09 – The effect of price on profit value and the rest of your life. Part 1. Marginal revenue and practice profits.

To best understand profit, let’s look at some basic management accounting.

Any business has two types of costs: fixed costs and variable costs. Fixed costs are the costs that the business incurs regardless of how busy that business is. They are costs that must be met even if there are no clients. Things like rent, professional membership fees, etc are examples of fixed costs.

Variable costs are the costs that increase with the amount of work that a business does. An example of a variable cost is the fee advisers pay to an outsourced SOA preparation agent, such as Simple Paraplanning. The fee to Simple Paraplanning is only paid where there is a client also paying for their SOA. So, when a new client is taken on, the variable costs increase. 

Variable costs are sometimes referred to as marginal costs. In terms of profitability, it is the link between marginal cost and revenue that really needs to be explored. 

Marginal revenue is the increase in revenue brought on by a particular piece of work. In financial advising, this is usually a new client, but it might also be an extra piece of work performed for a client. 

In order to increase profit, the marginal revenue for an extra piece of work must exceed the marginal cost. If marginal cost exceeds marginal revenue, the practice’s profitability will fall.

The greater the gap between marginal cost and marginal revenue, the greater the impact on profit.

Now let’s consider price. Price is, of course, the main determinant of marginal revenue. Therefore, the price that the practice charges for its services will directly impact on profit. Price must, therefore, at least exceed marginal cost if the practice wants to increase profit. 

A simple way to increase the gap between marginal cost and marginal revenue is to increase prices. Increasing prices will not effect marginal cost.[1] But it should increase marginal revenue. 

To give a simple example: a business has one client for whom it charges $100 per hour. It does ten hours work per year and there are no fixed costs. Marginal revenue is $100 per hour. The marginal cost in the business is $50 per hour. Therefore, marginal profit is $50 per hour. Total profit is $500. 

If the business increases its prices by 10%, the marginal costs will not change. But, the marginal profit will become $60 per hour ($110 minus $50). Times ten hours this becomes total profit of $600.

The increase in revenue was $100. The increase in profit was the same in dollar terms.  However, in terms of profitability, the increase was 20% ($500 profit became $600). This is the case even though the price increase was only 10%. 

The reason for the disproportionate increase in profitability is that the practice did not have to do any extra work. Consequently, marginal costs did not increase.  

Now let’s change the example a little and assume fixed costs of $200 per year. When the price is $100 per hour, and the marginal costs are $50 per hour, and the business does 10 hours work, the total profit is $300. ($1,000 minus $500 minus $200). If the price is increased by 10%, as in the above example, the total profit increases to $400 ($1,100 minus $500 minus $200).

This is an increase of 33% in terms of profitability. The reason for the extra percentage impact on profit is the presence of fixed costs. The greater the level of fixed costs, the greater the percentage impact on profits when a price is increased or decreased.

For this reason, businesses with relatively high fixed costs are often described as having more price sensitive profits.

The proportion of fixed costs will dictate how sensitive profit is to pricing: higher fixed costs mean greater sensitivity. However, regardless of what the extent of fixed costs is, the fact that prices impact directly on profit does not change. And, unless the business has zero costs, the effect on profitability of an increase in prices will always be disproportionate to the dollar value of the increase in prices.

The above analysis assumes that there is no drop in demand if prices rise. This is quite a big assumption, and leads us to a concept known as price elasticity. We discuss this in the next section.

[1] There is one exception to the idea that increasing prices does not effect marginal costs. For financial advisers whose AFSL takes a percentage cut of the practice’s revenue, this is a marginal cost that does increase with marginal revenue. Provided that the AFSL’s cut is not 100%, however, the increase in marginal revenue will be greater than the increase in marginal cost, leading to an increase in marginal profit.

By the way: Dover charges a flat, fixed fee to its advisers. The reason for this is that we were looking for a fixed cost model when we first started looking for an AFSL to work under ourselves. Fixed fees are much better for busy practices. When we could not find an AFSL offering this model, we decided to create our own.

The Dover Group