How To Find Out If Your Business Is Scalable
The scalability of a business essentially boils down to two factors, which are cost and revenue. A business is worth scaling once the financial model of the sales proven its profitability where the gross profit value is greater than its cost. And the most fundamental method to evaluate your business profitability is to break down the cost and revenue for each sales unit. While each business has different types of sales unit:
- For businesses that are customer-centric, its sales unit would be per customer acquisition;
- For businesses that are transaction-centric, its sales unit would be per transaction acquisition.
In the following contents I will elaborate how to measure the cost and revenue (gross profit) unit economics for these two types of business.
The unit economics for customer-centric business
For a customer-centric business, the unit of a sale is a customer acquisition, where a brand successfully acquire a customer to purchase its product or services. The cost of this sale unit is defined as Customer Acquisition Cost (CAC), which the cost is the marketing expenses to acquire a customer. Whereas the revenue is defined as Customer Lifetime Value (CLV), which sum up the total gross profit gained from each individual customer during their lifetime with a brand. Hence, the calculation for cost & revenue per sale unit are as follows:
A) Customer Acquisition Cost (CAC): The cost of winning a customer to purchase a product/service
CAC = Total marketing expenses / Total customers acquired
B) Customer Lifetime Value (CLV): The total gross profit gained from a customer during their lifetime with a brand
CLV = Customer lifetime in months * Average monthly transactions * Average order value * Gross margin %
While it’s quite straightforward to obtain average monthly transactions, order value and gross margin of a brand’s product/service, it may need additional calculation to find out what is their average customer lifetime in months. In order to find out average customer lifetime in months we will need to find out what is the monthly customer churn rate for a brand, and here’s the formula to find out monthly customer churn rate:
Monthly customer churn rate = Total customers lost in a specific month / Total customers in a specific month
From the monthly customer churn rate we will then able to find out the expected customer lifetime in months with the formula below:
Expected customer lifetime in months = 1 / Monthly customer churn rate
To further explain, we are taking the absolute digit “1” divide by the churn rate to get to the expected lifetime because that will tell us in how many times such X% churn will take place to become 100% churn.
Now with all formulas elaborated, let’s demonstrate the calculation of CAC & CLV with some dummy data.
For example, these are some dummy data for a food delivery app brand G:
|Total customer at the beginning of January||1,000|
|Total new customers in January||500|
|Total marketing expenses to acquire customers||USD 25,000|
|Total customers lost in January||300|
|Average monthly transactions||5|
|Average order value||USD 20|
|Gross margin %||35%|
Customer Acquisition Cost (CAC) = USD 25,000 / 500 = USD 50
Monthly customer churn rate = 300 / (1,000 + 500) = 20%
Expected customer lifetime in months = 1 / 0.20 = 5 months (it will take 5 times of monthly 20% churn to become 100% churn)
Expected customer lifetime value (CLV) = 5 months * 5 transactions * USD 20 * 35% = USD 175
There you have it! The CLV : CAC ratio for this food delivery app brand G is 3.5 : 1
We also found that the lifetime gross profit per customer is USD 125 (subtract CAC from CLV).
It is recommended to keep track of your expected CLV and CAC as early as possible once the above 7 data points are accessible (ideally after the first month cycle), so that marketers could manage the marketing campaign efficiently and minimize the ads budget burn rate. For example, by having the expected CLV & CAC for the first month, we could then assess how many more months do we need to retain the customer to purchase our product/service in order to pay back the customer acquisition cost in the first month. In this dummy data scenario, it will take 1.4 months to recover the acquisition cost, since the monthly gross profit is USD 35 while the CAC is USD 50.
The unit economics for transaction-centric business
For a transaction-centric business, the sale unit would be per transaction acquired instead of per customer acquired. It would then be simpler to quantify its cost and revenue, where the cost of a sale unit is defined as Transaction Acquisition Cost (TAC); and the revenue of a sale unit is defined as Transaction Gross Profit (TGP).
A) Transaction Acquisition Cost (TAC): The cost of winning a transaction
TAC = Total marketing expenses / Total transactions made
B) Transaction Gross Profit (TGP): The gross profit of a transaction acquired
TGP = (Total transactions value * Gross margin %) / Total transactions
Now let’s demonstrate both TAC and TGP using some dummy data below, say, this is January’s data for an e-Commerce store brand H.
|Transaction #1||USD 32|
|Transaction #2||USD 300|
|Transaction #3||USD 12|
|Transaction #4||USD 78|
|Transaction #5||USD 35|
|Transaction #6||USD 9|
|Transaction #7||USD 32|
|Transaction #8||USD 55|
|Transaction #9||USD 11|
|Transaction #10||USD 23|
|Total marketing expenses to acquire transactions||USD 500.00|
|Gross margin %||35%|
Transaction Acquisition Cost (TAC) = USD 500 / 10 transactions = USD 50
Transaction Gross Profit (TGP) = [USD (32 + 300 + 12 + 78 + 35 + 9 + 32 + 55 + 11 + 23) * 35%] / 10 transactions = USD 20.55
Here we found that the TGP : TAC ratio for this eCommerce store brand H is 4.1 : 10
And the gross profit per transaction is at loss which is -USD 29.46 (subtract TAC from TGP).
Although the cost and revenue per transaction acquisition in January suggest that it may not be viable for this business to scale, but in hindsight, there are a couple of things we could do to recover the loss.
- Since we know that the gross profit for a transaction is USD 20.55, we could cap the transaction acquisition cost to anything that is lower than this figure to attain profitability.
- Re-adjust the order value, or promote big-ticket items so that the TGP could yield better.
- Control the inventory gross margin to higher rate instead of the current 35%.
By optimizing these 3 unit economics variables – cost to acquire a transaction, transaction value & gross margin, we will be able to yield better profitability for a transaction-centric business.
Over to you: What is your business’s sale unit?
If you are starting a business that quantify your sales by transactions, then you will know that your strategy is pretty straightforward, which is to maximize the margin and minimize the cost to win each transaction. But if you are starting a business that quantify your sales by customer acquisition, then you will know that customer retention could give you an upper-hand to yield greater profitability even though you are sharing the same margin and cost as any other transaction-centric business.
At the end of the day, we are selling product/service to a customer, regardless of whether its a customer-centric or transaction-centric business.
So let’s say, you are given a fixed amount of marketing budget to acquire sales, which sales unit would you go for? To acquire a transaction for short term profit, or to acquire a customer for long term profit? It may appear as though all eCommerce business are transaction-centric, but in reality there is one thing that the multi-billions valued eCommerce companies namely Amazon (US$1.7T), Lazada (US$3.15B), Tokopedia (US$7.5 B), Traveloka (US$2B), & Bukalapak (US$1B) share in common – which is investing in customer retention or loyalty.
While the above unit economics demonstration clearly signified the advantage of customer-centric business, we should, by now be able to embrace the idea of branding if we are opting for the customer-centric route. Because branding is a constant effort to win your customers’ heart over, and over again. It is not just about what you want your customer to see or hear, but rather what you want your customer to feel about your brand, and all that happen along the journey they experience; from the moment they found your brand, till the moment they are committed to your brand.
Besides maximizing your business’s revenue from building customer relationship, it is also crucial to minimize the acquisition cost that able to achieve optimal acquisition volume, be it CAC or TAC. For the upcoming article I will also share how to optimize the acquisitions performance, what are the tool and template you could use to quantify acquisition cost-effectiveness if you are using multi-channels to acquire sales.