If you ask an economist for advice on how to make a good business decision, he or she is likely to tell you to think at the margin. This means comparing the cost and benefit of an additional action. My conversations with small business owners suggest that many of them do not follow this advice, which surprises me.
Consider the following example: You own a four-bedroom bed-and-breakfast on the Jersey Shore. A woman calls you up on a Monday morning in February to ask if you’d rent her a room for that Wednesday night for $65.
Should you take her offer?
Think at the Margin
The Revenue Side
In the summer, you are always fully booked, and get $350 per night on the weekends and $250 per night during the week. In the fall, weekend visitors pay $200 per night, while weeknight occupants spend $125.
However, weekdays in the dead of winter are another story. In February, you receive very few inquiries – about three per month – not even close to the number it would take to fill your place. Since you live in the house, you can’t shut the place down. Instead, you operate a mostly empty bed-and-breakfast all winter long.
Given the number of inquiries you receive in February, the odds are essentially zero that you will receive enough inquiries in the next 24 hours to fill all of your rooms. If you don’t rent to the bargain hunter who has just called, you are going to have an empty room for the night.
The Cost Side
You have a pretty good handle on your costs. You spend $400 per month on your utilities and $2,000 on your mortgage. Insurance adds another $100 per month. You spend about $300 per month on general upkeep and $300 to advertise the business. Those costs alone set you back $25 per room per day – 365 days a year.
You also pay your cleaning person $25 to clean a room. It costs you $5 in ingredients to make breakfast for a guest. You value your time at $30 an hour and you spend an average of one hour per guest (between doing all the paperwork to book a room, making breakfast and answering questions.)
What Economic Theory Says To Do
Microeconomic theory indicates that the lowest offer you should take is the one that exceeds your marginal cost. That’s $60 – the $25 to clean the room; $5 in breakfast ingredients; and $30 for your time. Those are the costs that you incur only if you take the prospective guest’s deal.
The cost of your utilities, mortgage, insurance, upkeep and advertising don’t matter. Those are sunk costs – past expenditures that cannot be recouped. Whether you take the guest’s deal or turn her down, you are still paying them.
Many small business owners find it difficult to take the $65 offer. They think about how little revenue the deal would bring in. How much more money the rooms generate in the summer months; how high their average costs are and even how much they hate bargain hunters.
But none of those things change the basic equation: If someone offers you marginal revenue that exceeds your marginal cost and no better alternative comes along, it’s in your interest to take the deal – think at the margin.
Margin Photo via Shutterstock