Engine Room Blog

Do you understand how to calculate the financial value of your clients and how you can use that value to make sound marketing decisions?

Less than one businessperson in a thousand really thinks in terms of the incremental lifetime value of their customers, or even knows how to calculate it. Yet the calculation and the very idea is easy and yields enormous benefits.

For one thing, if you know the incremental lifetime value of a customer, you can determine in advance how much you can afford to spend to acquire that customer. Moreover, you can reliably predict your cash flow well into the future.

‘Lifetime value’—a case in point

Lifetime value (or marginal net worth) is the financial value of your clients during the time they deal with you—their ‘lifetime’ at your business.

A case in point comes from a coffee roasting company with a mail order division. The company ran an advertisement that cost $12,000. The advertisement invited potential customers to accept a free coffee maker valued at $51.95 if they bought a sampler selection of fresh roasted coffee blends for $34.95.

Part of the deal was that the customers simply consider a ‘until further notice’ home delivery service—an order of their preference would be sent to them monthly and charged to their credit card. (They were under no obligation to sign up for the ‘until further notice’ agreement. They merely had to consider it. And regardless of their decision, they could keep the coffee maker.)

‘Until further notice’ arrangements mean that the arrangement continues until the customer gives the company notice to discontinue sending the product or service.

The hard cost of supplying the free coffee maker and the sampler pack leaves a net profit of $1.00 per response. When you factor in the $12,000 for an advertisement, you’d immediately conclude that 12,000 responses were needed just to break even, wouldn’t you?

Based on that, you’d probably think the coffee company would be mad to do it, wouldn’t you?

But let’s look more carefully at the numbers.

For each person who finds the ‘until further notice’ arrangement to be a convenient way to buy, the average annual gross profit is $245. So the response rate required to break even falls from 12,000 people to just 49!  Download our whitepaper to find out more..

WHITE PAPER: TOP TIPS TO INCREASE YOUR CUSTOMER'S LIFETIME VALUE TO YOUR BUSINESS

Many business owners are technicians who go out to work for themselves… When does it become a real business?

In the words of Michael Gerber – Business owners have an “entrepreneurial seizure”.  They look at their boss and think if he (or she) can do it then so can I.  What they don’t think about is the investment in plant, premises and staff that the Boss has made, or all the other work they do outside of the technical stuff – payroll, sales, marketing, debt collection, accounts payable….

In a small business the owner becomes a “Jack of all trades” and often at little recompense for those extra hours they have to spend doing the “administrivia” for the business.  If you take the income you earn and divide it by the real hours you work in your business – what is your hourly rate?  I have seen some owners where this calculation has them earning less than the minimum wage – often their employees are earning more than they are.

So is it a business or a job?

A business is something that earns you a return on investment over and above fair recompense for the hours you work.  The business makes a profit of $150,000 before owner’s earnings, a fair salary is $120,000, you have a business.  

It should also allow you to live the life you want – taking the leisure time you would like, doing the work you want to do.  Otherwise you have a job – and probably a poorly paid one at that.

How do you turn it in to a business?

Have a really good look at what you are doing - talk to your accountant about how you can improve the performance of your business. 

Be brutally honest about whether you can grow your business to generate the profits and cash flow to allow you to live the life you want to lead.

Then make sure you have the right team to achieve what you want, up-skill yourself and your team, create an action plan and go for it.. or make the hard decision – sell or close your business, get a job and live the life you want.

                                                  

If you only meet with your accountant once a year it is vital that you use that time to really understand how your business is performing and what you need to do over the next year to achieve your goals.  

The three key questions are:

1.  How did my business do compared to the previous year?

Sales may be up but profits down (or preferably sales are down, though profits are up).  Understanding whether this is a trend or caused by a one off event is essential to making decisions on how to have a better year.  

2.  Where has the money gone?

Often business owners are hit with a tax bill at the end of the year but have no cash available to pay it.  This may be caused by cash tied up in stock or debtors, or because cash taken out of the business by the owner is greater than the funds generated.  Often cash has been used to fund growth in the business without any cash flow forecasting. (If you want to know more check out our next 'where has the money gone?' seminar at www.engineroomca.co.nz/events ).  Cash is always King - if you cannot turn profit into cash your business may be growing too fast, or you are neglecting to put enough time into managing your business finances.

3.  Is my pricing right?

Pricing is 20% science and 80% art, but fundamentally if you are not making a profit on every sale, you need to review your costings and how you set your price.

4.  What is my business worth?  

While valuing a business is a project all of its own, your accountant should be able to give you an indicative valuation.  Understanding what your business is worth is vital to making decisions about getting it ready for sale, retirement and succession.

These three questions will lead to a whole lot more...

What can I do to increase sales?

How can I increase my profit?

How do I keep more cash in my business?

What do I need my business to be worth to fund my retirement?

I'd love to know what key questions you ask your accountant to help you with building your business.

I have just returned from India, one of the fastest growing economies in the world.  Since the my last visit two years ago the increase in infrastructure development has been huge.  As we left Agra and hit the first of the road toll booths our Guide explained that they were happy to pay as the new highway had reduced the travel time to Jaipur by three hours. The people of India clearly see development from a much more positive perspective than us and realize that their Government cannot afford to pay for everything.

Development is not hampered by the complex regulation of the west - some of which is a bad thing as there isn't even a minimum health and safety standard. But it also means things happen much quicker.  In the last 20 years the living standards for the lowest classes has moved to where the middle class were, and it is moving faster all the time.

Unemployed are offered work on a day by day basis.  If they register as unemployed and turn up at their local meeting place they are guaranteed a miminum wage of 220 rupees ($5.10) per day. If they are not offered a job as a day labourer at a better rate they are assigned jobs for the council working on roads, gardens and other developments.  

Much of the economy runs on cottage industry but as they become more urbanized the biggest problem will be managing demand for higher wages.

There is a significant emphasis on education and health with new educational facilities being built everywhere to cater for the needs of the lower and middle classes.

Sadly in New Zealand we no longer seem hungry to improve ourselves - now we think it is someone else's job to do it for us.  For all our talk of being entrepreneurial and number 8 fencing wire, we would rather go to the beach an earn the minimum we can for the maximum lifestyle.  It is time we raised our goals before we are taken over by the ambitions of countries like India.