Beyoglu is a Mediterranean restaurant on 81st and 3rd here in Manhattan. When Kelsey and I have guests, we often take them to Beyoglu for dinner, and we usually order the same dish: the vegetarian platter. Each platter comes with a wide variety of delicious spreads like hummus, spicy red pepper salad, and cracked wheat bulgar – with all the fluffly fresh-baked pita bread you can eat. A single platter ($14) will feed three people, or two with leftovers. It’s a steal, which is why we visit regularly.
Looking around at other tables, it’s clear that the platter is a best-selling dish – maybe the most popular in the restaurant. Here’s the business question: would Beyoglu make more money if they raised the price?
Profit Maximization
Most business schools teach that the purpose of a business’ management is to maximize the profitability of the company. While profit maximization sounds like a perfectly logical goal for a profit-making entity, paradoxically, it kills perfectly good businesses over time.
Imagine a fail-safe (and perfectly legal) product that would instantly increase your net worth by $1 million. Would you buy it if it cost $1 million? Probably not – there’s no point, since you’re not any better off after purchasing than you were before.
People buy from you because they receive more value than they give away in payment. The more value your customers receive in proportion to what they pay, the happier they are, and the higher the likelihood they’ll do business with you in the future.
Every business creates something of value for other people, which is then exchanged for money or some other form of value. In order to continue operation, the business must “capture” some proportion of the value that’s created in the transaction. The question is: how much?
Here’s the paradox: a profit-maximizer will answer, “as much as you can” – if they can get away with capturing 99% percent of the value created, they’ll do it. In doing so, however, the profit-maximizer is simultaneously eliminating the only reason people will do business with them in the first place.
Maximizing Value vs. Maximizing Profit
There are generally two ways a business can make more money: by increasing the value it provides, or by capturing more of the value it creates. Said another way, you can either choose to take a larger percentage of the pie, or make the entire pie bigger. By definition, you can only truly maximize one or the other. If you want to build a better business, which do you choose?
All businesses must capture “enough” value to cover operating costs and make it “worth it” for the people behind the business to continue creating value. After that point is reached, however, the best way to increase the profitability of any business is to focus on increasing the value the business creates.
The goal of every business should be to create 10x (or 100x, 1,000x, or 1,000,000x) more value for its customers than it captures in revenue. Every business that has experienced long-term success intentionally creates more value than it captures, and that’s okay. If you can consistently give away more value than you take, the world will beat a path to your door.
(For another great post that discusses value creation vs. value capture, read Work on Stuff that Matters by Tim O’Reilly.)
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Sounds like a great restaurant. I wonder if they price their food so low in hopes of bringing people into the place and selling some wine or beer, which is probably where greater profit margins lie.
Bill – Upselling is certainly part of the strategy, and their other dishes (kebabs, etc) are in the $20-25 range, which I’m sure they make a healthy margin on. I don’t think that the vegetarian platter is a loss leader (i.e. product with low/no margin designed to bring in customers) since the ingredients are pretty simple / low cost, but the generosity with the food given the price certainly brings people in the door – the place is *always* busy, with a 20-30 minute wait for a table.
I cannot agree more, actually I wrote a similar post weeks ago
Edward
Frontier Blog – No one ahead, no one behind
http://www.hwswworld.com/wp
I’ve made the same argument in MBA courses, so let me offer the counter response. The response that I always receive is that “profit” is not defined over the short term. The normal predictive measure of profitability, as taught in schools, is the NPV of the strategic plan, where the longer the planning horizon, the better (ten years would probably be a minimum; a hundred years would be great). With such a long-term view on profitability, incraesing customer value pretty much falls out as an obvious business plan.
Tom – good point. The problem with viewing things from an NPV standpoint is that it’s easy to make almost anything pay out over such a long time period. I’ve personally worked on large projects where the 1 and 3-year NPVs were horrible, and the project just barely squeaked by at the 5-year mark. The 5-year NPV was used to justify the project, but the project was killed a year or so after it launched because the shorter term cash / profit consequences were too great.
A hundred-year NPV would be great if humans were able to accurately forecast 100 years into the future. Unfortunately, we’re not – 5 years is a big stretch. That brings us back to the present: what are you doing *right now* to increase or decrease the value you’re providing to your customers, and are you making “enough” profit to justify your efforts? Little actions, positive or negative, accumulate in to huge results over long periods of time.
Interesting post. Are you really talking about price elasticity? http://en.wikipedia.org/wiki/Price_elasticity_of_demand#Elasticity_and_revenue
I like how you pointed out that there are multiple ways to increase profitability; however, I’m not sure that increasing the value you provide is one of them. If increasing the “size of the pie” cuts your profit margins to zero, you can provide all the value in the world and not make more money.
For example, if your blog (a free distribution of value that serves as advertising for your consulting business) becomes so popular that you have to spend all of your consulting income on webhosting fees (even though the consulting business is growing due to the added exposure), your profit margin has dropped to zero. You may be providing more value than ever to your customers, but so what? You’re broke.
The key metric is the profit margin. If you can provide more value to customers by scaling up while maintaining an acceptable profit margin, go for it. However, the opposite strategy may be a better idea. Tim Ferris (granted, not really an expert in anything other than self-promotion) points out in The Four-Hour Work Week that it may be better to target high-end customers who will pay more, even if it means you sell fewer units. If you can make your money with fewer sales, and that means less work, go for it.
Either way, what you’re really looking for is the right amount to charge. If that’s the case, it’s not a paradox – it’s an elasticity curve, which is a very well-known concept in economics.
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