Do you need to make a profit from every sale?

No.

I gave a one word answer only because this is a question that requires a yes or no answer and likely most won’t be paying any attention until it is answered with simple yes or no. Now that is taken care of let us look at the 50 shades of NO. As usual I don’t have answers only more questions that you can ask to arrive at your own answer.

It depends on what we mean here by “every sale” and “Profit”.

Does every sale here mean sale of each item (or SKU) treated in isolation from the rest of the basket?  Is there a basket of items – complements and other unrelated products – or there are only individual units? Is this a transactional sale with customer buying once and never ever buying another item or are there repeat businesses – for more of the same or complements (razor and blades)?

Profit is easy to compute, it is revenue less costs. Profit per sale is easier as well (or is it?) – revenue from that sale less cost of sale. If you ever sell only one product once to a customer whom you will never see, hear or feel the impact of (ahem, Social Media, WOM), then YES, you need to make profit from each sale.

Except profit per sale is the wrong metric because of the points I raise above. The right metric is profit per customer (customer margin). It is the total revenue from a customer from a transaction (for the basket of goods) less the total marginal cost to serve them. Taking it further, it is the total lifetime revenue from a customer less the total marginal cost to serve them during their stay with your business.

But customer margin is not so easy to compute because we need to know all the revenue elements – all complements, incremental sales, now and later, and the truly marginal costs that are attributable just to this customer.

All the revenue sources must be properly quantified and not based on wishful thinking. You can complicate this further with other fringe benefits from a customer like referral sales (if you can quantify them).

The marginal cost needs little more explanation –  the cost your business incurs just for this sale and otherwise would not incur.  It is not the same as dividing all your costs equally among all your products (or customers).

In cases where there are incremental sales – now or future – it is okay to not make profit on each item as long as it would result in overall total profit from sales that would not have happened if not for selling this item at “loss”. The point to note here is to ensure that you considered all opportunity costs of selling an item at loss.

Let us look at these concepts in the context of running a promotion – Groupon promotion.

Say  you run a 50% off promotion for your cupcake that sells for $4 and costs $2 to make. I addition to selling it for $2 you give $1 to Groupon meaning you will lose $1 ($4*.5-$2-$1) on each cupcake sold.

If you will never see (or feel) these Groupon deal seekers again then you are doing it wrong.

If their visit results in incremental sales in the first visit that results in total over all profit or repeat visits that result in overall lifetime profit then you are okay (assuming you have carefully considered other factors).

So the right question is not about profit on each sale but,

Do you worry about customer margin?

It costs 6-7 times more to acquire new customers over retaining existing ones …

No my account was not hacked (not yet, at least). I deliberately let this commonly repeated statement be the title without qualifying it.  Of course statements like these, (this particular one made famous by Loyalty Effect) cannot stand by themselves regardless of how popular the Guru who said this is.

Let us look at this closely

  1. Let us assume this statement is true. So shall we fire our sales team, shut down all marketing spend, stop product innovations and get rid of business development?  After all this statement indicates new customers are far more expensive. Then why bother?
  2. Let us take it to the extreme. Shall we stop after the first customer?
  3. Extending this even further, say you acquired the first customer at a cost of $1 and second at the cost of $7. Then by this logic does it cost $49, $343 etc to acquire third and fourth customer?
  4. What if you are essentially in a transactional business where you really need new customers every day because the current ones won’t be there tomorrow?
  5. How do you know it is 6-7 times or only 6-7 times? What are the data and metrics used? Was it based on experimental study?
  6. How generally applicable is this to your businesses – small and large, early stage vs. mature? Is the cost the same to all businesses?
  7. What about profits from new customers, is that 6-7 times as well?

You can see how ridiculous the statement sounds now. Here is a further breakdown of problem with this retention vs. acquisition costs statement.

First it is framed around cost and does not base it on marginal benefit and opportunity cost. I also doubt that the proponents know how cost accounting is done and most likely are allocating all kinds of fixed cost share to new customers. You need to have a costing system that can correctly capture only truly incremental costs for both acquiring and retaining. Simply distributing all costs to all customers won’t cut it.

Second it suffers from sunk cost bias. The fact that you spent some money to acquire a customer in the past does not matter in the decision to do everything to retain them. If you cannot recover the acquisition cost it is sunk. You should only look at future unearned marginal profit from each customer – existing or new. At decision time of spending capital on retention vs. acquisition you need to compute the opportunity cost and truly incremental profit from each path, not encumbered by the money you have already spent on existing customers.

