E-commerce – Bates Creek Consulting

We love our Guru’s but they aren’t helping

I have been saying for many years that we are using the word ‘guru’ only because ‘charlatan’ is too long to fit into a headline. Peter F. Drucker.

There is comfort knowing that someone knows what is going on and can help us by giving us their opinions about politics, stocks, how to live better and what to wear. All we have to do is to find the right guru – the right advice. We think we are reducing risk by following a guru, but we aren’t. But, at least we won’t look foolish alone.

There are not many physics guru’s because one important part of guru-ness is that the subject matter should be indeterminate, that is that it cannot have a single right answer. The stock market is prone to guru’s. There are no simple answers and what works one day, won’t work another. Investment shows on TV are about entertainment, not education.

By now hopefully you know that there are no stock market guru’s. It is simply not possible to forecast where the stock market is going in the short term. Most of what passes as forecasts are 20/20 hindsight or deal with relative valuation of the market. I think relative valuation is useful, you can buy the market at a discount. I know you will pay less for Christmas/Holiday cards in January (11 months early) than November. However, buying something at a discount doesn’t stop the chance that there will be a bigger discount later.

“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge. ” Lao Tzu

Politics is similar to the stock market. The guru’s in politics are no more accurate, and offer no more clarity than the stock market guru’s. Political forecast accuracy has been the subject of quite a few good books. Tetlock’s book “Expert Political Judgement” outlines his thoughts on why so many political forecasts go poorly. Philip Tetlock’s suggests that foxes are better than hedgehogs at forecasting. The fox knows many different things, hedgehogs know a few things well. His more recent book with Dan Gardner “SuperForecasting” offers examples of good and bad forecasts and includes some suggestions on how to do it better.

Forecasts are effected by circumstances and human behavior that in the short term can be identified, but in the long term (more than a year or so) have too many interactions to be of any use in forecasting. Like the weather forecasts which fall apart the further out you forecast, the longer the time frame the more human behavior and chance result in different outcomes.

“No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers.” – J. Scott Armstrong

There are a lot of guru’s in the business world. Harvard seems to grow them like tomatoes. The history of management includes a lot of ideas that turned out to be stinkers. Scientific management wasn’t a very good idea even when it came out. Re-engineering turned out to be another way of saying lay-off. I’ve spent hours debating core competencies which in the end, couldn’t be defined or implemented. Theories that can’t be tested are especially prone to guru-ness.

Trying to implement guru’s advice can be frustrating. I loved “In Search of Excellence” but the advice was general like “stay close to the customer”, which is almost perfect guru advice since you can always say you weren’t close enough. I call it Zott’s Law of Business Books. The more general, the easier to read, the less useful the advice. Kahneman’s “Thinking Fast and Slow” was a top business book of 2015 and is interesting and a good read. Again, not much useful advice.

J. Scott Armstrong also said, “If you can’t convince them, confuse them.” A lot of business guru’s wrap pretty simple ideas in complicated language.

The Principal Agent problem states that there are differences between principals and agents (owners and managers) and that making agents more like owners will solve the problem. I like Agency Theory, it explains a lot of behavior. We sought to fix this problem by giving executives stock options. Since then we’ve spent millions on stock options and it doesn’t appear that management is any more aligned now than before. The cure I think is worse than the disease.

We listen to these guru’s because we want an answer. The answers given aren’t necessarily right nor particular useful, but they are confident and we value that certainty. Guru’s use our need for certainty to sell us their opinions (and via advertisements, dish soap). In today’s world of fake facts, alternative news, spin and TV personalities who are selected and paid for their ability to speak confidently (without knowledge), our main defense is a healthy skepticism . Skepticism and an understanding that we live in an uncertain world.

Quidquid latine dictum sit altum videtur – Anything said in Latin sounds profound.

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Dr. John Zott is the Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are looking for a CFO for your e-commerce/retail/consumer company, or are a former student, colleague or would just like to connect – reach out.

The map is not the territory – Setting up a Chart of Accounts

Accounting is a numerical history of a business. We summarize the millions of transactions into a cogent one page document that tells the status of the business. The financial statements however, are not the same as the business. Alfred Korzybski said that “the map is not the territory”, referring to the object and its’ representation. A financial statement summarizes, and a summary leaves out details. Tracking which data goes where is the job of the general ledger and chart of accounts.

The core of reporting is the chart of accounts. Financial statements summarize sales into one line. Accounting might have half a dozen sales accounts and hundreds of departments, which all roll up to one single number – sales. These accounts are used to better understand the summarized information. Sales are reported net of returns, but accounting departments track the returns in a separate account so that department heads can see if return rate is trending up or down. If your ERP or sales software tracks returns, you probably don’t need a separate account for tracking that information.

However, accounts seem to proliferate. Charts of accounts grow over time – someone wants to know some summary fact of the business and the systems that generate that data don’t supply the summarized data to management. Commonly at retailers it is a POS (Point of Sale) system that runs the cash registers and reports summary data to a sales data warehouse or general ledger. Usually they only report data to the general ledger, so operating data is sourced from accounting records.

In an e-commerce firm it is the order entry and fulfillment systems, which may not be connected with purchasing or payroll systems. In addition, management has come to rely on the controls put in place in a general ledger system. In the 1990s we used a lot of database query tools that would often give different answers based on query design, so one meeting might have three different set of numbers based on who’d written the query.

