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Sunday, September 16, 2007

The economics and psychology of gross profits

And by gross profits, I mean disgustingly obscene profits. Forget the oil companies. If you want to criticize anyone for gross profits, it should be companies that sell food and drink for far above normal costs. Your vending machines with their $2.50 bottles of soda? That's just insane.

But even at $1.00, there's an incredible level of profit on a bottle of soda. And I doubt I'm alone in being more willing to buy a $1.00 soda than a $2.50 soda. It's a psychological thing. You're willing to pay for convenience, but don't want to feel ripped off.

If you travel, you may see two key examples of this situation. Compare the food that airlines sell to the food available in a hotel mini-bar. The airline sells a sandwich for $5.00. Most people know that two slices of bread, three ounces of meat, and some condiments are a lot cheaper, but the prepared sandwich is a level of quality above that. But they also know a sandwich from Subway, the closest comparison to the airline's sandwich, runs between three and four dollars. And that's outside the airport. Inside the airport, food is even more expensive. The $5.00 airline sandwich is probably the best deal, and the convenience of not having an additional item to carry on the plane makes five dollars both highly profitable for the airline and worth it to the consumer.

On the other hand, the cost of items in the mini-bar are truly obscene. $2.25 for a 69 cent candy bar? At that price level, I think two things: "I'll never buy that," and "I can probably find a convenience store or gas station in walking distance if I want that."

I fail to see how mini-bars are even profitable. Eventually, the food inside gets old, and needs to be removed. Do they even sell enough to cover that waste? But more importantly, would profits be higher with lower prices?

I'm reminded of an ancient computer game, a lemonade stand simulation, from school days. It was loaded onto a Commodore PET computer, using a tape drive, to give you an idea just how old. (Not as old as you think, since the school district was cheap.) Each day, given a temperature and humidity, you set the price for a cup of lemonade at your stand. If it's blistering, you can get away with 25 cents a cup, but if it's sixty degrees Fahrenheit, you might have to charge 3 cents. The goal is to maximize profits, with the highest income (price per cup times cups sold), considering expenses (cups and lemonade concentrate). I got very good at guessing the ideal price; I believe the sales formula was a parabola, with one ideal maximum price.

So, if a minibar sells 10 Snickers bars at $1.00 versus 1 at $2.25, I have a fair idea which makes more money.

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At 11:31 AM, Blogger Dave Justus said...

But what if a large majority of your customers have expense accounts?

At 12:33 AM, Blogger Greg said...

I thought about expense accounts. But when I travel for business, there's two reasons I don't hit the minibar. One, it doesn't feel right to take advantage of an expense account like that. Two, I think the company might not cover it.

Perhaps most travelers with expense accounts lack this ethical position and work for companies that lack careful control of expense accounts. It's not on the level of a man who brings three suitcases of clothes for a two-day trip and has the hotel dry clean all of his clothes, but I'd still think worse of an employee using an overpriced minibar.

At 2:34 PM, Blogger Dave Justus said...

I think though that sales people, and others more used to using expense accounts for entertainment and similar things, as well as higher placed executives don't think of it like that at all. One, they 'know' they will be covered and two, that is the sort of thing they spend money on all the time.


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