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?

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?

About your unsolicited business advice

You likely have seen this many times, perhaps in my own blog. Some expert walks by a store, salon or restaurant and sees some great big opportunities the business is missing out on. Their readers are treated to an essay of how the business got it all wrong or what it could be doing now.

Take for instance such an article I saw recently. (You will have to google this on your own to find the article.)

Someone buys chips in a supermarket, opens it to take a few before the checkout. While the store clerk folds the open bag at checkout an idea strikes. Wow, the store is missing out on new revenue and marketing opportunities – surely this one clerk thinks many people open their bag of chips, why not sell bag clips at the checkout counter? It is a revenue opportunity and if not the store can at least brand it and give it away for free for marketing opportunity. The expert is surprised by such incompetence on the part of the store – letting money slip through their fingers.

Let me make sure that this not a bad idea. It is indeed good idea but can a business act on every idea thrown its way or is it losing out because it isn’t?

Let us apply similar reasoning on the guru himself and say- Wow! This is a great monetization idea, why isn’t he hounding the store manager or the corporate buyers, business development folks with either consulting services or a supply of bag clips instead of writing a blog post about it.

Wieser coined the terms marginal utility and opportunity cost.

Underneath it all is the opportunity cost which we all forget when pitching our own ideas and ignoring what other opportunities available to the business (or the guru). Combine this with lack of knowledge about how the business measures its success and operates, presumption that the business did not already consider this, the tendency to generalize from single observation with a dash of hubris (some gurus, not this one).

In this specific case let us be clear that stores have done years of work on shopper behavior to maximize sales per cubic inch (square feet is so 2000). Stores operate on thinnest possible operating margin and are always squeezing out extra sales to make those tiny margin percentages make sense. Anything a store does needs to make sense on scale. Every cubic inch of shelf space has an opportunity cost – could they be stocking something else that is more profitable than say selling bag clips that a few may buy? Or could they be doing something completely different with the investment?

Exactly how big is the demand we are talking? A store clerk’s selective recall is definitely not what you would want to base a new product introduction on (unless every store clerk is recording every such instance over a period of time). This is extrapolating from one bad data point.

Even if they chose to do what will be the impact on their supply chain or sourcing?

I am just using this advice as example – you read even worse cases in tech blogs. Tech bloggers with no business experience telling billion dollar businesses what they should be doing with their products, how to set prices or who they should acquire next.

But can you blame them if their readers are eating it up and retweeting endlessly?

It is you, dear informed reader, who should skip past such pronouncements or at the very least ask some tough questions to the esteemed gurus and the well revered tech bloggers.

 

 

Answer to Pricing Puzzle – Pricing railroad transport for pigs and sheep in 1831

In 1831, in Liverpool-Manchester railway, it cost an Irish farmer 7.5p to transport a pig but only half of it for a sheep, because ______?

— Rags Srinivasan (@rags) April 7, 2012

This data comes to us from the book on history of railroads. The book does not tell us why there was price difference.

What follows is a speculation based on limited available facts and application of logic and not an authoritative answer on the history of railroad pricing.

So why would the railways charge different price for transporting pigs and sheep?

It might be tempting to think of weight argument but compared to weight of railroad cars, especially in 1831 when they did not have light weight anything, the weight difference  between the two farm animals would not even registered to make any dent in the fuel cost. Don’t forget the inefficiencies of the steam engine and the transmission losses.

Another possible argument can be made based on opportunity cost. This is based on space occupied by the animals. It is a very reasonable argument based on opportunity cost of space. Such an argument implies the pig occupied twice as much space as a sheep. Given there were no industrialized pig farms and no GMO fed pigs it is a stretch.

So we return to asking what job were the Irish farmers hiring the railway for? For transporting their animals to the market in shorter time. The only other alternative was horse drawn carriages which was unreliable and took much longer.

They would hire the railway if it delivered better profit despite its cost. So one of two possible scenarios are the most likely answers to this pricing puzzle

1. Sheep were sold at lower price than pigs. So the farmers likely did not see incremental value from choosing railways at the same ticket price for pigs. So railways aligned price with value delivered (and reference price).
2. There were other alternative avenues to sell sheep  – may be they didn’t have to go Manchester to sell them, they could sell them in close by markets. Railways had excess capacity (which is non-inventoriable) so they aligned price with low customer demand.

Net-Net it comes to customer needs and practicing second degree price discrimination.

What does this mean to you as Product Manager?

Consider a cloud service you are providing – be it SaaS or PaaS. Do you want to charge the same price based on metering (minutes and gigabytes) or align your price with value delivered to customers? How would define your offering such that those high value customers choose the premium option? What type of benefits should be in the premium option?

Other puzzles:

1. Restaurants charging fees for sharing 

If you are asking entrepreneurs to be rational

What is the biggest resource an entrepreneur can waste? According to Kevin Ready, author of  “Startup: An Insider’s Guide to Launching and Running a Business, it is not money. Ready says it is time spent trying to keep a start-up live long after its viability has been discredited.

Kevin Ready says,

I call this creature a “zombie start-up.”
… many intrepid entrepreneurs hold on and continue the vision — sometimes for years. Herein lies the true cost and risk of start-ups: Time.

When you hold on to a dead idea at the expense of other possibilities, even though you are not burning cash to keep it alive you are keeping yourself away from what you could be doing elsewhere.

Time is the one resource that we can never recover. The opportunity cost for chasing the wrong idea is immeasurable. What is the cost of a lost year? How about two years? A decade?

Kevin Ready makes a very good point. (Although he says we can’t put a price tag on time lost. We can.)

