If you’re like most organizations, your finance department focuses on overall revenue trends to forecast for the next year.
These numbers include things like year-over-year same-store sales, trends among product lines, forecasts based on product sales, macroeconomic conditions, and internal benchmarks like comparing this January to last January.
Those things are incredibly important and useful for revenue forecasting and budgeting for the next quarter or fiscal year. But there’s an input that you’re missing. It’s the source of your revenue, your customer.
Enter Customer Equity
Your customer data has a powerful potential to forecast revenue from the bottom up. But first, what is customer equity?
Customer equity is the total value of all of a retailer’s customer relationships during a given period — say, for example, a year. It addresses the following concerns:
- What are my existing customers going to spend?
- How many am I going to bring in?
- How many are going to leave?
Customer equity is calculated by multiplying the number of new customers acquired by the predicted lifetime value of those customers, which can be estimated based on previous purchasing habits, and it tends to be a fairly stable number. Customer equity is essentially the “index fund” of a retail organization — an individual “stock” may rise and fall, but, ideally, the value of the overall fund is always rising.
If you are a direct-to-consumer brand, every single dollar you earn is paid for by a customer. Your customer equity looks at the lifetime value or maybe future one-year spend of your customer base (and predicted new customers) to find the dollar-amount value of your customer file.
If you're on the financial side of the retail house, it becomes really fun to track. You have this always-evolving mix of customers coming in, customers fading out, customers churning out completely, customers heating up, customers cooling down, and the customer equity metric groups all that to give you the value of your customer base as if it were a portfolio of assets.
Does Customer Equity Do Other Cool Things?
If you’re keeping an eye on this “stock portfolio,” you might see an annual percentage return that is lower than expected. If you’re an especially proactive investor, you might be curious to learn what stocks performed well and which ones didn’t.
Stepping away from the analogy, customer equity is the highest-level number that tells you if your lower-level goals are summing up to success. It’s valuable information to have, but it’s also a lagging indicator that requires some drill-down to see how customer economics affect your growth rate.
To totally simplify, let’s say you start your fiscal year with a one-year customer equity forecast of $1000.
You have 100 customers in your file.
These customers can be broken down into three distinct segments according to predicted customer lifetime value (defining “lifetime” as one year).
Segment A comprises your high rollers. There are only 10 of them (i.e., 10% of all customers) but they will spend $50 each with your brand over the course of the year.
Segment B is your middle-tier spenders; 40% of your customer base who will spend, on average, $10 for the year, or 40% of your customer equity.
Segment C consists primarily of your discount shoppers and one-time buyers — a full 50% of your customers who combined represent only 10% of your customer equity, averaging $2 spent per person per year.
A Brief & Moderate Digression: By saying that it’s “not uncommon,” we’re really saying that it is very common to see, over the course of a year, a full half of top-decile customers, churn out or downshift their spending.
In this above scenario, that means that FIVE PEOPLE determine 25% of your annual revenue. While most retailers have a top decile that comprises considerably more than 5 people — say, thousands? — they’re still a small fraction of your customer base.
Now let’s say that for the CFO of the above-described Lilliputian retailer, the goal is to increase the company’s customer equity 10% year over year.
Let’s play out a few scenarios.
At the end of the year, mini-CFO looks at her customer equity again and sees:
Your customer file has dropped from 100 to 80 customers in total, but Segment A is now spending $75 per year and Segment B is spending $13 per year, while Segment C still represents 50% of your customer base at $2 per year.
Saving you the math, that equals $1,096, or a 9.1% improvement in customer equity. You were just shy of your 10%-growth goal, but that’s a massive improvement. Here’s your champagne.
Your customer file has increased by 50%, for a total of 150 customers. Great!
But! You lost half of Segment A and didn’t replace them with other high-CLV customers, so that segment is down from 10 customers to 5 of 150 (3.33% of your total base).
You’ve managed to maintain Segment B at its prior level of 40 customers at $10 per year, so that’s not bad.
The biggest point of growth for your business has been in Segment C, which doubled. That’s now 100 customers spending $2 per year.
While the new customer acquisition of 50% growth is impressive, and everyone’s patting themselves on the back for hitting such an improbable goal, if you look at it from a customer economics point of view, your customer equity is now only $860, a 14% year-over-year decrease in revenue.
Your business is losing value at an alarming rate, not to mention that the perceived value of your brand has now dropped precipitously — remember that this lower realm is where high-discount shoppers lurk — which means that the past year’s “growth” will make it harder to acquire high-value customers going forward.
Without visibility into the economics of each customer relationship, the entire company treats its platinum-level customers the same way it treats its lead-level customers (our affectionate term for customers who only buy at the steepest discounts — they’re a literal drag).
So what would our theoretical CFO of the world’s smallest imaginary retailer do to increase the value of the business, i.e., spend less while increasing customer equity?
We’re sure you have ideas running through your head, but let’s summarize from a strategic level exactly what they’d do:
- Prioritize keeping and bringing in more people that look like Segment A...
- While cultivating Segments B and C to increase annual spend and...
- Cut spend from acquisition efforts that attract the most Segment C-type customers.
Marketing, Product, and Customer Experience are all thinking about the best tactics to deploy with the budget they’re allocated. But, as we’ve seen, getting the best return on ad spend or product sell-through can still lead to dwindling customer equity.
If you’ve taken away anything from this article, understand the cautionary tale that without the lens of customer economics, someone with feet on the ground in Scenario 1 would think they were underperforming. And, perhaps more importantly, anyone in the weeds of Scenario 2 would be very pleased with their performance. If that happens, good tactics are thrown out and bad tactics get the money-pump. It’s like using your bucket to fill the sinking boat rather than to bail it out.
Which is why we need Finance to surface the customer economics, align the organization on the goals that actually matter to the bottom line, and drive more efficient spend in high-growth resources across the organization. In other words, use your bucket wisely.