Third, if the cost of acquisition is indeed high don’t you think you have a marketing problem? Is it likely that you are targeting wrong customers in wrong places with wrong product, versions, messaging and prices and hence wrong low value customers are self-selecting themselves to your service? Don’t you want to spend your resources fixing this strategic problem vs. worrying about retention?

Lastly the Innovator’s Dilemma.  What if the current customers are NOT the representation of future?  By choosing to focus your resources on them instead of new customers do you lose sight of new market opportunities, how the customer needs are evolving and how their choices for the job to be done are impacted by market trends and innovations?

Does the retention vs. acquisition pronouncement sound as profound as it did before?  I hope not.

How do you make business decisions?

Disputing the Claims Made About Merits of Group Buying

A recent article by Sam Decker, titled “Why Product Reviews Can Drive Group Buying Success for Retailers”,  makes predictive statements about deal driven customers from GroupOn like sites. These are not supported in the data. I call into question those statements:

  1. A recent Forbes profile on Groupon reported that the group buying site’s sales have reached $500 million“:  The Forbes article does not take into account the cost of sales to the businesses and that incremental profit from these promotions may not match up to alternatives. See my articles on GroupOn costs and profitability.
  2. Discount buying sites drive sales, but require brands to become better to retain profitable customers“: No data to support Mr. Decker’s claim that the deal seekers will become profitable. On the other hand, research by Prof. Utpal Dholakia sheds light on the lack of profitability from deal seekers because the repeat purchases do not materialize.
  3. By listening to customers, both on the retail and manufacturing side, business participants in group discount buying sites can increase their chances of converting coupon customers into full-paying ones“. Mr. Decker’s claim ignores the profile of the customer and the behavior of the deal seeking customer. If one business can woo away someone else’s loyal customer with a promotion, what makes this business believe that the customer will return because of great experience?
    As one of the Group Buying site, ScoutMob, depicts in its website, the customers getting the discount coupons score, do the victory dance and move on to next deal.
    Through 50% off promotion, the business has also set a low reference price in the minds of the customer, it is harder to improve that reference price just by listening to these deal seekers and by “over delivering”.

Businesses fail to account the opportunity cost and the incremental benefit from a deal seeker vs. that from acquiring a customer through non-promotional means.  Stating that these customers will return because of reviews and great service is not supported in the data!

Group buying is profitable to a business only if:

  • The product has high contribution margin (price less marginal cost)
  • The business has excess capacity (with sunk costs and no other way to monetize it)
  • There exists a segment of customers with low willingness to pay but reducing the price to include them will deliver less profit than your current profit (even though it is still profitable)
  • There exists a segment of customers with low willingness to pay that the business cannot reach through any other way
  • Businesses can serve these low willingness to pay customers without the full price customers knowing about it (third degree price discrimination)

If any of these are not true you have hard math in front of you for determining profitability, not service excellence.

An Alternative Look At GroupOn Marginal Costs

In my previous article I wrote about the necessary and sufficient conditions for choosing to run GroupOn campaign for your business.  I made a case for looking at the marginal cost of each unit sold to decide on whether or not to run a campaign. Alternatively, and in all fairness to GroupOn, we can look at the entire cost of running the campaign as “Fixed Costs” or “customer acquisition costs” and hence can ignore the marginal cost argument.

For instance,  let us use the $4 cupcakes that you make for $1.5. If you run a campaign to get 1000 new customers with a 50% deal  (for a promotion price of $2) and let GroupOn get its 50% cut, your total promotion cost is 1000 X ($2-$1-$1.5)  = $500

Yes you are selling each cupcake for less that what it costs to make and sell it. But another way to look at is, you spent $500 to sell 1000 units at $1 each, there by ignoring the marginal cost argument with the HOPE that these first-timers will spend more in the future.

That said, every other cost component – incremental investment, opportunity cost, etc – remain the same.

Next we can model the Lifetime Value of such first-timers based on:

  1. How likely will the customer revisit (or what percentage of customers will revisit) .
  2. On the average how many additional times they will revisit
  3. On the average what you will gain from each visit. Note that this not just average spend per visit but the profit from that spend.

If the total lifetime value is more than the total costs, then one can argue that it is worth doing.

See here for a very simple calculator.