The use of data warehouses should decrease demand for general ledger detail. Sales splits can be done in more detail using a database with all the relevant sales data, rather than the general ledger which might contain only weekly summary data. However as the needs of the company change, often it is easier to just add an account number than reconfigure a reporting system. Data warehouses – an idea that dates back 20 years – still don’t function as well as they should. So the g/l becomes a stand in.

I’ve typically used a couple of hundred “natural” accounts for businesses from $5m to $500b in revenue. An account like “sales” or “payroll” are called natural accounts. These are modified by department code and sometimes other codes for cost accounting or for projects. This can result in thousands of combinations. In a typical retailer with 100 stores they would support 60-70 natural accounts, for 6-7,000 combinations. Add in district and regional codes you could reach another 1-2,000 combinations. Designed right that level of detail is easily handled by your accounting team. Designed wrong and you spend hours trying to reconcile the source systems to the general ledger. Which adds cost without benefit.

Manufacturers sometimes have additional codes for production cost allocations. If you are running the same line in two buildings, under one department, you might also use a location code. All these codes end up making a chart of accounts pretty complicated. This is worsened if you end up layering on the complexity as you go, rather than plan it in. Knowing going in you will likely need a location or a production line code and planning for it makes a big difference later.

Much of the complexity of the chart of accounts depends on what information you will want to retrieve. Simple natural accounts and department codes can get a business a long way. Accounting codes begin to change if you are running project-level or fund accounting. Sometimes you can keep the reporting structure out of the chart of accounts. For instance, if you have a district manager with 10 units, you likely don’t track the district code in each transaction, but roll up the district report by selecting which units are in a district when you summarize the data. This is the default mode for most firms who report with excel. Changing the unit roll-up when a district manager leaves the firm is not Excel’s strength. Excel’s data summarization and analytical tools have improved, but realistically, converting from a trial balance to report is an area ripe for errors.

If you have online reports, managing the access in an ERP system can be a hassle, unless you have some hierarchy built into the system. Imagine allocating 600 units amongst 60 district and 10 regional managers? If each of the units had an assigned district and regional code, the reporting would be much easier to manage and control. With the rise of reporting dashboards, this feature is almost always built in.

The general ledger and financial statements are summaries but useful ones, where similar data is grouped, analyzed and decisions can be made. Too big a chart of accounts and you will spend hours managing complexity rather than providing information. Too small a chart and you will your time breaking out the details you need. A map is a representation of a territory which can be held in your hand and used to navigate. Good design and a thought for the future of the business will help develop a solid organization for your accounting data so that it will supply you the information you need to navigate.

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Paying a Price for Certainty

We all want certainty. We want our investments to average 5% return a year (7.375% if you are in the state of California), our children to grow up strong and healthy and it to only rain at night. However, life is uncertain.

Insurance is about creating certainty. A small cost is paid, instead of a small chance at a large loss. Health insurance is part pre-paid services (check-ups) and part joining a purchasing cooperative (in-network pricing is a lot cheaper than out-of-network) and part real insurance. Car insurance doesn’t include oil changes, although they do control where certain repairs are made. Not just insurance companies make money on reducing uncertainty.

I once had a competitor that sold a tuning service for radios and electronics. This advantage was a significant part of his marketing and brand value. At some time in the past, there might have been some value in swapping out vacuum tubes but since the 1960s most marine electronics were solid state. By the 1990’s there was nothing to be done to a solid state radio, and if they didn’t work out of the box, they had to go back to the manufacturer. He sold fear, uncertainty and doubt or FUD.

FUD was made famous by IBM, who would meet every new competitor in the computer industry with comments about reliability, threats of the loss of warranty coverage, rumors of financial difficulty and vague hints about losing purchasing status. For the longest time I’d hear the comment “no one got fired for buying IBM”. FUD works.

People will pay for security – even if the math suggests it is a bad bet. My firm started selling extended warranties on our products. This was a big money maker for Circuit City as electronics extended warranties had a 90-95% margin. For a while the staff wouldn’t sell them, they thought the extended warranties were a rip-off of the customers, and we had a no-hassle money back guarantee. Buying an extended warranty is not a good bet, but people appreciated the certainty and paid for it.

Eating at McDonald’s is not normally a “treat”. We select fast food because of the consistent product, price and convenience. We know what we are getting – uncertainty is reduced. Retailers who reduce uncertainty increase sales. Zappo’s can sell you shoes because they agree to take all returns. I doubt Zappo’s makes much profit on its shoes, the freight has to be killing them (see here) but given that Amazon owns them and Amazon is the worlds largest capital destroyer it is ok.

I see the problems with seeking certainty as a function of information asymmetry, competition and add-ons. The retailer that offers a money back guarantee knows how often goods are returned and when they sell you an extended warranty, the likelihood of your using the warranty. You can’t judge if it is a good deal or not. Those situations are referred to as information asymmetry, where one side knows more than the other. Learning more about failure rates can give you confidence to skip paying an extra 15% for a product, knowing the chance of fault might be 0.02%. A phone with a one year warranty and a three year overall life doesn’t present much time for a failure.

Your car insurance company knows more than you do about the likeliness of an accident and they price the insurance so that they make a profit. The car insurance company is kept honest by a competitive market place and regulators. Competitors push prices towards an equilibrium, which is lower in price than an un-competitive market.

