Profit Models

I get to see a lot of different business models.  Each model has a clear path to profitability.

There are businesses that have high return rates.  These businesses require high levels of customer productivity, in order to generate profit.

Demand		$5,000,000
Net Sales	75.0%	$3,750,000
Gross Margin	55.0%	$2,062,500
Less Marketing Cost		$750,000
Less Pick/Pack/Ship	10.0%	$375,000
Variable Operating Profit		$937,500

Many businesses do not have a returns problem, meaning that customers keep what they purchase.  When that happens, customer productivity doesn't need to be as great in order to generate profit ... in our case, productivity is twenty percent less, and yet, profit is the same.

Demand		$3,905,000
Net Sales	96.0%	$3,748,800
Gross Margin	55.0%	$2,061,840
Less Marketing Cost		$749,760
Less Pick/Pack/Ship	10.0%	$374,880
Variable Operating Profit		$937,200

I work with a lot of businesses that are struggling.  You can tell that the business had to manufacture profit via efficiency ... it becomes obvious when looking at the metrics.  Take a look at this one:

Demand		$2,540,000
Net Sales	90.0%	$2,286,000
Gross Margin	65.0%	$1,485,900
Less Marketing Cost		$457,200
Less Pick/Pack/Ship	4.0%	$91,440
Variable Operating Profit		$937,260

Productivity is really, really low in this case.  However, the business managed to optimize gross margin dollars, and are running an efficient distribution center.  As a result, the business generates a healthy amount of profit on low productivity.


The internet world loves business models that "scale" ... meaning that you generate profit on low margins and high volume.  Here's an example:

Demand		$14,525,000
Net Sales	90.0%	$13,072,500
Gross Margin	15.0%	$1,960,875
Less Marketing Cost		$500,000
Less Pick/Pack/Ship	4.0%	$522,900
Variable Operating Profit		$937,975

This is a very different business model, isn't it?  You need a high level of demand, a high level of marketing productivity, and an efficient expense structure.  Combined, you end up with the same level of profitability that you obtained via the other business models.


The pundits will tell you what kind of business model you have to employ ... hint ... they really like one that "scales", one with low margins and high volume.


The reality is that there are many ways to generate profit.  Chart your own course.

When Businesses Die

I always find it fascinating to watch what happens to businesses that are on the decline.

Viewed differently, there are four ways that customers interact with products, brands or channels.

• Isolation Mode. Customers stay loyal to this business mode, not opting for other products, brands or channels.
• Equilibrium Mode. Here, customers are likely to try out other products, brands or channels. Usually, customers purchasing from one product area (MP3 players) are likely to purchase from another product area (computer accessories), and vice versa.
• Transfer Mode. This occurs when customers are actively switching out of one product, brand or channel (dial-up internet access), migrating to another product, brand or channel (broadband internet access).
• Oscillation Mode. While rare, customers can switch back and forth between products, brands or channels, on an alternating basis. For instance, a customer purchases a new car, and deals with the sales department. Then, the customer switches to the service department. Eventually, the customer switches back to the sales department, for a new car. The customer is 'oscillating' between channels.

Life is very interesting when businesses are stuck in or slip into 'transfer mode'. How businesses respond to this situation largely determines their success or failure.

For instance, AOL customers transfer out of dial-up internet access, but did not transfer their allegiance to AOL's broadband product. AOL management evaluates the situation, and decides to figure out new ways to monetize their business via the loyal audience they possess.

Other business models attempt different ways to combat transfer. Network television represents an interesting take on this situation. As television customers migrate out of network television to cable, and then from cable to the internet, network television counters the loss of customers by increasing how much they charge advertisers.

Some businesses aggressively recruit new customers, to make up for the customers lost via transfer. As long as new customers can be recruited in a cost-effective manner, and at a rate that is greater than the rate which customers are transferring out, the business can be successful.

Other businesses pass the cost of a failing business on to the remaining set of loyal customers, further accelerating transfer to other businesses. Airlines charge $7 for a small sandwich, or professional basketball teams charge $100 a seat to sit in the lower bowl to help recoup out-of-control salaries. When implementing these strategies, the business must be mindful that there is a ceiling, and once the pricing strategy breaks through the ceiling, the remaining loyal customers will not come back.

At the end of the day, there are a small number of things products, brands or channels stuck in 'transfer mode' can do.

• Create new products and services that customers prefer.
• Acquire more customers than are transferring out of the business.
• Change the business model and associated revenue generation strategy.
• Require existing customers to increase their spend in order to offset customer transfer.
• Reduce expenses by reducing quality, outsourcing capital, or reducing capital expenditures.
• Sell the business.
• Close the business down.

What are your thoughts on this? Are there businesses you enjoy following as they deal with the transfer of customers to other products, brands or channels? Are there examples of what businesses can do that I failed to include in my list? What are your thoughts?