Beware the cost of hidden extras
By Luke Johnson
Financial Times
A central belief of modern business theory is the necessity to focus on a core activity – sticking to the knitting, as it were. But in the 21st century, an era of globalisation and digital transparency, I am not sure this maxim strictly applies.
For very many industries, ferocious competition and perpetual pricing comparisons mean an organisation’s main products are sold at little better than break-even. The internet encourages purchasing decisions based only on price. Qualitative issues are harder to discern on a computer screen – but price is plain (in theory). Hence gross and net margins have been relentlessly squeezed across everything from cars to cameras to home furnishings, as everyone tries to match the cheapest vendor.
In business-to-business transactions, procurement departments and online auctions have led to similar cut-throat pricing. Many suppliers now rely upon the “variation” principle that drives most profit for construction firms – a tendered contract will yield minimal margin, but any deviation by the client leads to supplemental work, priced at lucrative rates.
All sort of companies have adopted the approach of capital goods manufacturers. These producers sell their core range at cost and hope to make up profits through the add-ons. For example, engine maker Rolls-Royce essentially generates its profit from spares, service and maintenance once it has sold its aviation turbines for little return.
Consumer industries are not that different. The carpet trade is an example. After discounts, many traders sell basic floor coverings for a negligible contribution. But they then push add-ons at the point of sale, such as protection treatments at super-high margins. Similarly, electronics retailers sell brown goods at derisory margins, but obtain juicy profits from expensive insurance policies they sell on top. Car rental companies do the same, making the bulk of their profits from items such as fuel surcharges and collision damage waivers. The core activity is almost a loss-leader to attract customers.
The hospitality industry follows this trend. Diners focus on the cost of a main course, so restaurants try to keep these low – perhaps £10. On that the gross margin might be only 50 per cent. They then charge a massive £3 or more for a side order of beans or chips, where the gross margin will be 85 per cent or more. And, of course, restaurants add a service charge, which customers may forget to factor in when deciding how much they can spend. Meanwhile, the live performance sector is notorious for “booking fees” that add 10 per cent or more to the cost of a seat.
The arch exponent of this system is the no-frills airline industry. Airlines purport to sell flights for as little as 50p, but then charge for everything from credit card use to priority boarding.
In a way, even Britain’s Labour government adopted the same philosophy. It kept income tax unchanged for years, but introduced dozens of “stealth” taxes and gradually increased many other “minor” taxes to boost the overall tax burden significantly. Business and government both work to confuse and mislead the citizen, understating the true price (or taxes) to win customers (or votes).
The danger is that these tactics undermine trust in business (and indeed politics) among the public. The vast majority of consumers want to know the true, underlying cost of a product or service before they buy. They feel they are being ripped off if incremental costs are added that were not disclosed at the outset.
Yet commercial concerns must make a return, or they cannot reinvest and reward capital providers, and will eventually go bankrupt. That outcome reduces choice and allows the remaining players to price-gouge. Since there remains vast overcapacity in many industries, there is a tendency to over-produce, meaning goods will be sold at marginal cost. The irony is that the really expensive “core” items – an incredibly complex machine such as a car, for example – might make a paltry profit. The simple “ancillary” thing like finance is the method by which the industry makes much of its profits. As ever, capitalism defies logic but somehow still seems to work.
