Every now and then, you’ll see a news story about franchisees who are up in arms about being forced to sell a cheap burger at a loss.  The situation is typically something like this: the burger is being sold for 99 cents, but the cost is $1.15 when you account for ingredients, labor, rent, etc.

I’d feel sorry for the franchisees – if it wasn’t for the fact that they are wrong.

Let’s break the situation down a bit further.  Let’s say that the Kosmo Burger sells for $1.25.  The raw ingredients for the burger (meat, cheese, bun, etc) cost 50 cents, and fixed costs (such as rent) run $500 per month.

If we sell 1000 burgers per month:

Revenue = $1,250 (1.25 X 1000)
Variable costs (ingredients) = $500 (0.50 X 1000)
Fixed costs (rent, etc) = $500
Total costs = $1000
Total cost per burger = $1
Profit = $250

Let’s say that Kosmo Korporation’s executives force the franchisees to sell a “Junior Kosmo Burger” for 75 cents.  Ingredient costs are 40 cents.  The fixed costs remain at $500, but are now spread across the flagship Kosmo burger as well as the Junior Kosmo.  The restaurant sells 200 Junior Kosmo burgers for the month, in addition to the 1000 Kosmo burgers.  The numbers for the Junior Kosmo break down like this:

Revenue per burger = 75 cents
Variable costs = 0.40 per burger
Fixed costs per burger = 0.42  (500 / (1000 Kosmo Burgers + 200 Junior Kosmo Burgers))
Total costs per burger = 0.82
Loss per burger = 7 cents

That looks bad, but let’s look at the combined numbers for both burgers:

Kosmo Burger Revenue = $1250
Junior Kosmo revenue = $150 (0.75 X 200)
Kosmo Burger ingredient costs: $500
Junior Kosmo ingredient costs: $80 (0.40 X 200)
Fixed costs: $500
Total revenue: $1400
Total costs: $1080
Profit: $320

Wait a second.  Profits have jumped $70 from the example where we were selling just the Kosmo Burgers.  How did we add the unprofitable Junior Kosmo Burger into the mix and make more money?

The problem is that allocation of costs is an artificial construct used to estimate profitability.  It’s a quick and easy method to use to estimate profitability, but it doesn’t actually reflect the reality of the costs.  Really, the true cost structure is:

Costs = 500 + 0.50K + 0.40J

(K = Kosmo Burger.  J = Junior Kosmo Burger)

It is possible to make a profit by selling the Kosmo burger at any price higher than 50 cents and the Junior Kosmo burger for any price higher than 40 cents.  You simply need to hit a high enough volume of sales to offset the $500 of fixed costs.  You’re not going to go broke selling Junior Kosmo burgers at 75 cents.

A few related notes:

  • The cost structure used in the example is artificially simplistic.  You will also have expenses like labor, which is a somewhat fixed cost.  Very few fixed costs are completely set in stone – they are simply fixed “within the relevant range”, to use the words of my Cost Accounting professor.  Even facilities costs will vary if you outgrow your location.  The labor costs will stay the same until productivity approaches 100%.  At that point, you’ll need to hire more staff.  But if your workers are only about 50% productive, there’s no marginal labor cost related to an increase in customers – as you’re currently making inefficient use of those employees.
  • The low cost items can have an effect on profits if they cannibalize sales from existing products.  In our example, the Kosmo Burger has a gross margin (revenue – variable costs) of 75 cents, while the Junior Kosmo has a gross margin of 35 cents.  If I normally buy a Kosmo Burger but decide to buy a Junior Kosmo instead, the restaurant makes 40 cents less in gross margin.
  • Many people who buy the cheap menu item will also buy a high profit item (such as a soft drink) as well.  Thus, it’s important to pay attention to the impact of the total purchase on the bottom line.

(Still confused about the math in the example and wondering how a 7 cent loss on the Junior Kosmo turned into an increase of $70 in profits?  It’s because we’re spreading the fixed costs over a broader base – the fixed cost allocation for the Kosmo Burger would also be brought down to 42 cents.  If you’re still off by $4, it’s due to rounding).

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Kosmo is the founder of The Soap Boxers and writes on a variety of topics. Many of his short stories have been collected into Kindle books.

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