The Math
We have made a very simple VRM Calculator. Only a few inputs are needed to get started: the revenue and number of annual transactions for the 10th percentile customer. One can go with defaults for the rest.
Let’s take a business with 100 customers. If it is a business where customers tend to repeat transactions (retail, commerce, broking), the likelihood is that a small number of customers will account for a large percentage of revenue. Let’s take this split to be 20-60 where 20 customers account for 60% of revenue.
The 20-60 split is true for many businesses (except the subscription businesses like Netflix or the large single purchase ones like buying an automobile or a home). The 20-60 split in retail is well-known. (ome other businesses like gaming or broking may have an even more extreme skew like 10-80. We created a model for that also in the calculator. For the calculations here, we will go with the 20-60 model.
Let’s further assume we can model the revenue of each customer in the preceding 12 months into two components: the average value of each transaction and the number of transactions.
If we assume the 10th customer (ranked in order of customer value from high to low) does 4 transactions with an average value of 1000 units, for a 20-60 business the customer value curve will look something like this:
The area under the curve is the total predicted revenue. As can be seen this value is concentrated towards the left of the curve (the head). The head (top 20 customers) will generate about 60% of revenue. In this case, the top 20 customers will generate about 106,000 units of revenue, while the long tail (remaining 80 customers) will generate about 81,000 units of revenue.
The average revenue of the top 20 customers is 5 times more than the average revenue of the other 80 customers. As a marketer or business head, it is obvious that the customers in the head are many times more valuable than the long tail. Some customers are indeed more equal!
Let us now assume that a set of marketing initiatives targeted at the top 20 customers help grow the revenue by 15%. Thus, the 10th customer now does 4.2 transactions of 1100 units to generate 4620 units annually (vs 4000 units earlier).
In all likelihoods, the efforts directed at the top 20 customers will have a rub-off effect on revenues from the other 80 also. All the gross margin generated by the additional revenue will flow to profits. Guess what the increase in profits will be? 93%.
Because of the high contribution of the top 20% to overall revenue, the EBIDTA of the business almost doubles. (I have assumed 60% gross margin and costs at 50% of revenue. Post-VRM, I have assumed the same costs since much of the VRM ideas can be delivered via tech and not adding extra people. In fact, implementing VRM well can lead to lower ad spends because the targeting for new customer acquisition can be much more selective and linked to the attributes of the Best Customers.)
Here is how the full picture looks:
A small increase in revenue…leading to a giant increase in profits. This is what VRM can do for businesses. And yet – few actually make this magic happen.