The least competitive market is one where you have little time and no access to competitive prices or data about risk. This happens while standing in line, or in the midst of a transaction when an add-on is offered. Rental car companies are good at offering you several levels of insurance-like services (one full priced for 100% coverage, a second with a deductible, a third with a collision damage waiver) while all levels of coverage are priced extremely high. It is not unusual to pay $5-6 a day for coverage for your new car, and $40 a day for insurance for a rental car. The extended warranty is pitched to you at the register without any time to calculate the costs, benefits or risks.

Seeking security isn’t a problem, and reducing uncertainty isn’t bad. One consequence of a population that doesn’t understand probability is that we will be taken advantage of by providers of certainty. Be a smart consumer, do your research before you buy.

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Dr. John Zott is the principal consultant at Bates Creek Research & Consulting.

I am the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and I comment regularly on issues that affect growth businesses. If you are looking for a CFO for your consumer company, or are a former student, colleague or would just like to connect – reach out.

Three Thoughts on Balancing Profit and Uncertainty

Life is uncertain. Any entrepreneur knows that to start a business, you have to take a chance. You can calculate the risks, manage what factors you can, work as hard as you want, plan as extensively as possible, but there is always uncertainty and risk. Frank H. Knight defined risk as events that have a probability and a severity and are calculatable. Uncertainty is defined as those events without a probability and a severity. We face both uncertain outcomes and risk in our lives.

As a professional CFO, I’ve worked to limit uncertainty and manage risk. Eliminating risk and uncertainty however is impossible and will kill a business. The very nature of profit comes from taking a chance and offering a solution for a customer. A risk-free (and low uncertainty) business doesn’t exist. The closest we have to a risk-free return is a 10 year bond, which is trading today at about 2.2%. If you want to make more than 2.2% you are going to have to take on risk.

Running a business is about balancing all the factors: risk and uncertainty, the operations and the market so at the end there is a profit and a return on capital.

Profit comes from risk taking. The risk taking must be commensurate with the return, or it is foolish. Steven Crist wrote a chapter (see here) on value in the book: Bet with the Best: Strategies from America’s Leading Handicappers. Crist points out that even bets that are likely to lose (betting on a 4:1 horse, when the payoff is 12:1) can be a good investment.

Managing risk (and opportunity) sometimes means thinking about what could change. What assumptions are foundational to the business model which if changed would result in a serious impact to the firm? Although you think that there are relatively few of these, there are many, but thankfully they are relatively rare.

Many retailers were well aware of the impact of e-commerce, but few generated a capable response. Most dumped their catalogs and full product line on the internet and waited for customers. Worse yet, few planned for the inevitable loss of market share or the increase in new competitive business models (Stichfix, Frank + Oak, Thred-up) that might arise on-line.

Nassim Taleb talks about the four largest potential losses in Las Vegas, one of which became real: Siegfried and Roy’s magic and wild animal act was ended when a tiger attacked Roy. Roy later went on to say that he had high blood pressure and believed he had a stroke during the show and the tiger sensed that and was dragging him to safety. If Roy had died from the stroke and not the tiger attack, the result would have been the same, cancellation of the show. When a great deal of income depends on the health of one man, then there is a big assumption of risk.

Business decisions can increase or decrease risk and uncertainty.

Every decision we make creates new risks and uncertainty. Selecting a new ERP system? Hiring a new executive? Changing a key purchase policy? All will create both a primary effect and secondary effects that are unknown. Not making a decision, often called strategic dithering, creates additional uncertainties. Mark Fields was recently replaced as CEO of Ford, apparently because he wasn’t moving fast enough on self-driving cars (see here). I am not certain that a faster approach to self driving cars creates a lot more value than being second with a better product. But either way is uncertain.

Too often executive teams ignore risk and uncertainty factors in making their decisions. Anecdotes are easy to understand and are compelling although they are often sample sizes of 1. In the hedge fund business we used to say “beware the narrative” as we were afraid of being seduced by the simplicity of a good story. Balancing the trade-off between customers and operations without assessing the change in risk will likely lead to increased risky behavior and calamity.

Invert the decision making model – think about increasing risk.

Risk is necessary for profit, but risk as I’ve noted is calculable. Can you decrease risk for a customer and create greater sales and profits? Grouping uncertainty and risk can decrease overall risk. That is what insurance companies do. Offering a money back guarantee on products for a retailer is simple. If you realize you can return the product, you are more likely to buy, even if you are extremely unlikely to return the product. The highest margin item I’ve ever sold was warranties on electronics. Most are never used.

If you are a SaaS business, how can you lower the customer uncertainty and increase your payout? Most firms find buying a new system a major endeavor. They’d like to be married, without the process of getting married (which is a hassle). The risks are centered in the conversion, implementation, training and the first 90 days of the new system. Firms will pay to have implementation risk decreased.

Playing safe isn’t always a good option (see here). My local community has half a dozen businesses that are clever, deliver great value and could have a national presence. They don’t because the owners are happy enough with a small local business. Every couple of years change comes to the community or one of the owners and one of these businesses dies. I am not arguing all small businesses should become Staples, but as John Shedd wrote “A ship in harbor is safe — but that is not what ships are built for.”

Conclusion

I think a lot about balancing risk and returns. If you bet the long shot that is undervalued, you may win big, but you will most likely lose. Losing isn’t bad in this case, it is just one iteration of a process that brings a profit. Avoiding risk isn’t possible, but whatever approach you take, keep an eye on the tiger.

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Retail Apocalypse or Just Another Cycle?

