On 27 September 2007, European landowners got a rude surprise: their tier fees had increased overnight by 15-25%.
VAT is a sales tax levied by the European Union on goods and services passing through the value chain to the final consumer. Linden Lab chose to absorb this cost for a period of time then changed their policy without warning. The result was devastating – and it remains a serious problem.
[W]e have been asked quite a bit why we haven’t charged VAT before now. The simple answer is that Linden Lab was able to absorb the cost of VAT on behalf of its EU customers. Our business in Europe has quadrupled each year since 2004 and already it has more than quadrupled in 2007 through September. As a result, we can no longer afford to absorb these costs for European Residents.
Yet I draw the opposite conclusion: that because of its enormous success in the European market, Linden Lab can easily absorb VAT – and do so without detriment to non-EU residents.
COGS (Cost of Goods Sold) is a cost that varies with sales. The simplest way to think of it is the cost of hiring more salesmen or designers when your business grows. Alternatively, think of the cost of electricity for a restaurant. The more customers you have, the more food you cook, the higher your electricity bill. Needless to say, it would be foolish to turn away customers to save on electricity. You need to measure costs against revenues.
Gross Margin = Gross Revenue – COGS
By absorbing VAT, Linden Lab would face an increase in COGS. In other words, it would cost Linden Lab US$52 ($347-$295) more per month to sell a full region to a Brit instead of an American, which means gross revenue of US$243 instead of US$295 per month. Since it would still be profitable for Linden Lab to sell a full region at US$243 per month (and there would also be US$825 in revenue from the $1000 setup fee), the company is wrong to say it cannot afford such a sale.
Worse, passing VAT on to European entrepreneurs reduces Gross Revenue because:
- existing European entrepreneurs withdraw their financial and human capital
- potential European entrepreneurs are discouraged from investing
- reduction of European participation undermines the Network Effect (a term used by economists to describe increasing marginal returns)
In other words, passing VAT onto European residents is not free. While absorbing VAT reduces Gross Margin (profit), passing it on reduces Gross Revenue (sales). I maintain that absorbing VAT is the lesser cost – especially in the long term. I believe that Linden Lab is turning away customers to save on electricity.
There is more to it than money. The once-harmonious relationship between Americans and Europeans has come under increasing stress because of discriminatory pricing. The issue ran like an open sore for months as European entrepreneurs bled out of the game – never to return because of the recent rise of the dollar against European currencies. If SL is to be an American game, no problem, but unless LL reverses its policy of discriminatory pricing, it’s nonsense to pretend Second Life will become a ‘global village’ in the face of massive regional disincentives. A restaurant that turns away customers to save electricity is bad enough, but one that does so by setting higher menu prices for foreigners is unlikely to remain convivial.