By Gerald Wheelus
Let’s talk about the lifetime value of a customer and what that value means to you. Lifetime value has many meanings and has been analyzed by folks who are a whole lot smarter than me.
There are several definitions, the importance of which is more complicated than just a few figures and formulas. But determining that potential value has to be considered, especially if you are going to build a marketing plan to gain new business or if you have already earned the business and now you are trying to retain it. You need to know if the investment is worth it.
Definition No. 1: Total profit (or loss) estimated to result from an ongoing business relationship with a customer over the life of relationship.
In our business, customers come and go and we have to spend valuable time and money courting them and oftentimes, we risk a substantial amount of money on charge accounts to these very same customers.
With that we have to consider just what the risk is and ask if it is worth it.
Therefore, a customer’s lifetime value has to be considered, as it is the only way to calculate the risk. The equation is:
Customer = Gross Profit Dollars X Months.
This equation gives us an idea of the customer’s potential profit and that can help us in determining how much credit we are willing to extend to them.
That is why we consider the amount of time they have been in business and why a customer that has been in business for many years can be justified a higher limit than the one who just opened the doors. If you figure it this way, a new customer’s life expectancy might be three years or 36 months. If they will spend $2,000 per month at 30% gross profit ($600 per month), we can expect to a lifetime profit of 36 months X $600 for a total of $21,600.
We rely on those repeat customers and the substantial amount of monies they spend with us over the lifetime of their business. Although there are many factors to consider when extending credit, this customer may be worth the risk if we can predict a lifetime profit of $21,600. Although profit is the bottom line, we can also consider the sales this customer will offer us.
Definition No. 2: The amount of sales in dollars that a customer will spend with a particular company over their lifetime.
This same customer’s lifetime value is figured very similarly to profit, only the sales are the top thing considered and in this case, it is $2,000. So the equation to consider is 36 months X $2,000 produces the total sales of $72,000. The importance of knowing this is the fact that we have cash flow of $72,000. We now know that each month we have extended credit to this customer we must have an extra $2,000 to replace the amount of merchandise the customer has purchased from us. This is why we have to consider all the equations.
This customer costs us $2,000 to begin with until they have paid their bill. Because our bill came due and we paid it, we use our monies to replace the products they purchase and now we must have them to pay their bill so we can replace the monies we spent to carry them. If we know we can count on the money they have and will spend, then the risk is worth the reward due to the profit to be made: $600 per month or $21,600 for the three-year lifetime value.
Definition No. 3: The basic definition of “lifetime value” is the total amount of sales revenue the average customer contributes to the company over the life of the relationship.
Compared to the two other definitions, this equation is more concerned with averages of all customers that are retained. If you have 20 customers who have purchases of $2,000 per month, then the equation is easily figured. However, not every customer is the same. They spend different amounts at different gross profit percentages and they pay their bills in different ways; some even pay on-time and in most cases, those get a pay on-time discount.
Some pay cash every time they come in, some pay with a check at the end of the week, some pay by credit card. The scenarios go even deeper than that as we have to consider delivery costs. We should even consider the amount of defective returns we have to deal with from them.
The scenarios could go on and on, but they should be deciding factors in what the bottom line of the equations are and that is simply “net profit dollars.” We as salespersons concern ourselves with the sales and in some cases, the gross profit of the sale. In reality as a business owner/manager, the “net” is the bottom line.
Thus, to consider the average customer’s net we should use the equation of the average customer and what the cost is to maintain them and what we are truly making off of them. Average has too many equations and the one that is most commonly used is so complicated that Sir Isaac Newton or Albert Einstein could not figure it out.
However, the equations should be considered if you are considering large expenditures to acquire, maintain and retain the customer you are targeting. But, here it is if you want it from brandblackboard.com:
CLV = M – c – AC/1 – r + i
This is the simplified version of the formula where the variables are fixed across periods, and an infinite economic life is assumed.
M: This is the margin per customer. If we sell a widget for $10 and it cost $4 to make, this value is equal to $6
c: The cost of marketing to each customer; whether it is communications or promotional material. The cost of advertising and other marketing campaigns must be aggregated and averaged over the number of customers to obtain this figure.
r: Retention rate is the survival rate of customers on an annual basis. While this rate can vary year over year, in the simplified formula this is assumed to be constant over the life of the customer. If the retention rate is 75% for instance, then three out of every four customers repeat purchase the following year.
AC: This is the cost to acquire a new customer. Acquisition cost can vary depending on the industry and company. For a firm that uses direct mail for instance, it may be as simple as multiplying the response rate times the cost of mailing per customer. In retail, it might be the cost of the store lease averaged over all customers. Some firms and industries may not even have direct acquisition costs.
I: The discount rate adjusts for the time value of money and is typically the rate of inflation – or the alternative to investing the money used to operate the business.
We all wonder why we deal with certain customers and if the trouble is worth it, now we have a formula to work with.
The explanations of this are limitless, so if you find you have an interest to learn more there are limitless explanations on the Internet that might or might not help for the subject, but the lifetime value of a customer explanation has value to all of us if we stop and consider the equations.