Bricks & Mortar retail is suffering. People are shifting their shopping habits from in person to on-line. The on-line selection is greater, the prices are better and the shopping experience is relatively easy (in comparison to parking at the mall). Peter Drucker said that “What customers – at least a good many of them – want is not shopping that is enjoyable, but shopping that is painless.”

Although e-commerce will continue to grow, I suspect that on-line shopping will top out in the 20-30% range of total retail sales. The drawbacks of e-commerce (freight, timeliness, inability to touch or try-on) will limit sales to only a portion (although a very significant portion) of total sales. However, just losing another 10-15% of market share to e-commerce will make bricks & mortar returns even less attractive. It doesn’t matter if your retail chain is cannibalizing itself with a web site or it is Amazon, stores will continue to generate worse returns on investment. With lower returns, there will be less capital invested, fewer stores and fewer malls. The New York Times calls them Zombie Malls, the escalators are running but no customers.

There have been many, many articles on how the US is overstored. In 1990 the ICSC reported (Billboard 6/2/90) shopping central growth was dropping due to the country being overstored. ICSC reports the millions of net square feet added to U.S. Shopping Center space in their report “America Marketplace”. You can easily see the post 1980 recession slow down and the post 2008 recession collapse of growth. The dot.com era of 1999-2001 didn’t appear to matter. One conclusion is that the overstored retail space has gotten less overstored in the last seven years.

I don’t know what the right amount of retail space is in the US, but given this trajectory we will eventually reach an equilibrium where demand closer matches supply. However, when equilibrium is reached, a lot of today’s retailers will be gone.

Life Cycle

The usual life cycle for retail bankruptcies is a recession which weakens the retailer, a recovery which allows some breathing room and then another recession which puts the retailer out of business. This is the retailers’ version of the Eldredge & Gould “punctuated equilibrium”, where a significant event creates the opportunity for species growth (or death) followed by a long period of relative calm. Eventually another significant event punctuates the equilibrium and the game changes. This cycle is only slightly different from the normal recession/recovery/recession, as the punctuation now is the on-going loss of market share to e-commerce. If we get another recession, then we should expect even greater industry turnover.

The total profit of a transaction is split between the manufacturers (the product), real estate (the space), staff (the labor) and the retailer (the operator & the capital). This is an uneasy relationship, as total profitability is limited by the market. Each player takes the steps that create the most long-term value for their portion. The losers in the movement online so far have been staff and retailers. Next the cycle will impact real estate prices.

Tim Harford, who wrote “The Undercover Economist” suggests that over time, the landlord obtains most the profits of the relationship due to lack of substitution. Retailers combat this by negotiating long leases with renewals to lock in the lease costs. If business slows, those long leases can burden the parent company enough to cause bankruptcy. When retailers stop making money, they close stores, vacancies rise, the real estate centers stop making money and the price of retail space falls. Stores are closing at a record pace, and rents are beginning to drop (see here). Lower rents allow retailers a chance to recover and begin growth. However, things are a little different this time as e-commerce will still gobble up market share and retailers have loaded up on debt.

Debt!

One factor that is worsening the crisis is debt. Low interest rates and high equity valuations have caused growth companies to borrow funds to drive growth. When I was a student, we were told that carrying debt would lower the cost of capital as interest on debt is deductible and interest rates are usually lower than the cost of equity. This is an accepted part of finance theory and is used extensively by CFO’s to generate equity returns. Whenever you can invest at a rate of return that is higher than borrowed funds, you create a return to equity (see WACC). So if you can open units that generate a 40% return and are limited to 3 outlets due to limited equity capital versus opening 6 outlets with a mix of equity and debt you generate almost twice as much cash return. The only drawback is a subtle increase in risk and interest costs that comes with additional debt.

The risks aren’t always apparent. Low interest rates are great, but they don’t always stay low. When interest rates normalize, payouts will squeeze profits and options. Most loan agreements are based on covenants that call for enough earnings to pay a multiple of the interest and principal payments. Earnings in a growth company can be volatile as expansion, even if investment oriented, is accounted as expenses by GAAP. Banks use GAAP, not “reported” earnings.

Theoretically financing should not matter. Modigliani-Miller came up with a concept of capital structure irrelevance. They believed outside the tax effects of interest (vs. dividends which are rare), how you financed the company shouldn’t affect the intrinsic value. M-M’s insight was that you could imagine an investment pool that is half debt and half equity buying a company with no debt. The total investment would be leveraged, 50/50. If you bought the stock of a company that was half debt/half equity with a fund that was all equity, the pool together will still be 50/50 leveraged. Whether debt is held at the company level or at the portfolio level is irrelevant. However, the relative amount of debt in the system remains.

CFO’s that leverage their firms (as I did) find themselves taking on risk that may be better placed at the portfolio level. If the investors want leverage, they should borrow to make their investments. I’ve come full circle and consider debt a serious problem for growth companies. Yes, there are some instances when it makes sense, but in general it should be avoided.

The other big debt factor that will grow is lease debt. The great lease debate is now settled for the next decade. The FASB agrees that leases are debt. The new rules further muddy the financials as the value of the liability won’t represent the true value of the asset, and it will put another confusing and inaccurate calculation on the balance sheet. Retailers are readying to put trillions of debt on their balance sheets, drawing further attention to the risk.

Fear is the mind killer – Frank Herbert. Debt is the company killer – The Market.

Conclusion

The future is clear, malls are going to struggle and they are not going to turn into apartments (sorry Sears). The e-commerce story is only half over. Further retail consolidation is likely and we should be looking for new concepts that will be able to use that (now lower cost) space to deliver a product/service package that will compete with the convenience and prices of e-commerce.

