Healthy Business: Sweating The Details

I know, I know - you read social media, and you hear that the Finance Folks ... the Beancounters ... they're always messing with what you want to do ... they're questioning why your ad-to-sales ratio is two points higher than two years ago ... they're wondering why return rates crept up marginally.

There's a reason they do this. They sweat the details so that your business is healthy.

Look at these two companies ... one healthy, one unhealthy.

Both businesses generate $100,000,000 demand ... in other words, in both businesses, customers wanted to purchase $100,000,000 last year.

Now look at the subtle differences.

• The healthy business fills 97% of items / the unhealthy business fills 96%.
• The healthy business has a 23% return rate / the unhealthy business = 25%.
• The healthy business has a 41.5% gross margin / vs. 39.5% at the unhealthy business.
• The healthy business has a 32% ad-to-sales ratio / the unhealthy business = 34%.
• Warehouse costs are 10% for the healthy business / 11% for the unhealthy one.
• Fixed costs are 10% for the healthy business / 11% for the unhealthy business.

Those aren't big differences, are they?

But when evaluated across the profit and loss statement, the result is dramatic.

• The healthy business generates $6,139,518 Earnings Before Taxes.
• The unhealthy business generates $2,930,400 Earnings Before Taxes.

Every step in the profit and loss statement leaks one point or two points. And that modest level of leakage results in an unhealthy business - one earning less than half the profit of the healthy business.

Think about this, my friends.

Each business is equally successful at getting customers to buy stuff ... and that's the hardest thing to accomplish. This isn't the fault of the marketer, and it isn't the fault of the merchant. It's caused by all parties being sloppy.

The merchant doesn't forecast sales accurately or doesn't hustle when stuff sells out.

Instead of pleasing the customer the first time around (all aspects of the business), the unhealthy brand allows a return rate two points higher.

Incorrect forecasting leads to worse gross margins due to increased liquidations.

The marketing team are lazy and don't measure lifetime value properly and as a result bid too high for various keywords.

One warehouse uses people, the other robotics, resulting in a one point change in pick/pack/ship expense.

One business makes bad capital decisions, the other is careful, resulting in a one point change in fixed costs.

There are simple fixes to all of these issues ... the unhealthy business chooses not to implement the fixes ... they fire the Marketing leader and hire a new one ... every two years (it's her fault).

No, it's the fault of the culture at the unhealthy business - a business that does not sweat the details.

This is why you Finance Team behaves the way they behave.

Healthy Business: Teammates

Two years ago, I consulted with the healthiest business I've ever worked with. 

The most amazing thing about this business? The employees genuinely cared about each other. If you had six people in the room, you essentially earned the productivity of eight or nine people, because folks worked so well together.

Do you and your co-workers support each other? Marketing / Merchandising / Creative, all trying to help each other?

You can spot an unhealthy business a mile away ... people don't work well together, people don't like each other, and you have to push a boulder up a hill to get a decision made. Heck, I once worked in a department where the department head threatened physical violence if his wishes were not met. This led to three separate teams all trying to work on the same project, all competing against each other. That didn't turn out well. In another case, the Executive led terrifying meetings that caused people to walk out of the meetings ... weeping. Needless to say, the health of the business in this environment was ... sub-optimal!

Healthy businesses have employees who support each other ... the employees are not best friends, but they genuinely care about each other. And employees are allowed to make their own decisions ... with mistakes not being held against employees.

You (yes ... you, the reader) can change the culture of your business ... and in doing so, you may improve business performance, pushing your business closer to a Healthy Business.

Healthy Business: Testing

I fielded a call from an Executive. This individual wanted to understand the impact of a marketing tactic. The conversation went something like this:

Kevin: Did you test the idea?

Professional: Did I what?

Kevin: Before rolling out the tactic, did you test it, so that you knew the impact it would have on sales?

Professional: Heavens no. We were being strategic.

Kevin: What does that mean?

Professional: We workshopped a bunch of ideas on a white board, held a strategic session including all members of the Executive Team, and then picked the strategies we wanted to act upon.

Kevin: How is that being strategic?

Professional: Are you kidding? That's the essence of being strategic. A room full of Leaders making decisions.

Kevin: But now you are asking me what the impact of your decisions are, and you could easily have known the impact if you had the patience to execute a small test.

Professional: Just use some of your geeky math and answer my question, alright?

A healthy business wants accurate answers to questions.

Unhealthy businesses want somebody to "hack" the answer.

A healthy business possesses employees who want to learn, who want to understand how everything fits together. A healthy business then acts upon what was learned, and does not waste time retesting.

Unhealthy businesses want to be strategic, but their actions are not strategic.

A healthy business does this:

• Test.
• Learn.
• Act.

An unhealthy business does this:

• Theorize.
• Strategize.
• Lionize.

Yup ... since the unhealthy business doesn't want to learn, the unhealthy business creates theories. The theories are converted to strategies, and when the strategies don't work, the one who theorizes is lionized. This is one of the reasons why Marketing Executives are fired every two years.

