Business Advisor Network Blog

Let’s say your product has $50 worth of Gross Profit in it. When a customer makes a purchase, most business people tend to say “I’ve just make $50.”

Fair enough, but consider this:

What if the typical customer needs to buy that good or service every 5 weeks? And what if they’ll need to keep re-buying that product for the next 4 years?

If that was the case, then the sale might have been worth $50 … but the ‘lifetime value’ of the customer is $50 x 10 x 4 = $2,000.

In other words, instead of ‘closing’ a sale worth $50 in Gross Profit, we’re actually looking at ‘opening’ a relationship with a client who will spend a further $1,950 on products which we can provide. The only question is whether they’ll spend the balance of that ‘lifetime value’ with us, or with our competitors.

And that will largely be decided by how well we deal with the ‘delight’ and ‘repeat custom’ issues which we looked at earlier.

Now factor in the ‘lifetime value’ of new customers who’ve been referred to you by the existing delighted customer … and it starts to get really interesting.

So …, make sure you and your team look at every customer contact in the context of ‘lifetime value’. If you lose a customer (or fail to impress them enough to ensure they’ll come back), you don’t just miss the sale in question – but also the others which were yet to occur. Worse still, your competitor will pick that business up instead – so you’ve lost twice, because you’re strengthening the opposition at the same time as you reduced your own profitability.

And if you’re not busy, then invest your time in opening and building relationships with potential clients. Concentrate on building a relationship with them now, before you do business, rather than waiting until afterwards. When they’re ready to do business your name will spring to mind.

Don’t take the typical approach of contacting the customer only when you’re ready to sell, because the chances are that they won’t be ready to buy at that same point in time.

If relationship-building with potential customers doesn’t suit your business, then at least begin planning your promotional activities, again with the ‘lifetime value’ in mind. In particular, do some serious thinking about how much you’re prepared to spend on acquiring your new customers.

The rough formula for determining the number of sales required to break-even on your promotional expenditure is: Number of Orders (0) = Promotional Expense (P) ÷ Anticipated Gross Profit Margin (M).

So, if our promotion (P) was going to cost $1,000 and the Anticipated Profit Margin (M) was $50GP, then:

O = $1,000 ÷ $50

Therefore O = 20.

Importantly, if we squint our eyes and use two mirrors and a little sticky tape, this formula can be inverted to determine how much we can afford to spend on acquiring clients. The adjusted formula looks like this: Promotional Expense = Number of Orders x Anticipated Profit.

So, if our target Number of Orders is 20 and the Anticipated Profit Margin is still $50GP, then:

P = 20 x $50

Therefore P = $1,000.

In other words, if we spent the full $1,000 on promotions and promotional offers and picked up our 20 x $50GP transactions, we’d break-even. A higher number of sales, or higher value transactions, would make it a profitable campaign. Lower numbers would result in the campaign not being independently profitable.

But note that these calculations are based only on the value of a single transaction, rather than the ‘lifetime value’ of the customer. If we factor the anticipated profit from the customer’s full buying life into the equation, we arrive at a very different allowable Promotional Expense.

Specifically, if we keep our target number at 20 (recognising that we are now talking about a target ‘Number of New Clients’ rather than just a target number of single orders) and if the Anticipated Profit Margin is $2,000GP as determined earlier ($50GP x 10 transactions x 4 years), then:

P = 20 x $2,000

Therefore P = $40,000.

That’s obviously a MASSIVE difference in what you could consider spending. From a promotional budget of $1,000 you’ve just gone to a promotional budget of $40,000.

Of course we’re not recommending that you should spend that amount on winning your 20 new clients. (In fact, let us state that this would be unwise – because this calculation determines the ‘break-even’ levels. That is, if you invested your $40,000 in promotions you would have to acquire the 20 clients AND earn $2,000 worth of Gross Profit from each of them (being 10 x $50GP transactions per year for 4 years, as in our earlier example) simply to recoup the $40,000 you spent. (And before anyone complains, I realise that this is without allowing for ‘cost of capital’, the inflation rate and other factors which require a whole new and more complex formula. We don’t have the space to look at it in this issue – and this rough calculation is enough for us to see the point.)

What we’re trying to demonstrate is that a better understanding of ‘lifetime value’ puts you in a much stronger position to acquire customers and hang on to them. Even if, based on this understanding, you were to invest only a fraction of the amount calculated, you’d still be spending vastly more than most of your competitors. They’ll think you’ve gone mad and will be convinced that you won’t be able to sustain the generosity of your offers and the level of promotional activity, but you’ll be acquiring more customers than them.

And (if you delight those new customers enough to earn their repeat custom) you’ll harvest a bumper crop of profits over the life of each customer.

Virtual Business Advisor

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When working to improve your bottom line, focus on the “3 Keys” of “Lead, Lift and Leverage”.

The “Lead” key is all about the organization’s leadership and management. The “Lift” key is all about lifting the business’ turnover through better sales and marketing. And the “Leverage” key is about improving the business’ productivity and efficiency in all areas of the operation.

Guess where most people want us to start?

If you said “Lift”, you’re right. There’s always an overwhelming desire to see a quick increase in turnover.

That’s fine, of course, and usually easy enough to do. But it’s interesting to note that often the quickest way to improve bottom line profitability is through working in the “Leverage” area.