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SaaS – Churn, Ansoff and Unit Economics

Unit economics is the name for the analyis of an investment at a detailed level based on the customer, store or unit. This is the analysis we do when we are approving a capital project. A good recap of unit economics by Cleverism is here. This article uses Ansoff’s matrix and SaaS metrics to compare different businesses to illuminate the gaps between current business metrics and what different sectors can learn from each other.

I’ve written about Ansoff before (see here). Ansoff says that there are two axis to growth, product and customers. Ansoff’s matrix splits the opportunities into four segments. Selling current products to current customers, finding new customers for current products, selling new products to current customers and finally, selling new products to new customers. For different kinds of businesses, each of these segments are tracked by different metrics.

Turnover or churn is the statistic that tracks how long customers use your services or purchase your product. Different concepts result in different levels of churn. Parents buy diapers only as long as their babies need them, a couple of years. Certain B2B services might stay with a company for the life of the business. Even this, however, is not forever.

You can classify consumer businesses by their lifecycle, basically the length the product remains relevant to the customer. Churn works along Ansoff’s customer axis, and begins with the square titled market penetration and moves towards product development. When a customer signs up a for a service, their potential to stay is not always apparent. Some will stay for a long time. Some will not. Some concepts have very wide age range (McDonald’s) others are much shorter (say Rue21).

I am on the board of a small company that teaches music to 1-4 year old children and their parents. Every year a new cohort of 1 year old’s join and four years later they graduate out of the program. Annual customer turnover is over 25% based on the business model. Real turnover is higher because some families move and some families quit, and some children join at age 2 or later. I’ve calculate the churn by individual children, but if you saw the basic unit as the family, then churn would be lower, as some families have two or more children.

Defining the unit in different ways offers new ways to thinking about your business. For example, retailers usually define the unit as a store, while Wal-Mart saw the primary unit as the distribution center and the related regional stores. They wouldn’t open one store in a market, but would open one distribution hub, and many stores.

Subscription businesses like SaaS track churn as a way of monitoring customer lifecycle, see here for a great outline of SaaS metrics by David Skok. Selling only current product to current customers results in a slow decline in sales, because customers will eventually leave for one reason or another. Corporations have unlimited lifespans in theory, but in actuality they don’t. Innosight suggests the average S&P 500 company listing lasts about 18 years now (see here). Although a lot of firms last 100 years, even then firms aren’t immune to change, Radio Shack was over 115 years old when it declared bankruptcy.

Defining the implicit natural churn rate helps define the business model and SaaS firms should use that data to better identify add-on products or additional services to be offered. As client firms move through their lifecycle, SaaS can be a responsive force, focusing the solution so that software, service or solution remains relevant. This is moving across to the product development side of Ansoff’s model, offering different product to the current customer . In the case of the pre-school company, we are working on programs that extend our reach to 5-6-7 year olds. Adding additional years means that the churn rate will decline, but it will never get to zero.

If you can convince your current customer to buy more, typically subscribing additional services or purchasing more products, you increase the value of the customer relationship. Ansoff would call this selling current customers new products. Sales growth for a cohort of customers could grow, rather than decline. SaaS businesses call this negative churn. If churn is low enough and the service supports a rising price (either it was underpriced or continues to add value) then you can achieve negative churn without selling additional goods or services. Negative churn is very profitable because no additional selling costs are required, yet sales and margin increase.

Retailers would call negative churn an increasing “share of wallet”. Increasing your share of wallet was about selling more stuff to the same customers. Retailers have a concept called “same store sales”, which tracks the change in y/y sales through the same number of outlets. This is not the same as negative churn, but it is close. Same store sales could increase due to increasing customer count (new customers for current goods) or sell more new goods to the same customer (share of wallet) or higher prices. Positive comp sales also have a very strong impact on profits, as store location costs and location overhead are leveraged. Retailers focus extensively on the store as the unit, and would benefit from seeing customers as a unit also as SaaS businesses do. Recognizing that some segment of a population is aging out of your sweet spot gives direction to marketing and customer acquisition efforts.

In the wholesale business we track sales by dollar churn and by customer wins. Dollar churn is the similar to churn but instead of using number of clients, we use dollars of sales. That way big customers are more relevant. Wins relate to obtaining business from new customers. If it is a technology solution, a win would imply agreement by an organization to use a specific tool or platform, which as adopted through the business will result in additional seats and sales growth. Sometimes a win is just an initial “test” order from a customer which uses many suppliers. Either way this can be a significant step to increasing sales.

SaaS businesses offer fremiums or lower cost options, which like wholesale’s initial test order, start the customer getting familiar with the product or service. Given the value of a customer it seems obvious that most wholesalers/retailers should consider this strategy.

Investment and Life Time Value

The average selling price (ASP or average transaction size) and annual volume (also known as Annual Recurring Revenue – ARR – for SaaS) define a business model. If ASP is low, then the amount of service given at the transaction must be low. McDonald’s has an average transaction in the $5 range. This is why there is no service. The ASP for a Mercedes is $50,000, which means you get service at the point of sale.

The lifetime value of the customer (LTV) is a calculation of the total operating margin of all the sales to the customer. Obviously the higher ARR, the longer the customer remains, the higher the margin, all result in a higher LTV. If the LTV is low, then the amount you can spend obtaining a customer is low. A higher LTV allows for more investment in the customer. Obtaining a business customer that pays $20,000 a year in service fees could result in a typical SaaS LTV of $150,000 or more. That allows for a number of sales calls and demonstrations. If you are selling a $100 annual subscription, pretty much it has to be handled via email and on-line, with automated responses.

