Living in a SaaS world, we are often focused on LCV (Lifetime Customer Value) for a critical unit measurement of profitability. But, it’s also important to understand your product unit economics. True Profitability, a term and methodology developed by Pedro Ferro and described in his book by the same name, determines the specific unit economic value attributable to your products or services. It can also be applied to customers, more on that in a bit.
One of my subscribers, Roland Mosimann from Align Alytics, introduced me to this approach of value measurement. True Profitability is dynamic and a significant upgrade to cost accounting methods typically used to determine product profitability.
When a business evolves, especially during growth, various forms of complexity creep into the business model. In a dynamic business environment, we make decisions that seem like good ones, especially if it means more revenue. However, we lose sight of the costs that are necessary to make changes that enable revenue in a new and non-standard way.
For example, suppose you have a standard SaaS offering but a new potential client wants to apply it to a different problem and you build an offering around that, which requires its own development and maintenance cycle. Seems like a good decision to make the quarter revenue target, but, then, if this segment never grows and you are saddled with a one-off product and set of indirect costs you don’t really measure but pay for every month.
This kind of complexity creep becomes a true but hidden costs that erodes margins. This diagram shows the cycle of complexity-cost creep.
To apply this approach in a sophisticated business, True Profitability relies on the Pareto 80/20 rule. This means that in order to find the products and customers to rationalize, you rank your customers and products by value and then apply an 80/20 rule to each. The objective is to isolate the customer/product pairs that generate the most profits by quantifying levels of activity and complexity required to generate that value, also known as cost-to-serve.
It looks like this.
In the SaaS example above, the one-off product that never gained traction is inherently a “low volume” product and the customer that you created it for is a “low volume” customer. This Quadrant 4 (red zone) customer and product should be rationalized out of the business. The cycles of effort and indirect costs keeping this alive are not worth it. It’s easy to see with a single client example, but if you have many versions of your product, this becomes much more difficult to discern.
When you apply True Profitability in a more complex example, you can rank your product and/or customer profitability as shown below and the low volume products immediately jump out as problems. You can see the progression from Quadrant 1 to Quadrant 4 by product/customer below.
So, what do you do about this? How can you fix this and get rid of all that red negative margin on the right that accumulates and offsets so much of the green positive margin on the left. It may seem simplistic but if you shut these down you will instantly increase your profitability.
Here are some pricing ideas to attack the quadrants, including leveraging quadrant 1 to improve your business based on its strengths. (Note, there are ways in addition to price to attack the quadrants including cost cutting, process consolidation, supply chain improvements, etc.)
Focusing on Quadrant 4, you can see some approaches to solve your margin drag. Increasing price is an obvious one – force a decision with the client to give you more margin or exit the relationship. Annual price increase is an interesting one. Strategically designed SaaS contracts usually have annual price escalators in them. Notwithstanding market substitute pressure which could work against SaaS price escalators, this simple clause helps mitigate clients falling into Quadrant 4 as your business grows and the product portfolio expands.
Another application of True Profitability applies to customer acquisition costs (CAC). Using True Profitability, you can more precisely align CAC with these quadrants to make sure acquisition efforts are targeting the highest value customers, while finding ways to lower CAC for less valuable customers.
True Profitability is a methodology for analyzing your unit economics and generally has strong applications in more traditional businesses. But this proven method can be applied to SaaS and other current business models to provide critical insights into profitable, sustainable growth.
Visit Roland Mosimann and Align Alytics here.
Check out Pedro Ferro’s book here.
Read my LCV post here.
FAQs:
1. What is True Profitability, and why is it important for businesses?
Answer: True Profitability is a methodology that delves deeper than traditional cost accounting methods to determine the specific unit economic value attributable to products or services. It’s crucial for businesses because it provides insights into the real profitability of each product or customer, helping to identify areas of margin erosion and make informed decisions to improve overall profitability.
2. How does complexity creep affect True Profitability?
Answer: Complexity creep refers to the gradual accumulation of hidden costs and inefficiencies in a business model, often stemming from decisions made to accommodate growth or new revenue streams. This complexity can erode margins and distort profitability analysis. True Profitability helps uncover these hidden costs by focusing on unit economics and applying the Pareto 80/20 rule to isolate the most profitable products and customers.
3. How can businesses utilize True Profitability to improve profitability?
Answer: Businesses can leverage True Profitability to identify and address margin-draining factors, such as low-volume products or unprofitable customer segments. Strategies may include rationalizing product offerings, adjusting pricing strategies, implementing cost-cutting measures, or streamlining processes. By prioritizing high-value products and customers and addressing areas of margin drag, businesses can enhance their profitability and ensure sustainable growth.
About me
Throughout my career, I’ve been dedicated to driving innovation and strategic growth as a CFO. My ability to leverage analytics and data science has been instrumental in shaping successful business strategies. Let’s connect on LinkedIn and explore how my Fractional CFO expertise can help drive your company’s success with CFO PRO+Analytics.
