Customer loyalty programs, exclusive offers and marketing expenses are all based on the idea that a customer won’t be a one-time purchaser but will keep buying products for years to come.
Imagine, for instance, that you had complete knowledge about how much every one of your customers was going to give your business over their lifetime. Armed with such information, you could justify the expense of any outreach directed at that customer and dial down on expenses related to less-valuable customers.
In the real world such complete knowledge is impossible. The best we can do is consider all the variables involved in a customer’s likely purchasing behavior over time and then estimate how much they will be worth in the future. Here are six ways to do so:
- The simple calculation: The standard way to determine lifetime or future value is to look at your business’s average purchase value. You can do this by dividing your annual revenues by the number of purchases over that period. If you had a lemonade stand that made $120,000 one year, then you might determine that there were some 60,000 purchases that averaged out to $2 each. Next, calculate the average purchase frequency. You do this by dividing the number of purchases over a period by the number of unique customers. On a monthly basis, there were 5,000 purchases but only 1,000 customers who paid an average of $5 a month. The next step is to look at customer value. You get this by multiplying the average purchase value ($1) by the average purchase frequency (5). Next, look at the average customer lifespan, the length of time in which they will buy products. Let’s assume that’s five years. Finally, you get lifetime value by multiplying customer value by customer lifespan. So the LTV in this case is $5 a month for five years (60 months), which is $3,000. That’s the simple answer to the question “How much is the lifetime value of my customer?” In another example, the average Starbucks customer spends $5.90 a visit and visits 4.2 times a week, resulting in $24.30 a week. In the case of Starbucks, the average customer lifespan is 20 years, meaning she is worth $25,272.
- Custom calculation for profit margin: In this case, the equation takes into account the profit margin. In Starbucks’ case, that’s 21.3 percent. That makes the LTV $5,489.
- Classic calculation with retention rate and rate of discount: The classic formula takes into account the customer retention rate. This is the actual percentage of customers who repurchase compared to an equal preceding amount of time. It also looks at the rate of discount — which assesses what an investor would be willing to pay for a future cash flow. Factors like competition and inflation are also factored in. In Starbucks’ case, the rate of discount is 10 percent. If you multiply the average gross margin per customer lifespan (see above) at $5,489 by the retention rate (.75) divided by one plus the rate of discount (.1) you get $11,535.
- The average: Averaging out these three figures ($25,727 + $5,489 + $11,535) gives you an average LTV of $14,099 for that customer. Starbucks’ goal then is to spend less than $14,099 over that 20 years acquiring that customer.
- Separating good from bad customers: Of course, not all customers are created equal. Since the above is an average figure, one method of sorting out the best customers is to segment the customer base by their purchases: In another example, if you’re a printer you may determine that although larger companies purchase less frequently, their average purchases are higher than that of small business customers. Assuming that they stick around for the same amount of time, the LTV of the larger customer will also be more attractive. That means you might want to put more marketing focus on such customers.
- Factoring in changes in customer value: The problem with the calculations above is that they assume that consumers will never change their purchasing habits. In reality, there is a possibility that they will drop off (they might start making coffee at home instead of visiting Starbucks every day). On the other hand, they could also become better customers. As MIT research fellow Michael Schrage has noted, customers can contribute value in ways beyond how much they pay per month. Those include evangelizing for the brand on social media, offering good ideas and feedback and trying new products. Taking those attributes into consideration, smart companies can try to identify these very good customers. One, Schrage wrote, looked for correlations between LTV and Net Promoter scores. New capabilities can also improve customer value. For instance, supermarket customers who use self-service kiosks are more valuable than those who need a more expensive human checkout clerk.
There are other factors to consider as well. Customer satisfaction is related to the customer retention rate, but if there is a sharp falloff in customer satisfaction, it can a be a leading indicator that customer retention is also going to drop. An industry disruptor can also be a wild card. If you sold GPS devices in 2008, your LTV was probably way off because you could not anticipate that smartphone makers would soon incorporate GPS into their devices and kill your market.
A related factor is innovation. Companies like Apple and Amazon retain customers because the companies are constantly adding new features and upgrades. If they stopped doing so, customer satisfaction would fall.
As a rule of thumb though, LTV offers a good idea of how to rationalize and focus marketing spend if those other factors stay fairly stable. As Dwight Eisenhower once noted, thorough plans are generally useless, but planning is indispensable.