Dictionary.com defines “business” very simply as the “thepurchase and sale of goods in an attempt to make a profit”. Sounds simple enough but so few service businesses out there are able to measure how valuable each customer is to their bottom line without spending countless hours assembling spreadsheets. Perhaps the staff and leadership of your own company could make better decisions if this information was available on a moments notice behind a mouse click?
It starts with defining how to measure a client “contribution”; in other words when considering all incremental revenue and cost factors, both tangible and intangible, how much does each client add (or subtract) to your bottom line. If this information were readily available, focusing your staff on profit maximizing activities would be fairly easy; make sure to take care of your best clients and either transform or fire clients that are not contributing to your bottom line. Defining your contribution formula is more of an art than science but spending the time and effort to systematize this critical measurement will reveal that not all clients are created equal, even when they may look equal on a financial statement.
Revenue Contribution Factors:
For most businesses, defining the revenue side is pretty straight-forward and can be measured by looking at a cash flow statement. Other factors that can be measured at least somewhat objectively would be new business referrals and/or positive references that help you close business.
A few intangible/subjective factors to consider adding to the equation would be timeliness of payment, predictability of revenue, growth potential, and the complexity of closing a sale.
Let’s say you earned an equal 100k in revenue last year from two clients, ABC Company and XYZ Company. ABC Company pays invoices on net 15 terms and rarely if ever needs a reminder. They share with you that they have a 100k budget for your services that will likely increase approximately 10% each of the next three years (mediocre growth). ABC Company involves you in their timing and plans for your services. They consider you an important partner in their success and sincerely wants to see your business thrive. ABC Company has directly referred several clients to you and is always happy to take a call from a prospective client to help convince them that doing business with your company is a great decision. They have directly or indirectly helped you bring in $75k in new business for which you would have happily paid them 5% commission for their role in the sales.
XYZ Company typically pays net 45 after one or more calls or emails from your bookkeeper. They give you no indication of intent to make additional purchases in the coming years, and treats you as an unimportant vendor making each contract a new adventure in legal volleying and negotiation. This client is not interested in your success, has never directly referred business to you, and is not even on your reference list because you are not sure of the message they would deliver to a prospective client.
It’s obvious that ABC Company is worth more to your bottom line than XYZ Company. Businesses run on cash, not goodwill so clearly the cash collected from a client is by far the most important factor. But perhaps a formula that inflates or deflates cash collected to measure a client contribution would make sense. As in the example above, ff the positive contribution factors you deem critical are timeliness of payments, predictability, ease of doing business, and referral credit then define measurements to plug into the formula.
Client Contribution = (Cash received * (PAY * PRE * GRO * SAL)) + REF
Timeliness of payment (PAY): 15 days or less = 1.02, 15 to 35 days = 1.0, 35 to 60 days = .98, >60 days = .96
Predictability of revenue (PRE): very predictable = 1.02, somewhat predictable = 1.0, unpredictable = .99
Growth Potential (GRO): strong growth = 1.03, mediocre growth = 1.01, unknown or no growth = 1.0
Complexity of Sale (SAL): easy = 1.02, average = 1.0, difficult = .98
Referral business (REF): new business referred or enhanced by client * percent credit for account. Consider the client like a commissionable sales rep when determining how much of the revenue to credit them.
Given this formula, ABC Company contributed over $110k to your bottom line whereas XZY Company contributed approx $95k.
Coming next month: measuring the Cost Contribution Factors to calculate the Total Client Contribution (TCC)