Often when small businesses address marketing they plan to market to all of their customers the same way. Additionally, the focus is generally on immediate customer acquisition. As an Entrepreneur, I understand the marketers' desire and expectation for immediate business -- we live in a society that desires immediate gratification.
Have you considered that some customers are worth a whole lot more than others? Identifying which customers are most valuable to your business is extremely beneficial when making strategic marketing and sales decisions.
Understanding historical, present, and potential future customer interactions or revenue is essential when planning a profitable marketing program because it informs you how much business you can anticipate from your customers throughout their entire relationship with you. This approach to marketing is called Customer Lifetime Value. Customer Lifetime Value (CLV), sometimes referred to simply as Lifetime Value (LTV) is a prediction of the total value (net profit) generated by your customers' entire lifecycle. It can typically be calculated three different ways:
This simple approach provides a quick estimated calculation. In order to calculate this formula, you will need.
Average revenue per customer (over months or years depending on length of time addressing)
Average number of years (or months) that a customer is retained (Retention)
Cost Per Customer Acquisition
Simple CLV = ( Average Revenue Per Customer X Number of Years ) - Cost of Acquisition
A great case for using this formula is a subscription service with recurring costs. My favorite example is the gym membership. Let's look at the lifetime value of an urban gym customer who spends $75 every month for 3 years. The value of that customer would be: $75 X 12 months X 3 years = $2,700 in total revenue (or $900 per year). Gyms often waive initiation fees or offer free introductory months off of the membership. Heck, they could even give away an entire year of membership (much like SiriusXM does to premium car subscribers) and still remain profitable given the average lifetime of a customer. Average Revenue Per Customer CLV is a simple calculation and works for businesses with more predictable and steady metrics. However, for businesses that have all sorts of customers with different shopping behaviors, it's a bit misleading.
Additional approaches to formulating your Customer Lifetime Value include:
Custom CLV is a more detailed measure of lifetime value that breaks down customer spending at the per-visit level. Start by uncovering the following values:
Customer expenditures per visit (average $)
Number of visits per week (average)
Average customer lifespan (in years typically)
Profit margin per customer (%)
Custom CLV = Average number of years (52 x customer expenditures x number of visits per week x profit margin)
In this calculation, determining the rate of discount is crucial, as it enables businesses to determine the value of future revenue. Metrics to consider:
Average gross margin per customer lifetime
Retention, or percent of customers who re-purchase your goods and services
Rate of discount, or the interest rate for discounted cash flow analysis
Traditional CLV = Gross margin x (retention/[1 + rate of discount – retention])
CLV can often be a fine-tuning of the Pareto Principle, named after Italian economist Vilfredo Pareto. The rule, also known as the80/20 rule.states that 80% of your business can be obtained from 20% of your customers. Identifying which customers are most valuable to your business is extremely beneficial when calculating your marketing budget both holistically, and for each channel. Further, with the understanding that customers have different shopping behaviors which result in varying margins, frequencies and retention rates, you can filter your customer database into different cohorts or segments.
Not all customers are the same -- so why market to them and engage them in the same way?
Cohort Approach Use Case
For a more diverse customer database with different purchase behaviors and retention, you may want to consider the Cohort approach to CLV. The cohort formula calculates Average Revenue per Month Per Cohort (a group of customers who share an attribute or set of attributes). For example, you can segment out customers who made their first purchase in the same month. Or take a closer look into attribution and address CLV by acquisition channel, i.e., CPC, Facebook, or display advertising. You can even tabulate it by campaign within the same channel. This will help you understand if you are underspending or overspending on customer acquisition. For example, a Digital Marketing Manager may focus on finding undervalued keywords to acquire customers very cheaply, when instead there may be overpriced keywords that attract customers that are worth far more than the extra cost of a keyword.
The right formula will depend on your business situation. If you are a newer business, you will have to rely on a lot of industry data and statistics. If you are an established business, extracting and utilizing as much financial and customer business intelligence data as possible will inform the best marketing approach. The more customer and sales data you can capture to segment your database into different cohorts, the more cost efficient you will be in promoting your products and services.
Check out this infographic from Kissmetrics for additional explanations and cases for Customer Lifetime Value.