Do you need to make a profit from every sale?


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?

Customer Service Matched with Customer Margin

Take a look at these news stories


The first one is about a tech startup, Backup My Info

We love working with all of our clients, especially the smaller ones, but if we find ourselves spending all of our time helping the small customers get started with our service, we will not be able to grow into a $5 million-a-year business — or even remain profitable.

The second one is about Iron Man XC,

XC provides its 25 athletes with what it refers to as “high-touch” service: breakfast with the pros, a seat up front at the welcome banquet, Ford (a dedicated handler) at your disposal. He books your travel. He’ll find out your favorite snack is Oreos and have a pack waiting in your suite.

For non-XC athletes, a bike tune-up requires a sweaty, anxious wait at an overburdened cycling shop and lost sleep over whether a year of training will be lost to some stoner bike mechanic who fails to true a wheel. Not so for XC guys. Expected wait time: zero.

Was Backup My Info wrong to offer same great service to all customers regardless of what they spend with them?

What about Iron Man XC? Don’t you think the non-XC athletes who trained the whole year would love to have great mechanic service (with zero wait)? Why aren’t they offered the same great high touch service?

Customer Service and loyalty publications are rife with advice on how crucial it is to delight your customers, go the extra mile, keep them happy etc.  But such an advice is pointless or even downright dangerous in leading businesses down path to destruction. A generic one size fits all advice to provide same great service and experience to all customers is wrong.

The starting point of any marketing strategy is customer segmentation – finding out the needs of different customers, what alternatives are available them to fill those needs and what are they willing to pay for a service that offers to fill those needs.

For sure everyone would love to be treated as XC athletes if offered at same low price. But – if that high tough experience is not what they are hiring the product/service for or have no willingness to pay for such a service then it makes no business sense to offer that to them.

If you cannot charge for it you should not be offering it. That does not mean you start with same great customer service for all and try to distribute your costs as price to customers. You start with which customers value the service, find out what they are willing to pay and deliver that at costs that generate profit from each customer (Customer Margin).

Customer Margin is the total revenue a customer generates (from all transactions) less the cost to acquire and serve them.  You want a mix of customers that deliver positive customer margin – delivering same great service to all is not the way to get there.


Do you know your customer margin?

Other readings:

  1. Pricing the Customer’s Experience by Wim Rampen
  2. Beating Customer Expectations – An Experiment


Markup is just plain gross, not Gross Margin

An anonymous commenter on my previous post wrote,

maybe you need a refresher in the most basic tenets of finance and accounting because gross margin is a percentage, not an absolute dollar figure. you’re referring to GROSS PROFIT, but calling it gross margin.

First correction on this comment is – Gross Margin can be expressed as either absolute dollar value or as percentage. In most situations it is understood by context – especially by the practitioners. Gross Profit and Gross Margin are used interchangeably as well. See for example Apple’s earnings release

apple-gross-marginBut when Google Finance shows Apple’s financials they refer to it as Gross Profit.

Sometimes we see Gross Margin Percentage explicitly used to indicate percentage margin. Again practitioners are not confused by any of the terms even when two of them are used interchangeably.

What is Gross Margin? (or Gross Profit)

Expressed as dollar value it  revenue less cost of goods sold. Expressed as a percentage it is this difference divided by revenue.

The anonymous commenter (who seem to have inexplicably routed his IP traffic through, because I know MotleyFool is not afraid of making comments) added,

gross margin is the percentage that a company nets on the sale of a good after dividing it by its cost of goods sold.

That is not true. What this person is confusing with is  Markup. While Gross Margin (etc.) are financial accounting terms Markup is not. Its origins are in cost based pricing. You compute the cost to make a widget, add your preset margin you want to extract and call it the price.

Which you, my right tail readers, know is simply gross way to set prices. It would serve us all well if we banish the  “Mark Brothers” – Mark Up and Mark Down.

Another note on Gross Margin – it is a financial accounting term used for financial reporting purposes. The intended audience are investors and regulators. Since competitors can also see this companies do not want to signal their exact cost structure. So they  confound this number with a share of fixed cost allocation from manufacturing.

If you as a product manager or marketer going to worry about margin, worry about customer margin.

Metered Price Discrimination, Customer Margin or in the Vernacular of Social Media – Freemium

Consider these real life pricing scenarios that you see everyday:

  1. Six Flags Discovery kingdom sells its annual season pass for $49.99. According to its website, “Buy your Season Pass for $49.99, just $5 more than a one-day admission.”  Now why would they give away an unlimited entry annual pass for “just $5 more than a one-day admission”.
  2. Movie theaters charge extremely high prices, 4 to 5 times what we usually pay outside, for popcorn.
  3. Gas stations sell gas almost at cost and sometimes they even lose money due to credit card interchange

What is common in all these pricing scenarios? All these businesses are practicing what the economists would call as,  “Metered Price Discrimination“, or what marketers describe as, “Customer Margin“. There is nothing new, it starts with, “price discrimination” – charging different customers different prices.  Customers differ in the value they get from a product/service and in how much they are willing to pay for it.

