How Should Your Company Consider Customer Lifetime Value?

How Should Your Company Consider Customer Lifetime Value?

Preface

The concept of lifetime value is well founded in the sales and marketing field, where there has been a growing appreciation that it is cheaper and more profitable to maintain than gain and that a business needs to think over the long term regarding its customer relationships, rather than take a narrow, single transaction perspective. HP’s David Packard famously once stated that “marketing is too important to be left to the marketing department” implying that all employees are part-time marketers and so those in operations and service delivery also need to grasp the lifetime value concept and ensure that they play a role in nurturing customer relationships, so as to maximise both the return for the company and the value received by the customer.

This article first appeared on tenfold

Introduction

What is the value of acquiring one customer? Many marketing campaigns carefully consider this cost. They total up all the advertising and free perks offered before the customer commits to a paid product. However, once the customer commits, how much is that relationship worth? The customer lifetime value is the sum of all the customer’s purchases over the entirety of the relationship with the company. It can be the total over years.

While it may seem difficult to compute this value, it’s an important metric for evaluating the effectiveness of a marketing campaign. The lifetime value of a customer can influence how much companies decide to spend acquiring a customer. The value shows whether the acquisition cost was worthwhile. The customer lifetime value (or customer LTV) can be used to determine a good marketing campaign budget that balances lifetime value and acquisition cost.

The Customer Lifetime Value Formula

There are many ways to calculate customer lifetime value. Models range from the complexity of predictive analytics to a simple formula using average values. A formula that relies on averages is shown here:

Average Value of a Sale x The Number of Repeated Transactions per year x Length of Relationship in Years

The lifetime value calculation gives you the revenue from each customer as an average. To get to this number, use the total value of sales over the total number of sales as the average value. The number of repeated transactions per year can be estimated. In the case of a subscription service, this number is simple. A monthly subscription service would be repeated 12 times a year. To calculate a less regular interval, averages are useful. The number of transactions divided by the number of customers over a year will provide a close estimate. Finally, the value of the customer is multiplied by the years in the relationship. This simple customer lifetime value model will give a good estimate of a customer’s value to the company.

Starbucks Customer Lifetime Value

Calculating customer lifetime value can seem abstract until it is applied to a real business. Kissmetrics shows three ways to calculate the lifetime customer value of Starbucks customers. The ‘custom’ customer LTV is most similar to the one described in the previous section. To start, five Starbucks customer purchases are averaged into a $5.90 sale value. Then the customer’s number of visits per week is averaged to be 4.2. To convert this number into years, Kissmetrics multiplies by 52 (the number of weeks in a year). The final variable is the average customer lifespan, which is 20 years for Starbucks.

The Starbucks example also takes into consideration the profit margin. Many customer lifetime value calculations only look at the total revenue. However, the Starbucks example multiplies the value by the profit margin to get a better idea of the profit to the company per customer. The number at the end is smaller but possibly more useful. To further refine the customer value, companies can also subtract the cost of acquiring the customer in the first place. These refinements to the customer lifetime value model give a clearer picture of the profit from each customer, instead of the revenue shown in the simplified calculation above.

Linking Customer LTV to Acquisition Cost

Before starting a new marketing campaign, companies can calculate the customer lifetime value as a guideline for the acquisition cost. If the acquisition cost exceeds the lifetime value of the customer, the acquisition cost is far too high. In practical terms, if the average customer only purchases $25 worth of product but costs $30 to acquire, the company is bound to lose money. Fortunately, companies can determine how much they spend on acquiring customers and build a system that maximizes the customer lifetime value.

Two gyms serve as an example of linking customer LTV to acquisition cost. Gyms are a good example because they utilize a monthly subscription service. The calculation of the average sale and number of repeated transactions per year is simple. It’s the cost of the membership. If two gyms have the same pricing structure of $20 per month and an expected customer relationshipof 2 years, they both have a customer lifetime value of $20 x 12 x 2 years or $480. But each gym can take a different approach to the acquisition cost. The first gym may want the customer’s value to exceed the acquisition cost after 1 year. Therefore, they can spend up to $240 acquiring a customer.

The second gym may need to become profitable after 6 months, so they can only spend $120 acquiring a customer. These acquisition numbers are linked to the marketing campaign budget. A marketing campaign designed to acquire 10 customers would have a budget of $2400 for the first gym and $1200 for the second. Basically, a customer lifetime value model can help a business home in on a reasonable marketing budget.

Summary

A customer lifetime value calculation can guide the development of marketing campaign budgets by providing insight into how much companies should spend on customer acquisition. At the very least, customer LTV puts a limit on how much the company can spend to acquire a customer. To be profitable, companies need to have higher customer lifetimes values than the cost of acquiring a customer. A customer lifetime value is thus a very valuable metric for developing marketing campaigns.

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