Maximizing Customer Lifetime Value
March 22nd, 2013 // 12:47 pm @ Million Dollar Methods
It’s critical for all entrepreneurs to know the metric: Customer Lifetime Value (CLV). Not only does it yield a powerful number from which you can operate, it’s process also explores elements of your business that reveal opportunities for growth.
As with many metrics in business you can take the Harvard, text-book approach, which requires you to calculate Net Present Value and discount rates, but we aren’t in a classroom. Instead, we live and die (or more accurately eat and starve) by real, practical business math. Let’s take a simplified approach that sheds light on your business.
CLV = Profit per Unit x Avg # of Transactions
Profit per Unit (or Gross Margin) = sales price – cost of goods sold (or cost of delivery).
Average number of transactions per customer. This could be in terms of months if you have continuity; or number of repeat purchases, on average. To calculate this number, divide the total number of transactions by the total number of customers. It may help to do this for each product line or customer segment.
It’s advisable to be conservative with the number of transactions. Keeping it within a two period also helps with validity. If a customer buys from you every five years (like a car dealership), this metric loses part of its relevance.
Detailed Example #1:
A coffee shop’s average price for a drink is $2.50 with associated costs being $1.50, on average. Most customers come in 3 days a week, but some only on weekends; so the average number of transactions is 10 per month, or 120 per year.
The Coffee Shop’s CLV (based on two years) = $240
With CLV, we can now determine how much we can SPEND to get a new customers.
It’s up to each business owner’s preference (or tolerance of risk) how “negative” their willing to go. The Coffee Shop probably doesn’t want to spend the first year’s profit on acquiring the customer; but it certainly could spend $10 if it knows the average customer is worth $120 a year.
Detailed Example #2:
A credit monitoring services charges $30 per month, earning $20 in profits. The average customer last 8 months (found by dividing the 4,000 transactions over the last two years by the 500 customers who enrolled).
The credit monitoring service has a CLV of $160.
It seems like a very straightforward calculation. My guess would be, you had to do some math to find your Profit per Unit (unless you’ve been following along with this series) and Average Number of Transactions – which both tell you a great deal.
To Maximize Customer Lifetime Value, you can:
1) Increase Profit per Unit
2) Increase Customer Frequency
3) Increase Customer Longevity
The Coffee Shop must focus on increasing customer frequency, while the credit service has to increase customer longevity. Both can increase profit.
As I mentioned at the onset, the process reveals as much as the answer. We not only know how much we can spend to get a new customer, we also know our Customer Expiration point.
For the coffee shop, the average customer ‘expires’ after 2.5 drinks per week. If they could increase that number by one, its worth $48 per year PER CUSTOMER. With this number in mind, they could offer incentives to reach that number; perhaps buy 15 drinks per month and get 2 free.
The credit monitoring’s customer expiration point is 8 months. They could drop the price down to $15 starting month 9; or offer an 6 and 12 month membership plans. As simple as sending a free gift 8 months after enrolling could be enough to extend the expiration date.
Remember these are averages. It’s possible that the median number of transactions is more appropriate. For instance if 45% of your customer last 3 months or less and 45% last 18 months or more and only 10% are in the middle; then average will be misleading as it relates customer expiration.
Knowing your numbers is essential to profit growth. Small changes in Customer Lifetime Value can make a huge difference in personal income.
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