How to Calculate Lifetime Customer Value, Part 2 of 2

Valued Customer

Valued Customer

In “How to Make Money by Losing Money,” we introduced the concept of back end sales, and suggested it was worth giving away a $400 (retail) cellular telephone in order to get a $100 per month cellular telephone service contract.

How did we know? We simply subtracted the cost of the premium (the front end transaction) from the sum of back end profits over the lifetime of the vendor/customer relationship. In Part 3 we’ll learn how to use the Customer Lifetime Value to calculate useful things, like ad budgets.

Our hypothetical telephone company is a small start up. It has 3,500 customers, each locked in to a twenty-four month service agreement. The company’s net profit is $297,500 per month.

Over the first year of the contract those 3,500 customers will produce $7,140,000 in profit – approximately $1,020 each.

They will also produce $955 each in the second year. (There will frequently be a difference between year one and year two. More on that in a minute).

This means that even if every single customer stops doing business with this company, the lifetime value (profit) of every new customer this phone company can acquire is still $2,040.

Calculating LCV for your business.

This LCV number is important. Without it we can only guess at how much we are able to spend to acquire a new customer.

A. What is the profit on your average sale? $ _________

B. How many times will the average customer repurchase from you? _________

C. Multiply A by B to estimate your average customer’s lifetime value. For your company that value is: $ _________

Lifetime Customer Value = Pt (profit per transaction) x R (number of customer reorders)

Of course, this is overly simplistic.

In the real world, Lifetime Customer Value is a moving target.

Under most conditions, not all of those cellular telephone customers will complete all 24 months of the service agreement. If 14 percent cancel during the first 12 months, 3,200 customers will enter year two of their relationship with the cellular provider.

At the conclusion of the second year we can estimate that, freed from their mandatory minimum service agreement, 70 percent will either upgrade to a new phone with the same company, or sign with a competitor. Either way, they’ll be entering into a new 24-month agreement.

But the remaining 30 percent will appreciate the month-to-month nature of their new relationship with their cellular provider. 1,050 will enter year three with the company.

Also, the profit margin actually increases the longer a customer stays a customer, since older customers tend to consume fewer support services.

So, applying a bit more accuracy to our figures, the actual customer lifetime is three years. She’ll generate $2,205 in value to the company during that lifetime.

Calculating Customer Reorders for your business.

Your average sale figure is pretty straightforward. Simply divide total revenue by number of transactions. Estimating the number of times a customer will make another purchase is a bit more difficult.

You could divide the number of total sales by the number of customers, but that leaves us with a bit of a problem. Can you spot it? Exactly. Newer customers will not have ordered as many times as a long-term customer would have.

We’ll get more accurate data if we remove data from all customers who have not finished their relationship with you. But that means you must already have a good estimate for the length of time a customer is likely to continue to purchase from you. And if we knew that, we wouldn’t have to estimate. (Author makes “I’m going crazy” sound of index finger thrumming on lips).

OK. Let’s reconsider.

If you’ve been in business for several years, you can create a fairly accurate estimate by removing from your list of customers any who haven’t ordered anything from you in the last 12 months. Now, select every fifth (or seventh, or thirteenth) remaining customer until you’ve created a significant sample. Fifty may be acceptable. One hundred is much better. The larger the sample, the more accurate your results.

Calculate the number of days between each customer’s first order, and their last order with your company.

D. What is the number of days between the first purchase and the last for each customer in your sample? ___________

E. Sum the number of days as customers from each customer sample. The total is: _________

F. Now divide by the number of customers in your sample. ___________.

This is the average length of a customer relationship, in days. If you’re a younger company and don’t have records going back years, study your sales data. As closely as you can, estimate the length of the average customer relationship, in days.

G. Whether calculated, or estimated, how many days does this work out to be for your company? __________

Trim the database.

From your complete customer database, remove all data back as far back as the number of days in your average customer relationship. Count the number of sales transactions which remain, back to day one. Count the number of customers which remain, back to day one.

H. For your company the number of sales is: __________

I. For your company the number of customers is: __________

Divide the remaining total sales by the remaining number of customers and you’ll have a highly accurate customer reorder number.

J. Divide H by I. The average number of reorders for your typical customer is: __________

The final step.

Divide the average profit per sale (from A, above) by the average number of reorders (from G).

