DoctorPreneur, by John James, M.D.
Everything I do in business (and in life) is driven by equations. My favorite TV show is Bloomberg’s Game Changers.
Yep, I’m a math geek who likes business documentaries… suffice it to say, I’m not a lot of fun at parties.
After a long hiatus from my DoctorPreneur blog, I decided to rise from the ashes and combine two of my passions: game changing business models and math. Yep, I’m going to bore you to death with an applied business statistics lesson.
I believe that every business is driven by the unit economics of a single visitor. I also believe you can change the game by simply defining, quantifying and improving the variables in your unit economics. Our ecommerce business is driven by 5 major variables: Gross margin per sale, fulfillment cost, conversion rate, lifetime value and virality.
Gross margin per sale is simply average value of each transaction minus the cost of goods required to fulfill the order.
Fulfillment cost is the cost to pick, pack and ship an order.
Conversion rate is the percentage of website visitors who actually buy.
Lifetime value is the number of total orders a customer will place in the next several years.
Virality is defined as how many friends this customer will influence to become customers.
Putting these variables in an equation tells us the relative value of each person who walks through our virtual doors. Our equation looks like this:
[(Gross Margin - Fulfilment Cost) * Conversion Rate * Lifetime Value * Virality] = $$ per visitor
So, let’s assume an average sale is $100 at 50% margin and costs $10 to pack and ship. Let’s assume we have a 3.0% conversion rate from visitor to customer. Finally, let’s assume that each customer orders an average of 2 times and one out of every 100 customers tells a single friend. You’d get the following equation:
[($100 * 50%) - $10)] * 3.0% * 2 * 1.01] = $2.42 per visitor
The final three variable are insanely important. A small improvement in any of these three variables (conversion rate, lifetime value and virality) will dramatically change the value of a visitor. If you can build a competitive advantage in ANY of these three variables, you can change the game so drastically that you will destroy your competition.
Let’s take Zappos, for example. They give free overnight shipping and free returns to all their customers… seems expensive, right? Let’s assume they changed their “cost to fulfill” in the equation above from $10 to $30. If the other variables stayed the same, this would be their new equation:
[($100 * 50%) - $30)] * 3.0% * 2 * 1.01] = $1.21 per visitor
Ouch. If this were true, the value of a visitor would be cut in half. But, thankfully for Zappos, this final three “multiplier” variables did not stay the same. Their free overnight shipping tactic “changed the game” by dramatically altering these variables.
Let’s assume that their free overnight shipping promotion increased their conversion rate from 3% to 4%. Let’s assume that the customer was blown away by the service, and now purchased 4 times in their lifetime rather than only 2. Let’s also assume that one out of every 5 customers becomes an evangelist and tells 10 friends about the amazing service. The equation would look like this:
[($100 * 50%) - $30)] * 4.0% * 4 * 2.0] = $9.60 per visitor
If the numbers were similar to these, it’s plain to see why Zappos became the online category killer in shoes. Despite making less money per transaction, they destroyed the status quo model by building a superior model. I’m still wondering why we decided to sell cowboy boots and work boots against these guys!
A constant focus at Acumen Brands is making steady improvements in each of these five variables. We are on a never ending quest to squeeze pennies and percentage points out of our business equation. For example, we installed robots to decrease the cost of fulfillment. While business process improvement is great for finding pennies, it takes a paradigm shift to change the game. Like Zappos’ free overnight shipping, game changing business models are often counterintuitive.
Next week, we are launching the first of a series of controlled experiments designed to change the game. They are all counterintuitive, and each of them could flop miserably. That said, each of them changes one variable in hope of dramatically improving one or more of the three “multiplier” variables in our equation.
Give it some thought: is there a way you can change your game?
(John James, M.D., is a physician turned serial Internet entrepreneur. He rarely uses his medical degree while selling hunting gear online in his rapidly growing, VC-funded ecommerce company based in Fayetteville. You can also follow him on Twitter.)
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John,
Thanks for the peek under the hood!
But I’m going to have to play devil’s advocate and challenge that you may have oversimplified some very complex variables here.
Gross Margins and Fulfillment Costs are pretty straightforward, but your “multiplier” variables, even conversion rate, are far more complex than you’ve let on. In fact, I would recommend unique equations for each of your three “multiplier” variables.
Let’s take the most simple of the three, conversion rate.
Without delving into cohort specifics, let’s just consider traffic sources.
You’re going to see significantly different conversion rates among visitors coming from different sources. Direct traffic from users who have bought from you before are going to convert at a different rate than first time visitors through PPC advertisements. WOM visitors are going to convert at their own rate as well. Each conversion variable represents a different opportunity to tinker. If you know your past customers are converting at 7%, PPC visitors at 3%, and your WOM visitors at 1%, then you have a much better idea of where the opportunity is. And of course with smartphones and tablets you now get to track conversions across the different computing devices to decide where to stack your advertising resources.
As for lifetime value of your customers, I would recommend changing this variable entirely. Because I think it will cause you to test the wrong experiments to “hack lifetime value.” I will say this bluntly, you do not know the lifetime value of your customers. What you are calculating now is “the average number of purchases in a given amount of time.” Great! But trying to hack this metric is likely going to destroy your chances of hacking the metric you should really be using, brand loyalty. A “Lifetime Value Hacker” is going to do every thing they can to squeeze additional sales out of existing customers, which may be successful in the short term. But long-term these customers are going to start tuning you out and they’ll be gone forever. Brand Loyalty Hackers do everything they can to improve the customer experience and remove as much friction from the buying process as possible, enter Zappos. Loyal customers re-buy repeatedly without being coerced, and I would care to guess that there are many Zappos customers not just buying 4 times, but hundreds of times. One loyal customer can hack your entire business, email marketing will do nothing to get you there.
And lastly, Virality, which is the most complex of all.
I’m not naive enough to think that I completely understand virality, few people do.
What works one day, will completely bomb the next and vice-versa.
The are no rules, few truths and a lot of luck.
Jessica Black getting hundreds of millions of views.
Ashton Kutcher becoming on of the most followed people on Twitter.
A company built on lol cat pictures valued in the hundreds of millions.
My only recommendation when it comes to virality is to think big, test often, and get lucky, BIG TIME.
Ryan
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