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 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.
If you know someone who would find this article useful, please share it.
This could not be written any far more better. This is one of those things that a starting company forget. How long their customers will stay. Moreover, even if the formula has been given to calculate the lifetime lifetime customer value, if your company is not performing well to the needs of the customers, the effort of computing it will be wasted. That is why it is necessary to have a well structured business plan and management in one company.
Great post Chuck, this is a concept I try to explain to my Search Engine Marketing clients when they're struggling to set a budget.
Great to read. Basic and to the point ! Understanding and being able to track this information is a requirement for business success. It helps in setting business priorities and determining the 20% of customers that generate the 80+% of revenue. Now if the business can add on a factor for the refer ability of a quality customer…
Dick, that would be useful information. Let me ask, how differently would you treat those customers? The ones who are likely to refer you? Whatever you’d do differently, would it be practical to treat most customers that way?
Premium type programs can be developed for the best clients and those with more referrals. It would depend on what the specific client/customer values more. For some it may be access to a special membership club, discounts or first priority to products/services, premium content, access to another 3rd party related offering, pre-release announcements and access to new products, publicity, story about their business, etc. Knowing what matters most of each buyer would be identified in a CRM knowledge database..