Service Engineering Basics Lecture 13 PDF

Welcome to today's lecture! We'll be exploring several key concepts essential for understanding and managing a successful service business. 1 2 First, we'll discuss why customer acquisition cost, customer churn, a...

Welcome to today's lecture! We'll be exploring several key concepts essential for understanding and managing a successful service business. 1 2 First, we'll discuss why customer acquisition cost, customer churn, and customer lifetime value are crucial. These metrics help you focus your investments on customers who bring the maximum profit. Next, we'll examine why firms need a minimum number of customers to be profitable. This involves understanding the balance between customer revenue, variable costs, and fixed costs. We'll then move on to assessing the viability of a service business model by looking at the ratio of customer lifetime value to acquisition cost. A ratio significantly greater than one indicates a potentially successful business. Following that, we'll compare top-down and bottom-up market sizing approaches. Top- down market sizing involves market research to estimate the total market size, while bottom-up market sizing uses a funnel perspective to estimate the number of customers you can realistically acquire. Finally, we'll cover how to calculate profit and loss for a service idea through cost and revenue modeling. This will help you understand when your business will achieve a positive return on investment. 3 When embarking on a service engineering endeavor, the first step is to model the revenues and costs involved. This isn't rocket science; there are excellent Excel tools available to assist with this process. However, it's crucial to understand the specifics when it comes to services. A key point to consider is that almost every failed startup has a project, but what they lack are enough customers. When you have a new business idea, the tendency is to focus heavily on product design. Gabriel Weinberg, an expert in startup management, emphasizes that you should not only focus on your product. Instead, you should simultaneously and early on develop your customer base. Don't think solely in terms of product development. Conversely, don't focus only on acquiring customers. It's essential to develop both in parallel, a concept Weinberg refers to as "traction." One reason for this approach is the importance of managing customer acquisition costs. 4 This chart illustrates the annual customer acquisition cost in various industries in the United States. In sectors such as banking, telecom, and software technology, the cost can easily exceed $300 per customer. Consequently, substantial investments are often required just to attract customers to purchase your offerings. 5 When discussing characteristic revenue and costs over time, there are distinct phases to consider. On the X-axis, you'll see time, and on the Y-axis, revenues and costs. Initially, you start generating revenues once you have successfully acquired a customer. However, before acquiring the customer, you need to invest in acquisition, which means you begin with negative costs. This situation is compounded by the fact that not every investment in customer acquisition is successful. Once you start generating positive revenues, there will eventually come a point when you lose the customer. The time it takes to achieve a positive return can be quite lengthy. Therefore, it's crucial to maintain your customers over longer periods and continuously generate revenues throughout their lifetimes. 6 This brings us to the second challenge: customer churn. As we all know, customers don't always stick with their service providers. Think about your mobile service contracts, for example. How often have you changed your mobile service contract? For me, it's been two or three times. However, this varies significantly depending on the industry and market. Here are some statistics from the United States on yearly churn rates by industry. For cable services, which likely includes both cable TV and internet, about 25% of customers leave each year. The financial credit industry and online retail also see churn rates above 20%. This means that, on average, you lose your customers after about four years. High acquisition costs combined with high churn rates result in substantial investments needed to establish and maintain a customer base. This financial modeling is what we will discuss today. 7 When starting a business, one of the key decisions you need to make is where to invest your resources. Should you focus on customer acquisition or customer retention? The answer largely depends on the stage your startup is in. 8 If you have no customers, the answer is clear: you need to invest in customer acquisition. As you gain traction and grow your customer base, you'll start shifting your investments towards retention. Once you have a stable customer base, you'll likely invest more in retention than in acquisition. Do you know why this is the case? Why would you invest more in retention than in acquisition? It's because retaining a customer is generally much cheaper. While this can't be generalized for every situation, a common rule of thumb is that it's ten times cheaper to retain an existing customer than to acquire a new one. 9 We discussed customer lifetime value modeling last semester, so I won't go into much detail now. The key takeaway is that you should treat your customers as assets. In industries that produce physical products, companies invest heavily in physical assets and then assess their value over time, spreading out the investment. The same principle applies to acquiring customers, which is known as customer lifetime value modeling. This involves determining how much revenue a customer will generate over their entire lifetime and how much you need to invest in acquiring them. By answering these two questions, you can calculate an overall lifetime value. This helps you assess whether you have a potentially successful business case and identify which customers to focus your investments on. 10 11 So what does this mean for your profitability? Initially, the answer is straightforward: you have revenues and costs, and you need to model these. Ultimately, your revenues must exceed your costs. How can you model revenues and costs? For revenues, you have a revenue stream per customer, which can be a flat fee or transaction fees, denoted as alpha. The unit is money, specifically Swiss Francs per time unit, in this case, per month. So, alpha represents how much you earn from a single customer in Swiss Francs per month. On the cost side, we can distinguish between fixed costs and variable costs. Fixed costs, also measured in money per time unit, are incurred even if you have no customers at all. There is a baseline level of fixed costs regardless of customer count. Variable costs, also measured in money per time unit, are proportional to the number of customers. You can think of variable costs as the average cost of serving a customer, excluding fixed costs. 