Do you need to make a profit from every sale?

Do you need to make a profit on every sale? (consider buffet pricing and definition of profit/customer)

— Rags Srinivasan (@rags) February 1, 2013

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?

Celebrate the Second Anniversary of My Groupon Book

It was two Super Bowls ago I published this book, same time Groupon had their infamous Ad featuring Tibetian restaurant. Since their IPO a few months later their stock is hovering around $5 – far below its opening day pop but 150% growth over their 52-week lows.

How do you make informed decision about whether or not a business should run Groupon promotion?  Here is a chance to read this book for free, because you likely spent all the money on iPad and iPad mini. Or worse lost it buying high and selling low Groupon shares.

Fill out this form and the first 50 people will get the book that sells for $9.99 for free.

Even if you are not a small business owner you will find the chapters on demand curve and sales vs. marketing channel a refresher course for you.

Here is the link : Groupon Book

Two views on buying something on sale, from the same guru

In 2010 the marketing guru wrote about those 50% off Groupon deals thusly,

Groupon is a very different thing. Here, it’s not a hassle, it’s the fun factor. Buying this way is exciting, you never know what’s next, you do it with friends, the copy is funny, it’s an adventure. As a result, many Groupon customers in fact do convert to becoming long time patrons of the place they tried, because they’re not inherently cheap shoppers. When they’re on Groupon they’re hunting for fun. But if you offer an astonishing product and great service after they try you, they may convert into shopping with you for the long haul

Today a different opinion on why people buy something that is on sale,

The impulse big-sale buy is not a matter of acquiring a high value item they’ll need later at a bargain price today.

No, the consumer is spending money in exchange for the feeling, right now, of saving big. The joy of a bargain. The item is secondary, the feeling is what we just paid for.

You wouldn’t know that from the way people selling things act, but that’s what we buy.

You likely are wondering weren’t those purchasing cupcakes and spa packages with 50% Groupon deals were doing so just for joy of bargain?

Surely you are not surprised by Groupon woes?

Update 11/1/2012: Groupon valuation is back in news because of its rival LivingSocial’s woes.

In Amazon’s 10-Q filing late Friday afternoon, it disclosed that Living Social saw revenue of $372 million for the nine-month period ended Sept. 30. While that is up 120% from the same period last year, it reflects third-quarter revenue of just $124 million – down 10% from the June period.

If that sequential drop reflects an overall weakness in the daily deals business for the third quarter, then it implies potentially disappointing results for Groupon when it posts its own results for the period next week,

When valuing a company’s stock it pays to understand what pressing customer needs it serves and what unique value it adds. That is assuming you are Benjamin Graham, Warren Buffett type investor who takes the time to understand the business before investing.

Business model is value-creation and value share. A business that creates net new value for its customers gets to share in it. A business cannot get its share of value it did not help create, let alone grow exponentially.

If you are such an investor then Groupon’s announcements about lax controls should not come as a surprise to you. I am not referring to the $2 drop in its stock today but the news that led to it.

It is hard to describe Groupon’s business. In fact even Groupon is not clear about what it is.

For starters, it is a two sided market. It essentially brings together small businesses on one side and end consumers on the other side.

In general a two sided market adds value by unlocking value, creating new value or removing inefficiencies. It then gets its fair share of the net new value added. A two sided market must be consistent in its positioning – it must serve as the enabler for the jobs the two sides are seeking to do. There should be no asymmetry.

Take for example, eBay. It positions itself as the market place for buyers and sellers to find each other. No asymmetry here. EBay adds value by enabling transactions that otherwise would not have been possible.

What about Groupon’s role as two sided market?

What is its positioning to deal seekers? It tells them about, “one ridiculously huge coupon everyday” and its tag line is, “Collective Buying Power”. In other words it wants the deal seekers to hire it as a sales channel to buy products at steep discounts.

What about its positioning to small businesses? It tells them about, “guaranteed new customers”, “big exposure”, and “measurable marketing”. The story line goes, “these customers fall in love with your service and visit you again and again, paying full price”. In other words it wants the businesses to hire it as a marketing channel.