K. That number, your true lifetime value of a customer, is: $___________.

You can add a degree of sophistication (and accuracy) by discounting the value of future cash flows. It’s a bit complex, but if you’re curious, drop me a note.  And knowing what you can invest in bait and still profitably reel ’em in  gives you a major advantage when you’re fishing for customers.

Your Guide,
Chuck McKay

Marketing consultant Chuck McKay

Chuck McKay

Your Fishing for Customers guide, Chuck McKay, gets people to buy more of what you sell.

Questions about focusing your messages on specific stages of shopping may be directed to ChuckMcKay@FishingforCustomers.com. Or call Chuck at 304-208-7654.

 

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How to Make Money by Losing Money – Part 1 of 2

Light Bulb with Dollar Sign

Money Idea!

Would you buy a dollar for 50 cents?

OK, that one was easy. If you could hand me 50 cents, and get a dollar back every time, you’d push as many fifty cent pieces in my direction as I’d be willing to accept.

What about for 99 cents? Would you be as excited about that exchange?

Maybe. As long as there’s a profit to be made you might be willing to make it slowly.

How about $1.35? Could you imagine spending $1.35 to get back one dollar? Your first reaction is likely “no,” but the correct answer isn’t so obvious.

How could anyone stay in business losing 35 cents on the dollar?

Pretend with me that your music store consistently sells twelve guitars a week, at an average price of $850, and an average profit of $332 (39 percent).

You’re planning an Anniversary Week guitar sale, and have budgeted $10,000 for advertising. Knowing that you’ll get to keep 39 cents of every dollar you take in, it would seem that to recover your $10,000 advertising investment you’ll need to generate $25,641, or roughly 30 additional sales (for a total of 42) just to break even.

But wait a minute. Selling 42 guitars this week doesn’t have you showing a profit. You’re merely recovering your costs.

And what happens if you don’t sell 42 guitars? Wouldn’t you have been better off not advertising this sale at all?

Maybe we need to re-think this Anniversary Week sale idea.

Then again…

We probably will sell a lot of accessories. We’ll probably draw some new people into the store, and remind former customers that they used to enjoy shopping with us.

OK. Even if we can’t sell enough guitars to pay for the Anniversary sale advertising, we might sell enough other items to recover the ad budget.

And then there are the rumors of the way the new competitor does business. You’ve heard he will happily lose money on the first sale if he gains a new customer in the process. What the… How can anyone stay in business with a silly business model like that?

Well, your competitor has recognized that the customer who buys the guitar will also need a case, maybe a strap. Over the next weeks he’ll see the value of a battery-powered tuning standard, or a capo. He’ll need picks, and strings. Over his lifetime as a player, he’ll need lots of strings.

Then, too, over his lifetime as a player, he may purchase several other instruments, and all of the accessories. Maybe he’ll even need lessons.

If a business is willing to invest money in advertising to gain new customers, why not invest in the customer himself?

When we consider the probability of all those additional purchases, and all of the profit derived from them, would you be willing to lose a few bucks on the “front end” of this relationship to “buy” the customer, and gain a profitable “back end?”

Twenty years ago Jay Abraham brought up the concept of back end sales by telling the story of a coin dealer. The dealer offered a $23 starter coin set at cost, and gained 60,000 new customers.

  • Within six months, 6,000 of those 60,000 new customers each bought another $1,000 worth of coins. 
  • Two months later 2,000 of the 6,000 customers each purchased roughly $4,000 in additional coins.
  • Finally, 500 of the 2,000 bought another $10,000 each.

By being willing to break even on the initial sale, the coin dealer was able to generate a list of qualified customers who were responsible for $19 million dollars in additional sales:

Jay Abrahan's Coin Upsell data

Jay Abraham's backend coin upsell data.

And this part is critical: every one of the 60,000 names on the initial list turned out to be worth $317 in additional sales, even though nine out of ten of those new customers never spent another dime.

This is a great illustration of Lifetime Customer Value (LCV).

Make your profit on the back end.

How many customers would you be willing to sell at no profit, if it meant each would directly or indirectly generate $317 in new sales in the next year?

Would you maybe even be willing to lose money on the front end, if there was enough profit on successive back end deals?

