It seems obvious that you need to evaluate profit and business growth if you want to create a profitable and scalable business. Unfortunately, too many startup founders go crazy with excitement when they get market validation and start seeing some traction and the money coming in. My global research on startups showed that two out of three startups (68.4% to be precise) who dream about growth hacking have not estimated what that growth might look like. But the fact is that those startups who have achieved meaningful results in their business growth made a weighted decision on what growth directions to choose. They were successful because they had a great expansion to multiple foreign markets or adapted their product for different segments of the current market and tremendously increased their sales. These successful startups evaluated how much profit they could earn in different scenarios. They also evaluated their growth potential in different markets using different marketing channels. So, that’s the distinction between a dream about growth and a plan for how to achieve it!
Startup entrepreneurs and investors may have different appetites for profit margins and business growth potential. The main goal at this point is to determine if you should proceed with your business idea or not. In order to make a weighted decision, as those successful startups did, you should estimate your profit and growth potential and evaluate if there are any possibilities to make those numbers more attractive.
Estimate profit margin and possibilities to increase it
To estimate your profit margin and any possibilities to increase it, you should keep in mind the three main numbers that determine your profit margin:
1. Average production costs per product or service unit should definitely be included in calculations of your potential profit, but how these costs could be reduced is more of a production issue rather than a marketing issue
2. Average income per sale is a number that most startups usually pay attention to. It only includes the pricing strategy of their product, although it doesn’t really represent the true number. (We’ll talk more about the importance of up-sell, cross-sell, and other strategies helping to increase the average income per sale in future chapters.)
3. Average marketing costs per sale show how much money you have to invest in order to make one sale (sometimes it is called “customer acquisition costs” or “marketing costs per customer”).
Because average income per sale depends directly on the price level, you should be aware of how the price level affects the volume of your sales and total profit. Usually, the higher the price, the fewer customers who are willing to buy the product. It’s not always the case, but I won’t overwhelm you with the theory of demand elasticity. At a minimum, you should know these two simple, but yet very valuable formulas, and use them together with factual data from your market fit or channel verification experiments:
- Formula (1) shows how much total sales should increase if you apply a certain discount and want to keep the same profit (it’s obvious that if you apply a discount and your sales volume doesn’t increase, you are losing your profit, so there is no sense in providing a discount)
- Formula (2) shows the opposite case calculation. If you decided to increase the price (even though some customers might think it’s too expensive and won’t buy your product), the formula indicates how much you can allow your sales volume to decrease and still have the same profit (selling fewer units, but at higher price can result in even a higher total profit)
If you plan to run a sales promotion based on a discount or you pay out commissions to partners selling your product, evaluate the results of this formula and decide how likely it is to have such sales volume increase due to a particular discount or commission payout:
Keep in mind that we’re not talking here about strategic decisions (for example, if you are a cost leader, thus will always try to provide a lower price than your competitors, or if you are a premium brand that can’t be priced too low). This formula shows a plain black and white answer about what would be more profitable to you based on numbers, not opinions.
Average marketing costs per sale is another very important component for your profit calculation. There are many articles and even books about optimizing your average lead or sales cost (I highly recommend Startup Owners Manual by Dorf and Blank to learn more about this topic). But one thing should be kept in mind: marketing communication today is more complicated than ever before. It’s not enough to calculate your marketing costs per one digital advertising or sales channel to decide whether your communication channel is cost effective. You should focus on the effectiveness of entire sales funnel or sales pipeline. As we have already discussed, different communication channels might have different goals in your marketing strategy (not every marketing channel will try to sell your product at once, so it’s not correct to evaluate the effectiveness of a communication channel based on generated sales). After running a number of experiments using different channels and messages, you should come up with the average costs of customer acquisition through the entire sales funnel or pipeline. Take those costs into account for your estimated profit. In the next steps, we’ll talk how you could come up with ideas for optimizing these costs.
Estimate the potential reach of your target market
Ask yourself a simple question: which of your tested communication channels are scalable? How large is the target audience you can reach with these channels? If your target market is 1,000,000 but your tested channels can reach at maximum 100,000 potential customers, you still have work to do. It’s not a tragedy if you proceed with the implementation of your business model, but it just means that you have only found a way to reach 10% of your total target market. So if you are making any assumptions about your business potential, you should be careful. You still don’t know how to reach remaining 90% of your target customers and don’t have a clue how much it would cost you. It might be a good idea to continue experiments with new communication channels and add them to your marketing strategy if they are confirmed.
Check the effectiveness of your sales funnel/pipeline
Do you have clear conversion metrics for each stage of your sales funnel or sales pipeline? What is the industry standard and how you compare to it? Is the overall effectiveness of your sales funnel/pipeline satisfactory? Can you be profitable at this overall conversion rate? Can you improve it?
It’s much easier to answer these questions if you have your sales funnel/pipeline with conversion metrics in front of you.
Where is the bottleneck in this sales funnel? At which stage will you lose most of the potential customers? Looking at this sales funnel it’s obvious that there are some problems with Stage 2 (15% conversion with 85,000 potential customers lost) and Stage 4 (12% conversion with 10,560 potential customers lost). The overall effectiveness of this sales funnel is only 1.44% which means that only 1,440 potential customers out of 100,000 are buying the product, and only 576 become loyal customers (and make repeat purchases). What conclusions could you draw out of these facts?
Let’s say this startup is selling a digital product (with fixed one-time production costs and no variable costs) at a price of $14.99 and cost per lead is $0.50 (the same numbers from the previous example). It means that we’ll have to spend $50,000 to get 100,000 visitors to the landing page, but finally, we’ll sell our product only to 1,440 customers which will bring us $21,585 in income and $8,634 from repeated purchases. Not a good deal! We spend $50,000 to earn only $30,219!
For most business, 85,000 potential customers is quite a significant number so we need to think about how to stop losing so many leads. Without any other additional information, we can assume that there might be two general ways to increase the conversion at this stage:
- Optimize the landing page. Make it more appealing and more effective at guiding visitors to sign up for the free trial (solution: update the landing page and run A/B tests)
- Increase the quality of traffic to the landing page. It’s quite possible that most of those visitors are not truly your targeted customers (solution: check which channels bring visitors with the best conversion for signup, try to find new channels to reach target customers, and reduce spending on ineffective channels).
If we want to increase the conversion purchase after the free trial, we might consider:
- Talking to a customer who doesn’t buy it and clarify the main reasons for their decision
- Improving the process of follow up during the free trial and after it is over (put more effort in direct communication with the potential customer)
- Revising the offer (maybe potential customers would be more willing to buy a bit different package) and think about implementing a down-sell strategy for those who don’t buy after the full sequence of follow-up.
Let’s say after a few experiments and changes, we succeed in achieving higher conversions at these stages. Now the overall sales funnel conversion is 3,.52% and 1.41% for repeat purchases. This now means that in driving 100,000 visitors to the website, we make $52,764 in initial sales and $21,105 in repeat sales ($73,869 in total). If it’s possible to keep the same $0.50 cost per lead, it means we found a profitable business model for our digital product). Investing $50,000 to drive traffic to the sales funnel brings $73,869 in revenue.
Increasing the efficiency of your sales funnel/pipeline takes ongoing effort. Even when you do the market launch (introduce your product to the entire targeted market instead of just running tests in particular market segments), you should always keep an eye on your overall conversion rate and the ways to increase it. Due to their specifics and costs structure, different sales channels support different products and price levels. It means that not all channels will be effective and suitable for your product. Try to keep your sales funnel/pipeline clear of ineffective channels.
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