That is asymmetry (to put it mildly) in its messaging. Groupon cannot be a sales channel to acquire ridiculously huge discount and a marketing channel to acquire valuable customers at the same time.

What value does it add?

Businesses bring value to the table in the form of 50% off discount. Deal seekers add no value but get 50% off. Groupon gets its share of 25% from the businesses.

 

You bring a full pie.
Give half of it to my email subscribers.
Give half of what is left to me.
Take home the rest and wait.
It will not only grow to become a full pie, it will multiply into many full pies.

To repurpose Omar Khayyam, “the deal seekers having scored a deal, move on. No level of customer service will bring them back to pay full price for your cupcake they can get for 50% with their next coupon in the bakery next door”.

There is no net new value add. Just value distribution – from businesses to deal seekers and Groupon.  Groupon cannot take its share of value it did not help create.

So we have a business that most do not understand, even it does not have clarity on the needs it serves and adds no new value. How can you place a valuation on such a business?

Surely you are not surprised that such a confused business finds itself again in the accounting hot water?

There is a WSJ report that SEC may investigate Groupon. I see no reason for such an investigation at the expense of taxpayers. If irrational investors want to bet their money on a business they do not understand or chose not to understand, why should they be protected?

We can turn Groupon into a daily habit for consumers

The Wall Street Journal interviewed Groupon CEO Mr. Andrew Mason about his IPO and his business. The Journal throws a whole bunch of softball questions to Groupon CEO Andrew Mason.

They either deliberately failed to ask or focused on the wrong things like these,

1. Valuation – It is perfectly acceptable for a company to expect and set any valuation. It is up to the market to buy the shares at that price or not. Why question him on the valuation?
2. Asking about current stock price: What is the point of asking about the stock price to any CEO? When did anyone answer anything other than,
   

   “I’m aware of it [stock price], but I think as a company we aren’t driven by it. It’s a futile exercise to be responsive to the stock.”

3. On the employee memo leaking out: Mr. Mason asnwers,
   

   “If I knew it was going to leak,”

   and the  Journal reporter lets it slide. Really?

4. Questioning his maturity: This is an insulting question. Ask about his challenges and how he rounds up his gaps with an executive team.
5. Asking, How important is profitability?:  Really? Now who is being immature, excuse me, being unaware of the number one goal of any business? This question lets Mr. Mason talk about the growth, market share etc etc.

What questions they should have asked instead?

1. Question the contradiction–  When Mr. Mason said,
   

   discount to deliver more buying power for consumers, as well as solve better inventory management for merchants, delivering them more profits

   The question is how can you say more buying power to customers and more profits in the same sentence? Profit implies share of net new value created. What is the net new value created?

2. Is it  a sales channel or marketing channel?  When Mr. Mason said,
   

   solve better inventory management

   The question here should have been – are you a sales channel to dispose of excess inventory without cannibalizing  current full-priced sales or are you a marketing channel to acquire new full-price customers?

3. What happens when Groupon turns into a daily habit?
   The title of this article is a quote by Mr. mason in the article. What would happen if customers are used to the  “ridiculously large discount” they get from Groupon? What does this mean to the small businesses?
4. How does the upfront investment pay off in the long run? – When Mr. Mason said,
   

   There’s an upfront investment that we know pays off over the long-term

   The question should have been, is that a guarantee? hope? insurance? promise?  What metrics are you providing to small businesses to measure that pay off?  There is no data or assurance that deal seekers come back. Besides didn’t he just say, “we can turn Groupon into a daily habit for customers”?

5. Did you read the book?
   Why not buy a copy of this book and give it to all the small businesses before signing them up to do Groupon?

Capacity Concerns in doing Daily Deals

In my critically acclaimed book, “To Group Coupon or Not: Small Business Guide to Groupon and LivingSocial“, I introduced a 4C model to evaluate the relevance of Daily Deals to small businesses. One of the 4Cs is Capacity. We have seen many stories on how stores that did outrageous deals (or as Groupon says in its Ads, ridiculously low prices) were run over by  a mob of deal seekers. Very recently a British cupcake bakery was in the news for the same reason.