SaaS firms often use margin for the LTV calculation while “four wall” profits are used for retailers. Having the LTV can help you define how much money you can spend to obtain a customer (normally, cost of acquiring customers, CAC or CoCA). The CAC is the total investment required to acquire a new customer. In a retailer it would be the cost of a new store, in a catalog firm, the cost of a new catalog. Four wall profits are the variable costs driven by the addition of a new unit and typically don’t include any headquarters or regional management costs.

Although margin is a good proxy for profitability, it isn’t perfect. Skok recommends (see here) deducting the cost of the retention and expansion teams and the cost of service from margin. This would make the net margin SaaS calculation the achievement of the steady state of the business. Normally I’d have the cost of expansion in the cost of customer acquisition calculation, and leave it out of the net margin calculation. Theoretically it should only be in one place because the cost of service and cost of retention (the account managers) are variable costs driven by customers, while the cost of expansion (sales team) is discretionary. This isn’t unusual and it treats the account managers the same as the sales team. A lot of retail new store models also include some costs on both the investment side and the operating expense side. As long as you are consistent in assessing projects, it is fine.

The rule of thumb for SaaS is a 3x return on CAC. This is similar to the typical unit economic model of a retail store, which over it’s first ten years should generate 3.5x-4x the investment cost of the unit. SaaS companies ideally should discount the long term cash flows (DCF) of the expected life of the relationship to better reflect the LTV to CAC comparison. Most of the SaaS business models have been developed in a low interest rate environment, with relatively cheap capital so this hasn’t been an issue. As SaaS relationships extend out, a DCF makes a lot more sense. If you do use a DCF, the rule of thumb isn’t valid, and LTV/CAC ratios less than 3x can be profitable.

Retail is a little different because it fulfilled a demand for a product line in a geographic area. So if you are selling car parts, you cared about the vehicles owned in the area, not so much who owned them. As long as cars were owned, they will need parts. The CAC for retail is the cost of opening the store and stocking it. Unit economic slides for years boasted 40% ROI’s on stores by hiding inventory investment and other relevant costs. Sales forecasts were often suspect too. Hiding costs may look good in the short term, but overall ROI is driven by the accumulation of unit ROI’s, and smart analysts generally ignore unit economics that don’t aggregate to company economics.

The aggregation of LTV minus overhead costs should approximate the economic value of the business (debt + market priced equity). Usually there is an additional “option value” for the on-going business and the opportunity to enter new markets and develop new products. Standard DCF calculations that Wall Street analysts use attempt to convert the stream of profits over 10 years to an economic value. Unfortunately, usually 50% + of the value is wrapped up in the “in perpetuity” assumption, which is dropped in the 11th year to cover for the expected future stream of income. A good LTV model with realistic assumptions will help a CEO/CFO better plan for the long term value of the business, and communicate that value to investors.

Winning a loyal customer is valuable, but understanding the math is even more valuable. Returning to the diaper business, when you can calculate the number of diapers a child will use you can calculate the lifetime value of obtaining the parent’s diaper business. This gives a place to begin budgeting marketing expenditures, planning sales efforts and valuing the business. You can do this while still knowing that one day the parent will no longer purchase diapers and you will need to find a new customer. Thankfully people keep having babies.

There is a lot of similarity in unit economic calculations and enough differences to create some interesting ways of analyzing, displaying and investing in new operations.

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Dr. John Zott is the principal consultant at Bates Creek Consulting and works as a CFO for growth oriented businesses. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are looking for a CFO for your e-commerce/SaaS/retail/consumer company, or are a former student, colleague or would just like to connect – reach out.

Three challenges to E-commerce

I wrote earlier about product solutions and customer focus in my post about physical stores. Bricks & Mortar stores have the advantage of having the person physically present and able to try on merchandise, see how it might look in the home, gain ideas about additional items they may want. The perfect physical store. however has a built in barrier , too narrow a customer focus, there isn’t enough sales, too wide a focus and there is too much selection and there aren’t any profits.

E-commerce holds some hope for meeting our dream shopping experience. The e-commerce company has the same advantages as physical retail when it comes to buying and some distinct advantages in assorting product. Because they ship from a central location, they can have significantly greater selection stored efficiently in a warehouse. Web-sites can track preferences and construct a set of options that better match potential needs. However, they have there own challenges. Here are three I see.

Problem 1 Freight and Time
The downside for e-commerce is the cost of freight as they are selling (and shipping) in each’s and the wait for delivery. Cost and delay remain big reasons why e-commerce won’t end up with a 100% market share.

As much as UPS/FEDEX and the post office work at it, driving to the store and loading the trunk is still the cheapest and fastest way of home delivery. Shipping costs are very high for the last mile, but are pretty reasonable for the first 1,000 miles. You can have a container into the US for under $2,000 and it can hold 20+ tons of goods.

Amazon Prime offers free freight, not Fedex and UPS. UPS posts operating margins of 3-4x Amazon’s merchandise division. Amazon, I am sure has negotiated a great deal on freight, but freight is still 10-15% of the product price. If you’ve received a package from Amazon, you know they don’t ship efficiently either – as most boxes are less than half full.