  • Would you give away the $400 (retail price) cellular telephone, in order to gain the 24-month usage contract at $100 per month?
  • Would you give away the new $60 (retail) chrome plated coffee brewer to gain a customer who spends an average of $234 on your gourmet coffees?
  • Would you be willing to sell gasoline at an average profit of $14.32 per month (four, 20-gallon tanks), when that driver will spend an average of $31.92 each month in interest and carrying charges on your company credit card?

Yes, I suspect you would.

Next time, in How to Calculate Lifetime Customer Value, we’ll determine in dollars and cents the value of each new customer. We’ll also get a handle on how long that new customer will continue to do business with us. An important consideration when one is fishing for customers.

Your Guide,
Chuck McKay

Marketing consultant Chuck McKay

Chuck McKay

Your Fishing for Customers guide, Chuck McKay, gets people to buy more of what you sell.

Questions about making money on back-end sales may be directed to ChuckMcKay@FishingforCustomers.com. Or call Chuck at 304-523-0163.

 

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Zen and the Art of Persuasion. Part 3 of 3

Risk

Dice Spelling R-I-S-K

There’s a gas station at one of the Interstate 20 off ramps in Columbia, South Carolina that is rumored to have the lowest prices in town. If they don’t have the lowest prices, they certainly have convinced a large group of drivers that they do. Most hours of the day they have a constant line of cars at each of the eight pumps.

A casual observer will notice a young man drifting from car to car, speaking with each driver in sequence. The young man you notice on Monday will not be there on Thursday. Another young man will have taken his place.

And should the observer become an eavesdropper, he’ll hear the young man explain that he works for a glass company “up in Greenville,” has his materials with him, and can repair the dings and chips in the driver’s windshield for between forty and sixty-five dollars. He opines that the motorists insurance will cover it, reimbursing the driver so there will be no “out of pocket” expense.

Apparently, enough people accept his offer that it’s profitable for the young man, or one very much like him. They keep coming back.

Occasionally one of the motorists, wanting to “think it over,” will ask the young man du jour for a business card. He never seems to have one on him. Although he can name the company he works for, he can’t remember it’s phone number. No, he doesn’t carry a cell, so he can’t provide that number either.

In any buyer / prospective seller relationship, there are two basic reasons that people choose not to buy, and the young man carrying the battery-powered drill and pocket epoxy illustrates them vividly.

People don’t buy when they don’t feel the need for what you’re selling.

They don’t buy when don’t trust you.

People avoid risk on three levels.

  1. The biggest risk is that they’ll purchase the wrong solution – that they’ll have spent the money and still have the problem.
  2. But, there’s also the risk that the solution they purchase won’t last, and their problem will be back. (The variant on this is buying from a company who won’t warrant the purchase, or even be in business if the purchaser ever needs their support).
  3. And finally, if all of the solutions seem roughly equal, there’s the risk of over paying.

Put yourself in the mindset of someone who’s just become aware of a problem, which could be anything from “ring around the collar” to “my back hurts every morning when I wake up.” Whatever the problem she’s identified, she’s now looking for a solution.

Ring around the collar? One of the oldest formulas in advertising was perfected by major packaged goods companies like Lever Brothers and Proctor and Gamble. The familiar presentation is called slice-of-life, and is presented as if we, the viewers / listeners / readers are peeking in on a conversation between real people.

The formula is basic:

State problem. Agitate problem. Announce solution.

  • First, our slice of life dialog establishes that “ring around the collar” is an easily noticed condition which will reduce social standing.
  • The off-camera announcer states the problem: “You’ve got ring around the collar.”
  • He now agitates the problem: “Those dirty rings. You’ve tried scrubbing. You’ve tried soaking. You’ve tried powders. And nothing works.
  • We’re treated to a close-up demonstration of Wisk liquid laundry detergent being poured on the offensive sweat stain. The camera cuts to a close up of the same collar without the stains.
  • The off-camera announcer proudly announces the solution: “Wisk around the collar gets ring around the collar every time.”
  • This is a good example of a single-step ad. Its also known as an order generation ad. Its purpose is to get the prospect to recognize her problem, accept the solution, and purchase it. Now.

    Does order generation advertising work? Most assuredly, it does. You’ve seen examples of it every day of your life.

    The catalog from Sears or Terry’s Village. Every Yellow Pages ad. The “cash for gold” ads on television. The long-running television or magazine ads for Miracle Grow. A significant percentage of the letters in your mailbox from companies you’ve never heard of.

