In the 1950s Xerox invented a way to make dry copies without wet, smelly chemicals. But that’s not what made them successful. They became one of the largest, most profitable companies on the planet because of another innovation. The copier technology was wonderful but it cost more than people were willing to pay. So they came up with another invention: a new business model.
Instead of selling their machines, or leasing them for enough to cover the costs, they offered a lease that included a fixed number of copies per month with a commitment for the customer to pay a few cents for every copy they made above that. This got people on board thinking they wouldn't make many copies, but then when they found how useful dry copies were, they happily paid for more.
Another example of a business model is aimed at men who want to shave. One model is to sell the razor. Another is to give away (or sell at a discount) a razor that only takes blades you make a profit on. That’s why the cheapest handle that takes double edge blades (made by many companies) costs $13 but one that takes proprietary Schick blades sells fo $10 with three blade refills. The Schick replacement blades cost $2 each, double edge blades cost 11 cents. Someone selling a handle that uses blades which can be bought from someone else, has to make a profit on the handle. Someone whose handle forces customer to buy their blades every month, can afford to give the handle away. And we haven’t even mentioned selling an electric razor with no replaceable blades.
So, you might wonder, how does this apply to you if you don’t sell razors or copy machines?
It turns out there’s a formula for a business model that applies to every company.
(LTV-CAC) * N = $$
Let me tell you what that means and how to use it.
LTV is the LifeTime Value of a customer
CAC is the cost of a acquiring a customer
N is the number of customers
And $$ is profit.
This is obviously not an exact mathematical formula, but nevertheless it’s useful. Here’s why.
LTV – Lifetime value. This is the money the customer pays you multiplied by how often or how long they buy from you. From that you have to subtract what it costs to provide what they pay you for. There are several ways to increase the LTV. Get people to buy more from you. Get them to buy more often. Lower the cost of providing the product or service they pay you for (which is often called COGS – Cost of Goods Sold).
CAC – Customer Acquisition Cost. This includes all the money you spend to get that customer in the first place. It includes marketing, advertising, sales, sales support and the like.
(LTV minus CAC). This had better be a positive number. Meaning you can’t pay more to acquire that customer than the customer is worth. Anything you can do to lower the cost of acquiring a customer improves this factor. So does anything you can do to increase the LTV while keeping CAC the same.
Back when Netflix was publishing these numbers – before they started making their own shows, and before they started streaming – they were just sending DVDs to customers in the mail. They had a very simple business model. And it costs them about $40 to acquire a new customer. This customer was paying $6 or $7 a month, and Netflix had to pay for the DVDs and the cost of sending them back and forth in the mail. BUT, customers tended to remain customers for 24 months. If you do the math – they were very profitable.
Let's not forget N. That's the appropriate number of customers. Here’s what I mean by appropriate. Since it costs money to sell new customers, and it costs money to serve them, you want to keep your capacity to sell and to serve in balance. It does no good to spend money selling to customers you can’t afford to serve. Nor does it make sense to invest in capacity to serve more customers than your sales team can sell. If you have the wrong N it can eat up your profit.
WHY THIS IS NOT AN EXACT FORMULA
There are two reasons. One is timing. If you spend $40 to acquire a customer and they take two years to fully maximize their value to you, then you obviously have to have the cash to stay in business during that time. This calculation is called cash flow, and we’ll be covering it in more detail in a different module.
The other reason this is not an exact science is that sometimes an expense can be considered either CAC or COGS. To continue our Netflix example, they now have a different business model. Not only does streaming change their COGs but they also produce their own shows. Is the cost of making, say BIRD ??? a cost of goods, or a marketing costs? It’s a bit of both. Because it serves both purposes. It provides value to their existing customers and it provides a reason for new customers to sign up as well as a reason for existing customers to continue their subscriptions.
Let’s take another example. Starbucks or similar food establishments. The most successful ones often locate in high rent areas. Rent is not a cost of goods – it’s an ongoing operating cost. But it’s also a marketing cost. Being where more people are brings in more sales.
SO HOW CAN YOU USE THIS?
Even without it being an exact formula, you can exploit your business model. You can find ways to:
- Increase the LTV (as Xerox did by selling thousands of extra copies at a few cents each)
- Lower the CAC (as Xerox did by keeping their lease price so low it was an easy sell)
- Optimizing the number of customers so your ability to sell is in balance with your ability to serve. (As Netflix is trying to do by expanding to multiple countries).
In other modules we’ll cover more specifics.
In module xxx I’ll show you exactly how to calculate CAC and LTV
In module xxx I’ll cover different business models and give you specific suggestions to exploit them. We’ll cover:
- Brick & Mortar Retail
- Service Companies
- Combinations (like car repair)
- Recurring Revenue / SaaS models
