| Part
two: The power of lifetime value
Have you ever wondered why some companies seem to offer unbeatable
deals to sell you their products and services? Or why book,
music and video clubs can offer such fabulous products for
such remarkably low prices?
The answer is that they are exploiting the concept of lifetime
value. The lifetime value is what your average customer contributes
directly and indirectly to your bottom line over a few years.
All too often, businesses concentrate on the immediate returns
from a sale. But, assuming your products and services are
good, customers will usually buy more than once from you.
These follow-on sales are far more profitable since they involve
little or no marketing costs. Also, by looking at a customer’s
requirements in greater depth, servicing their needs better
and actively seeking referrals from them, a customer’s
value to your business soars.
Knowing your customers’ average lifetime value will
help you decide how much you can afford to spend on marketing
to catch new customers and how to increase what you earn from
existing customers.
The concept is probably more relevant to mail order, business-to-business,
or service sales where there is the opportunity to build an
ongoing relationship, rather than over-the-counter retail
sales. However, lifetime value is so important that one big
US burger chain drills this concept into all new recruits.
Using the calculations shown opposite, the burger chain discovered
that upsetting a customer over a 99¢ burger could result
in $18,000 of lost business.
If you have many customers, you will probably want to consider
average figures overall, or in segments according to customer
or product type. If you have relatively few customers, you
might want to consider the figures case by case.
How to calculate a customer’s lifetime value
A customer’s lifetime value is the amount they can
be expected to contribute to your bottom line over the period
of your business relationship with them. So you need to analyse
the profitability of your customers over several years.
First find out:
- The value of an average sale. Divide
total annual sales (products and/or services) by the number
of sales in a year. Let’s say it is £500. (A)
- Your profit margin. Let’s say it
is 20 percent. (B)
- Customers’ purchase frequency.
The total number of annual sales divided by the number of
customers in a year. Let’s say the average customer
buys from you four times a year. (C)
- Average customer lifespan. How long does
the average relationship last? Let’s say three years.
(D)
Here’s how to assess these values for a typical customer:
- Average annual profit per customer: (A x B) x C = (£500
x 20 percent) x 4 = £400.
- Average lifetime value: £400 x D = £1,200.
Additional business
Not included in this calculation is the amount of referral
business customers generate. Most clients will be happy to
give you referrals if you ask for them. The number of leads
you get and how many you convert will vary with each type
of business. However, it is fair to estimate that the referral
business generated by each customer is at least 50 percent
of their own contribution – that is, £600.
Why a short-term view is so unproductive
If you had concentrated your efforts on one-off sales, you
would have had to make 12 sales just to achieve the same level
of profit (18 if you add in the value of the referrals).
What’s more, you have to spend a fortune marketing
to reach and capture each new sale, which is wasted if the
customer doesn’t buy again.
How to calculate lifetime values for service industries
Where you sell an annual service, say preparing year-end
accounts, you can calculate a customer’s expected value
in a similar way.
You cannot be sure a customer will stay, but you can estimate
the chances of them renewing their contract each year, and
so work out the probable or expected earnings over, say, a
four-year period. The calculation is actually really simple
once you get the hang of it.
All you need to know is your average annual profit per sale,
and the percentage of customers who renewed their contacts
last year – or are likely to next year if you are new
to business.
For example, if your annual average profit per sale is £1,000
and each year you expect to retain 85 percent of last year’s
customers, whose average lifespan is four years, a customer’s
lifetime value is:
£1,000 x (1 + 0.85 + [0.85 x 0.85] + [0.85 x 0.85 x
0.85]) = £3,187
However, if the chance of customers renewing their annual
contract falls to 30 percent, the figures now look like this:
£1,000 x (1 + 0.3 + [0.3 x 0.3] + [0.3 x 0.3 x 0.3])
= £1,417
From this you can see the importance of keeping customers
more than happy.
The sprat to catch a mackerel
Your lifetime value calculation will also show you how much
you can afford to spend on winning a new customer. In our
first example, you could afford to spend up to £400
(the first year's profits) to win a new customer, even though
the value of a typical sale was only £500, and the margin
only £100.
Six ways to boost profits
The lifetime value calculation shows how you could dramatically
boost your bottom line by changing the key figures used to
derive it. So:
- Increase the net profit. Raising prices by as little as
5 percent would have a dramatic effect. Similarly cutting
costs by the same amount would increase lifetime value disproportionately.
- Increase the value of each order with special bulk offers
or by selling extra or complementary products. Usually the
hard part is the first sell (the burger). The add-ons (the
drink and chips) are easier and often more profitable.
- Increase the number of sales per customer per year by
a single sale. Consider special offers to make customers
feel warm towards you.
- Extend the lifespan of your customers. Review your customer
service procedures. Find out what they want and never take
good customers for granted. Contacts can change or rivals
appear.
- Increase the number of customer referrals. Few businesses
do this systematically and so waste a great marketing opportunity.
- Review your customer list for the past three years. Rekindle
relationships you have allowed to wither. At the very least,
touch base and ask for some referrals.
To see what effect these measures could have, let’s
say you increase sales value (A) by 10 percent to £550;
profit margin (B) by 10 percent to 22 percent; frequency (C)
by one to five purchases a year, while keeping the average
lifespan (D) the same. The average lifetime value leaps up
as follows:
- Average lifetime value = (A x B) x C x D = (550 x 22 percent)
x 5 x 4 = £2,420
The figure has more than doubled for very little extra effort.
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