One of the biggest problems for any business owner is the difficulty in determining the return on marketing activities, and even how to prioritize or budget for specific marketing efforts.
So in order to get to the basics of how we construct a marketing strategy, we need to understand a few fundamentals. One of these important, key fundamentals is Customer Lifetime Value, also known as CLV or LTV for Life Time Value.
What is the average client worth to your business? In hard numbers, what is the average dollar value of a single client’s worth?
The Garden Tiller
A few years ago, I bought a used rear tine garden tiller for my vegetable garden from a local small engine tool shop. It was a nice Ariens brand, which in the world of lawn and garden equipment was a pretty decent piece of equipment. The owner gave me a great deal on it since it was used.
However, my great deal on a tiller quit working on me after a couple of uses. The engine literally locked and would not turn over when I tried to pull the starter. Since the tiller was a piece of used equipment, I was concerned that I was stuck buying something on an “as-is” basis.
Fortunately for the both of us, the owner of the shop understood the idea of Customer Lifetime Value.
He apologized profusely for my inconvenience, and offered me the choice between my money back, or my dollar amount plus an additional 20% against the cost of a brand new tiller with a full factory warranty.
An even better deal! A great salesman closed the deal on a long-term customer.
Since then, I have spent thousands of dollars with the guy, and would be hard pressed to do business anywhere else.
Calculating Customer Lifetime Value
CLV is the amount of profit a single client delivers to your company for as long as the client is buying from you. The longer a customer stays with you and the more they purchase, the more valuable that customer is to your business.
Customer Lifetime Value is typically calculated as the net present value (the value in today’s dollars) of the profit you’ll earn from all of a customer’s purchases over time. When you know your Customer Lifetime Value, you have an extremely powerful tool that helps with:
- Acquisition Cost: You’ll have a better understanding of what you can spend to acquire customers.
- Targeting: You’ll know which customer segment delivers the most profit to your company and you can focus more marketing efforts toward that segment.
- Return On Investment: By using Customer Lifetime Value in your ROI calculations for marketing campaigns, you’ll have a much more accurate measure of campaign performance.
- Customer Retention: You can determine how much you can spend to profitably retain your clients.
- Single-customer Profitability: You can calculate the profitability of an individual customer.
Customer Lifetime Value becomes more important as your marketing budget rises and your client base grows. Yet even an early stage startup can benefit with a simple Customer Lifetime Value estimate.
Short-term Transactional Relationship
If you operate a bicycle rental stand on the boardwalk of a really popular beachfront tourist destination, your average, individual product sale might be a few dollars.
As the crowds line up to rent your bikes, you’re certainly getting a lot of sales, but it’s a good chance that each of your rental customers is just passing by.
The likelihood that you’ll ever see that customer again is a lot lower because of the nature of the business, the market, and the service you’re providing. Chances are, you’ll probably never see that customer again.
Long-term Value Relationship
On the other hand, a CPA’s clients could spend hundreds or thousands of dollars per month for accounting services. If a business spends $1,000 a month in accounting services, that client is worth $12,000 per year in sales.
Once a business owner finds an accountant he or she trusts, they could be a loyal client for many, many years. That client could be worth over $100,000 over a ten year span of time.
Businesses with recurring revenue streams like subscriptions, licensing, or regular retainer fees tend to be far more profitable because they naturally maximize Customer Lifetime Value.
If you operate a business with some aspect of subscription revenue, you’re far less focused on making a single sale to a client. You’re likely more focused on providing even more value and keeping the revenue stream for as long as possible. The longer a client remains subscribed, and the higher the price they pay, the higher the Customer Lifetime Value.
When you understand how much your average client purchases from you, and how long they remain a buyer, you can place a tangible dollar value on each new client that you acquire. This helps you make solid decisions across many areas of your business; because you can evaluate the impact of any changes you might make which could cause you to lose clients.
Losing a single bike rental customer isn’t really that big of a deal because it’s a few dollars and a random, single transaction in a giant pool of customers. However, losing a dedicated CPA client that represents hundreds of thousands in revenue over many years is a very big deal.
What is your Customer Lifetime Value?
So where does your business fall in the scale of effectively using Customer Lifetime Value?
Let’s start with the best case scenario – This would be a business that knows exactly how much each customer or client in each segment of the business is worth. The business focuses its efforts on acquiring clients in the most valuable segments and the business knows exactly how much it can spend to profitably retain a client.
