(Photo by Sami)
Even if you’re scared to balance your checkbook, to create a sustainable business you need to be able to calculate some basic business variables. Without this knowledge, you have no idea if your marketing is working, if your business is profitable, or if your pricing is reasonable.
To start with, you need to understand your COG (cost of goods). How much does it cost you to produce that widget? There’s the cost to create the widget (or purchase it) – your hard costs (if you create 10 widgets, it likely costs you ten times as much to make as the first one) Lurking in the background are your soft costs: utilities, rent, insurance, payroll, etc. By knowing your COG, you can determine if your pricing reflects your costs.
Your next variable is COA (cost of acquisition). How much money does it take to get a new client? How many pay-per-click campaigns? How many newsletters? How many phone calls? How many magazine advertisements? How many TV placements? You can’t start by copying someone else’s COA – their effectiveness depends not only on their actions but also on their offer.
Finally, determine your LTV (lifetime value of a customer) – how much money will your new customer likely give you over the span of time they use your product or services? If you charge $25/month for a service, and they use your services for a year (and then “graduate”), their LTV is $25 x 12 = $300.
A sustainable business requires a LTV > 4 * COA – or in English -“the amount of money your average client gives you over their relationship with you must be at least four times your cost to acquire them”. You need to have a well-funded sales cycle to ensure ongoing profitability. If you seek investors, they’ll know that if they loan you more money to acquire customers, they can rightly expect a clear return on their investment from your LTV.
If your LTV is out-of-whack with your COA, then consider either: raising your prices (to increase your LTV) or reducing your COA (by increasing the effectiveness of your marketing efforts). You don’t need to be a math wizard – but you do need to be money smart.