Who are your business’ best customers?
What types of projects make you the greatest profit?
Is your time underutilized?
What can you do about it?
Every business should know the answers to these questions. Do you?
For owners and managers of businesses that provide and sell services to clients—charging for your time and expertise rather than exclusively selling tangible products—one of the greatest challenges is identifying the most profitable projects and types of customers, understanding the real costs, and putting that knowledge to use when determining how to target and sell to potential customers.
That’s what we’ll address here.
Customer lifetime value (CLV)—customer profitability (CP), customer profitability analysis, or simply knowing who makes you (and will make you) the most money—is an important metric that can help optimize your business so that it makes you the most possible money while wasting the least possible time and resources. CLV simply calculates the net profit attributed to either groups or individual customers and is a common consideration within larger corporations focused on sales. It is often underutilized, or given no consideration, in small service businesses and startups.
Many small businesses sell a variety of different types of services—from consulting to product development—and each method produces different revenue streams which each have a different cost structure and unique indicators (e.g. a standard markup on a physical product where margin matters, or a flat fee or hourly rate for work on a project where time spent is a critical factor). They each have variables such as customer acquisition cost, inventory, budget, and payroll, among others, separating their Profit and Loss.
Simply put, each business is unique and so are its challenges and metrics; to accurately ascertain CLV requires comprehensively measuring these metrics and their outcomes.
Why should I care about CLV?
Determining customer lifetime value (CLV) can help you answer one of the most important questions about sales every business person wants to know: how am I going to offer the best product and make the most money with the minimum required effort in the future?
The goal of this piece is to provide context and a fundamental understanding of the importance of customer lifetime value for businesses, insight into the types of data to track, and to delve deeper to help consider your specific challenges and how to address them.
How to actually get the data (internal and external) and specifics for customer lifetime value can vary dramatically from business to business (e.g. an online survey versus a conversation with customers); it depends upon what you sell and how, and that is addressed below, along with how to use it. Each business is unique, and so your methods should be as well.
Data Is King
The value of good, complete data about your company cannot be overstated. It can absolutely make the difference between success and failure. Many small businesses and startups simply do not take the time to plan how to keep track of their data, don’t know what type of data to collect or how to organize it, or don’t put much (if any) effort into data at all. If customers are inquiring, invoices are going out, revenue is incoming, and there is cash in the bank account, many small businesses are content to just make things work—assuming that all business and revenue is equal.
All customers and projects are not equally valuable to your business, but having the right information is the only way to make that determination and be able to discriminate based on value. Disregarding the importance of data is always a significant mistake.
In growth, as has been proven ad nauseum in business, issues inevitably transpire that bring a lack of formality or procedure to everyone’s attention when goals aren’t met—and a failure usually leads to the implementation of processes and formality. If well executed, valuable lessons are learned, mistakes stop happening, and an improved process means the company has learned its lesson and it does better as a result. The process looks something like this, visually:
Source: Ray Dalio, Principles
Data collection is a prime example of this process. Older, more experienced companies usually have so many layers of procedures because of everything they’ve been through and learned as a result—while younger, more limber companies often try to avoid complexity. While many small businesses and startups seek to be very different than large corporations (often for great reasons), there is at least one essential area that every small business should aspire to follow larger corporations’ leads: track everything!
Accurate data about your business—from your revenue to expenses, to you customer costs and demographics—is one of your greatest resources for making decisions. If tracked and used effectively, it can lead you to find new customers, help make more money from your existing customers, and make better decisions.
Remember: the information you need is everywhere around you and possibly a great hidden resource; you need only to collect, organize, understand, and use it.
Collecting External Data
Some of the most useful data points to collect from customers are:
- Contact information: Physical address, email, phone numbers, point-of-contact for a client, and account owner within the company, etc. A large portion of sales in many businesses are generated from outreach and keeping in touch, so make sure your records are thorough.
- How they found your business—and why they left (if relevant): Did they find you through a referral, marketing campaigns, social media, direct outreach, internet search, etc.? Knowing how someone found your business and if/why they left is essential to recruiting and retaining new customers.
- User experience data: Understand how customers interact with your business and how much value they feel they get. An interior design firm, for example, should know that their customers feel they got a better result than doing it themselves. Use conversation, surveys, or analytics software to obtain this information.
- Your Net Promoter Score: Simply asking "How likely are you to recommend our business to a friend or colleague (on a scale of 1 to 10)?" determines if someone will promote your business (people who rate you highly) or damage your brand (people who rate you poorly). This score measures your customer experience and can predict business growth. If you’re curious for greater detail and how to calculate net promoter scores, read more here.
- Their purchasing and decision-making behavior: Learning what influences the purchase decisions of current customers can be a great tool in retaining their business. They may be working with you because of cost, convenience, expertise, connections, etc.; learning what is most important to them will position your business to keep delivering value. What drives their decision making should be noted and associated with their account. The key to driving higher sales is to understand your buyers’ purchasing behavior.
