Determining the Value of Your Customer
Sales are down -- time for some cold calls, right? Maybe not. Your most lucrative growth opportunities probably lie with clients you already have. Learn how to calculate (and maximize) a client's value.
It never ceases to amaze me: When business is slow, the owner’s first reaction is, “I need more customers.” I think this is a natural, but often misdirected response. Few business owners understand that getting new customers is the most expensive, time-consuming way to grow. In fact, it’s seven times more expensive to get a new customer than to increase business from your existing clients. Digital marketing and advertising is fundamentally different than the traditional marketing and advertising most of you have done. The old joke among business owners is that half of their advertising budget is wasted – they just don’t know which half. This is a typical observation for traditional campaigns that lack feedback, metrics, or analytics.
To put things in perspective, there are only three ways to grow any business:
1. You can prospect for new customers, the most common, difficult, and expensive approach.
2. You can increase the average order size from your existing customers.
3. You can increase the frequency with which your existing customers purchase from you.
The interesting thing is that these efforts are independent of one another: You don’t have to focus on one at a time. The successes you have in one area will be multiplied against the others, making it very easy to accelerate the growth of your business.
This month’s column will focus on growth from your existing clients. I’ll show you how to determine the value of your customer base, an exercise most businesses never do. The most valuable asset you have is not your hardware, equipment, or building: It’s your customers. How do you know if your customer base is reaching its full economic potential?
What is a Customer Worth to You?
Not all customers bring the same value to your business. We all have clients that are pains in the behind, ones we only do business with because they bring substantial volume. Actually, the biggest customers may not be all that profitable. Are they really worth the trouble? You need to compare them against the rest of your customers in order to decide.
There are many ways to determine the value of a customer for your business, including some that are quite sophisticated. I like to keep it as simple as possible. Start by dividing your customer list into two distinct groups:
• Active customers who have placed orders within the past 12 months.
• Inactive or latent customers who last ordered between 12 to 36 months ago. These customers may still remember you, but for whatever reason are no longer doing business with you.
Next, determine the average value of a customer over the last 12 months through a very simple calculation. Just divide your total sales for the past year by the number of customers you did business with over that time. You can also divide your annual sales by the total number of orders placed over the past year to calculate the size of the average job.
Take your customer account history and sort the clients in descending order based on the total business they’ve done with you. Look at the smallest orders and the largest orders by customer to get a better understanding of how your workload is distributed. Typically, the smallest customers order once per year for an event or another annual activity. Big customers buy frequently and place much larger orders than the average job for your business.
Next, look at the value a customer represents over a longer span of time. This brings active and latent customers into consideration and usually yields some interesting results. Pick a period for which you have the financial records – say, the business you’ve done since the start of the recession. Add up your sales between 2008 and 2014, divide that by the total number of customers in those years, and then divide by six to get the average yearly value of a customer.
Compare the result to the first number you calculated, the value of an active customer. If your business is like most I see, active customers will be worth almost twice as much to you as ones who go back over a longer period of time. It shows you the potential reward for reactivating latent business.
All Customers Are Not Alike
Using Microsoft Excel or a similar spreadsheet program, you can go much deeper into the data. Sort the customers by total business booked from highest to lowest and you should find some very interesting relationships. The most important one is that the distribution of sales will closely follow the 80/20 principle, meaning that roughly 80 percent of your sales will come from 20 percent of your customers. So if you had $1 million in sales from 100 accounts last year, the 20 biggest ones probably accounted for $800,000 of your revenue. Your numbers won’t fall exactly this way, but for almost any business, a small number of customers will represent a disproportionate amount of annual sales.
The 80/20 principle is often progressive. Take the top 20 percent of your clients, do the 80/20 calculation again, and it would mean that 64 percent of your sales come from just four percent of your customer base. Do the calculation one more time and it would suggest that over half of your sales were coming from less than one percent of your clients. Hopefully, this isn’t the case for you because it’s a very dangerous extreme. In such a business, losing the biggest customer can wipe out all profitability and threaten the company’s existence.
