Definitions of Key Customer Costs and Revenue Sources by Ian Headon and Andy Whalley

Index:
Initial revenue
Initial costs
Future revenue
Future costs
Loyalty (retention rate)
Influence value

Initial revenue
This is the revenue generated by the first sale of the goods and services to the customer. 

Initial costs

This is the cost of making the first sale plus the cost of the actual goods or service sold. It usually consists of:

• The Acquisition cost, usually taken as a percentage of the company's total incurred sales and marketing costs (assuming most of these are variable costs) in acquiring new customers, e.g. a company spends £500 on direct marketing from which it gets 5 customers, so the acquisition cost is £100 per new customer.

• The Product cost: This should be calculated based on the typical product or product mix sold, as many of the variable costs necessary to carry out the transaction should be included to reflect the true cost of the transaction. If you haven't come across this rationale before it is the heart 
  of Activity Based Costing (ABC) theory. 

Future revenue

The value of future purchases depends on the amount and frequency of incremental purchases and the loyalty of the customer (which determines the length of time the customer continues to purchase). This is essentially what we calculated in our shop example above. It usually consists of:

• Incremental purchases: This is basically how much will the customer spend in the future, how often and for how long, calculated into a total. For industries with periodic transactions, e.g. insurance, incremental purchase estimates are relatively simple. For others detailed customer purchase 
  history is 'data mined' to determine typical purchase patterns. 

• Service and support revenue: In some industries there are additional future revenues from service and support activities. Typical examples would be a service contract for maintaining PCs or indeed regular updates to a website to maintain its currency. Again the math is fairly straightforward - it's how much, how often, over what period and total. In some mature industries, e.g. automotive, service revenue is often more valuable - and more profitable - than product revenue. 

Future costs

It is highly unlikely that no further costs will be accrued to achieve future sales. So as done with initial costs, an estimate is needed of what these costs will be. Again both the cost of the incremental products/services and the transaction costs of the incremental sales need to be included: 

• Cost of incremental sale: The exact costs involved vary widely both by and within an industry. Broadly speaking 20% of the initial cost can be used as a rule of thumb.

• Cost of incremental product: This is the cost of the product or service that the customer purchases. It should include variable production and fulfilment costs specific to a customer or group of customers. 

• Cost of ongoing service and support: In many industries, customers require ongoing management and service outside incremental transactions. These costs typically include customer service and support calls, and back-office processing costs (billing statements, etc.) and may include ongoing sales account management or customer retention programmes (newsletters, frequent shopper or customer loyalty awards, etc.). Cost of services may or may not be billed to customer (see above).

Loyalty (retention rate)

This is simply the number of customers remaining with the organization in a given time period, expressed as a percentage. If we have 85 customers remaining over a period of a year from a total customer base of 100, the loyalty rate is 85%. By applying the loyalty rate, the company can discount future revenue against the likelihood that the customer will actually be around to make the purchase - in effect it is a risk management technique. 

Influence value

This is an attempt to estimate the value of referrals. In some industries referrals are absolutely vital to obtaining future business and as such a satisfied customer is worth more than just the sum of their own future sales. Influence value can be calculated in a number of ways, depending on the likelihood of the referral resulting in a sale and the costs associated with converting referrals to sales. A conservative way to calculate this is to multiply the number of customers referred by the reduction in customer acquisition cost over a typical new customer. The idea here is that referred customers are much easier to find and close than other new customers - the amount of sales and marketing cost saved by the referral is the incremental value.

(Andy Whalley and Ian Headon are the authors of The Universal Manager's Dossier 06 - Obtaining and Retaining Customers.)

Andy Whalley, Commercial Director, HeadWhay Limited, http://www.headwhay.com, 07974 188057, 
andy@headwhay.com