Wednesday, May 2, 2007

The 2% Fixed Overhead

Credit cards have revolutionized the way people shop. The widespread use of credit cards was one of the big differences with life in India that I had noticed when I moved to US for my studies. I had marveled at the ease of use of credit cards and the total replacement of cash that credit cards facilitated. I even used to champion for the credit card movement.

Though I liked the credit system I never, not even once, availed of any extra credit period but for the normal billing cycle of 29 days. I never had to pay anything extra for the credit facility provided by VISA(and/or DISCOVERCARD, and/or MASTERCARD as the case might have been). The cost of using the card and the cost of the credit (average 29/2 = 14.5 days per transaction) was paid as part of the cost of the products I bought. Being in software industry I was well aware of the transaction charges charged by the credit/debit card providers to the sellers of the goods or service.
Every credit card transaction would result in around 2% service charge with some minimum charge for the transaction. Debit card transactions are cheaper as the seller is only charged a per transaction fee(around 25 cents) + network charges. In the case of a credit card transaction the 2% service charge looks very nominal but if you consider that fact that you are given a credit of only 14.5 days you are effectively paying interest at close to 50% per year.

So for a person with enough bank balance it might seem better to use the debit card option as the charges are lower. Now here lies the funniest part. Irrespective of the type of transaction - cash, credit, check - you are billed at the same rate. So if you pay with cash the seller ends up making an extra 2% profit on the transaction. The buyer pays the 2% charge no matter what. The tables are tilted in favour of using the credit card.

What happens as a result is that all the products in the market are going to cost the end user 2% more than what it is supposed to cost. For a developed country like the US this might be fine. Additionally the revenues generated by the 2% overhead remains within the country and helps the overall economy. However for a developing country like India this 2% could be a big hindrance to development. A 2% overhead on all retail transactions would work out to be a huge amount and to add insult to injury, most of the charges get pumped out of the country to the card provider.

Initially establishments in India were charging the credit card service charges to the end user. The current trend is that it is being absorbed into the cost of the product. Could have been interesting if a big banking chain based out of India - like State Bank of India or ICICI comes up with a credit card of their own. I wonder why Reserve Bank of India did not bring forward a suggestion or regulation to make this happen.


  1. i certainly don't mark up my product for the fees associated with credit card transactions. my standard markup is 90%- and has been steadily for the last eleven years that i've been in business. even BEFORE i started accepting credit cards.

    it never even occured to me to charge my customers for that- i always chalked it up as part of the "cost of doing business," though it might be more profitable (but not by much) to go ahead and raise markup.

    i'm curious as to how many businesses actually DO adjust markup, or if this is just an "in theory" idea.

  2. Even if the dealer does not add the markup to cover the Credit Card transaction charge the customer ends up paying the service charges to the credit card company. You can also look at it this way - Had that customer paid you in cash you could have given the product for approx 1.37% less than what you had to charge him with the credit card without you incurring any losses.

    Effectively you are paying the credit card company from your profits. You could theoretically increase markups or accept the cost and not increase the markup but effectively the customer is paying 1.37% for the luxury of using the Credit Card.

    I am not saying that credit cards have to be banned or anything, just that they seem to be operating in a public sector domain, at least the debit card part. Nationalized banks should be able to operate very low cost debit card transactions system in their own respective countries.