Profitable Revenue is the last of the three categories of revenue, preceded by Referenceable Revenue and Scalable Revenue, that are discussed in other articles in this series. For this discussion, Profitable Revenue refers to the overall net income (actual cash) associated with a sale to a customer. At first glance and according to most definitions, revenue is deemed profitable if its gross margin - the difference between the amount paid by the customer and the cost of goods sold - is positive. Unfortunately, positive gross margin is only one factor that a startup needs to consider. There are many other costs that can have a significant impact on overall profitability.
To be fair, if the gross margin is negative, that is, if the cost to produce the product or service for the customer is higher than the sales price, barring any special arrangements, the associated revenue cannot be profitable. Of course, a sale that involves guaranteed recurring payments can be very profitable despite uncovered, upfront costs. Recurring revenue stream businesses are currently very attractive, assuming the company has the financial resources to initially fund the products or services.
Consciously pursuing negative gross margin business may be acceptable during the early stages of product introduction when the goal is to obtain Referenceable Revenue or before economies of scale begin. Obviously, there needs to be visibility to positive gross margins or the business will not be viable. Adopting a “loss leader” approach only makes sense if the long-term value of a customer is sufficient and highly probable to offset initial losses. For startups, cash is always in short supply and the day may never come when the long-term value of the customer is finally realized.
There is no question that recurring revenue models can be very attractive, especially those that leverage the Internet, cloud computing, and shared services such as Software as a Service (SaaS) offerings. By and large, these models minimize upfront capital requirements and generally are incrementally and affordably scalable. Initial gross margins may be low due to startup costs, but can quickly become profitable as volume increases. Other recurring models such as cellular providers and other similar utilities require huge infusions of capital that must be considered.
Focusing only on gross margin (and product costs) is a convenient, but simplistic metric that does not take into account the “below the line” costs associated with placing the product or service with the customer and providing on-going support. These costs, often incrementally incurred, can quickly consume any positive gross margin dollars. Often, in high growth businesses, these costs may not be obvious with new revenue masking the lagging support costs associated with past sales. When revenue growth slows, the bow wave associated with these costs such as warranty repairs and replacements, past software release support and upgrades, and customer service can easily cause an ever-increasing cash flow drain.
The costs associated with “placing a product” include advertising, marketing, prospecting, direct sales, and other follow-on activities must be considered. One simple but costly component is the number of actual in-person sales calls necessary to identify, sell, and close a prospect. If, for example, a prospect calls and asks to meet with you, the answer is never “I will see you in a few weeks when I can purchase a discount airline ticket”. Sales reps or CEOs of new companies typically will drop what they are doing and fly across the country to pursue a potentially “hot lead”. Often multiple calls are needed to close early adopters. It is easy to lump sales related costs into an SG&A or “overhead” category and never actually focus on the true cost to place a product. These initial high costs may be totally justified in order to obtain referenceable accounts or market traction. Also, the initial processes used may be very expensive and not intended to be the model planned when moving forward. As long as the product placement costs are well understood, they may be appropriate and, in fact, the only alternative.
Not only can costs be higher than anticipated, customer pricing may be lower for initial customers to entice them to buy. In virtually all cases the fear of being “stuck” with lower pricing after offering lower prices is overstated. Today, prospects are used to introductory pricing as incentives for early product adoption. The reality is that even with significant discounts, the overall placement costs will probably dwarf any reduced margin contribution caused by initial discounts.
Assuming adequate operating cash is available (which is a very big assumption), profitable revenue should be not be analyzed at a current, short-term, point in time summation of cash received and costs incurred. Instead, it should be considered in terms of the overall cash generated from the customer for the transaction versus the costs associated with servicing the customer over the life of the engagement. This value is referred to as the Lifetime Value of a Customer (LVC). There is a considerable amount of literature about LVC and how to calculate it. Independent of the method used and its sophistication, the concept is simple; it allows the prediction of Profitable Revenue - the most important metric in a business. But remember, long-term value is only important if there is sufficient cash flow to get to the long-term!