's better than keeping your price at $50 and not making a profit with 1,000 customers.
But, if 350 of your customers (35%) go away, you're now losing money. Are you willing to take the chance, not knowing how many customers will go away with your fuel surcharge price increases?
Let's revisit the idea that prices are set by the market. I assume that, in setting your price of $50, you looked at what competitors were charging and what people are typically willing to pay. If you blindly set a price based on your internal costs, you're doomed to fail.
But, let's say we put a $10 gas surcharge on our lawn business and only lost 5% of our customers. In this case, we make almost as much money as we had before, $8500 a month (you can do the math.) So, if you were justified increasing your price because costs went up… why didn't you increase price because the market would bear it?
If your cost had stayed at $20 and you increased price to $60 “because you could” (you wouldn't tell customers this), your profit would have grown from $10,000 to $18,500. So, if you see a business say “we're increasing prices because costs went up” and they don't lose too many customers as a result, you should ask them (if you're an investor) “why didn't you raise prices earlier?????”
So what do I recommend? As a business owner, charge as much as you can, as much as the market and your customers will bear. But also, you need to focus on cost reduction.
When your costs go up, don't just “boo hoo” and watch profits drop. Work on reducing costs in other areas. Gas prices went up, you have no control over that. Fine, use lean methods to reduce waste and reduce costs in other parts of the business. Gas prices went up, so think about your driving patterns and think about ways to reduce the amount of gas you use.
That kind of thinking is much healthier for your business, and dare I say the economy, in the long run than is the idea of “passing along cost increases.”
Another problem with “passing along cost increases” and surcharges…. where does the cycle end?
- Gas prices are up, increasing the cost of lawn maintenance
- Price of lawn maintenance is increased due to rising fuel costs
- Gas station owner has to pay more to have grass around station mowed
- Gas prices are increased due to cost of lawn maintenance
- Price of lawn maintenance is increased…..
You can see this is NOT a sustainable cycle. For one, gas prices are actually very competitive. Gas station owners can't just raise them willy-nilly. If the lawn maintenance company can raise them just “like that”, they probably weren't charging enough before. Secondly, this “we all have to pass along our cost increases” would lead to inflation and would really hurt the economy.
Here is an article that was in the Wall St. Journal about a Wyoming gas station company that is focusing on cutting their costs so they can sell gas cheaper (which boosts their volumes immensely, and I assume their profits also).
There is money to be made in selling fuel cheaper,” says Kristen Call.
Let's also look at stamps…. FedEx and others are adding surcharges, the Post Office has to try to raise prices (which is really basically the same thing).
“The Postal Service is not immune to the cost pressures affecting every household and business in America,” he said.
For example, each penny increase in the price of a gallon of gasoline costs the post office $8 million, and payroll, health expenses and other costs also have been rising.
And, unlike private delivery companies, the post office cannot simply add a fuel surcharge to its rates.
Maybe the USPS should look at reducing other costs and being more efficient rather than just passing their costs along to us?
What's next, companies adding “postage increase surcharges”? Stop the surcharges! Get lean. Get efficient. Get creative.
I'll tie this back to lean one last way. When Toyota charges a higher price for a model (Toyota Matrix) that is virtually identical to the GM model (Pontiac Vibe), is it because Toyota's costs are higher and Toyota is entitled to the profit? Of course not. Why does Toyota charge more? Because they can. The market has set the price for them.