Customer Lifetime Value
Increasing the lifetime value of customers
There are a couple of sneaky little concepts that I’d like to introduce you to this week that might just help provide a little more focus for your marketing efforts, so, a couple of questions for you … have you ever thought about:
- How much it costs to win a new customer?
- This is what’s called The Customer Acquisition Cost (CAC)
- How much you earn from a customer?
- This is what’s called The Customer Lifetime Value (CLV)
In most businesses the customer profile will be such that 20% of the customers deliver 80% of the sales. This is a “rule” that was identified by an engineer (all the best people are (but I have no bias, obviously)) called Vilfredo Pareto in 1896 and is known as the Pareto Principle …it's a great little rule of thumb that seeks to separate the “vital few” (the 20%) from the “trivial many” (the 80%).
It's great because if you can identify your 20% of customers that deliver 80% of your revenue you can go and search for more of them …(check out the previous blogs on segmentation) and CAC & CLV relate directly to this idea about focusing your efforts.
Customer Acquisition Cost (CAC)
Someone very clever once said something like “I know that 50% of my marketing spend is wasted … I'm just not sure which 50%”. It's pithy and it's clever, but if you want to ramp up your sales and marketing efforts you need to be even smarter …
The first tool making some attempt to get over this limitation is the idea of a customer acquisition cost (CAC) which like the old Ronseal advert suggests (if you are too young, You Tube it) is the cost of obtaining a new customer for your products and services.
So, how do you calculate your customer acquisition cost?
Basically, the CAC can be calculated by simply dividing all the costs spent on acquiring more customers (marketing expenses) by the number of customers acquired in the period the money was spent.
However, as with many management tools and techniques, there is more than one way of doing the maths, so, take the following as more “guidelines” than “rules”. The calculation needs to be consistent with how you think about your business and it needs to work for you.
One approach is what might be called the “macro approach”, you take all of your marketing costs over a period, say:
- Advertising, social media & PR costs
- Cost of the marketing team
- Cost of the sales team
- Design and creative costs
- Publishing & production costs (leaflets / literature / website etc)
Then divide by the number of customers obtained over the same period ...or even better, collect both sets of data for different periods and then make a comparison to establish any trends.
However, there are a few caveats about the metric that it would be useful to be aware of. For instance, there might be an upfront cost, sometimes called a sunk cost, to some marketing activities, it costs money to build a website, it costs money to build a sales team and the returns from a website or a sales team are often not seen immediately, so, it may be prudent to take into account the sunk or lagging costs and spread them over the duration being analysed.
But what About CAC Per Marketing Channel?
However, we can and, in my view, should (if it’s useful) go further to create more in-depth and perhaps granular analysis. You could establish the CAC for each of your marketing channels or activities which might, for instance, include:
- The sales team
- Social media Ads
- The website
- SEO / pay per click
- Networking meetings
- Trade magazine advertising
The objective would be to establish which channels have the lowest CAC you can then know where to better focus and ramp up your marketing spend. The more of your marketing money you can allocate to the lower cost CAC channels the more customers you are likely to get for your, usually limited, investment.
In order to do this, we need to flash up the spreadsheet and collect your marketing costs per channel per month… how much did you spend on each of the channels you employ? However, you may need to take some liberties with some of the data because sometimes you won't know exactly whether a new customer was obtained from the website directly or, for instance, from social media. Obviously, the more online the business is the easier some of this becomes, simply because of the automatic tracking ability built into most new tech’.
Improving your CAC
Once we know the CAC the reality is we can always be better, advertising campaigns can be more effective, copy can be more punchy, customer loyalty can always be improved. Tools like the 5 Ways and the Ladder of Loyalty (found in other blogs) explore some of these ideas in greater depth, so once the customer acquisition cost has been determined it's a case of picking apart the process and systematically ratcheting up each part of their process to decrease the cost of acquisition further.
So, we now know what it costs to acquire customers, let's think about their lifetime value.
What Is Customer Lifetime Value (CLV)?