12 Now, let's look at the formula. Simply put, your revenue per customer alpha, multiplied by N (the number of customers), needs to be higher than your fixed costs plus the variable cost per customer beta, multiplied by the number of customers N. This is straightforward and represents the first rule of profitability. 13 So what does this tell us? First, you typically need a minimum number of customers to make a profit. Let's revisit the formula. If you have no customers, your fixed costs won't be covered. Therefore, you need a certain number of customers to cover these fixed costs. Beyond that, you need to reach a threshold where you are profitable overall, considering your variable costs. In other words, you need a critical mass of customers. Additionally, we haven't yet discussed acquisition costs, which also need to be factored in. Your customer base not only generates variable cost revenues but also requires investment to be created and maintained. Thus, acquisition costs represent a third cost factor. 14 15 Let's take customer dynamics into account. There are two key factors to consider: the acquisition rate (λ) and the customer churn rate (r). The acquisition rate (λ) indicates how many new customers you generate over a specific time period, such as per month. This rate depends on the firm's efforts—the more you invest, the higher the acquisition rate. The customer churn rate (r) depends on the number of customers you have. It is measured as a fraction of the time unit, for example, 1 divided by the number of months. This might seem unusual, but remember that churn depends on your current customer base. If you have N(t) customers at time t, the churn rate r (measured in units of 1/time, such as 1/month) means that ( N(t) \times r ) gives you the number of customers lost per time unit. The key difference between the acquisition rate and the churn rate is that the acquisition rate depends solely on the firm's efforts and is measured directly in customers per time unit (e.g., customers per month). In contrast, the churn rate is measured in units of 1/time (e.g., 1/month) and must be interpreted in relation to the number of existing customers. To model customer dynamics over small time units (e.g., months), the number of customers N at time ( t + \Delta t ) (where \Delta t is a small time increment, such as one month) can be expressed as: [ N(t + \Delta t) = N(t) + \lambda \Delta t - N(t) \times r \times \Delta t ] \Delta t can be equal to 1 in the chosen time unit (e.g., one month or one year). For example, if you have been in business for 15 months, the number of customers in the 16th month would be: [ N(16) = N(15) + \lambda \times 1 - N(15) \times r \times 1 ] 16 Here's an example. Let's assume we start with no customers, an acquisition rate (λ) of 100 new customers per month, and a churn rate (r) of 0.3 per year. When calculating such functions and numbers, it's crucial to use consistent time periods. You need to either convert months to years or years to months. To transform the churn rate to a monthly rate, you can divide the annual churn rate by 12. So, 0.3 per year becomes ( \frac{0.3}{12} ) per month. Alternatively, you can adjust the acquisition rate to an annual rate. For instance, 100 new customers per month translates to 1200 customers per year. Interestingly, this will result in an asymptotic curve. At a certain point, you will reach a steady state where the number of customers stabilizes. 17 When will this steady state be reached? It occurs when your acquisition rate equals the churn rate multiplied by the asymptotic number of customers. In other words, ( N ) as a function of infinity represents this asymptotic number of customers. Why is this the case? Let's revisit the formula. When the acquisition rate equals ( N ) times the churn rate, a steady state is achieved. The associated formula is: [ N = \frac{\lambda}{r} ] 18 19 This number, derived from acquisition costs, allows you to evaluate whether you can achieve a positive long-term business case with the current number of customers or if you need to invest more in customer acquisition. 20 There is a relationship between the retention rate (r) and the customer lifetime (L), expressed as ( r = \frac{1}{L} ). For example, if a customer’s overall lifetime is 30 years, the retention rate would be ( \frac{1}{30} ) per year. This relationship helps you determine a meaningful retention rate, as it's often easier to estimate the overall lifetime of a customer—the period they will stay with you. For instance, consider your mobile service contract. If you typically switch providers every 10 years, you can use this to estimate the retention rate, which would be ( \frac{1}{10} ) years. 21 22 23 We just discussed the relationship between the retention rate and customer lifetime. Next, let's look at how to factor in the acquisition cost of a customer. Returning to our profit model, we consider the difference between revenues and costs, now including acquisition costs. We have already introduced the acquisition rate (λ), measured in customers per month. We also know the total number of customers, the monthly revenue per customer, the fixed costs per month, and the variable costs per month, all in Swiss Francs. Now, we introduce the acquisition cost (γ, gamma), also measured in Swiss Francs. The acquisition cost component is calculated as γ times λ, representing the cost of acquiring new customers. To generate positive revenues, our overall revenues must exceed the sum of fixed costs, variable costs, and acquisition costs. 