Now let’s talk about the average or just doing okay scenario – this is where the business has a pretty good idea who the most valuable customers are, but might not know how much they can spend to acquire those clients or keep them around.
These businesses might use some fairly general ROI calculations for marketing campaigns, which can help, but those calculations are probably not complete and there’s room for more improvement in targeting and spending marketing dollars.
Now the worst case scenario – this is where the business has no idea what a client is worth. The business can’t calculate what it should be spending to acquire or keep any particular client, and has no idea what their marketing budget should be. Marketing decisions are random, shooting from the hip, and the business is rarely ever confident in any outcomes.
Calculating Customer Lifetime Value
So let’s talk through calculating Customer Lifetime Value.
There are a few numbers you’re going to need for your Customer Lifetime Value calculations.
- For any specific product or service segment or line of business, you will need to know the specific Cost of Goods Sold. This is the cost to physically produce a finished product or deliver a specific service in terms of time and overhead.
- Second, we’re going to need the Gross Profit. This is the difference between the Cost of Goods Sold and the Price of the product or service.
There are different ways to calculate these things, so you must determine how your business uses these formulas in your accounting.
Next we must determine our customer segments.
A segment is a similar group of clients who use your product or services.
A segment can be based on specific products, kinds of services, or can even be customer-focused like being based on attributes such as geographic clustering, or other demographics or psychographics.
It’s really up to you to figure out how to define your customers.
There’s no real right or wrong answer.
In fact, you will want to examine different segments and their profitability. You may discover something completely new about your sales and customer base.
Now that you’ve classified each segment, you must determine how long each customer stays with you on average.
This is the lifetime of the customer, and you can look at things like calendar time they spend as your client, the frequency of purchases, and other buying patterns.
Ultimately you want to come up with some idea of how long the customer stays with you based on number of transactions or calendar time frame.
Net Present Value
Now, there are also some other deeper financial concepts that come into play like Net Present Value and discounting of future cash flows. This is important to get a very accurate understanding of the financial implications of any decision using customer lifetime value, because the true value of the customer’s revenue technically should be discounted.
Net Present Value discounts future cash flows based on two factors:
- First, the fundamental uncertainty in predicting future revenue streams; and,
- Second, we have to recognize that a discount rate should be applied to future revenue based on the fact that you cannot invest money until you receive it.
This is commonly called the “Time Value of Money.” So $1000 next year would only be worth approximately $950 today, if you could earn 5% on the money this year.
In a low interest rate environment, we can very easily argue that cash received today has little investment value over a three-year time horizon. Lifetime value is inherently a long-term metric because it recognizes both the immediate (this year) and longer term revenue adjusted for things like customer attrition and the time value of money.
Okay, so once you have arrived at the Customer Lifetime Value, you can calculate things like:
- The total profit your business earns on all their combined purchases
- The overall probability they will continue to make more purchases from you
- The total value of the future revenue of the customer if you had all the cash in hand today
Now here’s the real power of Customer Lifetime Value… you can now calculate how much money you can feasibly spend to acquire and keep a customer.
If you have a Customer Lifetime Value calculation for a customer segment, you can do things like:
- Set a maximum budget that you can spend to acquire a particular type of customer
- Calculate whether or not any particular deal will be profitable or not
- Identify customers in a particular pattern who haven’t made the next purchase in that pattern. These customers are more likely to defect, so you can develop a retention campaign around those specific customers.
- Start using more accurate ROI calculations. When you calculate the profit over the total lifetime value of a customer vs. the profit you get on the first sale, you can get a more accurate assessment of what you’re getting for your marketing dollars spent.
To me, it’s always interesting to see the crazy amounts of money a business will spend to attract a new customer, yet how little they will spend to retain an existing customer.
For example: an auto manufacturer will spend millions on Super Bowl TV ads without even thinking about it. But what about the customer retention programs at the dealership level?
Great companies focus on delighting their customers, which means their customers never want to leave. These companies understand the value of their customer, and consequently, they invest in every aspect of the value chain—manufacturing, distribution, support, and design—to make sure that every customer touch point exceeds expectations.
For most businesses the net present value of the Customer Lifetime Value is often exponentially greater than the value of the immediate sale at hand. And yet, because most business owners don’t understand this concept or they don’t view it this way, many companies let that wildly profitable revenue stream walk right out the door.
By gaining a deeper understanding of the TRUE VALUE OF A CUSTOMER, the goal is to keep those revenue streams alive!