The Hardest Transformation: Changing What Your Measure
“If you cannot measure it, you cannot improve it” – Lord Kelvin
“You are what you eat.” – Anthelme Brillat-Savarin
“You can’t manage what you can’t measure.” – Peter Drucker
“You are what you measure.” – Anonymous
Imagine Kelvin, Drucker, and Brillat-Savarin sitting down to a meal prepared from a Blue Apron subscription box. What would they think of today’s digital business models, tapping into troves of data, with more moving parts and seemingly endless opportunities to measure?
When industrial-era companies attempt to start a new business, or transform into digital services businesses, adopting new mindsets is often the hardest part. The primary dominant logic of the firm must change starting with the core unit of economic value.
Shifting from Products to Services
In a box-based business, the box is the primary unit of economic value quickly followed by income statement metrics. In a discussion about quarterly results, you’ll hear questions like: “What’s the order uptake?” “What’s our contribution margin?” “How can we improve our channel margins?” Whether selling through retail or an established sales force, box-based executives going to bed at night thinking about boxes and margins. “How many more boxes can we sell?” “How do we improve our margin?”
In a digital services business, you’ll notice a big difference.
The unit of value is no longer the box. It’s the customer relationship. Quarterly discussions all center around the KPIs of customer health. The questions across many digital service business models are the same: “How is retention trending?” “What’s our lifetime value?” “What’s is the cost of customer acquisition?” Whether selling razors and razor blades, digital storage, online games, cloud-based design software, or subscription clothing-in-a-box, digital services executives go to bed at night thinking about customers. “How do we get people to stay longer, refer their friends, and value us more?”
Customer Drivers to Digital Service Models:
What’s driving this shift to digital services and direct relationships? A number of technical and cultural trends indicate that customers seek digitally-driven service offerings:
From things to services: In an attempt to simplify and declutter, we seek experiences that are temporary, rather than assets we have to store.
From ownership to rentership: 20-30 somethings who grew up during the recession see cars, mortgages and other big-ticket items as a risk rather than investment. Companies who survived the recession shifted heavy capital expenses (Capex) to lighter operating expenses (Opex), a trend which helped further drive cloud service adoption.
From linear to circular: A younger generation is showing interest in how things are made, re-used, and re-energized, avoiding direct-to-landfill waste. Companies are taking more responsibility for the full lifecycle of their products, and services business models help them create and capture value throughout.
From buying as a pleasure to buying as a time-suck: For daily needs like food and beauty products, we want time-saving convenience which reduces our cognitive load. For business buyers, it’s easier to try a free version of the software and selling up vs. going through extended procurement cycles.
From passive consumption to outcomes-based performance: Evolving in the health and other sectors, key stakeholders are demanding tighter partnerships and pay-for-outcomes contracts. Digital service models are better prepared for plug-and-play multi-partner combinations.
Decoding the KPIs of Digital Business Models:
]The # 1 You Need to Measure: Retention (and its Opposite, Churn)
In the leading digital business model archetypes of today, retention is the name of the game. Companies ranging from Netflix to Dropbox to Stichfix to Dollar Shave Club make more money from existing customers staying with the service than from net new customers. One of the drivers of such aggressive exponential sales growth for these companies is the later stage result of compounded loyal, repeat customers returning for more.
The metric for measuring churn: the # of churned customers / the total number of customers in any given time period.
Retention curves come in different shapes and sizes. In a healthy business, the retention curve flattens out as customers get value from repeatedly using the service. A few people cancel after the first month. Then some more people cancel in the following months as they decide whether or not to keep paying. Then at some point over the next 12-18 months, those left become long-time committed customers and the churn stops.
In an unhealthy business, customers find ways to cancel and get out of their contracts until there are no long-term customers left. Blue Apron, the subscription box company mentioned at the start of this post, is suffering from poor retention rates.
The Growth Metric: CAC to LTV Ratio
In the first dotcom era, companies famously paid a fortune to acquire “eyeballs” but failed to turn users into paying customers. In the digital business models of today, you do want to know if you can make more profit from your customers than it costs you to acquire them. You’ll need to determine two basic numbers:
LTV = the Lifetime Value of a typical customer
CAC = the Cost to Acquire a typical Customer
Lifetime Value: Best viewed through the lens of churn and retention rates following cohorts of customers, lifetime value estimates the average: Lifetime = 1/Customer Churn
Cost of Customer Acquisition: Understand the total costs you spend to acquire users and turn them into customers. Add up all of the critical sales and marketing expenses, including the cost of salaried salespeople, content creators, external SEO specialists. In your calculation, only count net new customers that can be attributed to that period’s acquisition efforts (don’t count your lifetime value returning customers). CAC = Total cost of Sales and Marketing in a period / # of Net New Customers Acquired.
While many debate the formulas, methods of measurement, and heuristics, a number of fast revenue growth companies have followed some variation of the following ratio:
This means for every $3 in lifetime value, $1 is spent on customer acquisition, to achieve a successful sales growth curve.
In digital business models, cohort measurement is how you determine patterns and trends over time, and attributing key acquisition activities to the effect on lifetime value and payback period. A cohort is a set of customers grouped by common characteristics.
Google Analytics now shows customer cohort by time period (when users first came to your site). Other marketing analytics dashboards give you the ability to group by size spend, acquisition channel, and other attributes.
The Perils of Digital Service Models:
Digital services revenues from models like SaaS or subscription box sales are slow to build at first, with cash outflow far outpacing cash inflow in the early stage. You can kill a digital service business model by stepping on the gas before you’ve achieved high customer retention rates. In the startup world, there is natural attrition- companies fail to get Series A or survive the jump to Series B if they cannot prove they have created a service that customers love.
Strong digital service businesses make sure they’ve achieved service-market fit measured in lower churn or higher retention.
When larger incumbents invest in digital service models, they often miscalculate the growth phase, imagining that the launch phase is similar to the product launch of a box or product-focused market scale-up.
Net Present Value is hard to calculate accurately before you begin because of the high likelihood of failure at the moment of scale-up. Retention and marketing leverage (CAC: LTV) are such critical drivers in the model you will benefit from funding those businesses that demonstrate their ability to deliver the best metrics and tinker over time, rather than trying to predict these results ahead of time.
Worse, incentives stay aligned to product-first box-centric KPIs, with stronger carrots for short-term larger-ticket sales rather than recurring revenue contracts.
The most successful incumbent strategies have involved carefully planned licensing-to-services transformations, for example, Adobe shifting to SaaS models and Microsoft shifting to SaaS, PaaS, and IaaS models.
The Promise of Digital Service Models:
Once the business is established and takes off, it can grow very quickly as new customers are added to cohorts of returning customers, and recurring revenue predominate. Companies need measurable systems in place to track all of the moving pieces.
Product development is not an upfront-only spend, but instead becomes a steady and increasing investment in new service development. The work of agile service development is accompanied by agile marketing, with fully connected systems in place, product and marketing teams have strong visibility into the business.
Growth becomes a function of achieving customer milestones, and the business focused on how to perpetually create value through the customer’s view. Digital service companies thrive when they love their customers more than they love the product and service they are delivering. They aim for a North Star vision that improves the lives of the customers they serve. Ultimately, in a digital service business, she who amasses the largest tribe of high lifetime value customers wins.
Jen van der Meer is the Founder of Reason Street and is an Assistant Professor at Parsons School of Design Strategies. Jen is on a mission to measure the value of everything. She believes that business models can be designed to build the future we want to see.