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Understanding the Economics of Marketing

Marketing Strategy Part 1 – The Economics of Marketing

Understanding the economics of marketing is a critical concept that many small business owners have not either been taught or has sufficient experience to fully understand. As a result, one of the biggest mistakes small businesses make is pricing their products and services “Too Low”.

What does “Too Low” mean?

It means that you do not have enough money baked into your price to allow you to cover the Cost of Acquisition of a client. You may also be signaling the market that your products are not extremely high quality, however, that is an entirely different discussion we will have in the future.

Understanding the Long Term Value (LTV) of a Customer
Understanding the Long Term Value (LTV) of a Customer

There are four concepts that must be considered when evaluating the economics of marketing. They are:

  1. LTV – Lifetime Value of a customer. This is the Discounted NET Present Value of the future profitability of the customer over their lifetime as a customer with your business.
  2. COA – Marketing Cost of Acquisition. This is the average $ amount that you have to spend to get one new customer.
  3. Margin – This is how much $ you make above the direct variable costs of providing the product or service you sell.
  4. Price – What you charge for your product or service.

LTV – to calculate the LTV you must know the following things:

  1. Sale Price you charge.
  2. Frequency of the average customer purchase cycle.
  3. Margin % on Sale Price earned per sale.
  4. How many purchase cycles will the average customer make before they quit purchasing?

Note: Most businesses have customers that return periodically. Restaurants, Financial Advisors, Attorneys, CPAs, Insurance Agents, Clothing stores, Pet Sitters, Pest Control, etc. Some businesses have a product or service where repeat purchases are highly unpredictable… Auto Sales, Criminal Defense Attorneys, Funeral Homes, Real Estate Agents, etc.

If you have a business where your clients regularly repeat their purchase from you the client represents an annuity stream of income and you must use the Present Value of an Annuity formula to determine how much the client is worth over time.

Calculating Margin

If you sell a product for $999 and that product has a cost of $325 then you have a $ Margin of $674 which is 67.47% of the Sale Price.

If you only sell an average of one item per customer and your customers rarely or never return to purchase from you again then you can easily answer the question…  “What would you pay to get a positive cash flow of $674?” 

Your answer may be different from mine, but, I might pay as much as $300, depending on how efficient my marketing efforts were and how large the market is. The key question is how long you have to wait between spending money on marketing and getting paid by a customer. A long time between paying your marketing bill and collecting from a sale can eat a lot of available cash while you ramp up marketing. If the lag time between outlay and income is short you can simply start pouring massive amounts of money into your marketing efforts… and up goes your profits.

If you only sell an average of one item to a customer and you make $674 the LTV of the customer is $674… minus your marketing costs.

In our next issue I will address how you compute LTV for a business where the customer regularly repeats their purchase. Recurring purchases are like an annuity so we will learn how financial valuation concepts apply to marketing.