Finance for Product Managers. Part 2 — introducing customer lifetime value for a simple online business
Overcoming the high cost of customer acquisition.
In the first post in this series we imagined a simple online popup store selling toy cars for one month in the run-up to Christmas. Sadly it appears to be a guaranteed way to lose a lot of money, as the cost of acquiring customers via online ads is much greater than the projected revenue. In this post we shall begin to look for ways to make the business viable.
Our initial assumption was that we would sell one toy car per customer for a gross profit of $4 per car. With operating expenses of $11.13 per customer we are looking at a loss of $7.13 per car sold. On a per customer basis our profit/loss looks something like this:
Revenue per customer $5.00
Expenses
Cost of revenues $1.00
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Gross profit $4.00
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Operating expenses
Shop rental $0.03
Transaction fees $0.10
Shipping costs $1.00
Advertising $10.00
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Operating profit -$7.13The obvious line in this calculation to focus on would be the advertising expense, which represents our cost of acquiring a customer. It is reasonable to ask if we could reduce this number, and there are ways we might try to do this. But for an e-commerce business a customer acquisition cost of $10 is not atypical, and we are unlikely to greatly improve on this. So if we can’t acquire our customers for significantly less, our only option is to get each customer to spend more money with us.
Our shop is open for one month, and we have assumed that each customer will buy one toy car at $5 apiece. Another way to express this would be to say we have customer lifetime value of $5. You could also call it average order size, in this case it makes no difference. If each customer bought two cars instead of one then they’d spend $10 with us and meet the cost of their acquisition. The ratio of customer lifetime value (CLV) to customer acquisition cost (CAC) is of fundamental importance. We will cover calculating CLV for different kinds of business models in more detail later, but in this case it’s simple. In order to have any shot at making the business work, we need the CLV:CAC ratio to be greater than one.
How much greater? Suppose we stopped selling individual cars, and only sold them as a set of three for $15. Our CLV:CAC ratio would be 3:2, each customer would spend half as much again as they cost to acquire. However this doesn’t mean we’d be in overall profit, as we must remember our other costs:
Revenue per customer $5.00 | $10.00 | $15.00
Expenses
Cost of revenues $1.00 | $2.00 | $3.00
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Gross profit $4.00 | $8.00 | $12.00
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Operating expenses
Shop rental $0.03 | $0.03 | $0.03
Transaction fees $0.10 | $0.20 | $0.30
Shipping costs $1.00 | $2.00 | $3.00
Advertising $10.00 | $10.00 | $10.00
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Operating profit -$7.13 -$4.13 -$1.33At this point the simplistic assumption about shipping costs starts to look significant. Probably the cost of shipping a small plastic car doesn’t scale linearly. Let’s say that we can ship three cars for $1.50. Now we can make a tiny profit per customer. If we were able to shift our entire stock of 1000 cars then we’d have 333 customers, with one car left over as a souvenir. Our overall profit and loss would look like this. We can make $27 after tax!
Income $4995
Expenses
Cost of revenues $1000
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Gross profit $3995
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Operating expenses
Shop rental $29
Transaction fees $100
Shipping costs $500
Advertising $3330
$3959
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Operating profit $36
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Taxes $9
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NET PROFIT $27It’s a lot better than a loss, but as a return on an investment of $1000 it’s pretty pathetic. What about raising the price of our cars? There’s a limit to what the market will bear, and selling three $1 plastic cars for $15 is pretty good going. In a more realistic scenario we might still sell single cars for a slightly raised price, and try a combination offer to encourage people to buy in multiples. Say one for $7.50 or three for the price of two. We could model how that would stack up depending on the proportion of our customers that took up the offer:
We end up back in the same place. It’s impossible to sell these toys singly at any realistic price and not lose money, we need a revenue per customer of around $15 to break even.
Let’s rethink our proposition. Suppose that instead of selling toy cars to wrap up singly or in threes under the tree, we offer a gift that lasts all year. Sign up and your child receives a different car in the mail each month, addressed to them. We’ll assume that we have that many different kinds of car in our stock. Let’s call it $4 a month, but for simplicity’s sake assume we can persuade people to pay $48 upfront. The maths for this look much more attractive:
Revenue per customer $48.00
Expenses
Cost of revenues $12.00
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Gross profit $36.00
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Operating expenses
Shop rental $0.35
Transaction fees $0.96
Shipping costs $12.00
Advertising $10.00
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Operating profit $12.69With sufficient cars to supply 83 customers we can make a total operating profit of $1053, which makes a net $790 after 25% tax. That’s a 79% return on our investment of $1000, not too shabby at all, even if we will spend the next year packing and posting toy cars.
The relatively high cost of acquiring customers and the consequent imperative to maximise revenue from each one has nearly led us to one of the most popular online business models — a true subscription product. We will explore that further in a future post, and consider the financial implications of running a business for longer than a single month.