    Let’s review those three risks.

    Our slice-of-life laundry lady is highly likely to purchase Wisk, now that she’s seen, and accepted, the premise of the ad: “Wisk around the collar gets ring around the collar.”

    1. Is she risking the wrong solution (no pun intended)? She recognizes ring around the collar as her problem, because she sees the sweat stains every time she does laundry. This appears to be an exact solution. Minimal risk.
    2. Is she risking that her solution will be temporary? No. It’s a disposable product. If it doesn’t work as well as she expected, she can simply not replace it when she runs out. Again, no real risk.
    3. Is she risking paying too much?* Probably not. If our shopper purchases the economy size “32 load” bottle of Wisk, she can expect to pay roughly $7.50. If she pays $7.83 will that price increase damage her cleaning budget? Hardly

    Without the perception of risk it shouldn’t surprise us that this customer will quickly decide to buy the product.

    Single-step ads tend to work best for simple, non-technical, and inexpensive products. The simpler the proposal, the easier it is to explain in a small ad. This is the principle which makes classified advertising work.

    But what if the product or service needs more explanation than will fit into a small space ad, or half a minute on TV or radio? In general, the more complex the product, the more technical the nature of the product, the higher the price, the less likely a single-step ad will convert people from prospects to customers.

    Back to the lady with the backache.

    She wakes up, and groans while getting out of bed. By her second cup of coffee she’s moving freely and has forgotten about the stiffness.

    But one day she realizes that this “back hurts first thing in the morning” business has gone on for weeks. In her mind (which is where it counts), that realization moves her backache to the status of a problem. Problems need resolution.

    She begins to pay attention to what web marketers call “keywords.” Keywords aren’t limited to the Internet. Regardless of medium, they are one or two word phrases that trigger her reticular activation system and reach her conscious brain. In her case, the words will be “backache,” and “morning backache.”

    Now that her subconscious is aware that they are important she begins to notice the advertising messages which surround her. As her eye skims the newspaper the keywords seem to leap off the page. She’ll be riveted to certain radio ads. She’ll stop talking during television advertising in which the keywords resonate in her conscious mind.

    • “Morning backache is a sign of a too soft mattress. See how good you feel after 30 nights on a Simmons Beauty Rest.”
    • “Morning backache is a sign of poor posture. WalkFit Orthotic Shoe Inserts helped over 90% of the people tested reduce pain levels in their feet, knees, spine and pelvis.”
    • “Morning backache is a sign of poor spinal alignment. Should that stiff neck or sore back persist, call your Doctor of Chiropractic.”
    • “Morning backache can be treated with Doan’s Backache Pills. They relieve the aches and pains and that helpless feeling of stiffness, so that the system can be restored to full health.”
    • “Morning backache is a sign that the vital magnetic energy from the earth’s natural magnetic field has been interrupted. Magnetic insoles provide penetrating magnetic therapy for the entire body while soft massage nodes stimulate reflexology points.”

    Multiple products promise to relieve her discomfort. Multiple disciplines claim to treat her condition. With the limited knowledge she possesses as an entry level shopper, she could easily choose the wrong solution, or one that doesn’t last. Without knowing which solution is appropriate she could easily overpay. She’s swimming in risk.

    Sellers would love for her to buy from a single-step ad.

    From the seller’s perspective a single-step order generation ad is a quick sale. It doesn’t require any follow up. Done well, salespeople may not even be necessary. The process seems so simple, so straightforward, so easy. “Here’s my offer. Come buy it.” There is no intent for these ads to build image or “brand” the advertiser. Their only purpose is to get the sale. Miss Prospect will buy, or not. No second chance.

    But Miss Prospect may not be ready to buy when you want to sell. She may not need it today. Even if you do, she doesn’t know you. She doesn’t know your product. From her perspective she’s surrounded by risk. Did I mention that she doesn’t know you?

    Risk Graph

    Amount of Risk at Each Stage of Shopping.

    She needs information about how you can solve her problem. She needs information about your professional reputation. She requires more information than can fit into a small newspaper or magazine ad; more than will fit into a radio or television ad.

    When she’s in the early stages of seeking a solution for her problem, Miss Prospect will want to see a demonstration, read a specification sheet, see an estimate, meet for a consultation, or expect a presentation before she buys.

