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Wednesday, November 24, 2010

Group-Buying's Retail Math...

... & your long term business health !...
by David Bookout

Related Post: to-discount-or-not-to-discount.

Since the last post I've been talking, listening, reading and percolating on the "group buy" phenomenon as it relates to long term business financial health. In general there seems to be a void of conversation relative to how long it actually takes for a business to "make up" for the customer acquisition cost they take on when embarking on the group-buying path. To illustrate the retail side financial mechanics of group-buy I've created a few examples. This first one illustrates a high level income statement for what I would call a healthy transaction.

40 North is key ~ Business health is critical and just like physical health, understanding some basic principles can go a long way in keeping your business viable long term. To me, THE King ( or, THE Queen, if you'd prefer ) of these principles on the business side is "Gross Margin". Gross Margin is hands down the key factor to watch for each and every transaction. As a rough rule, businesses that are NOT generating a minimum of 40% at the gross margin level will have a difficult time sustaining long term Business Profitability. In short, the lack of healthy vital signs in these areas make for a short lived business existence.

But what if your business doesn't have enough customers ?

To Market We Go... Retail businesses need to sell their products and services, right ? To successfully do that the business must make a clear offer to a customer, and that customer needs to able to hear that offer, and be wiling to accept it in a way that provides for long term business financial health for the retailer. In short, a customer is NOT a customer until they pay for products and services. This is especially true for entrepreneurs and while there can be many reasons for a venture to be compelling, there is no better test of a business model than cash flow.

Our second example illustrates why, from a retailer's perspective, executing a Group-Buy offer may not be a good choice. Note the Net Profit LOSS of $65. Some might say "I'm not worried about that, that's just the first purchase, we'll make it up over time."

But what really happens ?

Well, let's take a closer look... it may be a very, very long time before you turn a profit... First, let's look at the customers second purchase, which in this case we've said will be without further discounting. But we still need to account for the $65 loss from the first visit, so that goes back into the equation. Note that the second purchase, at full retail, still only allows us to compensate $10 towards the previous loss. So, at the end of two transactions the retailer has lost $55 ~ remember, I said the customer must pay ~ so, it looks like the wrong entity is paying to provide the offer. Right ?

And, here's where people might say "Wait a minute, you've already accounted for the loss." But have we ? True, we've accounted for the original $65 loss, but we've only been able to reduce that loss to $55 after the second visit. So, we need to carry that same $55 loss into the next transaction.

Then again and again... in visits 3 thru 7 ~ If we are not including a second group-buy discount in any of these transactions why can't we move from the red ink of loss into the black ink of profitability ? The answer lies in the -$30 "below the line" expenses that are generated from a whole list of non-direct expenses such as phone, insurance, equipment leases, etc., etc. With $40 generated at the gross margin line we need to pay others $30 for those expenses leaving $10. Had we not carried the transactional loss into the equation we would be making money. But we can't just dismiss the loss and expect to maintain a healthy perspective.

Note that after 8 transactions we've made $5 !

Big Box Confusion ~ Entrepreneurs frequently work with the false interpretation that losses can be made up over time, or within volume. BUT NOT in most SMB situations, time and volume is pure fantasy. Why ? Because the Big Box Model ( read WalMart, Costco, etc. ) relies on an economy of scale that most small to medium businesses don't have access to. These big stores have sophisticated systems for understanding blended gross margin. They also the benefit of hundreds of thousands, if not millions of transactions per hour. They've also driven the below the line expenses of each store to the smallest percent they can ~ that's why they are called big boxes. Group-buy does NOT magically emulate these conditions, and as we've just seen, the group-buy model doesn't deliver quick profits.

So, who benefits from group-buy ? ~ Consumers, the group-buy company, and, perhaps, a very small fraction of small to medium businesses that have a healthy pricing model and a high transaction rate ~ but, why would such businesses then need group-buy ?... Thanks for reading, would love to hear your thoughts !! - db

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