If you want to improve business performance, try the Test / Learn / Act approach.

Healthy Business: Newness

I was in a meeting back in 2002 - the Chief Merchandising Officer of the online division was being beaten silly for not having enough new merchandise. At the time, I was a huge proponent of running winning items out there over and over and over and over and over and over and over and over again until they were dead tired. This thought process was drilled into my skull at Lands' End ... turtlenecks and mock turtlenecks in the first twenty pages of the catalog, no excuses ... same stuff, year after year after year.

Then I got to see what a "newness agenda" looked like at Nordstrom. Wow. I guess new merchandise works! Four straight years of healthy bonus payments will cause anybody to acquire an appreciation for new merchandise.

Back in 2013, I performed a Merchandise Forensics analysis for a company that was struggling financially. I noticed that this company had very few new items, and when they launched new items, the items typically failed.

Then you run fifty Merchandise Forensics projects, and the story repeats.

1. Healthy Businesses have a committed investment in new merchandise.
2. Healthy Businesses identify winning new items at rates far better than competing brands.

Businesses that fail to find successful new merchandise have to "cheat". There are many ways to cheat.

• Discounts / Promotions.
• Fake new items. For instance, moving a button around on a shirt does not make the shirt new - but the company will call this a new item and promote it as such to the customer.
• Arbitrary focus on "winning" products as a way to mask new item issues ... "it's what our customers demand of us."
• Blame ... "marketing can't find the right customers for where we want to take the brand."

The healthiest businesses increase the number of new/winning items, year-over-year.

The healthiest businesses increase the rate of new/winning items to new/average items.

The healthiest businesses have a marketing process in place to expose new items to large audiences at minimal cost.

Unhealthy businesses resort to discounts/promotions to sell stuff customers don't want. Yes, this includes free shipping promotions. Free shipping 24/7/365 does not fall into this category.

Healthy Business: Word of Mouth

The healthiest businesses I work with do an outstanding job of generating new customers via word-of-mouth.

Think about Betabrand ... they have a customer acquisition program designed to amplify word of mouth.

Of course, they're using discounts/promos to offer an incentive for you to refer a friend. But they also have those goofy glasses that provide word of mouth, they allow you to upload a photo while wearing the glasses to create word of mouth (and you earn a discount in the process).

Zara calls advertising a "pointless distraction" - they have more than ten million Instagram followers, and the imagery creates word-of-mouth that results in new customers at minimal cost. Not the quantity of new customers a catalog generates via a co-op, but that's not the point, because the cost is essentially zero.

Nordstrom has the legend of the person returning a tire to a store, earning a refund in the process. Word-of-mouth.

Every successful company I work with has some form of a word-of-mouth program.

I work with catalogers that have a 40% ad-to-sales ratio. Needless to say, they have no choice but to invest advertising dollars, because nobody is spreading the word on their behalf.

The healthiest companies have an enormous glut of new customers that they cannot possibly attribute back to paid marketing programs.

The least healthy companies obsess about attributing a meager number of new customers to expensive paid marketing programs.

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.

Healthy Business: Growth Metrics

Each company has a unique culture. Of course, you already knew that, but the culture frequently determines how healthy the business is.

When I worked at Lands' End, our Marketing Department was obsessed with 10% pre-tax profit, so much so that I am still obsessed with 10% pre-tax profit levels twenty-five years later. 

If you are Wal-Mart, then 10% pre-tax profit is not achievable (#grossmarginsaretoolow). But for most of us, 10% pre-tax profit is more than achievable. And at Lands' End, back in the day, there was always a vigorous back-and-forth about how to achieve 10% pre-tax profit. Acquire a lot of new customers? You protect the future, but you hurt your pre-tax profit rate today. Send the 51st catalog to a customer this year? You grow sales, but you make it close-to-impossible to achieve a high pre-tax profit rate.

Then I moved over to Eddie Bauer. The CEO, one of my favorite business people of all time, would announce that it was our job to "DRIVE SALES PROFITABLY". What the heck does that mean? It means you only had one choice ... you had to increase sales and you had to increase profit at the same time. You could not grow sales and hurt profit. You could not hurt sales and grow profit. That really boxed you into a corner. It shouldn't come as a surprise that sales/profit weren't healthy at Eddie Bauer, because the culture did not respect profit - how could it when profit could only improve if sales improved?

Nordstrom was a merchandise-centric organization. If you sold stuff the customer loved and did it at reasonable gross margins with good customer service and you minimized expenses and avoided overstocked items, the p&l worked. Oh, the p&l worked. We routinely generated 12% - 14% pre-tax profit and grew the top line at a healthy rate.

I've worked with 200+ brands since founding MineThatData. About 25% are able to increase the performance of metrics that align with a growing, healthy business.