- Demographic information (B2B or B2C): Age (individual or business), gender, income/revenue, location, etc., and countless other metrics by which you can segment your market provide key insights into sales patterns. This shows you how well your customers match your projected demographics when you develop the products or services you’re selling.
A good Customer Relationship Management (CRM) system should handle all of this.
How should you collect this information? That depends upon your type of business and how hands-on you are with customers. For service businesses that interact extensively and directly with their customers (e.g. an interior design firm), most of this information can be obtained by having customers fill-out general information about themselves—whether as part of a contract or at the time of a sale—at the outset of a business interaction, or may be able to be documented by you or your sales team through conversation; and the rest can be obtained by a follow-up survey or conversation at the completion of a transaction. Other demographics, like income data for example, can be obtained or estimated through tracking addresses rather than directly asking for it.
The most important thing is that you get and track this information in a way that fits within how your business operates and isn’t obtrusive to the customer. For service-oriented businesses, that’s usually just talking to your client and learning about them through conversation.
Collecting Internal Data
Aside from tracking your business’ financials like profit and loss—which of course you should absolutely be doing—some other internal data points to track that differentiate the various elements of your business are:
- Identify your revenue per customer. A simple process that identifies how much money each customer spent. If you had multiple projects with an individual client, each one should be separated and classified independently. Accounting software like Xero makes this easy.
- Segment your types of revenue offerings by products and services. Each revenue-generating part of your business should be segmented and tracked. For example, an architecture firm that also does interior design, furniture design, and brand development must factor P&L differently with each, not just focus on the aggregate. Accounting software like Xero makes this easy.
- Segment your project costs: your business must track the revenue and expenses of each revenue category differently. Some client projects primarily cost a business material while others cost time and payroll. Some costs are one time expenses that can be spread out amongst many projects, while others are directly applicable to only one. Accounting or project management software will make this process easier.
- Track your time: Where are your hours going and are they optimally productive? The only way to know is to have employees track how much time they’re spending on tasks. Whether you are spending your time on sales, flat-rate projects, hourly-rate projects, business development, or administrative things can have a dramatic effect on your business’ performance—but you won’t know unless you track it. Yes, this can seem overbearing but the data can be extremely useful and can lead to beneficial productivity decisions (e.g. 80% of your time should be spent on client focused work, 15% on sales, and 5% on administrative tasks). For example, if your company charges a flat rate for a project but an employee spends 10 hours working on it that costs you more than the project then you know you have to adjust your rates. Harvest is a great way to track your and employees’ time
- Track your inventory and assets: the value of your inventory represents ownership, assets and investment in your company and should be reflected on your balance sheet. Small business owners should keep an updated list because in addition to equity, inventory effects project costs and cash flow. Accounting software makes this easy.
- Customer Acquisition Cost (CAC): How much money did you spend to acquire each customer? Factor in your marketing expenses, time, travel, etc., and CAC can be calculated by simply dividing all the costs spent on acquiring more customers by the number of customers acquired in the period the money was spent. Be sure to attribute specifics to customers when possible (e.g. that plane ticket and hotel to land an account).
The prospect of many different factors coupled with complexity in data—from what and how to track it, to when and where to enter it—can cause paralysis for business owners and managers and lead to inaction. Often, advanced planning isn’t possible because a business’ organic growth may lead to unplanned avenues. This commonly requires revision and backtracking that can be frustrating. Your business’ revenue streams, expenses, what to track and how to track it should be reviewed frequently to insure problems are identified early and they are addressed through the development of strategic plans.
Have a plan to review your process regularly and standardize it.
How to Track Data
You can invent your own processes, but it’s usually easiest (and most time efficient) to just use pre-built systems to keep track of your business’ core data. Some key things to keep in mind:
Invest in tools that will help you:
- Accounting/bookkeeping software: Create useful, specific categories within your accounting software so that expenses are tracked in detail.
- Time tracking software: track your time spent on different tasks while you’re working. They should fall under the primary categories that you spend your time on.
- Customer resource management (CRM) software: keep track of all the data--from demographics to decision making behavior--related to your clients in one space so that it’s organized and easily accessible.
Be aware of industry-specific tools that can make your job and process significantly easier. For example, an Interior Designer may benefit from a program like Design Manager, a tool similar to Quickbooks but tailored to the industry’s needs. Whatever your industry—from travel to design—a simple search might identify a custom tool that can both make your job easier and your business’ data better.
The right tools are a worthwhile expense because if used correctly they will keep track of all of your most essential data and present it in an organized manner. You can then export your data into spreadsheets that will allow you to organize it and gain insights. This can save you countless hours and money.
Once you have the basic data you can do more complex analysis including:
- Identify which employees are generating the most income.
- Identify your most profitable clients.
- Use segmentation data about your profitable clients to get more of them.
Standardize your processes and update your data, like categorizing expenses, weekly for example, or have a bookkeeper do it. Have a good method to stay on-top of tasks while information is fresh and prevent a backlog.
