Value of Recurring Revenue vs. One-Time

Discussion in 'Growing and Managing a Business' started by nickcoons, Feb 17, 2013.

  1. nickcoons

    nickcoons
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    We offer some services that generate recurring revenue, and others that generate one-time revenue at the time of sale. Obviously a sale that results in a recurring revenue of $5,000/month is more valuable than a sale that results in a one-time revenue of $5,000. And obviously, a sale that results in a one-time revenue of $5,000 is more valuable than a sale that results in a recurring revenue of $1/month.

    What I'm trying to do is figure out how to calculate where that line is so I can focus my company's resources. Am I better off with a one-time $5,000 revenue, or a recurring revenue at $300/month? Most of our recurring revenues or open-ended (i.e. subscribing to a service) and so don't have a specific ending time.. the service continues until the client no longer sees value in it (and we work to make sure that never happens). In two years of business, we have yet to have a client discontinue any of our recurring services, so I don't even have data to figure out how long, on average, a client will stay with the service. I'd like to think that no client will ever cancel, but I doubt we're achieve that 100% success rate.

    In calculating this, I have to somehow take into account an average length of time (where it's open-ended, is there a standard method here?) of supplying the service as well as the value of having the money now vs. later. (i.e. $5,000 right now is better than $500/month for 10 months).

    I'm interested in ideas on how to make these calculations.. thanks!
     
  2. BacklinksInc

    BacklinksInc
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    Sorry but this is the biggest no brainier. OFFER BOTH MAN!, why miss out on cash over something so silly. You make the packages and let the client decide, meanwhile working on funneling traffic or something else more constructive lol
     
  3. nickcoons

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    Is this supposed to be a serious response? Knowing how to calculate the value of recurring revenue is important. I'm not sure why you casually dismiss it as silly.

    In the midst of a sales meeting, I offer whatever the client needs regardless of my internal revenue model. This has nothing to do with my question. My question revolves around calculating what a sale is worth. When you sell something, don't you want to know how valuable that sale was? Is that silly information?
     
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  4. ArcSine

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    Assuming you've accounted for any cost differences (such as any administrative expenses you incur with respect to a recurring revenue stream--e.g., monitoring costs, client communications--and diffs such as the timing of how commissions are doled out in a one-timer vs. a recurring revenue sale) and you're thus stating your revenues in 'net' terms, then you'd do your comparison on the basis of "present value".

    The computations are trivial; the tricky part is estimating an appropriate discount rate. In addition to the previous Wiki link, you might Google the term "present value" for more insights into this point. But in general, the discount rate will be a function of the degree of uncertainty associated with a given revenue stream. (To your advantage, while estimating discount rates is an entire topic unto itself, you won't need to make a career out of researching it to the nth degree. For the scenarios you've described you'll find that your calculations are pretty insensitive to variations in the discount rate, within reason. Just use any rate which kinda-sorta makes sense with respect to the riskiness of your clientele, and that'll be plenty good enough.)

    Just to toss out a couple of examples (and supposing that 10% annual, compounded monthly, is a good discount rate)....

    • A 20-month stream of 272.45 has the same economic value as a one-time revenue of 5,000.

    • If choosing between having the customer pay 5,000 up front, vs. 400 per month, you'd need the monthly option to extend for at least 14 months in order for it to provide you with greater economic value than the up-front option. At 13 months, the 5k-immediate wins by a nose.

    Both of those calcs follow immediately from the 'present value of an annuity' formula you'll see on that Wiki link.
     
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  5. Ted

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    There are other things to take into consideration too though other than just raw numbers. Aren't there?

    For instance, is it easier to sell a client a one-time $5,000 product or a product that costs $300 per month? My guess is that you will find it much easier to sell the $300 per month model.

    Also, what are your recurring monthly costs to service this customer?

    If you have ongoing costs built into your business model, then certainly a model based on a monthly fee would make more sense. Wouldn't it? Because, what are you going to do if your monthly cost to serve a client doubles unexpectedly? Would you need to increase the price of your onetime offer? Would you end up losing money because of a low priced onetime offer?

    Another thing to consider…

    A business that has a steady monthly income is far easier to manage than a business that has up months and down months. Steady cash flow is the envy of every businessman.

    For your situation…..

    I would think this would be a relatively easy decision.

    There is a reason why car dealers advertise their cars as being $399 per month instead of $38,000. They make more money on the monthly sale and it is easier to convince a customer to purchase.


    If you really want to break it down into simple math then do this:

    Take your profit from your onetime sale. Calculate what your return on investment is going to be if you were to invest that money over the next one year, two years, three years, four years, etc. Plot it on a chart or a spreadsheet.

    Take your profit from your monthly sale. Calculate how much profit you add up month after month after month over the same period of time as the onetime investment. Plot it on your spreadsheet also.

    That will give you a really easy comparison to look at when deciding whether to charge per month and how much to charge per month.
     
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  6. nickcoons

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    Thank you, ArcSine and Ted, for your responses. To provide a little more information, the numbers I'd be inputting into these calculations are the net amounts. So if I make a one-time $5,000 sale, I'd be looking at $5,000 minus all of the costs associated with generating that sale (cost of goods, payroll, commissions, etc). The same would be true for recurring (taking into account administration, etc). That part seems trivial.

