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The One Year, Thirty Minute Challenge :: Week 27 :: Finance :: Lifetime Customer Value

I remember it vividly. I was a freshly minted consultant. It was one of my first engagements. The client’s business was growing quickly, but at the end of every month, he barely had any money left.

So, I did an individual profit and lost statement for every single customer. I did some quick math and calculated the percent of each revenue dollar (at his current volume) that went to cover fixed costs, then applied the remainder of that dollar to the variable costs associated with each individual customer. Not a perfect methodology, but it worked well for quickly flushing out the problem. Eureka – the lightbulb moment. For every revenue dollar from the client’s biggest customer, he was breaking even (the reasons why are interesting, but that’s another story for another day). The more this giant customer spent, the more my client “broke even”. We applied the same methodology to every other customer and even found a couple that he went backward on for every dollar the customer spent.

I’m a strong proponent for a P/L for every customer. I realize it only makes sense in certain industries, but if it works in yours, you should do it.

That’s not the topic for this week’s One Year, Thirty Minute Challenge, but that type of math is at the heart of this week’s exercise.

In many industries, a company is upside down financially when they first begin a relationship with a customer. The costs associated with marketing, advertising, selling, onboarding and servicing the customer the first time exceed the revenue from the customer’s initial purchase. Hopefully, just a few purchases in, the company is right side up and making money. In the course of calculating the acquisition and onboarding costs, the company should be projecting and making customer experience decisions based on the potential lifetime value of the customer. Loyal, happy customers, depending on the industry, could represent a lifetime revenue stream of 1000s, 10000s or even 100000s of dollars. Happy customers tell their friends. That can translate into even more lucrative customers.

This week’s One Year, Thirty Minute Challenge is to identify the factors that constitute the lifetime customer value calculation for your products and services.

Let’s jump into this week’s exercise.

  • What are the costs associated with acquiring a new customer? Depending on your industry, it could include annual marketing and advertising expenses (divided by the number of new customers each year), direct selling costs (lead generation, sales technology, sales salaries, sales commission), onboarding costs (customer training, installations services).
  • What does the customer pay for the product?
  • How many times will the customer buy the product? What is the range from the most sporadic customer to the most loyal customer?
  • What does it cost to produce each copy of the product? Depending on your product or service, it will include cost of goods sold, plus additional costs for packaging and delivery.
  • What does it cost to service already acquired customers? There might be customer service calls, technical support calls or costs for billing and collecting.

 

The math should look something like this –

Number of times purchased * purchase price

– number of times purchased * cost of goods sold (and additional costs)

– initial acquisition costs

– ongoing support costs

= total lifetime value

You’ll probably want to do some math that’s similar to what I did in my initial illustration to reduce the top line purchase price number to reflect the impact of fixed costs.

So, what do you do with this information once you have it? Here are some ideas –

  • What are the primary drivers of purchase frequency? How can we move less frequent purchasers to more frequent purchasers allowing us to spread the acquisition cost over more units and consequently increase lifetime customer value?
  • Can we draw any correlation between purchase frequency and acquisition costs or support costs? Does a more expensive acquisition equal a more frequent purchaser? If so, maybe the extra acquisition cost is desirable? Maybe there’s an inverse relationship between frequency and support cost – the more they use the product or service, the less they need support.
  • If a customer is ready to defect, what can we do to save them? Is there any correlation between defecting customers and their use of support? Based on their potential lifetime customer value, what can we afford to spend to keep them?
  • How can we leverage the personal networks of high total lifetime value customers to find more like them? They should be our best brand ambassadors.
  • Since high total lifetime value customers have demonstrated a willingness to spend money with our company, are there other products or services that might be of interest to them?

 

Once you’ve completed your exercise, begin educating your team on the importance of lifetime customer value. The first time that new customer walks through the door could be the beginning of a long and profitable relationship. Treat the opportunity that way.

The One Year, Thirty Minute Challenge :: Week Three :: Finance :: Fixed Costs vs Variable Costs

I hesitated to do this one and especially hesitated to do it early in The One Year, Thirty Minute Challenge because it surfaces most frequently with solopreneurs (or those with just a handful of employees). Larger and older companies have already figured it out or else they wouldn’t still be around. However, when I’ve seen it with past clients and corrected it, the results were so dramatic (it’s been the difference between staying in business and going out of business), I felt like I had to share it early on.

It’s really just a math problem. Instead of explaining, let me illustrate and then give the steps for this week’s exercise.

ABC Company charges $60/hour for their widget repairing service. ABC Company is very busy, doing all the widget repair they can handle. They are always booked a couple of weeks in advance. It might be because they are at the lower end of the widget repairing market. Their competitors charge $75 – $80/hour for the same service. The owner of the company pays his widget repairing employees $35/hour (the market rate), leaving him what he calculates as a $25/hour margin. However, at the end of every month, he just has a few dollars in the bank – not even enough to cut himself a check that would equate to 40 hours at minimum wage. So, what’s the problem? It could very well be that the owner is failing to take into account fixed costs.

