“Compounding is the 8th wonder of the world.” Mitch Rales, co-founder of Danaher.
Brands like Hermes understand how to use compounding effects in their business because they understand a fundamental truth:
Not all customers are equal.
In my previous long post we talked about understanding your Capital → Sales → Capital cycle in order to improve the efficiency of your machine (your company). In this post, I want to talk about leveraging that efficiency through compounding effects to maximize your chances of success.
But first, what does Mitch Rales know?
Danaher has returned an astounding 1800X on invested capital and a 21% annual return over 4 decades. But Danaher doesn’t just make investments. They acquire businesses and then make them better through their unique process honed over decades called the Danaher Business System which seeks to make continuous improvements. These improvements compound over cycles and times.
So, Mitch knows a little something about investing and the power of compounding improvements in a business. You can hear Mitch directly in a fantastic podcast episode on The Art of Investing.
I want to discuss three aspects of compounding:
1/ It’s cycles, not time. Every time you turn your inventory, a cycle has happened. Our lives are structured around measures of time. We have today. We make plans for this week. We budget for the month, quarter and year. As a result, we tend to analyze based on these measures of time. But compounding effects happen in cycles that rarely match our timeframes. So when thinking about compounding effects in your business, think in terms of cycles, not time.
For example, I make an improvement to unit economics that increases profitability. Each time I make a sale, I make 1% more. I do this over thousands and hundreds of thousands of sales and I drive more cash. I invest this extra cash into more inventory and ads and spin the cycle again. My 1% improvement is compounding by the number of cycles I do.
2/ You can’t achieve compounding effects until you dial in the efficiency of your machine as exemplified by the Capital → Sales → Capital cycle. Get it wrong enough and your compounding works against you where each cycle just puts you further into the red. And not having this cycle right means you risk borrowing too much and making getting the cycle right even harder or raising too much and suffering serious dilution.
ASIDE
Like the example above, your unit economics work on cycles determined by the buying behavior of your customers, but are reported in units of time. Your OpEx typically works in cycles that are tied to time, often measured monthly. For example, payroll, rent, utilities, legal, software etc are usually monthly.
The faster you can spin the Capital → Sales → Capital cycle, assuming positive economics, the more cash you will have for OpEx.
Understanding the cycle speeds of your sales, customer acquisition and OpEx will help you better prioritize your efforts at improvement because you will better understand the compounding impacts of the improvements.
3/ The most powerful compounding force is a high value customer base.
Your best customers exert multiple compounding forces on your cycle.
- For the Sales to Cash cycle as measured by FCF / Net Sales
- they buy at higher AOV’s because they buy higher priced products
- they buy at full price and
- they return less.
- they love your brand, so they drive more Word of Mouth and bring in more organic customers.
- For the Cash to Sales cycle as measured by Net Sales / NWC,
- they are easier to plan inventory purchases for because you know them better
- they make more purchases
- they purchase faster
- they love your brand, so they drive more Word of Mouth and bring in more organic customers.
Not all customers are equal
It’s important to understand that these compounding effects happen only with your best customers.
You already know from experience that all customers are not equal. Some are awesome and act like the ones above. Some buy sporadically. Some are discount hounds. Some you never see again and the worst steal from you through fraud.
So, how do you apply this? How do you acquire more best customers and leverage them? How do you use their compounding effects most effectively?
To get to the answers, we will go through these topics.
What is the purpose of a company?
Do you really want to build a brand? Is that what you are doing today?
Customers are your greatest asset. The accounting treatment is misleading (and wrong).
ROAS and MER are not your guiding metrics for brand building advertising.
Cohort analysis is a sub optimal tool. Focus on the brand pyramid.
As we explore these topics in future posts, we are going to challenge a lot of conventional wisdom and accepted practices. But the goal remains the same - to help you as a leader of an omni channel brand maximize your chances of success.
So, let me know your thoughts so we can improve the best practices for everyone’s benefit.
Previous post: Capital, Cash and Growth. Tuning the Machine
Mitch Rales interview: Art of Investing. Mitch Rales - The Art of Compounding
https://www.joincolossus.com/episodes/37099495/rales-the-art-of-compounding