    I guess what I'm not sure how to calculate is the cancelation rate since I have no data with which to guess, because none of our clients have canceled.

    What I did last night was put together a spreadsheet where I enter in the monthly net amount, the monthly cancelation rate, and the annual inflation rate. So if the net is $100, the monthly cancelation rate is 1%, and the annual inflation rate is 5%, then in month one the subscription is worth $100, in month two it's worth $100 - 1% of $100 - 1/12th of 5% of $100, in month three it's worth $(month 2) - 1% of $(month 2) - 1/12th of 5% of $(month 2), and so on until I calculate it out for 1, 2, 3, 4, and 5 years (or however long I want). Each month, the value goes down because as more time passes, the risk of cancelation increases as does the toll taken by inflation. Then I just sum it all up. Does this look like a valid approach?

    The inflation rate is easy enough to plug in because there's plenty of data there. But the 1% cancelation rate is where I have trouble, because the cancelation rate over two years is 0%. I know that won't continue (as good as we are, someone is going to cancel sometime :) ). Do I just have to pick a random number that sounds good until more time passes and I tweak it in the future? Ted, is the "discount rate" you were referring to? If so, I agree that calculating it seems tricky given the lack of data I have.
     
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  7. ArcSine

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    You're sorta warm to the right track, conceptually, but you're probably making it a bit tougher on yourself than need be. If you simply want to compare the true economic value of some cash flow stream of a fixed monthly amount X, against a single immediate cash receipt of Y, the 'present value of an annuity' formula I referred you to earlier has your calculation neatly tied up in a closed-form solution.

    If Excel is your spreadsheet weapon of choice, use the following built-in function (all of the popular spreadsheet apps have this function, and the syntax may be identical or slightly different):

    =PV(A1 / 12, B1, -C1) (just be sure to put the formula in any cell other than the three input cells).

    ...where...
    • Cell A1 contains an appropriate annual discount rate (more on that in a minute);
    • Cell B1 contains the number of months you assume a particular payment stream lasts; and
    • Cell C1 contains the fixed monthly payment amount (and yes, insert a negative sign before "C1").

    The result of that function, given those inputs, is the single immediate amount which has the identical economic value as the monthly payment deal you've loaded into Cells A1, B1, and C1. Just as a test, try it out on a hypothetical monthly deal that calls for 30 monthly payments of $200 each, and assuming a 10% annual discount rate. Your result should be 5,289.41, which is the upfront one-time payment to which you'd be indifferent as to receiving the one-timer or the monthly deal.

    By fiddling with the quantity in Cell B1 you can run immediate "what-ifs" on different lengths of time (duration of a contract), since that's one of your "anybody's guess" variables. For example, changing B1 from 30 to 20, say, shows you that if you'd expect the client to stick with the program for just 20 months rather than 30, that's economically equivalent to an upfront payment of about 3,670. (Hence, if you could sell 'em on a one-timer of 4,000 in lieu of the monthly arrangement, better for you.)

    Your approach---laying out everything explicitly, month by month, across a spreadsheet---isn't wrong, but it overlooks a convenient shortcut. Because your client's contracts involve fixed monthly amounts, their valuation reduces mathematically to a simple closed-form solution, one which happens to be built into Excel and other spreadsheet packages (as you probably guessed, the "PV" in the function's call stands for "present value"). And so comparing a 20-month duration to a 30-month deal is as simple as changing Cell B2, rather than setting up 50 or so rows of individual monthly calculations.

    With respect to the discount rate you use in the calcs (Cell A1), choose an interest rate you'd probably charge if you were to loan money to that customer for 2 - 4 years. Note that you'll probably start by guessing what rate that customer could obtain borrowing from a bank, and then you'll add a few percentage points to allow for the additional risk you'd bear vis-a-vis a bank (your hypothetical loan would be subordinated and unsecured).

    With this approach you gain another nifty shortcut: the inflation factor is built in. Interest rates, as quoted by banks and other lenders (i.e., your starting point, as I mentioned) include a cushion for the inflation expected to be realized over the loan's duration.
     
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  8. Ted

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    Here is another way to approach your dilemma.

    Consider what the market will bear.

    What price are you selling your service for if it is one-time? Calculate your profit based on that sale.

    What price would the market bear for your service if you were selling it per month instead of onetime? Calculate your profit assuming a period of two years as a starting point.

    Which pricing option earns the most profit?

    I suppose you could account for inflation devaluing future dollars or account for opportunity cost if that money had been invested elsewhere, but I think the difference in profits will make the whole inflation analysis and opportunity cost analysis kind of pointless.

    I think you will find that the monthly option far out-earns the onetime payment option. Also, any additional time frame beyond that two year mark is pure profit.

    I have a feeling this will make your decision a lot easier.

    And remember, you don’t want to base the price you charge customers on how much it costs you to perform the service. You want to base it on the price that people are willing to pay. Try to find the sweet spot in the price/sales curve for maximizing profit.
     
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  9. nickcoons

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    Thanks again for both of your replies.. the information provided is very helpful, and I think I have my questions answered!
     
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  10. scifi

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    Have you heard this saying

    Eat the hen at once or keep eating the egg laid by hen on periodical basis, choice is your, trade off is between hen and eggs...

    I think I am making a reasonable point here..
     

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