Fixed costs are those incurred by the business just by being open. They wouldn’t change, even if the business serviced no customers or sold no products.

To illustrate with our fictitious organization, the owner of ABC Company pays each month –

Rent on the Shop $1000
Payments on Two Trucks $600
Tools $200
Truck Insurance $300
Liability Insurance $400
Utilities $400
Cell Phones $400
Accounting Service $150
Internet Service $100
Health Insurance $2500
Advertising $500
Total $6550

That’s $6550 to keep the doors open and the lights on (so to speak). If the two widget repairers get 40 billable hours per week every week, they log 344 hours per month (40 hours per week * 4.3 weeks in a month * two repairers). To cover these fixed costs shaves $19.04 off each hour that ABC company bills ($6550 / 344 hours = $19.04).

When the owner pays the widget repairers, variable costs kick in. Variable costs are those that are driven by volume of work or product produced – for instance, hourly wages, the cost of materials to build a product, shipping costs for a product, etc. In our example, the owner incurs variable costs of $35/hour in wages and an additional $2.67/hour to pay the employer share of Social Security and Medicare.

Here’s what’s left of the $60 the owner collects from customers –

$60.00   Customer rate
– $19.04   To cover overhead (fixed)
-$35.00   To the widget repairer (variable)
-$2.67   To cover employer share of Social Security and Medicare (variable)
3.29   Remaining margin

So, the $25.00 per hour margin the owner thought he was creating with his pricing and salary policy is really $3.29. Now it’s apparent why his competitors are in the $75-$80/hour range for the same service. It’s also apparent why he has no money left to pay himself at the end of the month.

You might be wondering if I’m exaggerating for purposes of this exercise. Unfortunately, the answer is no. I’ve worked with one client where the margin number was 0 and another where the number was in the single digits.

Let’s move on to this week’s exercise.

1.  For the last three months, go through your checkbook or copy of Quickbooks (or whatever your bookkeeping methodology is) and list each fixed expense.

Here’s a starter list (it’s by no means exhaustive). Go through your records and be thorough in finding every fixed expense.

Rent or loan repayment for your place of business

Vehicle payments or leases

Vehicle insurance

Business insurance (property, liability, E&O, etc)

Health insurance

Professional services (accounting, legal, consulting)

Technical services (website, internet, email, desktop support)

Communication (landline, cell phone)

Office supplies

Advertising

Administrative employees (those who would be paid even if no services or product were delivered)

Property Taxes

Total the numbers and calculate a monthly average for fixed expenses

2.  Calculate the opportunity to cover those fixed expenses – 

For service businesses –

For the last three months, calculate the number of hours for which you can collect money from customers (i.e. hourly charges that you can use to cover fixed costs) and calculate a monthly average.

For businesses that sell products (this calculation is trickier if you sell multiple products with different price points) –

For the last three months, calculate the number of units across which you can spread the fixed costs and calculate an average.

For retail businesses –

For the last three months, calculate the number of hours you are open, across which you can spread fixed costs and calculate a monthly average.

3.  Calculate the fixed cost to be covered each hour or by each unit –

Service – monthly fixed costs / monthly billable hours = fixed cost to be covered each hour

Products – monthly fixed costs / monthly units = fixed cost to be covered by each unit

Retail – monthly fixed costs / monthly hours open = fixed costs to be covered each hour

4.  Incorporate the fixed cost per hour/per unit into your pricing model.

For service businesses

variable cost per hour

+ fixed cost to be covered each hour

+ desired margin

= Customer price per hour of service

For businesses that sell products

Cost of good sold (labor + materials or purchase price)

+ fixed cost to be covered by each unit

+ desired margin

= Customer price per unit

 For retail businesses, the use of the number is a bit different

 Aggregate price of all goods sold in an hour

 – aggregate cost of goods sold in an hour

 = aggregate gross margin

Aggregate gross margin must be greater than fixed cost to be covered in an hour

Calculate this over the course time to determine which hours the retail establishment should be open.

5.  Check these calculations frequently. As volume (more hours or more units) goes up, fixed costs per hour or per unit go down, until you increase volume enough that you have to add fixed costs (hire another admin person, buy another truck, lease a bigger building). At that point the math changes again.

6.  I realize this week’s exercise can get complicated very quickly. If the simple examples in this exercise aren’t sophisticated enough for your business, consult your accounting or bookkeeping professional.

This exercise is incredibly important and could be the difference between staying around to serve customers for many years or being gone in just a few months.

If you have questions on this week’s challenge, contact me at 816-509-9838 or mchirveno@clearvision.consulting

Use the comments section below to benefit other business owners and managers by sharing insights you gained by working on this week’s challenge.