24 We've already discussed the asymptotic number of customers you can achieve over the long run by comparing the acquisition and retention rates. We had a formula where λ (the acquisition rate) equals ( R \times N ) (the churn rate times the asymptotic number of customers). In our cost function, you can substitute λ with ( r \times N ) when considering a long- term perspective. This models a situation where you have a constant number of customers. Substituting λ with ( N \times r ) helps you reflect on the sustainability of your business case. In the long term, you aim to reach a steady state with a constant number of customers, and you should be profitable in this scenario. Using this equation, we derive a necessary condition for profitability. If we ignore fixed costs and divide the remaining terms by ( N ), we get: [ \text{Revenue per customer} - \text{Variable cost} ] must be greater than [ \gamma \times r ] (the acquisition cost times the churn rate). If this condition is not met, you won't be profitable, even before considering fixed costs. 25 26 This is particularly interesting from a cost perspective because it provides a concrete number of customers you need to reach to become profitable. For a service startup, this is valuable information as it gives you a clear target for achieving profitability. 27 We've already introduced the concept of customer lifetime and discussed customer lifetime modeling last semester. This is a straightforward way to model customer lifetime value. You simply take the difference between the revenue per customer and the variable cost per customer, then multiply this by the customer's lifetime. This gives you a simplified estimate of the revenue a customer will generate over their expected lifetime. Now, consider the acquisition cost (γ), which is the investment required to acquire a customer. To ensure profitability, the customer lifetime value must be at least equal to, and preferably higher than, the acquisition cost. This is another necessary condition for your business case. If we rearrange the equation by moving ( L ) to the right side, we get ( \frac{1}{L} = r ). We already are familiar with the resulting equation: the revenue per customer minus the variable cost per customer must be greater than or equal to the acquisition cost per customer (γ) times the churn rate (r). Again, this is a necessary but not sufficient condition, as it does not account for fixed costs. 28 You can use this equation to derive a helpful indicator: the ratio of customer lifetime value (CLV) to customer acquisition cost (CAC). This ratio is calculated by dividing the customer lifetime value by the acquisition cost. Ideally, this ratio should be greater than one, but how much greater? The ratio of CLV to CAC is crucial. If the ratio is 1:1, you will lose money because fixed costs are also involved. A ratio of 3:1 is considered quite good. If the ratio exceeds 3:1, you might consider investing more in customer acquisition. Of course, this is a general rule of thumb and may vary depending on how fixed-cost heavy your business is. However, when the CLV to CAC ratio is very high, it might be a good idea to invest more in acquisition. 29 30 31 32 Up to now, we have discussed theoretical market sizes and the number of customers you need to attract to become profitable. We also talked about acquisition costs, but we haven't addressed how realistic these models are. It's essential to perform a reality check and compare your theoretical models to the actual market. Two approaches to do this are top-down and bottom-up market sizing. Let's start with an example of top-down market sizing, which describes the size of the addressable market. Consider the market for coffins in the United States. Suppose you want to enter the coffin business and need an informed estimate of how many coffins you might sell per year. You can begin by describing the potential addressable market (PAM), which includes people in your target market and those who could potentially be in the future. For coffins, you might start by considering the global number of deaths per year, which is about 55 million people. If you earn $2,500 per coffin, the potential addressable market would be $138 billion. However, this is unrealistic because you won't have a global coffin business. Next, focus on the total addressable market (TAM), which represents the market in which you are actually present. For coffins, this could be the number of deaths per year in the U.S., which is about 1.1 million. Multiplying this by $2,500 per coffin gives you a TAM of $2.7 billion per year. It's still unrealistic to capture the entire U.S. market, so you need to consider how many people you can reach with your sales and distribution channels. Suppose you have a large network of distribution partners and can reach 25% of the market. This gives you a serviceable available market (SAM) of $675 million (25% of $2.7 billion). Finally, it's unlikely you'll achieve 100% market share within the serviceable available market. Assume a realistic market share of 10%. Your serviceable obtainable market 33 (SOM) would then be $67.5 million (10% of $675 million). 33 Now it becomes clear why this is called a top-down approach. You start with the potential market, then narrow it down to the market you are actually present in, consider your distribution channels, and finally estimate your realistically obtainable market share. This process helps you determine the number of customers and potential revenue. Reflecting on our theoretical work, we identified a number ( N ) that makes your business profitable. You can now compare this theoretical number to the realistic number of customers you can reach based on your market sizing assumptions. This comparison allows you to align your business modeling with market realities. However, the top-down approach does not account for the effort required to win new customers. 