So what does this mean for you? Another way to look at the 80/20 principle is that about 20 percent of your customers are willing to spend
up to four times as much with you as an average client. Within that subset, some customers will spend a lot more than that. Regardless of where your exact results fall, separate your customers into the top one, four, and 20 percent based on volume. You’ll very quickly see the potential for developing additional business in these segments.
Determining Lifetime Customer Value (LCV)
Another good measure of customer worth is the lifetime customer value. Simply put, the LCV represents all of the business an account has done with you from the moment you began working with them.
There are many ways to calculate LCV and I don’t want to get bogged down in math. A simple measure would just be to take the customers who have not worked with you in the past year and add up all of the business they placed prior to that to get their LCV. The important thing to recognize is the customer’s value over time. I haven’t found a business yet that was fully aware of the profit potential of its legacy customers. This is one of the strongest arguments for not going out and looking for new customers first, instead taking the time to maximize revenue from your existing clients.
In 2007, the Harvard Business School did a study on LCV across multiple industries. The study found that the net profit on sales for a first-year customer, across all industries, was only six percent. That’s not much, and it would probably be even lower for the graphics industry due to the high level of competition.
Harvard also tracked how a customer’s worth increased over time, and the results were astounding. Across all industries, the net profit
for a six-year-old customer increased to 43 percent – more than seven times the profit of a new customer. The factors behind the massively higher profit numbers were even more surprising. In addition to becoming much less price sensitive, mature customers bought more frequently, placed higher average orders, generated a greater margin per order, and required less overhead costs associated with handling the jobs. For example, the customer would call and say, “Just repeat my last order.” The amount of time taken to duplicate an existing purchase order
and processing it was far less than creating a new order from scratch. An additional benefit was that the learning curve to determine exactly what the customer wanted and how they wanted it delivered dropped significantly over time. Finally, the study found that mature, satisfied customers generated new business for the companies through referrals.
Simple Steps, Big Results
The Harvard study makes it crystal clear that keeping your existing customers happy is the most important thing you can do to significantly in- crease your net profits. What should your exact strategy be to maximize your customer value?
Let’s go back to the customer list analysis we did earlier. Pay particular attention to the customers in the top three segments, those in the top one, four, and 20 percent. Typically, these are mature customers who have had some history with you. They know, like, and trust your work and the relationship. These are also the customers with the greatest potential to expand business.
Spend some time looking into the buying history and patterns for each of these high-value accounts. Pay attention to the frequency and consistency of their orders. Often, customers get busy and run out of product before they realize they are low on inventory. If you see inconsistency in their purchase frequency, simply set up a reminder schedule to check on them before it becomes a crisis. Besides smoothing out the cycle, you’ll make sure they always have enough product on hand. If they run out, both of you feel the pain.
Look for ways to migrate the borderline customers from the 20-percent group up to the second tier in the top four percent. Get creative. Similarly, think about ways to push your second-tier customers into the top one percent of your client base. Minimize the possibility of losing that big whale of a customer.
Almost every large printing business I work with has a story about losing its biggest customer. Sadly, the majority of the reasons have nothing to do with quality, service, or price. It’s almost universally attributed to a decline of the relationship. Typically, this happens when you begin taking them for granted, handling the easily processed orders. Something changes on their end – promotions, new hires, reorganizations, etc. – and you find yourself dealing with someone who has no connection to you. Before you know it, you get a call out of the blue saying they are switching to a new vendor. By then, it is almost always too late.
The message is to focus on the highly valuable accounts you have now. Protect the relationships and reach out to people beyond your normal contacts. Aggressively focus on increasing the frequency of sale from your high-potential accounts in the second and third tiers. Finally, look for ways to increase the average order size with all of your customers, especially those in your top tiers.
The time you take to analyze your customer base will be very well spent. You’ll gain insight and understanding that can act as a launch pad for your growth this year. At the same time, you may discover potential vulnerability within your book of business. No one likes surprises and this exercise goes a long way toward making sure that you’ll only have pleasant ones.