Compute Your Customer Lifetime Value
Everyone talks about customer lifetime value, but few have actually calculated it. The process is not that difficult. When you finish this article, you will be an expert.
In the first place, what is lifetime value? It is the expected profit that you will realize from sales to a particular customer in the future. Although it builds on past customer history, LTV is all about the future. It is based, primarily, on the customer's expected retention and spending rate, plus some other factors that are easy to determine. To understand LTV, let's begin with a typical LTV table.
In this table, 100,000 customers are acquired originally. We are following their purchase history for the next three years. The first thing you will notice is that 40% of them disappear after the first year. The retention rate is only 60%. In future years the retention rate grows. The loyalty of retained customers is higher than that of newly acquired customers. As customers stay with you, their number of orders per year and their average order size tends to increase.
We are assuming a 70% cost of sales. Your number may be different. The cost typically goes down after the first year. The cost of customer service to existing customers is usually lower than that to new customers. It costs you $55 to acquire a new customer. This is computed by taking all your advertising and sales costs and dividing this by the 100,000 customers that you acquired. We are assuming that you spend $20 per customer per year on subsequent marketing, including the cost of the database that provides the information needed for this table, and is used to provide the personal communications needed to improve the retention rate.
The Gross Profit is simply the revenue minus costs. We have to divide this by a discount rate to get the Net Present Value of the expected profits. The discount rate (based on interest rates) is needed because future profits are not worth as much in today's money as present profits. The formula for the discount rate is:
Where D = Discount rate, i = interest rate, rf = the risk factor, and n = number of years that you have to wait. With a risk factor of 2 and an interest rate of 8%, the discount rate in the third year (two years from now) is D = (1 + (.08 x 2))2 or D = (1.16)2 = 1.35.
The lifetime value is calculated by dividing the cumulative LTV by the originally acquired 100,000 customers. The LTV in the third year is $53. That means that the LTV of the average newly acquired customer is $53 in the third year. In this one number we have encapsulated the retention rate, the spending rate, the acquisition, marketing and goods costs, and the discount rate. It is a wonderful number.
From this table, you can learn quite a lot. As you can see, acquiring new customers is not a profitable activity. Customers, in this case, become profitable only in the second and third years. This is typical. It is why money spent on increased retention has a higher payoff than money spent on acquisition.
We have calculated an average LTV for a group of 100,000 customers. We now have to figure out the LTV of each individual customer. This is done by creating customer segments. How you develop customer segments is an art. It depends on your customer base and marketing program. Segments might be by age (Senior Citizens, College Students, etc.) or by spending habits (Gold, Silver, Bronze) or by product type (Deluxe, Regular, Economy), etc. However you do this, you can redo your LTV table to create a LTV for each segment.
Jane Adams, one of your customers, may be a Deluxe customer, who spends about $300 per year. The LTV of the Deluxe customers for example, may be $100 in the third year. They may spend an average of $200 per year. So Jane Adams third year LTV is $150 ((300/200)*100)). You can set up a program to compute this number for every customer and put that number into your customer database.
LTV can thus be a valuable tool in your marketing arsenal. You treat customers with high LTV (high expected future profits) differently from those with low LTV. You spend more to retain them. Some customers may even have negative LTV. Why spend a lot of money trying to retain these losers?
The LTV table can be used to evaluate the expected results of new marketing programs before you have spent millions on them. When you come up with a new initiative, estimate what it will do to the retention rate and the spending rate (orders and average order size). Some marketing programs will fail this test. Their benefits will be lower than their costs. They may cause LTV to drop rather than to rise. Don't fund them.
The table can also be used to validate your LTV calculations. All of the numbers shown in the table above are real numbers (not assumed numbers like "awareness"). When the second year arrives, you can go back and see what was your actual retention rate and spending rate. If you have been too optimistic or pessimistic, you can learn that and do a better job next year.
LTV is thus a wonderful marketing tool which costs very little to calculate, and can return rich rewards in terms of improved marketing strategy. You now know how to calculate it. Go forth and make money.