COGS in the VAT Machine

On 27 September 2007, European landowners got a rude surprise: their tier fees had increased overnight by 15-25%.

Questions about VAT 2007-09-29

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.

VAT are you talking about 2007-10-5

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.

Publication history:

SL Newspaper, 24 August 2008

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One Response to COGS in the VAT Machine

  1. COGS in the VAT Machine – an Elaboration on the Original Article

    Linden Lab, a global company operating in different markets, had a choice to price its product universally or according to aggregate costs in different markets. To charge different prices for the same product is called ‘discriminatory pricing’. It is not a negative term. It simply means that the market is divided into different segments for the purpose of pricing a product specifically for each segment.

    At first, Linden Lab treated VAT as a variable cost within the European segment of its global operations. Then, in late September 2007, without warning, Linden Lab changed its policy from treating VAT as a cost of sales to passing it on to European residents. I believe this policy reversal undermined LL’s stated goals of economic growth across a single, global market community. I also believe Linden Lab lost money. How is that possible?

    All businesses face variable costs associated with sales:

    • office/warehouse rent
    • salaries/wages
    • utilities (electricity, gas, water, telephone, waste removal)
    • IT (hardware, software, telecommunications, consultants)
    • administrative costs (furniture, printing)
    • transportation costs (shipping, staff subsidies, vehicle maintenance)
    • research and development costs (trade magazines, conferences, surveys)
    • marketing and advertising costs
    • accounting and legal costs (professional fees, subscriptions, registration fees)
    • financial costs (export-related currency costs)
    • taxes (national, state/provincial, city/local) (income, sales, excise)

    These costs increase as a business grows (more employees, bigger office space, higher telephone bills) These costs also vary depending on geographic location. Office space is more expensive in London than Virginia. Wages are lower in Singapore than California. Taxes are higher in New York City than Amsterdam.

    Now let’s do some math. Presume three scenarios:

    A: $6 profit based on revenues of $10 and costs of $4
    B: $6 profit based on revenues of $12 and costs of $6
    C: $7 profit based on revenues of $15 and costs of $8

    Presume three locations/markets:

    US: $9 profit based on product price of $5, revenues of $15 and costs of $6
    UK: $8 profit based on product price of $5, revenues of $15 and costs of $7
    EU: $7 profit based on product price of $5, revenues of $15 and costs of $8

    The average profit across locations is $8.

    You become curious. Why are costs $8 in the EU market? Upon investigation, you discover that salaries/wages are much higher in the EU than the US or UK – even though office rents are cheaper. So, you decide to pass the higher salary/wage cost on to your EU customers. Sounds good in theory, but there is a problem: increasing the price of the product may reduce revenues because it also reduces demand. For example, a restaurant increases its prices and fewer customers show up.

    C: $7 profit based on product price of $5, revenues of $15 and costs of $8 becomes
    D: $6 profit based on product price of $6, revenues of $14 and costs of $8

    Now your three locations/markets look like this:

    US: $9 profit based on product price of $5, revenues of $15 and costs of $6
    UK: $8 profit based on product price of $5, revenues of $15 and costs of $7
    EU: $6 profit based on product price of $6, revenues of $14 and costs of $8

    The average profit across locations is now $7.67 instead of $8.

    The real issue, therefore, concerns the relationships between price, revenues and costs. Without hard numbers from Linden Lab, one cannot know the true financial situation. Perhaps the numbers work in LL’s favor and I am proved wrong, but let’s be clear about the nature of the issue. It has nothing to do with politics. It has everything to do with LL’s European operations and the effect of a significant price increase within the European market on average global profits. My argument is that Linden Lab made a policy error that was and continues to be harmful to economic growth. I also believe it reduced LL’s profits.

    How can an increase in price cause a decrease in revenues?

    • account downgrades from Premium to Basic
    • downward pressure on the demand for land (reducing new land production)
    • downward pressure on the market price of land (reducing the relative value of land to tier, encouraging land abandonment)
    • reduced financial and human capital investment

    How can discriminatory pricing itself cause a decrease in revenues?

    • increased political friction between residents in different geopolitical markets (‘Inequity Aversion’, ‘Schelling Points’)
    • increased resident transaction costs (information, search and arbitrage costs)
    • reduced customer satisfaction, increased negative publicity
    • potential loss of global market share
    • diminished ‘Network Effect’

    Has the change in Linden Lab’s policy on VAT hurt Second Life?

    Perhaps Linden Lab did the math and preferred a reduction in COGS to a reduction in Gross Margin. I have my doubts. Linden Lab has a poor track record on strategy and policy. The company later admitted mishandling VAT; Openspace sim product/pricing was a disaster. I therefore believe LL did not think this issue through. Looking at the latest economic statistics, I see stagnation. Therefore, I believe that Linden Lab inadvertently sacrificed long-term growth for short-term revenues. I believe it was a shortsighted decision that has undermined economic growth and hurt the company.

    The bottom line is that this issue is not about politics, ethics or taxation. Yet it has become a hot-button political issue in the minds of many, generating the unnecessary and destructive friction I describe in the original article. Linden Lab has unwittingly divided the resident community into factions. If it also turns out that LL’s average profit went from $8 to $7.67 then everyone is doubly worse off.

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