    See the problem? One-step ads work best when the offer is simple, and inexpensive. They work when the prospect is a late stage shopper, and is very close to making a purchase. But when Miss Prospect is an entry stage shopper, is bewildered by the sheer number of choices, and feels overwhelmed by risk, they tend not to work at all. Mr. Advertiser schedules his single-step offer to run in the noon newscast, and at 12:15 is standing at the door wondering where all of the buyers are.

    If we’re selling mattresses, orthotic shoe inserts, chiropractic services, analgesic pills, or magnetic therapy – if we’re selling anything which takes a more detailed explanation than “this detergent gets the dirt out” – we’ll do better breaking the sales process into two or more parts.

    Instead of asking Miss Prospect to commit to the purchase, we ask that she only commit to the risk-free next step in our selling process.

    What’s the risk-free first step?

    Example 1:

    How do Proctor and Gamble minimize the customer’s $7.50 risk for any of their new detergents? They offer a free sample of the product. Enough for two or three uses. Miss Prospect tries the soap, likes the way it cleans, really likes the new fragrance, and adds the product to her next shopping list.

    Summary: the manufacturer invests roughly 57₵ to acquire a new customer of their consumable product. Its likely that she’ll spend roughly $90 per year re-purchasing it.

    Example 2:

    “If we pre-qualify you and your claim is denied, the Scooter Store will GIVE you your new power chair or scooter, FREE.”

    Summary: by offering a “pre-qualification,” the advertiser gets the complete personal information on an active prospect.

    Example 3:

    “Well I married my dream girl, I married my dream girl, but she didn’t tell me her credit was bad…” This delightful ad for Free Credit Report dot com offers a three bureau credit report, at no cost to the caller. There are two reasons this one is worthy of note. First, it uses network television (with only :30 seconds to tell a story) to drive traffic to a web site where there’s no limit to the amount of information which can be presented to the prospect.

    But, pay close attention to both the tiny screen writing and the subdued voice over, each of which say, “Offer applies with enrollment in Triple Advantage.” Did you catch it? The entire 30 seconds pushes the free credit report which people get by enrolling in a monthly credit monitoring service for $14.95 per month.

    Summary: for the price of a single credit report (no incremental cost to the advertiser), and by focusing ONLY on the premium – the free report – they get a subscriber who will pay nearly $180 per year.

    Imagine trying to convince people to sign up for a monthly credit monitoring service in a :30 second single-step TV ad. “Call now. Protect yourself from identity theft for only $14.95 a month. Operators are standing by…..” But asking them to identify themselves by requesting their own credit report? How elegantly simple.

    They call it two-step marketing, but…

    It may be the second, third, or forth step which closes the sale after the first step provides the “lead.”

    Or it may be a series of progressively larger sales. Roy H. Williams says the subscribers to his free newsletter may become familiar enough with his writing to purchase a $12.95 book. Some of the book buyers may purchase a $49.00 video, or a $495 training program, or a $3,000 three-day seminar. Some of those purchasers will become consulting clients. Roy calls this his “gravity well.”

    Whether you call the two-step process a prospect funnel, a gravity well, or lead generation, there are a few things you can do to maximize its effectiveness.

    Not everyone you meet will be a qualified prospect for what you sell. And remember that qualified prospects still won’t buy if they don’t believe they need what you’re selling, or if they don’t trust you.

    Two-step marketing allows you to persuade your prospects that what you sell is the exact solution they’re seeking. More importantly, it allows them to experience your trustworthiness. And both are critical to the reduction of perceived risk among your prospects.

    And risk makes the bait less attractive when you’re fishing for customers.

    Your Guide,
    Chuck McKay

    Marketing consultant Chuck McKay

    Chuck McKay

    Your Fishing for Customers guide, Chuck McKay, gets people to buy more of what you sell.

    Questions about focusing your messages on specific stages of shopping may be directed to ChuckMcKay@FishingforCustomers.com. Or call Chuck at 304-523-0163.

     

    ___________

    *Doesn’t it strike anyone else as odd that so many business people skip by the two more critical perceived risks, and immediately cut price to stimulate sales?
    ___________

    This article is one of three on this subject:

    Part 1: How Does One Educate a Customer

    Part 2: How to Steal Your Competitor’s Customers

    Part 3: Zen and the Art of Persuasion

    ___________

     

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