August 31, 2016

Healthy Business: Profit per New Customer

The healthiest businesses generate profit per new customer.

Well-run businesses lose money on new customers but make up multiples of profit downstream.

An unhealthy business loses money on new customers and generates minimal downstream profit.

Let's assume you use paid search to find customers, and let's assume that all paid search customers are first-time buyers (obviously not true, or as some say, obvs not true).

We'll assume you are paying an average of $0.50 per click. In the first example, let's assume that you have 60% gross margins, and you lose 10% of sales to pick/pack/ship expense.
  • Clicks = 1,000.
  • Ad Cost = $0.50 * 1,000 = $500.
  • Conversion Rate = 2%.
  • Average Order Value = $100.
  • Orders = 1,000 * 0.02 = 20.
  • Sales = 20 * $100 = $2,000.
  • Gross Margin = $2,000 * 0.60 = $1,200.
  • Less Ad Cost = $1,200 - $500 = $700.
  • Less Pick Pack & Ship = $700 - $2,000 * 0.10 = $700 - $200 = $500.
  • Profit per New Customer = $500 / 20 = $25.00.
This is what a healthy business does. A healthy business prints money. A 60% Gross Margin sure makes a difference, don't you think?

What happens if Gross Margins are 35%?
  • Clicks = 1,000.
  • Ad Cost = $0.50 * 1,000 = $500.
  • Conversion Rate = 2%.
  • Average Order Value = $100.
  • Orders = 1,000 * 0.02 = 20.
  • Sales = 20 * $100 = $2,000.
  • Gross Margin = $2,000 * 0.35 = $700.
  • Less Ad Cost = $700 - $500 = $200.
  • Less Pick Pack & Ship = $200 - $2,000 * 0.10 = $200 - $200 = $0.
  • Profit per New Customer = $0 / 20 = $0.00.
We just established why healthy businesses have healthy gross margins. At a tepid gross margin rate, we are breaking even on profit per new customer.

Let's assume that we do a bunch of discounting and free shipping. As a result, it costs 20% to pick/pack/ship the order. Gross margins drop to 30%. But conversion rates increase to 2.5% because of the discounts/promotions.
  • Clicks = 1,000.
  • Ad Cost = $0.50 * 1,000 = $500.
  • Conversion Rate = 2.5%.
  • Average Order Value = $100.
  • Orders = 1,000 * 0.025 = 25.
  • Sales = 25 * $100 = $2,500.
  • Gross Margin = $2,500 * 0.30 = $750.
  • Less Ad Cost = $750 - $500 = $250.
  • Less Pick Pack & Ship = $250 - $2,500 * 0.20 = $250 - $500 = ($250).
  • Profit per New Customer = ($250) / 25 = ($10.00).
And there we go! We have an unhealthy business. Low gross margins coupled with discounts/promotions cause us to increase conversion rates, but we lose money on each new customer. Now we have to make up money downstream in order for the relationship to be profitable ... and worse, we've trained the customer to expect discounts / promotions, so it will be even harder to generate a full-price / profitable order in the future.

A healthy business has better-than-average gross margins.

Better-than-average gross margins enable the business to generate profit when acquiring a customer.

Lower-than-average gross margins make it harder to acquire a new customer.

Discounts and promotions require considerable downstream profit to offset money lost acquiring the customer.

Look at all of your customer acquisition efforts. What fraction of your new customers are acquired at a profit? Well over half of your new customers have to be acquired at a profit in order to have a fighting chance of managing a healthy business.