The article features a twenty-four year old single mother woman, who speaks no English. She has two young children and is the target of the mayor's new program. The woman wants to get her GED and then become a teacher. With her situation, that is about as likely as my left butt cheek becoming the queen of England. Actually the odds in Las Vegas favor my butt cheek.
Only a population called Baltimorons could elect a mayor this stupid. Her plan will attract lots of people for sure and grow the population, but what type of population will she attract? She will attract lots of people, who need lots of government services and pay next to nothing in taxes. How will she pay for the expansion of government services? She'll raise taxes on the affluent.
Most affluent people don't become affluent by being stupid. When the mayor raises taxes they'll leave. The net effect of the mayor's program will be an increase in poor people and a decrease in the affluent. Before long Baltimore will be bankrupt. If you own any Baltimore muni bonds, now would be a good time to dump them.
Commercial businesses unwittingly do the same thing with customers that the mayor of Baltimore is doing with her constituents. They drive out good customers in favor of bad customers. In the insurance industry, this is called adverse selection. Please forgive me if I've used this example a few times before.
Let's say you own a life insurance company, and you decide that you don't want to discriminate against anyone in your potential customer pool. So you decide to insure anyone. Of course, you realize that to do that, you have to raise your rates as you'll be insuring terminally ill cancer customers as well as healthy young customers. You figure that the higher premiums you collect from healthy customers will offset the losses from insuring terminal cancer patients. The math all works out just fine except for one factor.
You have competition. Your competitors, who refuse to insure terminal cancer patients, will undercut your prices for healthy customers. All your healthy customers will leave for the lower premiums leaving you with only terminal cancer patients. Now your business model doesn't look so good. While this seems like an extreme example, small businesses make similar mistakes all the time. They work hard to attract exactly the wrong types of customers.
One of the mistakes is offering coupons and incentives to new customers only. To show why this is a problem, let's use my favorite business as an example, the doggie do do pickup business. I wish I owned one of these franchises. I can't imagine anything more joyous than driving to the office each morning to manage a workforce whose best career option was picking up dog feces. It must be nirvana. In an earlier post, I examined the business model behind the doggie do do pickup business. If you haven't read that one, please take a look.
Let's assume you are fortunate enough to land one of these franchises. Let's also assume you have two competitors. All three business have one hundred customers, and all three businesses provide the same great level of do do service. All three businesses also want to grow and start marketing campaigns offering discount coupons. Your two competitors offer a 10% discount to new customers only, but you go against the grain and offer a 10% discount to your returning customers as well.
Here's what happens from a Boolean logic standpoint. If you're not familiar with that term, find a sixth grade math student. Since all of you provide the same level of service, you are all competing on price. Your two competitors will each get new business by taking it from each other. However, eventually your two competitors will run out of new business to get. They have to constantly refresh their customer bases with new customers, who will then leave to get a 10% discount somewhere else. Eventually, all of the customers end up with you since you are offering your repeat customers the 10% discount to stay. You eventually steal all of your competitors' customers, who never leave you.
Your competitors were practicing adverse selection. They were trying to attract new customers with an offer that created an incentive for existing customers to leave. Early in our CPA practice, we did the same thing. We offered new client discounts through Money Mailer.
After a couple years of doing this, we learned the lesson you just learned in the doggie do do example. We were attracting new clients who were price sensitive. Most of the clients we got from the direct mail offer didn't come back the next tax season. They left for someone else's discount offer, and they had plenty to choose from.
Here's a little insight about the CPA business. We don't make much money the first year we have a client. We have to examine prior year tax returns and look for carry forward items like tax credits. We also aren't very familiar with a new client's financial affairs and have to do a lot of digging to make certain we aren't missing any potential deductions. We spend much more time each year on new client returns than on repeat clients with whom we are very familiar. First year clients are expensive to service.
Here's where adverse selection comes in. Our mailer was attracting exactly the wrong type of client for us, We were getting one and done's, our least profitable type of client. Since we aren't the brightest guys on the planet, it took a couple years for this to sink in.
Now we do something entirely different. We don't offer incentives for new clients. We offer incentives for existing clients. We give a $50 gift card for referrals from existing clients. This program accomplishes a number of really great objectives for us. First, it makes existing clients aware that we are looking for new clients. $50 isn't much of a financial motivator for our mostly affluent client base. If they don't like us, $50 isn't enough to motivate them them to give us referrals. But, it delivers the message that we value their referral efforts.
Second, and perhaps even more important, good clients refer other good clients. Our absolute best clients come from referrals. At one point, I took a look at the eventual number of clients I got from one existing client. The resulting total of referrals from other referrals totaled more than twenty from this one original client. Better yet, these clients came back year after year. Our best marketing expenditure had nothing to do with approaching new clients. We got a lot more for our marketing money by spending it on existing clients. No more adverse selection for us.
After almost a week of Redskins training camp, I am VERY disappointed with RGIII. He has yet to throw a touchdown pass in the NFL. You say, “But Frank, they haven't even played a single game yet.” I don't accept excuses. Where's Babe Laufenberg when you need him? Probably still fishing in Mexico. Long time Skins fans will get that reference.
As always for real tax and accounting advice, please visit our S&K web site at www.skcpas.com. Thanks for reading!
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