A key component of any good business is the ability not only to keep up with numbers, and to do so accurately, but to understand the factors behind them. This is where economic models come in to play.
An economic model is a tool designed to isolate and analyze the core drivers of financial performance. Weeding out excess variables enables you to focus on each of these drivers, individually, and accurately measure and assess them, accordingly.
It is important to understand that an economic model is not a business plan or a business model, nor is it the basis for a budgetary or forecasting framework.
It is a framework for looking at the behavior of a particular output in response to controlled changes in variables. Economic models can help a business understand the revenue generated by each of its customers, and estimate how it relates to and can be impacted by investments in marketing, product development, or administration. They are therefore critical to determining which strategies best serve a company’s goals, and what adjustments might be made to improve the economic profit per customer.
So how does a company formulate its economic model? First, it needs to identify and define its buyer or customer base. Is it comprised of end-users, partners, resellers, stores, or someone else altogether? Does it have defined business segments under GAAP (Generally Accepted Accounting Principles)? Once this definition has been established, there are five key components of an economic model that you must determine:
- Lifetime revenue generated from your customer
- Gross profit from this revenue
- Costs to acquire a customer and to maintain a revenue stream
- Costs of developing new products and services for new, future revenue streams
- Any other operating expenses, namely administrative costs
The ultimate goal of an economic model is to determine whether or not there are gaps or inefficiencies between the company’s targets and its data, which requires establishing some benchmarks to judge the results by. OpenView established the following average targets based on the key performance indicators of a dozen software companies using their S-1 and Post IPO annual SEC filings:
- Lifetime revenue of customer: 3x average annual revenues
- Gross profit / margin: 50%+ for perpetual license, 75% for SaaS
- Customer acquisition and revenue retention costs: 70% of revenue or less
- New product / service development costs: 30% of revenue or less
- Administrative costs: 25% of revenue or less
- Economic profit: -25% of revenue or more
Compare these targets with your company’s results. Each of these analyses will help you identify possible drivers of your performance, but you’ll need to continue to “peel the onion” to analyze the underlying data in full.