The advantage of recurring payments

One of the best things about payments in the UK is the ubiquity of the direct debit system. From gym memberships to contact lenses to television licenses, all sorts of subscriptions are sold on a direct debit based model.

The mechanism is simple – the merchant, with the consent of the customer, sets up a direct debit system with the customer’s account such that a specified amount is debited periodically. This direct debit system can be cancelled at the customer’s discretion, resulting in automatic annulment of the subscription.

This is a great business model because it allows businesses to acquire customers for a repeated transaction, without the latter having to commit for too long a period.

The key feature of the direct debit system is the customer opt out. That the account will be continued by default means that it takes explicit action by the user to terminate the subscription, which helps the business acquire customers with the cost amortised over several time periods. The any time opt-out feature (which the user can do at her bank’s website or app, without consent of the merchant) means that the commitment at any time for the customer is for one period only, making the product an easier sell.

In the absence of the recurring payment based model, the business will either have to offer short term “subscriptions”, which implies a customer acquisition cost at each period, or long term contracts, which takes a higher upfront commitment from the customer making it a much harder sell.

In that sense, a recurring payment model offers a nice middle ground, resulting in value being unlocked for both the business and the customer, resulting in enhanced welfare all around.

In that sense, the lack of a recurring payments system is a key shortcoming of the payments scene in India. While it was possible to do this earlier, current rules by the Reserve Bank of India require authorisation by the customer (in the form of two factor authentication) for every transaction, making them opt-in rather than opt-out (the opt-out feature is key to amortise customer acquisition cost).

The updated version of the unified payments interface (UPI 2.0) was supposed to offer this recurring feature, but media reports say that the update is being rolled out without this feature. That is surely an opportunity missed for India’s businesses to grow.

Two kinds of Customer Acquisition Cost

A few days back, there was a story in Mint (Disclosure: I write regularly for them, and get paid for it) about Urban Ladder’s increasing losses. This was primarily on the back of increased marketing expenses, the report said.

Losses at Urban Ladder Home Décor Solutions Pvt. Ltd grew eight times to Rs.58.51 crore in the year ended 31 March from Rs.7.62 crore in the year-ago period, according to data available with the Registrar of Companies. Revenue rose 60% to Rs.19.21 crore from Rs.11.88 crore.

Advertising and marketing spending accounted for more than half of its expenses of Rs.77.72 crore. The online retailer spent Rs.40.24 crore on marketing, a whopping 11-time increase from Rs.3.57 crore a year ago. Employee costs surged to Rs.16.58 crore from Rs.4.69 crore.

With the startup madness starting to be tempered, with some companies (such as SpoonJoy) shutting down, others scaling back operations (TinyOwl, FoodPanda) and some others firing lots of employees (Helpchat, LocalOye), one of the big concerns in the startup ecosystem is “cash burn”, with a large part of the burn in most companies being accounted for by the cost of “acquiring” customers – you need to let your potential customers know that you exist, and get them to try you out in the hope that they become your regular customers.

All this is in the hope that once you “acquire” a customer, he will become a regular customer and so you defend your spend to acquire him (“customer acquisition cost”) based on the total profits you can make from him over a long period of time (“Life time value”). It’s not uncommon nowadays to see “CAC” and “LTV” being mentioned liberally in LinkedIn posts.

The problem with a lot of startups is that they continue to give “inaugural discounts” well after inauguration in order to achieve higher growth and customer base, only to see these customers disappear when the discounts disappear (US-based HomeJoy is a good example for this). In fact, I had written recently on the “optimal extent” to which a company should discount its products (the level at which the company can be profitable in “steady state”).

The thing with Urban Ladder is that while they are currently spending a lot of money to acquire customers (and a lot of it is through hoardings, known to be among the least effective ways to advertise),  they are not going the discount way. In other words, while they may have the odd seasonal discount the customers they acquire through their marketing activities still have to pay full price for the goods they purchase.

What this means is that customers once acquired have a higher chance of sticking on as long as they like their product – which is likely if Urban Ladder is doing a good job of designing products and marketing them to the right kind of customers. Even if Urban Ladder is going to cut down its customer acquisition spending at some point in time, that will only have an effect on the new customers being acquired, and existing customers will remain in the system.

Contrast this with a customer acquisition strategy built around discounting, where once the acquisition spend falls, existing customers are also affected and become more likely to exit the system.

So while it is fashionable to talk about “customer acquisition cost”, how this cost is incurred is important in determining how long the customers will stay. Spending on “third parties” (!= customers) to acquire customers is more sustainable than spending on customers. It is important to take this into consideration while determining if a company’s acquisition spending makes sense.