4 Steps for Calculating Customer Value
We’re finance guys at heart, but we’ve learned that metrics such as operating profits, EBITDA, and revenue growth can only approximate the real performance driver of your business: customer value.
Understanding customer value is by far the most important thing you can do to identify ways to grow your business. If you understand the value of your customers you can:
- Determine which customers to invest in
- Identify new customers and markets to target
- Agree which product and service lines should be offered and promoted
- Change pricing to extract more value
- Identify the unprofitable customers you should “fire”
- Understand where to cut costs and investments that are not generating growth
In fact, a robust understanding of the lifetime value of each of your customers can provide an even clearer view of the value of your business, plus the potential opportunities to increase value going forward.
Here’s how we develop a detailed understanding of the lifetime value of our customers:
Step 1: Calculate the profit contribution of each customer in the current year
Determine revenue per customer minus any attributable costs to servicing that customer, including cost of goods, cost to service, etc. If you don’t have customer-level financials in your accounting system, do your best to roll up financials across product segments. If you are in a business with hundreds or thousands of small customers, develop a set of customer segments by rolling up product lines or estimating the buying patterns of various customer types.
Step 2: Develop a realistic estimate of how long you might retain each customer
The relative duration of a customer relationship is more important than the absolute timeframe. Determine which customers are more loyal and which are likely to be repeat buyers and how often they buy.
Step 3: Estimate the cost to acquire or retain the customer
Some customers may require large discounts or heavy marketing investments up front, but little or no cost to retain. Others may require a costly reselling effort every month. Estimate the cost of this on a yearly basis.
Step 4: Do the math
Build a simple cash flow model combining yearly contribution projections, costs to acquire or retain, and continue the cash flow for the projected life of the customer relationship. Be sure to subtract an “overhead charge” for your total operating costs and include any capital costs if customers require incremental capital investment (e.g., working capital or equipment). Discount future years at a reasonable cost of capital (8-10 percent is usually a good number to use—no reason to get too technical).
Most businesses are surprised by how many customers are unprofitable when they create a “fully loaded” estimate of customer profitability. Businesses are also likely to find drastic differences in the value of various customers and segments.
This calculation of customer value may cause you to question many of your previous investments and give you a better view of where to allocate future investments.
KARL STARK AND BILL STEWART | Columnist | Co-founders, Avondale
Karl Stark and Bill Stewart are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree.