This post first appeared on the VCCircle blog here. I have added some additional thoughts below based on some feedback and questions I got.
In an earlier post I had talked about a key difference between developed and developing economies being that startups in developed economies can buy products and services on a purely variable cost basis. In this post I am going to focus this observation on cost of collections and how it impacts life-time-value (LTV) of a customer. LTV and corresponding customer acquisition costs are critical to determine long term financial viability and strength of the business. The general method to calculate LTV is to have a model for lifetime revenues and subtract from it cost-of-good-sold (COGS) to come up with the LTV number. In economies like the US it is typical to not include collections costs in these calculation because regardless of the type of business (B2B, B2SMB, B2C) or transaction amount ($0.99 song on iTunes to $100K B2B billing) the collections costs is purely variable and in steady state is about 1-2% of revenues so it doesn’t really materially affect the LTV calculation. This has been made possible by the omnipresence of electronic payment methods where the marginal cost of closing a transaction is minuscule; a reliable and enforceable credit rating system for consumers and business; and finally a law enforcement framework which provides the necessary the carrots and sticks to consumers and businesses to follow through on contractual obligations.
This framework does not necessarily apply to developing economies, certainly not to India. Vast majority of the transactions in India are in cash with very little penetration or growth of electronic payment systems. As a result most collections in the B2C space are done at retail locations or using COD etc which in turn require follow up reconciliation and management. But the key characteristic is that there is a FIXED minimum cost per transaction after which the cost becomes variable. In other words:
- For electronic payment methods, cost of collections = 2% of transaction amount
- For cash collection methods, cost of collections = MAX of (Rs100, 1% of transaction amount)
This has a very meaningful impact on LTV calculations especially when transaction amounts are reduced. Let me illustrate this with a comparison between three scenarios, one where collections is purely variable cost, one where there is a fixed minimum but low number of transactions and one where there are high transactions.
As can be seen from the table, the 3rd scenario dramatically changes the complexion of the business even though in all three businesses the revenues and COGS are the same.
Getting rid of that minimum amount per transaction in India is non-trivial. As I mentioned earlier this will require electronic (automated) payment methods, which in turn require robust credit rating institutions and which in turn require reliable law enforcement. All this is beyond the scope of the startup ecosystem. At Canvera we focus heavily on high transaction amounts for cash transactions, provide incentives to make electronic payments, only go after business that we see annuity value in so that over a period of time we can optimize the cost structure, and try to collect advance deposits where possible. This is work in progress and after 3 years of investments in technology, processes and infrastructure we unfortunately still don’t have the scale and cost structure that a purely electronic payment network can provide. But we are acutely aware of these costs and factor them in our calculations.
After the post first appeared on the VC Circle blog I got quite a few questions and I’d like to address one of them around the minimum cost per transaction I talked about earlier. I’ll consider two separate cases: COD and Retail payments.
Minimum cost per transaction in COD
There are many sources of this minimum cost and these include:
- Cost for a person to show up at a residence/office is fixed and not dependent on the amount being transacted.
- Customers refusing the product when the delivery/cash collection person shows up or simply having to make multiple attempts at delivery/collections
- Fraud: for the economics to work the person delivering cannot make a lot of money. At the same time increasing their “throughput” means allowing them to handle larger and larger sums of money which in turn creates perverse incentives. And adding more checks and balances adds more cost. There are other sources of fraud that are inherent with cash handling and reconciliation even after the money has been safely delivered to an office.
- Cost of reconciliation and properly matching with the right order. This is a fixed cost independent of the transaction amount
- Fake currency: as the business scales this issues shows up very quickly – in fact in all of Canvera’s regional offices have fake currency detectors since there was non-trivial fraud