I was with an e-commerce furniture business (I was younger and much more comfortable slamming my head against a wall) and the freight issues were daunting. The product was hard to ship, had unusual shapes and had to be carried into the home. Every dent, nick, mark or spot had to be fixed, no matter how minor, either at delivery or in a second visit. Getting the goods from the factory to a store was inconsistent, and getting from factory to home was far worse. There is a reason why Ikea flat packs their furniture, it ships cheaper and any scratches you put in it are your own custom additions.

Amazon has taken steps with their lockers to reduce the cost and speed delivery, and other e-commerce sites have gotten better at packing items in bags which weigh less than boxes and ship cheaper. Drone’s won’t deliver packages cheaply, you’ve got to fight gravity, which until we invent flubber or mine unobtanium, is a loser game. Maybe driverless delivery vehicles will be an option, but realistically that is still a long way off.

The solution here is to better use the resources we have. Amazon has a same day delivery service, which is priced for prime customers at $5.99 for up to $35 and free over $35. So an order for $25 comes with a 24% shipping charge. Without prime the delivery charge is $8.99 + $0.99 an item. If the average order is $50 and three items, then the freight is also about 24%. An option, but not a cheap one.

Amazon recognizes we are still going to visit a grocery store and the Amazon lockers are nearby. The US Postal Service visits each house 6x a week, so lighter packages can use this cost-effective option. Amazon is considering a bricks and mortar store where after ordering on-line, they pick and pack your goods and you drive by and they load your trunk. This eliminates the delivery issue.

The freight and delay problem is physics, time, weight and distance. For bulky or heavier goods, or perishables this problem won’t ever go away.

Problem 2 Seeing vs Seeing & Touching & Tasting & Smelling and Hearing

If you know what you want, e-commerce is great. One copy of a book is the same as another copy. If what you want has smell, can be touched, sampled or tried on, it is a barrier to an online sale.

My wife is a knitter and my favorite socks are hand knitted. These socks are made with self striping yarn (the yarn is colored in lengths such that you naturally get stripes). Although there are a lot of on-line yarn shops, most yarn is sold in person, because knitters will be spending a lot of time holding the yarn and the feel is important.

Knitters buy a lot of yarn, but given the collection my wife has, each purchase decision is unique. Some online knitting stores offer sample skeins, lavish descriptions, or a lot of detail to help you make up your mind. All of these steps work to lower the barrier to a sale.

The catalog industry dealt with this issue for years, and J. Peterman probably does the best job of romanticizing a mundane product like a t-shirt (this one $29).

On the banks of the Seine, lots of students and tourists hoping to be mistaken for natives, lots of blue-and-white striped shirts… but that deckhand over there, throwing a hawser out to a tour boat, he’s wearing this shirt.

E-commerce has an advantage, you can show multiple pictures, multiple colors add pages of information that you couldn’t fit in a catalog. However lots of products still lack key information. This t-shirt at Walmart.com is under $6 and although the prose lacks the background story of the J. Peterman version, it is still a lot of copy. The missing piece is the fabric blend which apparently uses X-Temp technology. By the way J. Peterman doesn’t share that information either.

E-commerce companies can focus on goods that either don’t appeal to the other senses (i.e. books) or they can sell goods that you already know and enjoy and are rebuying. When they get into goods that have other sense parameters, they need creative strategies to help close the sale.

Problem 3 Personalizing and Privacy

The promise of e-commerce was to make stores more personal. They are better but are still failing.

To be the perfect store, the shop keeper needs to know you like a personal shopper does. Currently, too many sites still don’t get the reality of being human. No matter how much I like a pair of shoes, if they aren’t in size 12 (or 12.5), I can’t buy them. Humans have height, width, shapes, and we exist in a physical
space. A lot of sites have improved, but it is still maddening to pick out something and find out that the only size available is XS. The implication of not being directed to search by size is that the store has all sizes in stock. When they don’t they’ve broken a promise.

Amazon comes the closest to my fantasy perfect store. They generally suggest similar goods to what I have bought before. The algorithms are still weak and often what they push seems more important than what I want. Recently on my home page from Amazon I was shown an introduction to innovative products that included a very nice set of women’s shoes. I don’t buy women’s shoes. My wife buys shoes, but not on my Amazon account and not these.

They also featured a Tim McGraw & Faith Hill album. I don’t like Tim McGraw or Faith Hill, so wrong again.

My landing page always includes a pitch for a Kindle Fire, although I own one already (and two kindles, and yes, it is a disease). At Christmas I often buy my wife the knitting books she has placed in her wish list. Then for the next four months I am inundated with offers for more knitting books without the option to remove them from my recommendations.

Amazon’s dash button is helpful, again because so much of buying is rebuying. Once we pick a solution (for toothpaste, soap, batteries or footwear) we tend to reorder that product until we grow dissatisfied or hear of something better. So far, I’ve yet to use a dash button.

Privacy remains a big issue. Amazon’s approach is more than a little creepy as they use your searches to change the home page. However, many sites, even after logging in, offer no personalization, which is uncaring but obviously way less creepy. I don’t mind that the waitress at my local breakfast place knows my breakfast preference. I don’t mind that my favorite cashier knows my name. However, neither of them will start asking about what I am shopping for on other sites or keep a detailed record of my browsing history.

Ideally, we’d own our preferences, and share what we wanted when we arrived at the site. Our avatar would include what we normally buy, size and color preferences. And when we leave, our avatar would leave with us. That is the way it works in the real world (until they start this from Minority Report or this from real life). Until we come up with some portable way to manage our preferences and control who sees them, then we will suffer with e-commerce retailers knowing a bit too much about us for comfort.