34 That's why there's also a bottom-up approach. How does the bottom-up approach work? It starts with the effort required to win a customer, using a sales funnel to estimate a realistic number of customers you can acquire. In a business-to-business (B2B) context, the sales funnel begins with an initial contact, such as meeting a potential customer at a conference or fair. This initial contact is not yet a qualified lead. The next step is a qualification check to determine if this contact is a realistic customer for your offering. As visualized by the funnel, only a percentage of all contacts will become qualified leads. From there, you collect facts about the client and develop a tailored value proposition. Not all qualified leads will be interested in your solution, so the funnel narrows. Next, you present your offering to the customer, but not all will invite you to present, further narrowing the funnel. Only a smaller percentage of those presented to will evaluate your offering, an even smaller percentage will enter into negotiations, and finally, only a fraction will sign a contract. Thus, the sales funnel becomes progressively narrower. 35 Now, the question is, what is a realistic number of contacts needed to generate a successful closing? Here are some typical ratios for a business-to-business setup: Starting with 100 contacts, only 15% will result in presentations. Of those, only two-thirds will evaluate your offerings. Finally, only 4% of your initial contacts will actually sign a contract. This means that 4% of all your initial contacts will become customers. While these ratios are typical for B2B setups, they highlight the sheer volume of contacts needed to reach certain thresholds for acquiring new customers. Sales is a capacity-intensive process requiring significant manpower. For example, if you aim to generate 400 new customers per year, you would need 10,000 initial contacts. This leads to questions about the number of sales personnel required to generate and manage such a large number of leads and whether this is realistic. A bottom-up approach to market sizing can help answer these questions. In summary, when discussing customer acquisition and determining the critical number of customers, you should: 1.Model revenues and costs to determine the critical number of customers needed for profitability. 2.Conduct top-down market sizing to get informed estimates of the realistic number of customers in your target market. 3.Perform bottom-up market sizing to estimate the realistic number of customers you can reach with your sales team. These three perspectives must come together to create a realistic goal for your business case. 36 37 Lastly, let's briefly discuss how to describe a service business case in a tabular format. This procedure is not strictly defined, but it typically involves using Excel sheets to model your business. You will define the time unit for modeling, which can be monthly or yearly, and then collect and organize the different cost and revenue positions. Here’s a concrete example of modeling a software-as-a-service (SaaS) business. The relevant cost positions include salaries, office costs, infrastructure costs, and marketing costs. You need to answer questions such as: How many people do we need and when? What profiles and salaries are required? How much setup and product development time is needed before serving the first paying customers? Usually, you will have outgoing payments before generating any revenues. For office costs, consider the annual rent and other office supplies. Infrastructure costs might include cloud services like AWS, which can be significant for a SaaS business, as well as legal services for drafting contracts. Marketing costs include expenses for acquiring new clients and fixed marketing expenses such as search engine advertising. All these positions are summed up to an annual total cost figure. This example is based on a startup CEO's shared experience and Excel sheet. He planned on a monthly basis, starting with two people in the first quarter and adding two more in the second quarter, and so on. This is a short-term calculation. Often, you start by modeling on a yearly basis for longer time scales, typically five years or more. In the first year, you will likely not achieve a positive return on investment, so you need to model a scenario where you realistically achieve a positive return over time. 38 We've covered the cost side, so let's move on to the revenue side. This includes pricing assumptions, such as the amount customers are willing to pay for your solution per month. In this example, we assume $1,000 per client per month. You also need a churn assumption to estimate how long the average customer will stay and how many will leave each month. Next, consider the number of new trials. How many companies will you convince to try your solution, and what is the conversion rate from trials to paying customers? With an assumed trial-to-paid conversion rate, you can estimate the number of new customers purchasing the subscription and calculate the monthly recurring revenue (MRR). Let's look at the associated Excel sheets, specifically the second tab in the model. The projections are highly dependent on the assumptions made. For example, a 40% growth rate in new trials is a strong assumption. Similarly, a monthly subscription growth rate of 10% is also quite optimistic. These assumptions are necessary for an initial revenue calculation. From there, you can conduct a sensitivity analysis to see how changes in the monthly growth rate affect your revenue projections. This helps determine if you will still have sufficient monthly revenues under different scenarios. 39 This business also has a second revenue stream: consulting. We have an hourly rate and an average number of billed hours per active client per month. In addition to subscription revenue, we generate consulting revenue per client per month, which depends on the number of clients. In this example, we start with 16 billed hours. 40  Next, you can review both costs and revenues in the profit and loss (P&L) statement. This includes monthly subscription revenues and consulting revenues. Adding these together gives you the total revenue per month. On the cost side, you have salaries, office expenses, IT expenses, and marketing expenses, as detailed in the first tab. Summing these gives you the total cost. From the total revenue and total cost, you can calculate EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). This process is straightforward: you collect all the different costs and revenues, sum them up, and analyze the totals over longer time periods to model when you will achieve a positive return on investment. 41 42