Luckily, the customer lifetime value is also like the Ronseal advert…it pretty much “does what it says on the tin”. The customer lifetime value, or the lifetime value of the customer, is the total revenue a business can reasonably expect from a customer throughout their time with you as a paying customer. As a result, the metric covers things like:
- The (annual / monthly) revenue from the customer
- The average purchase frequency
- The period they remain a customer
So, mathematically, the equation becomes:
CLV = Average Purchase Value x Average Purchase Frequency Rate x Average Customer Lifespan
So, let's say you are a contractor of some kind, where you might undertake an initial installation project for say £50k (could be lifts, IT, M&E contracting, fire equipment, security alarms or any other type of contracting) followed by an ongoing service contract for, say, £5k a year. Additionally, you typically keep a client for say 10 years. The lifetime value would be:
- £50k initial installation
- £5k x 10 years = £50k
- £100k total lifetime value
So, how does Customer Lifetime Value help?
Lifetime customer value helps in a whole variety of ways, not limited to:
- Calculating the future value of the customer (you can begin to predict the amount you can gain from a customer throughout your trading relationship)
- Helping you identify the most profitable customer segments, some segments are possibly more profitable than others and identifying these helps you identify sectors having, for whatever reason, different profitability profiles. Once identified, you can target your customer acquisition activities to get most bang for your Buck…and in doing so you drive down your customer acquisition cost
- Identifying the most profitable product / service offerings. It hints at what products and services the customers with the highest CLV purchase from you. This allows you to focus your improvement and development efforts on your most sought-after products and services.
Essentially, customer lifetime value provides background information that allows you to improve your targeting processes to better secure the maximum value from your customers.
Obviously, with some businesses the sums become a little more complex but the idea remains the same. One of our clients is a distribution company providing a range of construction clients, all at different sites and locations with the stuff needed on building sites; wheelbarrows, sledgehammers, hard hats, high vis jackets and (believe it or not) coffee, tea and biscuits (literally). In this instance, getting to the final number becomes slightly more complex, but the maths remains the same.
CLV = Average Purchase Value x Average Purchase Frequency Rate x Average Customer Lifespan
Obviously, once you have determined the lifetime value it might also be prudent to add into the mix the profitability of the particular segment. We have another client an IT provider, and the hardware provision is typically traded at a much lower margin than software… But that is probably going a little bit beyond customer lifetime value.
Improving the Customer Lifetime Value
So what, you may ask! Well now that we know how to calculate the CLV the next obvious question, like that for customer acquisition costs, is “How do I improve it?”
Well, there are a whole variety of ways to improve the CLV but the majority are focused on improving just a few key aspects:
- Upselling / cross selling
- Customer satisfaction
- Customer retention
Upselling / cross selling
You increase the customer lifetime value while upselling and cross selling. This is about what we call our “McDonald’s question” “Would you like fries with that?” The question you need to ask yourself is what are my fries? Of course, they may not just be fries there might be a whole number of products and services you could upsell and cross sell and this needs to be managed, thought through, systematically and carefully applied… you want to help the customer, not become a foot in the door salesperson.
A variety of research suggests that satisfied customers will both spend more money and spend it more often, so, if you want to improve your CLV, it’s time to understand and then invest in, increasing customer satisfaction. Idea’s might include:
- More personal or more regular contact with clients
- Offering free or value added products and services
- Developing a forum for listening to customers… getting their feedback and acting on it
Study after study confirms what we all intuitively know, keeping a customer is a lot more cost effective than finding a new one, so, customer retention is also critical if you want to drive up your CLV.
One study by the renowned consultancy Bain & Company suggests a mere 5% increase in customer retention rates can increase a company’s profits between 25% to 95%. So, ideas for increasing customer retention include:
- Implementing reward, referral and loyalty programs.
- Improved technical / customer support.
- Improved after-sale services.
Knowing and then benchmarking your customer acquisition cost and your customer lifetime value on a monthly, quarterly or even by client basis are powerful tools for helping companies deliver improved efficiency and effectiveness into both their marketing and this sales processes.
Customer lifetime value is also important because it encourages companies to shift their focus from quarterly targets and profits to the longer-term health of their customer relationships. It is also important because it can provide an upper limit on spending required to obtain new customers.
The processes for how you acquire new customers and how you keep them should be systematically picked apart and examined in detail to see where changes and improvements can be made to reduce the customer acquisition cost and improve the customer lifetime value.
By taking a systematic and focused approach to both customer acquisition costs and the customer lifetime value you will both grow the business and bolster your bottom line.
Related tools and ideas
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