Written by Peter L. Wyro, M.B.A. of www.justcherry.co
Peter is the CEO of Cherry, an ROI-Ready Inbound Marketing Agency. For nearly 20 years, he has helped transform businesses into highly-valued assets. His expertise is marketing strategy and new product development.
One of the biggest challenges that marketers face is justifying their investments. How much should your business spend to acquire a new customer? If you spend too much, you’ll eventually go out of business. If you don’t invest enough, you might be missing opportunities to grow – much to the delight of your better-informed competitors. The stakes associated navigating this dilemma are pretty high. Forecasting future cashflows by calculating customer lifetime value is an essential practice in figuring out how to invest in your ideal customer.
Customer Lifetime Value
Your investment in acquiring a new customer, like any investment, should be less than the value that a single customer returns to your business. But how do you determine what value a customer will bring to your business in the future? This brings us to one of the most important executive KPI’s (key performance indicators), Customer Lifetime Value or LTV. Just as it sounds, LTV is a powerful measure that estimates the future value of a typical customer over an average customer relationship lifespan. Improving LTV can make a big difference on the bottom line, but first you need to have some visibility into the various factors that influence the measure.
At the most basic level, LTV can be calculated by determining an average customer's cashflows (or profits) over the lifetime of your business relationship, less the costs to borrow money to invest in your business and the initial costs to acquire the customer. Let’s assume that an average donut-buying customer spends, on average, about $10.00 per transaction (averaging the purchases of many customers) and the average profit margin over food costs are 80% (yes, 80%). Let’s use historical data to measure how frequently an average customer visits the donut shop (twice a month) and the average lifespan of the relationship (3 years).
The average customer, using the most basic LTV calculation is worth $576. That’s a lot of donuts.
If you want to take things a step further, you can also include two other important factors, a) the average retention rate, and b) the current discount rate or the average cost of capital. These measures will help you understand today’s value of a typical customer.
- Average Purchase Cycle: e.g Daily, Weekly, Monthly, Yearly
- Average transaction value
- Average number of transactions per purchase cycle
- Average lifespan of customer Years
- Average retention rate = % of customers you retain each purchase cycle
- Average profit margin
- Current discount rate. This varies between 8% and 15%, but you can use 10% to start.
Simple: a (365, or 52, or 12, or 1) x b x c x d
Advanced LTV: Above Answer x (e / 1+g-e) - less costs to acquire.
You can determine which customer groups are more profitable and adjust your investments, priorities, and strategies accordingly.
You can optimize your acquisition strategies to leverage the ones that drive the most profitable business. That doesn't necessarily mean the lowest costs, but the combination of factors that lead to the optimum number of new, profitable customers without over OR under investing.
Enhancements to your offering, inclusive of products and services, may result in increased retention and expanded purchase volume. Pricing is also an important factor. Optimizing your product assortment or perceived value, might command higher prices with the right segments.
What kind of difference would it make in the profitability of your customers to be able to borrow at a highly competitive rate?
Measuring and continuously monitoring LTV can help business owners evaluate financial performance, relative to their acquisition costs. Understanding the different metrics that contribute to your LTV can provide valuable insights about strategies and priorities that can help justify your marketing investments and make an impact on your bottom line.
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