Economic Model Part 6: Characteristics of Attractive Economic Models
January 11, 2012
This is the Sixth in a series of posts that I am writing aimed at helping entrepreneurs maximize their economic performance. You can find a summary of the full economic model series here . My last post described the characteristics of the best spreadsheet models . This post describes the characteristics of attractive economic models.
Characteristics of Attractive Economic Models
How do you know that you have an attractive economic model?
The ultimate economic model has 5 characteristics:
1. Your cost of acquiring new customers is low relative to the cash flow that they generate for you once they become customers. This is a pretty simple idea, but really important to capital efficient growth. To grow, you generally need to invest cash against growing your go-to-market engine (some combination of sales and marketing) and that investment is returned by new customers giving you cash in the form of gross profits (customer revenue less the costs that you have to serve your customers). The better the return on investment per unit cash invested in new customer acquisition, the better your economic model.
2. Your existing customers have high gross profits/margin. The more gross profits (again, customer revenue less the costs that you have to serve your customers) that you get from your existing customers, the better your economic model.
3. Your Customers stay with you for a long time and increase their business with you over time. The longer your customers stay with you and the more you grow your gross profits from them over time, the better your economic model.
4. You can get away with a small amount of R&D for your existing customer segments and still maintain/grow your competitive advantage to your current customer segments. Assuming that you are maintaining/growing a reasonable competitive advantage over your current and potential competitors, the lower your R&D spending relative to your gross profits for your current customer segments, the better your economic model. This is a tricky point, as you do need R&D spending to maintain/grow your competitive advantage and make sure that new competitors can’t easily come in and take away your market. Also, you may have R&D investments separate from the R&D spending associated with competitive advantage aimed at your current customer segments (that might open up new segments, help to improve aspects of your economic model, or be associated with some other benefit to your business).
5. You can grow in your current customer segments for a long period of time (the longer the better). The longer you can grow your current business with the same economic model performance, the better your economic model. Another way of saying this is that you want a large enough target market.
If you don’t understand these 5 basic economic model components for your business, then you have some work to do if you really want to get on top of your complete economic model. If you understand your economic model, but you don’t have to have all 5 characteristics that create the best economic model, then your understanding can lead you to some management focal points. For example, you should be able to generate some insights on areas of your company that you could be working on to achieve a better economic model and the insights will also be helpful in determining your growth strategies going forward (more on this in later posts).
Note that I have specifically NOT included either the level of sales and marketing investment or the R&D associated with developing new customer segments as part of judging the attractiveness of your economic model. These are investments that need to be looked at separately so that you can more clearly judge the attractiveness of your economic model. In other words, you can have a great economic model while having a high level of investment in sales and marketing, R&D, and/or investments other areas of your business, but in order to judge the attractiveness of your economic model, you need to sharply look at your economic model by ignoring the level of the investments that you are making.
The most attractive economic models have low cost of customer acquisition, high gross margins, and customers who stay with you and build their business with you over time. In addition, the costs associated with running your business and increasing your competitive advantage are small relative to the gross profits that you make as a business, offering you a great bottom line opportunity now or in the future. Finally, you have a market size that is large enough for you to grow for a long period of time. If you have all of these characteristics, you are all set. If you don’t, perhaps their are some insights that you can identify that will help you to improve your business.
My next post: “Everyone Loves an Economic Engine”
If you want to learn more about economic models, keep reading. I would also appreciate any comments or suggestions that you have, as I plan on turning this series into an e-book and I want to make sure that it is as clear and complete as possible.