How Much Is a Customer Worth?
There is currently no accounting standard for customer lifetime value. Here is our proposal.
Financial support for CX initiatives often falls woefully short, compared to other initiatives such as digital transformation. A frequent problem is that the CEO and leadership team treat CX as market research. Report cards are the primary output.
There is a more fundamental issue, though. The customer is at the center of CX. But we have no accounting standard for how much a customer is worth.
A CX team gathers customer feedback. It proposes an initiative that will improve customer retention rates by 2%. How much is that worth? As of now, there is no consistent way to answer that question.
After 15 years of experience with over one thousand NPS implementations, we recognize the lack of answer as a major problem. We now want to propose the solution.
Bear with us as we first expose a relatively traditional approach that works. Then read our radical new solution.
Value customers the same way you value companies
When companies and their investment banking partners place a value on a company they want to acquire, there is one single, universally accepted methodology: Discounted Cash Flow. The value of the target company is today’s value of all future cash flows that you expect the company to generate. At a technical level, this is EBITDA cash flow.
The value of your company is the same as the value of your customers, current and future.
Most companies do not track this information at the level of an individual customer
With the exception of B2B businesses that have a very small number of customers, almost no business tracks financial data at the level of the individual customer. Large outsourcing companies are examples of situations where there probably is a P&L for each of their largest customers, at the very least.
So what can you do if you do not have P&L data? One method that you can agree with your CFO is to divide customers into useful segments or groups. Here are some examples:
- Customers who have made a one-time purchase versus customers who have an ongoing contractual relationship with your company.
- For businesses that do not have annuity contracts, split customers into groups in terms of RFM. RFM is Recency, Frequency, and Monetary value of their purchases. Customers will be in each of the three groups with different ranks
- Customers who buy directly from you versus those who buy via resellers, usually providing lower margins.
Attaching financial values to the groups
For businesses that have annuity contracts, use past renewal rates as a baseline for future renewal rates. It is important to think of renewal rates in terms of dollars, not units. Customers can renew contracts at a different value to their prior contract.
The data needed to get to something resembling EBITDA by category is below. We are also including data points that are affected by changes in customer happiness, even if they do not enter into traditional P&L accounting.
- List prices.
- Discounts or other price reductions that you have granted your customers, and which are not part of a standard published discount table. This is where you give additional discounts to unhappy customers to encourage them to buy more or to renew a contract. These discounts are sometimes referred to as ‘contra revenue’ and they do not show up in standard P&L accounting.
- Net revenue.
- Cost of Goods Sold. This cost includes anything you provide to Detractors free of charge, for example. COGS does not include sales and marketing costs. Those are ‘below the line’ costs, not considered in Gross Margin, and are considered in Operating Profit numbers.
- Cost of attracting a new customer. You will use this to establish the cost of replacing a customer who leaves.
Agree a set of these numbers with your CFO and you will be off to a good start.
Smile. There is an easier, more radical way. We propose it now.
We believe that DCF should be declared the accounting standard for such calculations
The value of your company is the same as the value of your customers, current and future
As we said already, the only correct way to value your company is Discounted Cash Flow. But what is the source of that cash? There is only one source: your customers! Both the ones you have now and the ones you may reasonably expect to gain in the future. What this means is that your customers’ collective lifetime value and your company’s DCF are identical.
To get this value – TCLV – do as follows. Using standard DCF calculations, get the DCF value of a one-point improvement in the collective contract renewal rate for all of your customers together. Call it $X. Confident that you have a CX investment that will improve renewal rates by 0.5%? Multiply $X by 0.005 (which is 0.5%). You have the ROI on that investment.
You can break the figures down. Say your financial data shows that Promoters buy more often or simply more than Passives. Calculate the difference in DCF between the two groups. Use it to justify investments that will turn Passives into Promoters. Repeat with Detractors versus Passives.
To be credible, your justifications should focus on what the Detractors, Passives and Promoters tell you they want you to improve.
Conclusion: People have been making TCLV calculations far more complex than necessary
When thought about in terms of company value and the fact that company and customer value are identical, Customer Lifetime Value becomes an easy concept. We believe that DCF should be declared the accounting standard for such calculations. We will do our best to make this happen.
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