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It is tempting to evaluate the success of a company based on its sales. Judging by the recent headlines from the business section of the Wall Street Journal last week, it seems you’d be a fool not to.
However, while sales may make headlines, they don’t always make profits. In today’s highly competitive business environment, it is critical for business leaders to have an accurate understanding of the true profitability of the products and services they offer to customers. Yet, many don’t.
Various factors influence profitability, including sales mix, customer acquisition costs, customer lifetime value, and variable costs, among other items. Traditional financial reporting does a poor job of measuring these. While implementing the processes and reporting to track the data needed to accurately evaluate sales can be difficult, the upside of doing so can be well worth it.
In this article, I aim to introduce and summarize some of the factors that impact profitability, starting with more rudimentary elements and quickly delving into more sophisticated topics. In turn, I hope to help small to medium-sized business owners better understand the drivers of their company’s profitability and make better decisions about what products and services to sell, in which markets and channels, to which customers, and at what price.
Sales Mix
Sales can comprise a mix of various products and services sold to different customers. Each product or service has a different cost to make or provide and thus has different gross profit margins. Understanding how sales mix, whether measured by product, customer, channel, or market, impacts a company’s profitability is fundamental to making sound business decisions.
To illustrate, Kohl’s, the national department store, offers several types of khakis. It can sell one of the national brand khakis it carries like Dockers ($39.99 each) or one of its private-label brands like Sonoma Goods for Life ($34.99 each). However, which khakis do Kohl’s prefer to sell? The answer depends on each item’s gross profit margin. Gross profit margins on private label and national brands for retailers are, on average, 40% and 17%, respectively.[1] Applying this to Kohl’s, then Kohl’s generates $6.80 of gross profit on each sale of Dockers versus $14.00 of gross profit on each sale of Sonoma Goods for Life. All else equal, Kohl’s should prefer to sell its Sonoma Goods for Life khakis and should consider focusing its efforts on expanding its private-label offering.
Customer Acquisition Costs
Customer acquisition costs measure the cost of acquiring a customer (e.g., advertising and marketing expenses) and are not captured in the typical gross profit analysis depicted above. Customer acquisition costs vary by channel and media and tracking and analyzing acquisition costs at the channel and media level is important to accurately understanding profitability. (Understanding how to calculate customer acquisition costs is beyond the scope of this article, but for those interested, read “Why Unit Economics Like CAC and CLV Matter To Your Business”).
Elaborating on our previous example, let’s assume that a customer of Kohl’s buys a pair of Sonoma Goods for Life khakis for $34.99 online via Kohl’s e-commerce website (www.kohls.com), and another customer purchases the same pair of Sonoma Goods for Life khakis for $34.99 via one of Kohl’s retail stores. Which sale does Kohl’s prefer now? The answer partially depends on how much Kohl’s spent to acquire each customer. For simplicity, let’s assume that Kohl’s advertises online via social media and email and, on average, spends $5.00 for every acquired e-commerce customer and that Kohl’s advertises offline primarily via direct mail and, on average, spends $7.50 for every acquired retail customer. With this additional information, we now know that after customer acquisition costs, Kohl’s earns $9.00 in profit on each sale of a pair of Sonoma Goods for Life khakis to an e-commerce customer and $6.50 in profit on each sale to a retail customer. Thus, all else equal, Kohl’s should prefer selling khakis to e-commerce customers and should consider focusing its efforts on growing its e-commerce business.
Customer Lifetime Value
Some customers are extremely loyal and make multiple purchases with a company over their lifetime. Other customers are more fickle and may make just a single purchase and never buy again from the company. Customer lifetime value takes into account these differences and attempts to quantify how much profit a customer is expected to generate for a company over the entire duration of that customer’s relationship with a company, as opposed to just one transaction at a point in time as we have been doing in our previous examples. (Understanding how to calculate customer lifetime value is beyond the scope of this article, but for those interested, read “Why Unit Economics Like CAC and CLV Matter To Your Business”).
What if the above customer acquisition cost example had instead used the Dockers khakis? Assuming the same customer acquisition costs (i.e., $5.00 for e-commerce customers and $7.50 for retail customers), then Kohl’s generates $1.80 in profit after customer acquisition costs on each sale of Dockers khakis to an e-commerce customer and loses $0.70 in profit on each sale to a retail customer.