It is likely that these are extreme cases (that is why they are reported in the national news media). Most businesses may not see a mob scene. The limited takeaway here should be, these businesses did Groupon like Daily Deal promotions without understanding their capacity utilization and suffered the consequences. Your small business should not do the same mistake.

The questions small business owners need to consider are

1. Should I be doing the 50% off daily deal given my current capacity utilization?
2. What is the arrival pattern of deal seekers compared to my regulars?
3. Can I manage their arrival rate to better utilize my daily excess capacity?
4. What are my new capacity costs, opportunity costs and gains if I did a daily deal?

When I was explaining my Groupon calculator and capacity utilization to a Small Business consultant, she remarked,

But small businesses, especially salons and cupcake bakeries do not know what capacity utilization is or how to measure it. How should they do it?

Mind you, there are sophisticated capacity utilization software used by Airlines and Hotels. The methods should be simple enough for most small businesses to not only understand and but also practice. For starters, I will refer you to a children’s show on PBS Kids called Cyber Chase.

Past Perfect Prediction

Convinced that the last piece he needs to activate his powerful new machine is hidden in Slider’s garage, Hacker threatens to evict the teen unless he pays up on an old debt. Enter the kids and Digit. As a way to raise the money, they convince Slider to open the garage for business – just like his dad did. They do, but quickly discover that there’s more to it than meets the eye. Can they unlock the past to find the key to saving Slider’s future?

The kids run some sort of oil change garage to raise money. They have to order Cryoxide, the raw material that costs $15 a can (marginal cost) and expires at the end of the day (capacity cannot be carried over). They charge $32.5 for the service. They place an order for Cryoxide the previous day and it gets delivered next day morning.

The key here for these kids is to understand current capacity utilization and use that information to place future orders so they don’t end with either excess capacity (which is a loss in this case) or shortage (which is lost opportunity). Here is how they go about finding their capacity utilization

1. They find one receipt from their father’s files that shows a sale of 66 cans. Based on this data point the kids expect to serve 66 customers  – good start
2. As it turns out they could use only 30 of the 66 cans. The excess capacity of 36 cans is a loss.
3. They quickly figure out that that was just one data point and it was also from a Saturday whereas they started work on Monday.
4. Their initial search gives them one past receipt for each day of the week – getting better
5. Not satisfied with the data-set they search more and find receipts for the whole month – getting better. (Note the 30 number)
6. They find the average demand across these 30 days use that information to place an order for each remaining day of the week – not bad at all, (roughly right beats precisely wrong)

Measuring your businesses capacity utilization is no different from this. Here is how you go about it:

1. Data Collection: Like the kids’ father who kept receipts, you need to start collecting data on daily sales. You likely have this data already. You need to include in this data, weekday vs. weekend classification and exceptions like holidays.
2. How many days worth of data is needed? The number 30 is not an accident. It is a rule of thumb for assuming that the data is normally distributed. In your case you need at least 30 days worth of data. That said, this should be a continuous process. You don’t stop collecting data after 30 days.
3. Simple Estimate:  A simple estimate of capacity utilization is to calculate the average across these 30 days. You can use that as an approximate for future demand. You are not going to be that far off. You can stop here if you want to.
4. Refined Estimate: You not only calculate the average but you also calculate the variance – how much the individual days differ from the average. You can use the average and variance to make statistical prediction about future capacity utilization (ask me how).
5. Further Refinement: You can take it to next step separating your weekdays and weekends. Since you only have 2 weekend days vs. 5 weekdays, you will need to collect receipts over 4-5 month period. Once you have that, then you do Step 4 above for weekdays and weekends and use that to predict your future capacity utilization

This procedure only describes how to find your current capacity utilization. It gets complex when you do a Daily Deal. All your careful capacity management based on past receipts are not useful when suddenly 1000 people show up to buy your cupcakes. This is when you end up turning away your loyal regulars and more.

Now returning to the original capacity questions you need to consider before doing a deal

1. Should I be doing the 50% off daily deal given my current capacity utilization?
2. What is the arrival pattern of deal seekers compared to my regulars?
3. Can I manage their arrival rate to better utilize my daily excess capacity?
4. What are my new capacity costs, opportunity costs and gains if I did a daily deal?

Ask me how you can answer these.