Why care about conversion value?

Fact: The value of your business is no more than the sum of its future profits.

As a business owner, increasing this value–the sum of your future profits–is at the root of every decision you make. As an experienced entrepreneur, you’ve developed intuitions that enable you to “feel” when you’re pointed in the right direction.

You’re good at what you do, and those intuitions should be trusted for good reason. At the same time, having a complete understanding of the relevant conversion values for your business will not only help you to grow the overall value of your business, but will also help you do it with less time, with less waste, and with a higher degree of confidence.

When you know which conversions create your greatest profit increases, you can grow your profits more efficiently!

So what is conversion value?

As we’ve discussed before, conversions can be defined in a number of different ways. In general, a “conversion” is simply the result of a potential client/customer reaching a desired outcome within your sales process.

For the context of this conversation, we’ll limit our look at conversions to outcomes that occur on your website. Even within those confines though, you may define a conversion as a lead. You may want to define a conversion as a completed transaction. You could also define a conversion as the download of your newsletter, or in a number of other ways.

Conversion Value is the simply the amount of profit increase your business will experience as a consequence each time the event being measured as a “conversion” occurs.

How is conversion value calculated?

Conversion value is calculated differently based on the lenses that you’d like to look through. In the short term, the calculations are a bit more simple, but it is generally wise to take a bit of extra time and care to calculate the long term relationship between additional conversions and your profits.

Here comes the math, but don’t lose focus. It is easier than it may appear at first glance. After we define a few terms necessary to calculate conversion value for a specific product or service, we’ll run through some examples that reinforce the concept in simple terms.

Average Deal – Revenue collected on average per new sale
Closing Ratio – Sales / “Conversions” (the % of “conversions” that become new sales)
Profit Margin – Profit / Revenue (the % of revenue that is profit)

Short Term Conversion Value =
Average Deal X Closing Ratio X Profit Margin

While many businesses would end the analysis here, it is crucial to look at things from the long term perspective as well. Defining metrics like Customer Lifetime Value is necessary to properly study the consequences today’s marketing will have on tomorrow’s profits.

Lifetime Repeat Business – Average revenue per customer following initial deal
Customer Lifetime Value – (Lifetime Repeat Business + Average Deal) X Profit Margin
Word-of-Mouth Multiplier – % of additional revenue created through word-of-mouth gains

Long Term Conversion Value =
Lifetime Customer Value X Closing Ratio X (100% + WOM Multiplier %)

What is conversion value in my business?

So why is all of this math important to your business? Again, it helps you make sound decisions, increase future profits, and in turn, grow the value of your business.
How does it work?

Let’s consider the example of ACME Manufacturing Inc. ACME produces Widgets and Gizmos. In the following examples, we’ll define a “conversion” as a new lead generated online.

Below we can see how ACME will use its marketing and accounting data to calculate conversion values for both product lines.

Widget Conversion Value:
Average Deal – $3000 average initial deal
Closing Ratio – 20% of new online leads result in a new deal
Profit Margin – 35%

Short Term = $210
Average Deal X Closing Ratio X Profit Margin
$3000 X 20% X 35%

Lifetime Repeat Business – $8000
Customer Lifetime Value – ($3000 + $8000) X 35% = $3850
Word-of-Mouth Multiplier – ACME research indicates a 15% value increase through WOM gains

Long Term Conversion Value = $885.50
Customer Lifetime Value X Closing Ratio X (100% + WOM Multiplier %)
$3850 X 20% X 115%

Gizmo Conversion Value:
Average Deal – $1500
Closing Ratio – 28%
Profit Margin – 44%

Short Term = $184.8
Average Deal X Closing Ratio X Profit Margin
$1500 X 28% X 44%

Lifetime Repeat Business – $6500
Customer Lifetime Value – ($1500 + $6500) X 44% = $3520
Word-of-Mouth Multiplier – ACME research indicates a 22% value increase through WOM gains

Long Term Conversion Value = $1202.43
Customer Lifetime Value X Closing Ratio X (100% + WOM Multiplier %)
$3520 X 28% X 122%

So what is the value of this data for ACME?

The profound value in this data for any business is that it quantifies marketing efforts in terms of profit increases. We can see that even though the short term value of a Widget Conversion is higher, the long term value of a Gizmo Conversion is higher. This could prove to be very valuable information when choosing how to allocate a limited budget for example.

BONUS TIP:

It is important for ACME to understand its cost of acquiring a conversion as well. The Cost-Per-Acquisition metric simply measures the amount of money ACME will spend on average to generate a new conversion. In this case, the cost to acquire a new online lead.

Having an understanding of acquisition costs also allows ACME to study the Return on Investment (ROI) for its online advertising efforts promoting Widgets and Gizmos.

Let’s assume that the CPA (Cost-Per-Acquisition) structure for ACME looks like this:
Widget CPA – $175
Gizmo CPA – $200

Short Term Widget ROI – ($210 – $175) / $175 = 20%
Short Term Gizmo ROI – ($184.80 – $200) / $200 = -7.6%

Long Term Widget ROI – ($885.50 – $175) / $175 = 406%
Long Term Gizmo ROI – ($1202.43 – $200) / $200 = 501%

This example illustrates why measures like Customer Lifetime Value are so important. When only evaluated in the short term, the Gizmo campaign appears to be unprofitable. When evaluated properly in the long term, it has the highest ROI.

At the end of the day, ACME’s numbers suggest that the advertising campaigns for both Widgets and Gizmos are profitable. In most cases, unless ACME were facing inventory issues or other environmental challenges, a common approach would be to to continue increasing the monthly budgets in both campaigns as long as ROI remains positive.

Because it has a clear understanding of how its online advertising efforts directly impact it’s profits, ACME can develop the right strategy to grow the company’s value with the highest efficiency and confidence.

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