I would also add a close relative of opportunity cost,  sunk cost. Many are not able to walk away because they have already sunk so much of their time and money into the venture. Doing so may seem like they are wasting their “investment”.

But recognizing sunk cost bias, walking away from what is sunk and taking into account opportunity cost before making choices are rational behaviors.  If entrepreneurs are wired to do scenario analysis, calculate expected value over all possible options, consider opportunity cost of leaving their current job, etc.,  they would not be entrepreneurs at all. (See The Mind of an Entrepreneur and that of an Analyst.)

It  takes an irrational sense of optimism to believe their venture will be a big success when the base rate says less than 3% of the ventures live past their third year.

It is the irrational sense of optimism that makes an entrepreneur.

Don’t ask those irrational optimists to look at opportunity cost.

Mental Accounting and Other Errors in Home Buying

Image via Wikipedia

Homeownership –  the American Dream. The one that contributed significantly to the Great Recession and is still responsible for the slow recovery we are seeing. There is some change in this love to own a home, among some demographics,  but not much to call it a shift.

To explain why we still prefer buy vs. rent will take a book, so let us keep it brief and look at the errors we commit in our thought process. There was an article in The Washington Post that wrote about a research that found, “Average American’s don’t think like Economists”.

Are economists average? – "Average Americans don’t think like economists" – The Washington Post http://t.co/Q6AAaaCF via @alexpozin

— Rags Srinivasan (@rags) January 28, 2012

That explains a lot about our love for buying homes.  I should add, when it comes buying or selling their own homes most economists don’t think like economists.

1.  The Seller pays all the realtor fees– The first thing any realtor will tell a prospective homebuyer is, “you don’t pay me anything, the seller pays me“. Conflict of interests aside, how does the seller really pay? It does not come from a different pot the seller has. The seller pays by including it in the price of the house.A moment’s reflection will convince  you that the day you sign the 2564th document they thrust in front of you during closing, you are down 5-6%. In other words even if you sold the house the next day you will lose 5-6% of the price you paid.
2. Rent is down the toilet – Rent is an expense. By extension every expense we make is down the toilet. Besides this ignores the fact that your interest payments, most of your monthly mortgage payments are just that in the first few years, are down the toilet too. Interest is the rent you pay to use the bank’s capital to buy the house.
3. Interests are tax deductible, rent is not – True and this could be used as a another point to bolster the case, “rent is down the toilet”.  First there are limits on mortgage interest tax deductions. Second, renters indirectly get the advantages of the tax deduction.
   When you rent a home or apartment recognize that they are owned by somebody who is paying mortgage interest on that property. Because of the tax deduction the cost to own is reduced and hence  more are willing to get into the renting business. As more such owners buy to rent it out, the supply of rental properties increases and hence the price decreases. If there were no deductions fewer people may own rental properties and the decrease in supply will push up rent. Either way renters get part of the benefits of mortgage tax deduction.
4. Prices will always go up –  There is enough data published by Case-Shiller that says prices don’t go any faster than rate of inflation. We all suffer from optimism bias, ignoring the downside and giving higher likelihood to favorable scenarios.
   Even if it did, what does it mean to us to take advantage of the new higher prices? We need to sell the house first. Where would we live then and what would be the costs? If your home price went up so did the whole neighborhood, city,  and state. Unless you are ready to move to a low-cost state there is no upside to the home price increase.
5. Opportunity cost of down payment – This is huge for those buying houses in Bay Area. When you sink 20% of the price of the home in one illiquid asset you are losing out on the opportunity cost of investing the same capital in any diversified fund.
   While realtors tell you, “when stock market goes down you are left with nothing to show for but even when your home prices go down you have a place to live”, you need to ask
   – will my mortgage payments stop? No.
   – Is my down payment safe? No, that is wiped out with just 10-20% down swing in home prices.
   –  will i still have job in the same neighborhood? Unlikely.
   If the stock market is wiped out, will be home market be any better? They are not completely uncorrelated. At least you get diversification when you invest your down payment in a broader market.
6. Locking in my “rent” for next 30 years – This is usually stated as post-purchase rationalization, “at least I know what my payments will be for the next 30 years”.  If the economy goes south, you are liable for the same level of payments even if the market prices for rent are lower.
   If indeed rent goes up, then you need to realize that you are maintaining the same quality of life at a higher cost even though there is no additional money flow. In other words you could rent the home out to take advantage of higher rent and reduce your standard of living by renting a lower quality place for you.  The net is there is no advantage in locking in payments.
7. Unlocking  equity – Homeowners repeat this phrase as if it were a self-evident truth. They speak as if they sold part of the house and cashed out without really giving up that part of the house. The basic accounting equation is
   Assets = Liabilities   + Equities
   When you buy the home it is added to the asset column at the price you paid and the mortgage you took is added to the liabilities. The down payment is added to equities column. The two sides of the equation are matched.
   When market price for homes goes up it does not really do anything to the asset side unless you are doing mark-to-market accounting (which we don’t). If we did that then the assets column will go up. The increase in left side of the equation is balanced by adding the same amount to the equities column.
   What you do when you take out a home equity loan is move some or all of that increased equity to liabilities column.
   The net is, you are liable for the additional loan you take out.  It is not like you are issuing new stocks to convert the asset class to cash.

There you have it, the seven errors in our thinking that leads us to prefer buy over rent.

Other articles:

1. Home Staging – Why our willingness to pay is higher with staged homes?
2. Ignoring the downside – Prices will always go up
3. Slow decline in home prices – why prices are slow to fall
4. Home Prices – Value gap