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Training Summary: The Financial Formulas For Scaling a Consumer Product Business
The financial formulas for scaling a consumer product business that I’m sharing with you here are really only applicable if your goal is to build a scalable venture. If you’re just looking to run a lifestyle business you can disregard this article – but if you want to build a scalable consumer product business, these are the numbers that you need to understand
The Bad News About Consumer Product Businesses
The bad news is that consumer businesses have start up costs tied to developing a product and inventory. So in other words, there is a long, gloomy valley at the beginning of your business when you’re likely to have overhead that exceeds your income. Also whenever you have inventory, you’ve got to move physical things around which means complexity. So complexity and startup costs mean that there is a fair degree risk involved in these types of businesses
The Good News About Consumer Product Businesses
Because this business is challenging to get set up, there are barriers to entry. So, once you’re up and running you’ve got a natural moat around the business. You also have scalability and today the sky is the limit with easy access to global markets both in terms of suppliers and potential customers. Finally there are established financial formulas for this type of business which is what we’re going to be exploring today
So let’s talk about the financial formulas for scaling a consumer product business and the three numbers that are key making it successful over the long run!
The First Financial Formula for Scaling Consumer Product Businesses: Gross Margins
Gross margin is the foundational number for your business. Gross margin is the difference between the total cost of manufacturing your products and what you’re able to sell them for. In other words, it is the percentage of revenue from each individual sale that you keep before expenses (on average).
Gross Margin = (Total Revenue – Cost of Goods) / Total Revenue
Say you ordered $100,000 worth of goods from your factory and let’s say there were 100,000 of them so that each cost a dollar. Let’s now say you were able to sell 10 of those items for $4 each to have total revenue of $40.
The cost of those 10 items was $10. $40 (revenue) – $10 (Cost of Goods) = 30. So that’s 30 / 40 for a gross margin of 75%.
When I’m speaking of cost of goods (COGS), I’m talking about every expense and cost that you had in order to get your products into a warehouse or basement or wherever you keep them so that you can sell them – but nothing to do with your overhead, marketing etc.
Gross Margin as Leverage
Gross leverage is the leverage in your business because overhead tends to increase over time in more of a linear fashion while Revenue tends to grow exponentially. In fact in your first year you could grow fifty or a hundred percent because obviously you’re starting from zero. Over time you’ll maybe be growing at 10% or 20% a year but you’re your overhead is generally going to go up more out more or less incrementally over time so you’ll have this gap guy that begins to widen over time.
Consumer Product Brands Need A Gross Margin Of At Least 50%
You’re going to need 50% to 60% gross margin to survive in this business. If it’s higher that’s great but without this margin your business is probably not going to work. If you’re still in the early stages of your business and not yet turning a profit – but you’ve got some good margins: hang in there! This type of business needs to reach a certain scale before it starts to make sense.
Why do you need 50%? First of all you need to pay yourself and cover overhead and that’s going to come out of your gross margin. You also need to invest in growth. You may find you need to wholesale your product and to pay sales agents. You may eventually need to liquidate some of your products. As you move to sell to the larger retailers, they are going to hammer on your margins. So, you’re going to want to make sure you have the ability to get and sustain ta 50% margin
I would also encourage you to look at your gross margin by Channel or segments as this will give you insight as to how to allocate funds which I’ll get into with the next couple of concepts .
You might be willing to compromise on margin for volume sales. Marketing is another benefit that may justify taking a lower margin. (For instance if there was a retailer that’s very prestigious , being in this retailer would give a big boost for your brand’s credibility.) You have to assess these on a case by case basis but ensure you overall (average) margin is maintained above 50%.
The Second Financial Formula for Consumer Product Businesses: Customer Lifetime Value
Customer Lifetime Value (CLV) is the average amount that a customer spends on your products over the lifetime of a relationship with that customer. It should increase over time as maybe you expand your product offering or deepen your relationship with the customer.
Customer Lifetime value Formula = Average Basket Size X Average Repurchase Rate
Customer Lifetime Value (CLV) is the average amount that a customer spends on your products over the lifetime of a relationship with that customer. It should increase over time as you expand your product offering or deepen your relationship with the customer.
Customer Lifetime value Formula = Average Basket Size X Average Repurchase Rate
It’s a simple formula: it’s the average basket size (average size of an individual sale) multiplied by the average repurchase rate for each customer. For instance, if you go to the grocery store once a week and on average you’ll be spending $100, that’s going to be a high lifetime customer value!
If you’re a young business the repurchase rate may be hard to establish because you haven’t been through an entire lifetime cycle with a customer. But estimating it is going to be better than not having a number at all. Use comparable businesses as a rule of thumb: consumable products versus discretionary lifestyle products can have a different trajectory. Consumables people are going to be repurchasing at a higher rate.
The other value of customer lifetime value is it thinking about in terms of the whole purchase process. In other words, how do you increase customer lifetime value by focussing on different stages your relationship with a customer? It’s very expensive to convert somebody to a paying customer but it’s a lot less expensive to re-market to your existing customers.
The Third Financial Formula for Consumer Product Businesses: Customer Acquisition Cost
Customer Acquisition Cost (CAC) is how much it costs you to “buy” (or market to) a customer. You want to use your customer acquisition cost with two the other two numbers that we’ve already been talking about. In other words, you want to calculate:
Gross Margin X Customer Lifetime Value = Net Revenues per Customer
You can then look at Customer Acquisition Cost (CAC) against net revenues per customer.
For instance, say we’re running Facebook ads and we’re spending $5 in on Facebook to make $10, If we’re not considering your net revenues per customer against your CAC we may simply be trading dollars or even losing money, despite running what looks like a profitable campaign on the surface.
The Target Customer Acquisition Cost For Consumer Product Brands
The Target CAC for a scalable business is 3 : 1 . In other words, the net value of a customer should be 3X the cost of acquiring them. So looking again at our Facebook ads, 3 : 1 at a 50% gross margin would demand a 6x return on ad spend (when accounting for 50% gross margin) to be in the sweet spot.
With this information, you can now assess your marketing expenditures with a true baseline. For instance, If your ratio is 1:1 you’re spending too much to acquire a customer. if the ratio is 5:1 you’re actually spending too little and can afford to ramp up your acquisition until the ratio falls below 3:1.
A New Way To Think About Your Business
Whether or not you’ve got all these numbers at your disposal right now, I’m trying to give you a new way to think about your business. I want you to think of each channel as a system that you’re building that allows you to leverage your time or money.
Use the numbers to compare the efficiency of each Channel and increase or decrease your resource allocation to the most efficient Channel or customer segments.
Have a question or about the financial formulas for scaling a consumer product business? Leave it below and I’ll be sure to respond!