1. Increased Merchandise Productivity.
2. Increased New Customers at an Acceptable Cost.

In the three examples above, only Nordstrom was able to do both. Nordstrom consistently grew Merchandise Productivity by finding merchandise customers loved. By doing this, Nordstrom could acquire new customers at an ever-cheaper cost, further growing the business.

Eddie Bauer had failing Merchandise Productivity. This put tremendous pressure on New Customer Acquisition - it became more and more expensive to find new customers, requiring the brand to discount more and more often, which grew sales but completely eroded profitability. The least healthy of the three businesses, Eddie Bauer had no positive metrics to speak of. You know what has happened in the 20 year since, don't you?

Lands' End had flat Merchandise Productivity. When Merchandise Productivity is flat, it becomes very hard to grow. Because the company had a policy of no discounting back in the day, the only way to grow was by spending more money on marketing to existing customers (i.e. Marketing Productivity) or by finding New Customers at an Acceptable Cost. Lands' End prospect catalogs from back in the day were a great example of Marketing Productivity - comparable new customer counts at a lower cost, driving up the number of new buyers, which grew sales and ultimately increased future (but not short-term) pre-tax profit.

This is why I harp on the two most important growth metrics.

1. Increased Merchandise Productivity.
2. Increased New Customers at an Acceptable Cost.

If you get this right, top-line sales grow, your ad-to-sales ratio looks great, and cash just drops to the bottom line. The healthiest businesses continually find merchandise that customers love, and the increased productivity makes it easier to find new customers at an acceptable cost.

Healthy Business: Ad-To-Sales Ratio

It's 2002. I'm sitting in the CMO's office (my boss) at Nordstrom. We're setting budgets for 2003. I look at the profit-and-loss statement, and two rows stick out to me.

• Net Sales = $8,000,000,000 (yup, that's eight billion).
• Marketing Expense = $144,000,000.

I pull out my calculator (yes, I had a giant calculator back in 2002 ... the CFO of the online channel called it the 'Green Monster') ... and I performed a bit of math.

• Ad-To-Sales Ratio = $144,000,000 / $8,000,000,000 = 1.8%.

I looked at my boss, the Chief Marketing Officer. I asked a simple question.

• "Is that right? Our ad-to-sales ratio is 1.8%?"

She gives me this dumbfounded look, and says something along these lines.

• "I'm sure we could find ways to cut the fat out and lower it, if that's what you are asking."

That wasn't what I was asking.

Key competitor Macy's has an ad-to-sales ratio of around 6%. Their business is less healthy.

Many e-commerce brands have ad-to-sales ratios between 5% and 15%. They spend a lot of money on Search and Facebook. Many e-commerce brands "hack" their way to sales not by spending ad dollars but by optimizing the online experience coupled with word-of-mouth from social/mobile endeavors.

The best catalog brands have ad-to-sales ratios between 10% and 20%. Lands' End, currently struggling, has an ad-to-sales ratio of around 14%.

The worst catalog brands have ad-to-sales ratios between 25% and 40%. Yes, I said 40%. I see it happen all the time. You cannot tell a cataloger with a 40% ad-to-sales ratio to mail fewer catalogs ... the reason the ratio is 40% is because the staff LOVE to mail catalogs ... they get more satisfaction from putting a catalog together than they get from generating profit.

Ad-To-Sales Ratios are dependent upon Gross Margin percentages. If Gross Margins are north of 60%, you can absorb an Ad-To-Sales Ratio around 30%. If you are Best Buy, no such luck ... your Gross Margins might be +/- 25%. An Ad-To-Sales Ratio of 30% would bankrupt Best Buy. So your Ad-To-Sales Ratio must be sufficiently lower than your Gross Margin percentage.

Having said all of that, the most profitable brands I work, after accounting for business model and gross margin structure, have Ad-To-Sales Ratios that are low. Customers love the merchandise these brands sell, and consequently, they do not need to be advertised to in order to buy something.

In fact, the following sentence could be repeated after every blog post I write.

• The most successful brands I work with earn customers who love the merchandise sold by the brand, and as a result, these brands do not need to advertise to generate sales."

Make Commerce Great Again

For the next few weeks, I'm going to talk a bit about what a healthy business looks like. 

Between my Diagnostics projects and my Merchandise Forensics projects, I have data points for about 100 e-commerce, retail, and catalog brands over the past three years alone. Good data points - one row for every item a customer purchased for the past five years. In a typical year, I analyze about 500,000,000 rows of customer purchase transactions ... about 5,000,000,000 rows since founding MineThatData.

Not Google-sized data of course ... but more transactions than your favorite vendor or trade journalist analyze within a Diagnostics / Merchandise Forensics framework.

So I know a little something about what a healthy business looks like.

If we want to Make Commerce Great Again, we're going to have to get away from our myopic focus on campaigns. You cannot understand how ants behave by studying individual ants. Similarly, you cannot understand how customers behave by studying individual campaign performance.

Tomorrow, we'll begin talking about healthy businesses. If the series goes well, I'll assemble a booklet based on the topic.