The Leverage key is largely about ‘reducing inputs while maintaining outputs’. In other words, it means trimming the fat, without hurting the
muscle.

In many, many cases this can be achieved VERY quickly. And more to the point, a reduction in costs is often far more valuable than an increase in sales.

For instance, let’s say your business is achieving an after-tax net profit of 5%. And let’s say your product cost is 70%.

If you reduce your product cost by just 2%, you’ll achieve the same after tax profit as you would from a 17% sales increase!

Realistically, a 2% reduction in product costs could be achieved in the time it takes to make a couple of phone calls. On the other hand, a 17% increase in sales could take months.

Why not call YOUR suppliers (and their competitors) and ask what discount you’ll get if you fix your accounts in 10 days instead of 30?

What if you collect, rather than have them deliver?

What if you arrange storage, rather than use their warehousing space?

What if you buy in bulk?

What if you refer new clients to them?

And what about your under-utilised labour and facilities?

One of our clients now sub-lets its machinery from “midnight to dawn” when the equipment would normally sit idle. The income earned means that the company’s own production is virtually free. Other clients now use their scrap to create inexpensive but attractive knick-knacks which they use as “value adders” and gifts to clients.

The moral to the story? Simply this: work on ALL 3 keys. If you focus on just one or two, you simply won’t achieve the best or fastest possible result.

Virtual Business Advisor

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We have previously looked at profit as a return being measured by ROE.  ROE is great for comparative assessments over various businesses to see which are best at converting sales into returns to investors. But ……..

ROE ignores risk. Obviously if your business is investing in lottery tickets, this is pretty high risk. However, you may have a golden streak and earn 1000% on your investment – but you know this is not sustainable. Other times you know you will just lose all money spent on buying lottery tickets. Common sense tells you that this is a very high risk strategy – unless you know the winning numbers in advance! You would consider very closely whether you want to take the risk of losing your entire investment for the potential of an extraordinary return should your numbers come up. In fact a rational investor would probably quarantine the investment to the “what they can afford to lose but don’t mind” bucket.

There must be a better way of bringing risk into the calculation. Well, as always, there are a number of ways it can be done but there are a couple of fundamental issues to grasp.

Risk is in fact often used erroneously instead of volatility. Think about the lottery example – the issue is the extreme volatility in return – from complete loss to 1,000% return.

Volatility is measured by what is called beta. The more volatile, the higher the beta – the less volatile, the lower the beta. By applying the appropriate beta to the return generated, you can then reflect the risk in the return. And by then dividing this risk adjusted return by your investment, you can effectively compare all investment opportunities on an “apples to apples” basis with risk adjusted in the comparison.

However, it is difficult to get a handle on what the beta is in the world of privately owned business. With ASX listed investments, the whole market has a beta of 1.0. If a share is calculated to have a beta of 0.8, this means it should move with less volatility than the overall market. One with a beta of 2.0 would move far more (up and down) then the overall market.

All sounds a bit pointy headed doesn’t it? What happens in the real world?

What is generally done in private business sales or purchases, is that the earnings multiple is adjusted to reflect the perceived or actual risk. This adjustment in the multiple a person is prepared to pay (because the business is seen as more, or less, volatile investment) “makes up” for the risk.

To put it in perspective, someone may pay a 2 times earnings multiple for a business reliant on luxury car sales whereas they may pay 5 times earnings for a business seen to be stable and recession proof (e.g. health based industry).

Marshall Vann – Realistic Business Solutions

How to book a meeting with a business advisor, mentor or coach?
Find out about Government Grants for Queensland business?
Would you like to become an Accredited Advisor?
Need information on how to prepare a business plan?
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In a recent post, I discussed the various types of profits that are used for many purposes. It got me thinking, I know everyone wants to make a profit – but not many smaller businesses think about what is a reasonable profit.Generally in small business people either start off the business from scratch or buy it from someone else. The earnings expectations differ depending on this:

Start from scratch – the owner expects to at least earn what they could as an employee, plus a bit more for the pain and effort of running the business.

Purchased – the owner still wants a reasonable “salary” type return plus want some return on their investment on the purchase (quite often this is tied to paying interest on debt used for the purchase).

Whilst both of these are valid, there are not particularly economically rigorous. A far more rigorous approach is based around Return on Equity or ROE. ROE is NPAT divided by equity (or capital or your investment) and measures how efficiently a business generates profits given how much money is tied up in it

Every business has some level of investment by its owners. In a purchased business, the purchase price plus transaction costs is an obvious investment.

However, even start-ups have an investment – even if it just an old desk, chair and filing cabinet that you use to run the business. But what about your car that you use half for business, the advertisements in the local paper, the computer you use, your time (you may earn the same salary you expect as an employee but work twice as many hours).

If you are a business owner, you should be clear in your expectations about what an acceptable return on your investment is. Whilst there are many formulae and bases for calculating return, ultimately it is the owners call as to what is acceptable.

In the next post we will look more closely at the ROE calculations and give some guidance as to what is acceptable and what goes into determining your profits used in calculating ROE.

Marshall Vann – Realistic Business Solutions

How to book a meeting with a business advisor, mentor or coach?
Find out about Government Grants for Queensland business?
Would you like to become an Accredited Advisor?
Need information on how to prepare a business plan?
Do you want a step by step guide to growing your business?
Become a sponsor or partner of BAN and connect with small business decision makers?
I wish to make a donation to help small business.