I think all three barriers can be dealt with in time. The equilibrium between physical and virtual retail will be based on the problems, relative costs and benefits. The US Department of Commerce has e-commerce at about 12% of retail sales, which based on my experience will end up closer to 20%.

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Two Ideas to Improve Bricks and Mortar Retailing

The Perfect Store

Imagine you are visiting your perfect store. Each item is carefully and thoughtfully selected for you. Everything from your favorite foods to clothing that fits your style, that fits your body and your budget. There are also things you need around the house, books, movies, technology all carefully and thoughtfully selected and displayed for your potential purchase. Maybe there would be a section of new items that an expert has suggested you’d enjoy. Customer service would be like an old friend saying hello.

Compare that vision with shopping today. The stores are vast and the portion that is “yours” is very small. We call it a “treasure hunt” as product is crammed in around narrow aisles and you are left searching through racks for your size. Customer service (if found) consists of “Can I help you find something” which speaks to the level of disorganization that even the staff recognizes you will need help finding what you want.

Why aren’t Bricks & Mortar stores like my perfect store?

The reason why physical stores aren’t perfect, is that narrow market segments (like an individual or family) don’t buy enough to justify the investment in inventory, real estate and staffing for a store. The store of today is not that much different than the market of 4,000 years ago. Retailers add value by buying in bulk, then ship it locally and sell the items in each’s. The merchant provides convenience, selection and a lower cost of freight.

Retailers have to appeal to a broad enough audience to achieve a certain level of gross margin dollars per square foot to pay the bills make a return on their investment. The executives may talk about the customer, but the reality is they buy thousands of the exact same thing in a range of sizes and colors. They are focused on a market segment. The retailer used to be able to add selection of add-ons with rich margins. E-commerce has ended that. Customers can comparison shop, order and pay before they leave the aisle in your store, faster and easier than standing in line at your store. E-commerce has the same dilemma if they don’t have unique products. Competition is only a click away.

The reality of physical retail is that in any single shopping trip the majority of merchandise in a store is irrelevant to you. I recently went to Home Depot for cabinet hinges. First, I was accosted by the solar guy (they must have some incentive plan) while passing by plumbing, light bulbs, paint, tools and hot water heaters. All of this selection was without value to me, I just needed hinges to hang my cabinet doors. It was worse when I was in the boating industry. The parts you need for a Hobie Getaway (my boat) are pretty different than a 32’ sailboat and are completely different than a fishing boat or a big cruising powerboat. Of the 20,000 sku’s we could cram into a store, we’d be lucky if 1,000 applied to a single customer. At least at Home Depot, I may need some of that stuff, sometime.

Physical retailers have an advantage; the customer is there in person. Here are a couple of ideas that retailers can use to better compete against the encroachment of e-commerce.

Sell Solutions, not Products.

Customers shop to solve a problem and retailers that solve problems rather than supply product will get more sales and win. Personal shoppers already do this. Selection can be a way to provide answers but this will require different selection strategies and different ways to display merchandise.

My favorite wine store in Pacific Grove was run by a former catering manager (now unfortunately retired) at a big Pebble Beach venue. He assorted his wine by the food it paired with – sections for fish, beef, chicken, deserts, cheeses. We don’t buy wine that way (anywhere) as we are focused on the the varietal, the age, the label. However, when we select wine to drink or serve we try to pair it with what we are serving. Wine stores rarely offer that advice. Someday I hope find wine that is sectioned by my real needs, like this for your brother in law, this for your book club, this for when the boss visits. Now that would be useful!

Ikea is a showroom where they solve the problem of living in a smaller space but staying organized and neat. Each vignette is designed around a hypothetical family. They are brilliant at flat packing their products and giving ideas on how to solve household problems. The furniture store in town has a sea of couches and chairs. Few are shown in a normal pattern you’d see in a home.

Focus on a Customer

Retailers who focus on product too much lose focus on the customer. Product focused firms think of buying and selling product before they thinking of serving a customer need. I think focusing on a customer segment is not as good as focusing on a single person with a problem. We are empathetic to individuals, not to classes of people.

Best Buy implemented a customer focus program called customer centricity by coming up with a series of archetype customers. Each store was then focused on one archetype (a married woman with two children who needs appliances, a college professor who likes high end stereo music, a 15 year old video game player). This was a huge step forward for Best Buy, but in the end it had to change, because to be successful they needed to address pretty much all of these segments in every store. The key point was they went from selling laptops and dishwashers to thinking about what customers needed and then rethought the store layout and service plan.

Auto parts retailers carry a lot of parts. But because of state licenses and registrations, they can buy registration information by area. They know which cars are located where, which autos are at the age where they break down, and what parts are most likely needed. Auto parts stores are focused on their customer – the owner of the 6+ year old car. When they stock parts, they stock based on the local need, and they stock all the parts for the job. They want you to leave with everything you need to get your vehicle working again.

Ikea’s hypothetical families focus their merchandise team on solving real world problems for real people. They are selling a way of living as a part of selling their furniture. They use names and have pictures of happy families (models?) supposedly living in these tiny apartments.

I think there is still life in physical retail. People like to touch, view, compare and try on goods, an experience that e-commerce can’t provide.

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Dr. John Zott is the CFO for Carlson Wireless Technologies, and Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are a former student, colleague or would just like to connect – reach out.