Do The Math: Calculating Customer Profitability
The recent high-profile collapse of several consumer dotcoms reminds me of the old garment-district joke about shirtwaists. The dress manufacturer is telling his buddy, “Well, I’m losing a nickel on every shirtwaist, but that’s okay, ‘cause I’ll make it up in volume.” At that point, we laugh, because we all know darn well that no volume efficiencies will erase a loss at the variable cost level.
I don’t know how some of the consumer dotcoms convinced Wall Street that they were ever going to move into profitability over time. No amount of repeat buying, of cross-selling and upselling, will overcome a sale at a loss. I suspect the VCs were secretly pinning all their hopes on the Greater Fool theory, that they could cash out earlier than the next guy before the bubble burst.
The truth is that some product categories are not suited to e-commerce. The economic equation simply does not close. It’s not serendipity that only a handful of product categories are sold successfully through catalogs today. The consumer dotcom version of e-commerce is based on the economics of mail order.
Let’s take pet supplies–a category that has never supported a mass-market catalog. Here we have a product that is physically hard to ship; it’s close to commoditized, and difficult to differentiate successfully; margins are low; unsold inventory is not returnable–on nearly every count, pet supplies are a disaster for this channel.
The same thing goes for toys. Here we have bulky products, difficult to ship, with razor-thin margins. Worst of all, merchants must make product commitments from vendors 8 months in advance, long before the kiddies will determine the season’s hits.
This is why, when Jeff Bezos was casting around for a product to run through the nascent e-commerce distribution channel, he selected books. Publishers, god love them, allow returns of unsold product; in fact, the book wholesalers maintain 80% of Bezos’s inventory for him. Better still, shipping costs are workable compared to price–consumers are generally willing to pay about 10% of the total price on shipping and handling. And, if his customer service is first rate, Bezos can count on plenty of repeat buying, which will, one hopes, take him to a profitable customer situation eventually.
So what do merchants do when they are stuck with difficult product lines and unprofitable customer situations? They differentiate. They either retreat to a niche, offering hard-to-find products at premium prices to a small number of loyal customers, or they come up with some added value, like extra services, to increase their margins and bring them into profitability.
E-commerce merchants need to do the math. First, they need to generate a positive trading income on transactions. Second, their customers have to cost less to acquire than the profits they generates over time. This is the concept known as lifetime value, and it’s calculated by adding up the present values of all future expected contributions from the customer. The next step is subtracting the acquisition cost of that customer, or group of customers, from that sum. If the result is positive, bingo. If it’s not, in aggregate, the business is doomed. And no amount of hits, unique visitors, inventory turns, or even market share, will make up for unprofitable customers.