The Lifetime Value of a Customer
This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.
Most businesses understand the importance of customer relationships but have not quantified the impact of those relationships on bottom line results. The lifetime value of a customer is a valuable tool for measuring the contribution a customer makes to the bottom line and a useful basis for developing marketing strategies that effectively target the most attractive customers.
How to calculate the lifetime sales value of a customer
The lifetime value of a customer is a relatively simple calculation. The first step is to calculate the lifetime sales value of the customer. This is done by multiplying the number of annual customer purchases by the average sales amount and then multiplying that by the number of years they remain a customer. If the customer averages $500 in purchases three times a year for five years, the lifetime sales value is $500 average sale x 3 purchases per year x 5 years, or $7,500.
How to calculate the lifetime sales value of referrals
The second step in determining the lifetime value of the customer is to calculate the lifetime sales value of new customers added as a result of the customer's referrals. To arrive at this value, multiply the number of annual referrals by their average purchase size and then multiply that by the frequency of purchases and the number of years. To illustrate, assume the customer's referrals yield two new accounts per year for the five years the customer is active and the referred customers also make three $500 purchases per year for five years. The lifetime sales value of these ten new customers is $500 average sale x 3 purchases per year x 5 years x 10 referrals over five years, or $75,000.
How to calculate the total lifetime profit value of the customer
The lifetime profit value of the customer is calculated by multiplying the total customer and referral lifetime sales by the gross profit margin. If the gross profit margin is 50 percent, the lifetime profit value of the customer including referrals is $75,000 x 50 percent, or $37,500. Even this may understate the total long-term value of the relationship because the referrals themselves can also make more referrals, further enhancing lifetime customer profit value.
The true benefit of the lifetime customer value concept is in bringing to light the fact that customer relationships are much more valuable than is commonly perceived. This calculation reflects this economic reality and suggests that if the marginal value of nurturing existing relationships and acquiring new ones exceeds the marginal costs of doing so, there is a significant long-term economic benefit to the firm.
Deficiencies in other methods of calculating lifetime value
There are other methods of calculating lifetime customer value, but this method is the most straightforward for marketing decision-making purposes. Some methods use net present value methodology and discount future profits, making the calculation much more complex and requiring numerous assumptions, including discount rates and other variables. Other approaches subtract corporate expenses from the value to arrive at a net income lifetime value. This dilutes the marketing decision making value of the approach and introduces a multitude of other complications including the frequently arbitrary allocation of corporate and other expenses not specifically related to the customer relationship.
Lifetime customer profit value and marketing decision making
The customer lifetime profit value calculation is a valuable tool in the marketing decision making process. One application is to measure increases in lifetime value as a result of service improvements, communications programs and advertising initiatives. Because of the high lifetime value of current customers and lower cost considering the acquisition cost of new customers, expenditures to solidify and enhance relationships with existing customers will be a good investment worthy of being high on the marketing priority list. Customers with a high lifetime profit value need to be targeted and customers with very low or no lifetime profit contribution should receive less emphasis.
In terms of marketing strategy, the more you know about existing customers the better you can communicate with them, nurture them and enhance the sales potential of the relationship. Knowing who your high value customers are can be helpful in designing marketing strategies and pursuing promotional channels that will attract customers with similar characteristics.
Initiatives can be taken to further enhance customer satisfaction and encourage customers to develop referrals. Operationally, an emphasis on excellent customer service and relationship building should permeate the culture at all levels of the organization. Advertising, social media, special offers, emails and other communications channels can help to solidify these relationships, increase business from existing customers and help generate more referrals. The enormous value of referrals can clearly be seen in the lifetime profit value analysis. Even a small increase in the number of referrals will have a huge impact on sales and profits.
Why you may not want to keep some customers
Every business has some customers they would rather donate to a competitor. The customer lifetime profit value approach is useful in determining which customers are not contributing to overall results. These customers may be infrequent purchasers who generate little or no gross profit and provide no referrals. In some cases, they may be demanding to the point of being a distraction from providing superior service to the high lifetime profit value customers. At the very least, few efforts should be made to encourage them to stay and, depending on the business, they may even be discouraged. A small professional services firm, for example, may politely indicate they are too busy to take on the assignment.
Lifetime customer value is a useful tool in developing marketing strategies
Lifetime customer value provides important insights into the long-term value of customer relationships and can be useful in establishing marketing strategy priorities. Marketing, communications, service, and advertising strategies can be developed to deepen the relationships with existing high value customers, generate referrals from satisfied customers and find new customers to support the achievement of long-term marketing and profit objectives.
The lifetime value of a customer is a useful way to quantify the long-term value of a customer relationship. This value provides insights into the true long-term benefit of the customer relationship and can be used to establish marketing priorities to support the achievement of growth and profitability objectives. It can be a useful guide for targeting marketing, communications and sales promotional programs that will deliver the best long-term results.
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