Let us start with a simple case where the only way to monetize a customer is the price they pay. Let us keep it really simple and assume all costs are sunk and the marginal cost to serve a customer is $0.

For each price point you set, there will be different number of customers willing to pay that price. That is your demand curve. Your job is to find the price that maximizes profit – if you increase the price you will lose some customers but gain more from the remaining ones,  if you decrease the price you will gain new customers but lose revenue.

Total profit ∏1 = p times N ; price is the only lever you can control

Now consider the case where there are many different ways to monetize the customer (let us still keep costs as $0). For example, amusement parks charge parking, sell you lunch etc. Then you have several different levers to control,

Total profit ∏2 = p times N + R1 * n1 + R2 * n2 + ….

where R1, R2 etc are average revenue from each additional service you sell or ways you monetize the customer and n1, n2 are the subset of customers that generate that revenue stream. It is trivial to see that n1, n2 etc are directly a function of N.

Your goal now is find the entry price p that maximizes total profit and not just the profit from price paid. For example, movie theaters may set the ticket price lower such that they bring in lot more people but make up for it from the subset who are willing to pay higher price for popcorn. Similarly gas stations attract more customers with lower gas price and sell high priced snacks and drinks in their stores.

This is Metered Price Discrimination – some customers get away with paying the low “entry fee” while others pay more by consuming additional services at different prices.

Now consider the special case where the entry fee, p =$0. You have what is described as “Future of pricing”, freemium. You give up on monetizing entry fee and focus only on profit from other revenue sources.

Total profit ∏3 =   R1 * n1 + R2 * n2 + ….

There is nothing new, radical or futuristic about it.

If you have done the analysis, know your customers and find that ∏3 is better than ∏2, then by all means set the price to $0. You need to know ex ante, what the different revenue streams are going to be and how many customers will generate that. You cannot go in with a free model assuming that once you get customers in you  can monetize them later.

If all you have is hope, or promises of a marketing guru quoting some extreme examples that show higher ∏3, you have have your work cut out for you.

If Apple is going after customer’s wallet, it is your competition

iPod Shuffle for  junior:                                         $49
iPod nano for the runs:                                          $149
iPod Touch for mom so we can FaceTime:         $229
iPhone 4, of course to FaceTime with mom:      $199
iPad for  spouse:                                                      $499
Apple TV, something for the family:                    $99
Games, Music, Rentals:                                          $56

Total:                                                                         $1280

Money left for buying $139 Kindle?                    $0

Sometime back, Mr.Bezos said in a NYTimes interview that iPad is not a competitor for Kindle. May be iPad is not a direct competitor, but with a portfolio of products aimed at complete share of a customer’s  wallet (besides food and essentials), Apple is everyone’s competitor – be it Amazon, Apparel makers or vacation resorts.

The key is in asking what job is a customer employing Apple products for (hint: not the ones I listed above).  We better ask now because Apple seems to know the answer!

Price Promotions and Customer Loyalty

When price sensitive customers walk out of your stores, does it make sense to keep them at all costs? Specifically can you keep them by driving down prices? Can price cuts bring back customers who walked out to cheaper alternatives? It is tempting for businesses to run price promotions and reduce prices on key items (loss leader)

In the recent Goldman retail conference, CEO of  grocery chain SuperValue, had this to say:

More items really cheap don’t bring in more people

While promotions and loss leader pricing do bring in customers, it is almost impossible to keep those customer. If customers are willing to walk out of their customer stores to take advantage of your promotion, what will keep them coming back the next time? Anecdotally,  we all know people who do their weekly grocery shopping in three or four stores, just to take advantage of low prices of specific items. Mr.Craig Herkert, CEO of SuperValu, said “price promotions only destroyed our gross margins”. In other words, loss leaders stop being loss leaders and price promotions become just a profit loss.

If there is no unique value you add to your customers or can continue to offer low prices (as Wal Mart does) is it profitable to do price promotions?

Here is the customer profitability vs. loyalty matrix I did some time back:

Customer Loyalty Vs. Customer Profitability
Customer Loyalty Vs. Customer Profitability

If your customers are in the lower left quadrant, does it make sense to give them more benefits in the form of lower prices? Your action should be to increase prices for these segments and apply your limited resources on the top right quadrant.

Do you know who your high margin and high loyalty customers are?