Thursday, July 21, 2011

COA 102: The Impact of Customer Acquisition Cost on MSP Profitability

In our last blog post (titled “COA 101:  A Primer for the MSP on the Cost of Customer Acquisition”) we provided an introduction to the concept of “COA” (the acronym for Cost of Acquisition used by many executives and investors in recurring revenue businesses) and we talked about why COA is such a critical part of an MSP’s growth plan. At MSPexcellence, we believe that COA is the single most important factor to measure and control when scaling a managed services business and maximizing its valuation either for an upcoming investment round or for an M&A event.  So in this post we are going to take the COA concept one step further and explain the nature of its impact on both short term and long term profitability for an MSP business. To help make this explanation as clear as possible, we have created a diagram to illustrate COA in action.  After all, a picture is worth a thousand words and COA can be a difficult concept to grasp with only a written definition and a formula for calculating its value.  

So take a few moments and study the diagram below. It will help you to visualize the critical role that COA plays in scaling your MSP business. The diagram shows the customer acquisition ramp for a hypothetical MSP business that is launching a new managed service.  Each newly acquired customer is represented by a row of colored squares from left to right with each square representing the Monthly Recurring Revenue (MRR) collected from the customer. Every month, the MSP business acquires a new customer and, as a result, a new and incremental revenue stream is set in motion one customer at a time.

The colored squares are divided in half with one part colored red to represent cost and another part colored green to represent the profit realized during the term of the managed services contract. For each new customer, the colored squares in the early months are red on both top and bottom. This illustrates the fact that you must incur a cost to acquire the customer and you must also incur a cost to deliver services to them – these are very separate and distinct cost elements. The cost of acquisition is represented by the top red half of the revenue square and the cost of service delivery is the bottom red half of the square. After some number of months, the cost of acquisition is recovered. The COA is paid back by the gross margin dollars remaining after all service delivery costs are met.  In the example above, you will notice that it takes 9 months of gross margin to pay back the cost of customer acquisition for each new customer acquired. Then beginning in the 10th month, the customer becomes profitable and stays that way for the life of the contract, or multiple contract terms assuming the MSP maintains a low churn and strong contract renewal rate.

After you study the diagram for a few minutes, you will begin to see the importance of managing COA on both your short term as well as your long term profitability. There are many insights to be gleaned from this diagram and each one is significant so let’s cover them one at a time.

1.   First of all, notice the compounding effect of a recurring revenue business. It’s much like saving for retirement. If one new customer with an MRR of $2,000 is added each month (equal to 20 users at $100 per user per month) then after four years you will have a million dollar recurring revenue business. That means your recurring revenue business will generate a million dollars per year for as long as your customers renew and you would never have to add another customer to keep that million dollar revenue run rate going. Isn’t recurring revenue is a beautiful thing? How can you consistently add a new customer every month? All you need is a consistent customer acquisition strategy where your sales and marketing functions operate according to an effective and efficient execution model. It’s very achievable, but it won’t happen by chance – and it must be managed.

2.   Next you will notice that during the first year of customer acquisition, your MSP business will not be very profitable. That’s because you have not reached critical mass in your customer base – the majority of your customers are still within their first 9 months of acquisition and have not generated enough margin dollars to pay back their acquisition cost. They are in the “Acquisition Cost Recovery Zone” and as long as you are acquiring customers, that unprofitable zone will always be a fact of life. But you will also notice that during the second year the profitability picture changes dramatically. In year 1 only a few of the squares (monthly recurring revenue) are profitable. In fact, in this scenario, less than 10% of the first year revenues are profitable. However, in the second year more than half of the MRR squares become profitable. If your customer acquisition rate stays constant, then each year the proportion of profitable squares to unprofitable squares will increase and your overall business profitability will rise accordingly. So much so that by year 4, 90% of your MRR will be profitable revenue and only 10% of your revenue (i.e., new acquired customers) will be unprofitable. In other words, the profitability picture flips from a very unprofitable situation to an extremely profitable one over time.

3.   How can you minimize the number of red (unprofitable) squares and maximize the green (profitable) squares? The answer is to manage your cost of acquisition to the lowest possible level so that the time to recover COA is reduced and the path to profitability is accelerated. How can you reduce your COA?  You must find the inefficiencies in your sales and marketing functions and continuously improve them.  Where are they? Well, that depends.  Excess COA could be in your sales compensation plan, or your pipeline close ratio, or unusually long sales cycles. In the marketing area, your COA might be too high because of your cost per lead, or your lead qualification rate or maybe your overall lead volume is not sufficient to consistently drive sales activity. With the right sales and marketing metrics in place, you can find these inefficiencies and then you can identify and implement strategies to correct them.  

4.   Finally, let’s look at the actual numbers implied by the diagram above and use this COA metric in a real world scenario. We have already pointed out that in this diagram the COA cost recovery time is 9 months. If your average MRR is $2,000 per customer and your gross margin is 50% (we are using round numbers here for simplicity) then each month you will generate $1,000 of margin dollars to recoup the cost of customer acquisition. So a 9 month COA implies a $9,000 cost to acquire each customer. Where did that $9,000 go anyway?  Let’s start with selling expenses. If we ballpark your cost per sales rep at $100k per year (including salary, commissions, overhead, T&E) then each month a sales rep accounts for more than $8,000 in selling expenses.  So the next question is how many deals at $2,000 MRR does a sales rep close in a month? If the answer is only one deal per month, then most of your $9,000 COA has been spent on selling expenses alone.

Now let’s look at marketing expenses.  If you spend $200 per lead and you qualify 1/3rd of your leads into the sales pipeline and then you convert 1/3rd of the pipeline into customers, then you have just spent $1,800 on lead generation ($200 / 30% / 30%) to acquire each new customer.  Are there any marketing staff or sales support staff not already counted?  If so, then add them in too. Now add in all other sales and marketing expenses for creative services, PR, trade associations, demo equipment, literature, etc.  COA is your total cost of customer acquisition including all fixed and variable sales and marketing expenses.
If you currently have a high COA (e.g., the time it takes to recover your COA is greater than 12 months), then your goal should be to move to a low COA model as soon as possible. Otherwise you are burning margin dollars unnecessarily and undermining the profitability of your business. Which of the diagrams below do you think looks more like your COA efficiency?

A low COA model will enable you to acquire the most customers in the shortest time frame at the lowest impact on your operating margins. But the question becomes how to make the move from a high COA model to a low COA model. The only way to manage a process with so many variables is to create a Go-To-Market plan and then execute against that plan. Then you must measure your COA performance constantly and improve it over time.  With an efficient, consistent and scalable go-to-market model and customer acquisition program you will build up your customer base, maximize top line revenue growth and maximize your bottom line profitability all at the same time. Here is a summary of the steps we recommend to move from a high COA model to a low COA model.
The chart above summarizes the factors that increase COA and the steps you can take to improve your COA efficiency. You may only need to address one or two of these factors to optimize your COA…or you may find that you need to take all five steps to address them all. In any case, you owe it to yourself and your business to take a hard look at your cost of acquisition and then take the necessary steps to optimize it.  Just ask any serious investor in recurring revenue companies ... Mastering your COA is not only the key to increasing your profitability it is also the key to maximizing the valuation of your MSP business.

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