Now, which sale does Kohl’s prefer? That answer depends on the expected customer lifetime value of each customer type – i.e., whether the customer is expected to be a recurring and, if recurring, how many purchases they are expected to make over their lifetime.
If we expect the retail customer to buy, on average, three (3) pairs of Dockers khakis from Kohl’s over its lifetime and the e-commerce customer to purchase, on average, two (2) pairs over the same period, then Kohl’s should prefer the retail customer. Why? While Kohl’s makes more money on the initial sale of Dockers to an e-commerce customer, only accounting for the first transaction ignores the future profit Kohl’s generates on each of the customer’s subsequent purchases.
After the initial sale, arguably, Kohl’s no longer needs to spend the same amount on advertising and marketing to generate the next sale to an existing customer since Kohl’s already spent money to acquire these customers. While there may be some cost associated with retaining each customer, for simplicity, let’s assume that Kohl’s customer retention costs are $0. In that case, Kohl’s generates an additional $6.80 in profit from each subsequent sale to an e-commerce customer and a retail-customer. This realization is critical. As a result, Kohl’s should expect to earn a total profit of $12.89 over the lifetime of its relationship with the retail customer and $8.60 in profit with the e-commerce customer. With that in mind, instead of expanding its e-commerce channel as we previously concluded, perhaps, Kohl’s should focus on growing its retail store channel due to the more loyal nature of this customer type and thus higher expected customer lifetime value.
Other Variable Costs
To truly understand the profitability of a sale, it is essential to ensure that any analysis accurately captures the entirety of variable costs associated with that transaction. Thus far, we have specifically identified cost of goods sold and customer acquisition costs. These variable costs are relatively well known (and usually easy to track), but often other variable costs are less obvious to identify (and difficult to track); many times, companies report these costs in overhead expenses as opposed to cost of goods sold further muddying the waters.
Continuing with our example, what if the e-commerce customer had used a 25% off coupon, but the retail customer paid full price? What if the e-commerce customer paid by credit card while the retail customer paid in cash? What if Kohl’s policy is to pay retail sales associates a commission on each item they sell? Or, what if the e-commerce customer received free shipping or ordered the khakis by calling a customer service representative in Kohl’s call center versus ordering online? Each of these hypotheticals has a direct cost associated with it and thus impacts the profitability of a particular sale. In the case of the coupon, there is a reduced net sales price; in terms of a credit card transaction, there are associated merchant processing fees; in terms of commissions, there are additional wages and payroll taxes; in terms of free shipping, there are postage costs; and in terms of phone orders, there are call center costs.
This list of variable costs is not exhaustive. For each company and industry, there are multiple other examples of variable costs that may be associated with a sale that impact profitability. To fully understand how profitable a type of sale is, one must fully understand each variable cost, and importantly, have the systems, processes, and reporting in place to track and report the data in an accurate and timely fashion.
Summary
It’s easy to get excited over sales and overemphasize or extrapolate their impact on a company’s performance. Unfortunately, not all sales are created equal. In today’s competitive business environment, it is critical for business leaders to have an understanding of the true profitability of the products and services they offer to customers and the expected value of those offerings over the lifetime of a customer as opposed to a single transaction. Yet, many don’t. Often this is because companies don’t have the right financial reporting in place, do not collect the right data, or lack the resources necessary to measure profitability accurately. The result is that companies are making critical decisions about what products and services to sell, in which markets and channels, to which customers, and at what price based on incomplete or inaccurate information. While correcting the problem to allow the company to accurately measure the profitability of a sale is hard work, companies would be well served to do so. Once done, companies will have a detailed and accurate understanding of what drives cost in a company and can then make smarter decisions on what should be done differently to increase not just sales, but profitability.
The partners at Cronkhite Capital have over 10 years of experience buying, selling, and operating small to medium-sized businesses across industries. If you are interested in learning more about how Cronkhite Capital can help improve the operating performance of your company, please reach out directly to Ryan Hammon. Email - rhammon@cronkhitecapital.com Phone - (415) 847-8103.
Sources:
[1] https://knowledge.wharton.upenn.edu/article/more-choices-in-store-indias-retailers-are-stocking-up-on-private-label-brands/
