In this article we are going to look at possibly the most important concept and key performance indicator in any business, the customer lifetime value (CLV).
You will see the concept also referred to as:
- The lifetime value of a customer (LVC)
- The marginal net worth of a customer (MNW)
The Definitions Of Customer Lifetime Value
It is a KPI that explains how much a customer on average is worth to a business of its entire relationship.
You will see some people refer to it in terms of sales revenue.
This is wrong and misleading. It can cause you to make the wrong decisions about attracting and retaining customers.
It should be value in terms of profit (Contribution less customer driven overheads).
Please don’t get caught up in chasing turnover for the sake of making your business sound good.
Marginal Net Worth is a related concept used by marketing guru Jay Abraham to look at the customer lifetime value net of the acquisition costs.
Why Is This Lifetime Value Measure So Important?
If you know how much profit you can earn from a customer, it guides your decisions and actions in three ways:
- It tells you the maximum amount you can afford to spend on acquiring (or buying) customers.
- It focuses the mind on the cost of losing customers and letting them lapse through apathy, poor service and little communication
- It encourages you to find ways to increase the lifetime value.
I explained the idea of encouraging customers to spend more and more often in…
It focuses attention on the entire process of managing customer relationships because the cost of losing customers too early is very clear. It emphasises that customers are assets of the business to be cherished.
There are genuine reasons why customers can stop buying but too often, it is the fault of the business and it can therefore be corrected. Even if a customer has stopped buying, you can revive the relationship by being proactive.
How To Calculate The Lifetime Value Of A Customer
There are a number of ways that you can do the arithmetic. Pick the method that is most meaningful to you.
The Easy To Calculate CLV
The average spend in a year by a customer * The number of years a customer will continue to buy * the average contribution margin.
If a customer spends £400 in a year and buys for four years and has a margin of 50%, the lifetime value is…
£400 * 4 *50% = £800
Sometimes, particular customers require special support in terms of promotional activities, extended credit terms and consignment stock.
If you’re looking at the potential value of an individual customer, you should build these factors into your calculation.
The Harder Way To Calculate CLV
Some businesses don’t have an even spending pattern during the relationship. Instead it may be front end loaded or back end loaded.
This encourages an approach to look at the current value of future cash flows by taking into account the time value of money.
While interest rates for interest receivable are very low after the Credit Crunch, businesses still find it expensive to borrow money.
£100 now is worth more than £100 in 12 months time.
The cash flows from an average customer can be forecast and the future receipts and payments can be discounted back to the net present value of the customer.
This isn’t the place to go into much much detail but I will be writing about Net present value and discounting future cash flows.
Calculating the Marginal Net Worth
This measure nets out the contribution margin or profit fro sales to the customer against the costs of acquiring a customer.
In many ways, your entire business is about maximising the marginal net worth of customers. Focusing on the net measure can help you identify times when it is sensible to increase the customer acquisition cost (rather than the natural instinct to reduce it) because the lifetime value is high (for a particular segment) and can be increased.
Bringing Referrals Into The Equation
You hope happy customers will refer your business to other people.
These referrals can be brought into the calculation although it starts to get very complicated. Particular is you take into account the differing roles of attractors, passives and detractors from the concept of the Net Promoter Score.
How Is Your Relationship With Customers?
Is your business designed to create strong, long-lasting relationships with customers?
Or do you have a transaction focus that looks at each little piece of incremental business?
You may need to rethink how you manage your customers and reward loyalty. Too often businesses are caught up in the chase for new buyers that their existing ones get a raw deal. A great example is what often happens in financial services like insurance (low first year premiums) and banks (special bonus interest for the first year).
I recommend you take the time to think about what your business does to encourage customer retention.
Jay Abraham and The Power of Lifetime Clients
I mentioned Jay Abraham earlier. Here is a 5 minute video of him telling a story about the importance of back end marketing.
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