Calculate Customer Lifetime Value
Once you’ve tracked the above data points, you need to determine the following for each of your current customers:
- How much money has each customer paid you?
- Over what timeframe did each customer pay you?
- Margin / How much did it cost you to make the product that the customer bought? (If your business has multiple streams of revenue/project types, you’ll need that data for each and can simply run seperate CLV calculations by revenue stream.) This could be in two different ways:
- How much did it cost you to acquire the customer?
- (optional) How much will the customer spend?
- (optional) How much of your fixed cost should this customer cover?
- (optional) Customer retention rate.
Once you have determined those variables, a general formula to calculate customer lifetime value (CLV) is:
Annual profit contribution per customer X
Average number of years that they remain a customer
Less the initial cost of customer acquisition
Imagine you own an interior design company that launched 3 years ago. You’ve had a number of sales but you’re not sure how the underlying metrics look, so you want to determine your customer lifetime value. Here’s how to go about doing so in a spreadsheet:
- Transactions: Put all of your sales transactions into a table that lists sales amounts, and identify the sources of your customers.
- Customers: On separate tab, determine how many clients fit into different categories by source and sum up how much they have spent, over what time frame, and what they spent it on, on a per-client basis.
- By Source of Customer: Determine how much each source costs to put together: customer acquisition costs, costs of goods sold (COGS), and profit.
Then you’ll have the data needed to determine customer lifetime value to date and see what areas are working best for your company.
The categorized information should provide the following example data:
The objective is to be able to segment your customers and identify which are the most valuable:
The chart above demonstrates that not all types of customers are equal. It is commonly not the customers that account for the majority of revenue that generate most of the profit because of high costs incurred. This is particularly true for flat-rate projects where time spent does not equal revenue generated, particularly if you haven’t mastered the art of predictive pricing. In the interior design example, imagine a large customer that you spent most of one year working full time on for a large but flat rate, but which also prevented you from taking on other, higher-margin projects.
At the other extreme of the spectrum are the small, infrequent customers that never purchase enough to cover the cost of acquisition and administering accounts.
This graph is generated when net margins are plotted against customers according to their revenue size. While many customers may not be generating a positive net margin, most make some contribution to overhead. It is critically important to understand the overall profitability of tranches of customers and consider how they interact with your business, which relationships are the most beneficial, as well as how relationships can be more successfully (profitably) managed as a result. Each type of revenue stream should be plotted and compared to each other, which will tell you what types of projects are most beneficial to your company.
In our example interior design company, on a set marketing budget, we can see that certain customers aren’t worth the expense (e.g. those gained through events) and effort, and therefore should not be actively pursued because on average they don’t spend as much, while we should attempt to find more customers online. This information allows us to direct our limited/fixed marketing budget wisely.
We’ve established that all customers are not equal—and all potential customers are not equally worth your time or investment. Considering customer lifetime value will allow you to identify which types of customer you should focus on—and those that are not worth pursuing.
You can do this by identifying customer lifetime value for each of the following segments:
- By the source of the customer.
- By the customer’s location.
- By the type of project / revenue stream
- (B2B) By the size of customer.
- (B2C) By the customer’s wealth (approximated by zip code).
- Etc… (The variables you could use to determine metrics are virtually unlimited).
How To Use CLV Data
Once you’ve tracked and obtained your CLV, external and internal data, you can put it into action by making consequential decisions. You’ll know:
- Who are your business’ best customers?
- What types of projects make you the greatest profit?
- Are you wasting time?
- Are you doing enough to grow your business instead of just dealing with the current business?
- Are you working on your business or in your business?
What can you do about it?
Your sales team (regardless of size) should always be looking for effective ways to attract new customers, cut down on customer acquisition costs (CAC), and increase customer satisfaction and retention. Having this data should help you determine an effective strategy to target new customers.
But do you know how much each new customer is worth to you once they’re acquired? If not, then how do you justify marketing and sales budgets? You must obtain CLV for each element of your business.
The Role of CLV in Growth
One of the most valuable applications is using CLV to frame a better understanding of your customer acquisition cost (CAC). Your CLV:CAC ratio reveals a lot about the health of your business model.
Many startups and small businesses struggle to grow because their CAC is higher than their CLV. Once you calculate CLV, you can focus on optimizing this ratio – which ensures your business continues to grow at a healthy rate.
When you segment your data points by different types of customer and revenue in the business, you get a full picture of the health of the business and which areas to focus on. Continuing our interior design example, you may find that designing custom furniture is time consuming, expensive on materials, and ultimately low margin and that it’s not worth focusing more energy on at this time. To grow most optimally, you may determine that you want to focus on design projects that pay by the hour.
Tips to Drive-Up Your CLV
- Incentivize repeat customers and stay engaged with them.
- Improve customer service by asking questions.
- Know how much your projects cost and adjust your prices.
- Target your most valuable customer type (digital marketing, targeted marketing, social media, etc.).
- Manage your time well by knowing where to focus your energy.
To get a free excel template for doing the analysis shown above, click.
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