What are your customers worth? Sure you may be able to put a monetary value on transactions, but do you know the value of each new customer relationship? If you do, then you can decide just how much to spend to acquire each new customer. See how to calculate the value of your customers in March’s Biznology newsletter.
We all talk about how much we value our customers—they’re the lifeblood of any business. This month, I don’t want to talk about how much we value our customers, but rather how we value them. Just how do you attribute a monetary value to each of your customer relationships?
Let’s first look at your existing customers. Suppose the goal of your campaign (or of a change to your Web site) is to raise the number of orders or to increase the order size of existing customers. In that case, optimizing for profit (or profit margin, or Return on Advertising Spending, for example) is exactly what you want to do. You want to spend a bit more on marketing to those customers and take in well more than you spend.
To decide how much to spend on increasing conversions from existing customers, using metrics that place a value on the actual conversions—profit, profit margin, and others—work just fine. But new customers are worth more than the value of their first order. What’s it worth to acquire a new customer?
Answering this question is critical for your Internet marketing because it tells you how much to spend to attract someone new. Some companies find it challenging to place a value on conversions for existing customers, but as complex as it is to value conversions, you ain’t seen nothing yet. Let’s look at what a new customer is worth.
For most businesses, you can assume that once you’ve sold something to a customer, that you have a better chance of them buying from you again. If they like what they got from you, then they might be back. Certainly there are some businesses where repeat business is unusual, but most industries live off their repeat customers.
Repeat customers are easier to persuade to buy, if only because they have fewer questions. In some cases, they require no marketing at all. Because that is true, it stands to reason that the value of acquiring a new customer should take into account more than the initial order.
Suppose you manage a car repair business that specializes in BMWs called Car Groomers. Your Web site attracts many of your new customers, who are looking for the absolute best care for their pricey cars. Your site explores why BMWs need special treatment, and how your staff is trained to provide it. You offer a free 150-point inspection as part of the first service for any appointment made on the Web.
Because of that free offer, the first service appointment is quite low in profit. You really start to make money when the customers come back, especially when they eventually need major repairs. So how do you know what you should budget for each new customer?
Get to know Customer Lifetime Value—usually called simply Lifetime Value (LTV). LTV calculates the total profit that a new customer is worth to your business.
Car Groomers can use LTV to think about their new customer acquisition costs. Suppose their profit on an initial appointment is only about $20, but they average $80 on subsequent appointments.
How do you decide what a lifetime is? If it really stretched for a human lifetime, you wouldn’t be able to calculate it until your customers were dead. (At that point, you might not be as interested.)
If you’ve been in business a while, you might be able to estimate the length of a “customer lifetime.” Car Groomers’ records show that the average customer returns regularly for three years after the initial visit—averaging four times each year—before disappearing.
No one at Car Groomers knows exactly why people stop coming back. Perhaps some have bought a new Mercedes instead of a BMW. A few might have been turned off by a bad experience. Others move away. No matter, some folks are regular customers for many years, while others drop out after one or two visits. The average is three years, so Car Groomers can use three years as the duration of a lifetime. If you don’t have this information for your business, take a guess—but be conservative, because that keeps your spending lower (and more likely profitable).
So, how could Car Groomers calculate LTV? Four visits per year multiplied by three years gives you 12 visits in a lifetime. The profit on the first visit is $20, but the other 11 visits provide $80 of profit each ($880), yielding a total value of $900.
But it’s not that simple, unfortunately. Although the numbers total up to $900, the truth is that $900 payable over three years is not worth $900 today—it’s worth less. The question is, “How much less?”
Net Present Value (NPV) tells us that answer. NPV calculators ask you for your cash flows and your discount rate (which you can think of as inflation or interest rates—it’s the cost of money over the three-year customer lifetime). With a three percent discount rate, the NPV of $900 is around $850. That means that $850 is the Lifetime Value for a new customer—if Car Groomers spent $850 in acquisition costs for each customer, they’d break even. Every dollar saved becomes more profit.
As with valuing conversions, calculating Lifetime Value is not always easy, especially in a large company where it can be hard just to get everyone to agree to the same formula. Some people believe that you should consider the attrition rate of your customers for each repeat purchase, rather than just using the average number of purchases from a customer over a lifetime. Others argue that new customers referred by that customer have value that should be counted. I chose to present the formula as simply as possible here, ignoring these complicating factors.
Despite the roadblocks, some companies, such as Hewlett-Packard and Bass Pro Shops use LTV to measure their online marketing. Instead of arguing about the complexities, I recommend that you “do it wrong quickly” by using these principles if you can, even if the metrics themselves are not as accurate as you’d like in the beginning.
Remember that the $850 we calculated for LTV is an average. Some of Car Groomer’s customers will be worth more than $850 (because they deliver more than $900 in profit over the three-year customer lifetime) and some will be worth less. You’ll raise your profits if you can concentrate on acquiring more of the customers that are above the average.
To concentrate on the high end of the market, use RFM analysis. Some of your marketing tactics will draw customers who show higher recency in the first few months. For example, Car Groomers may notice that more customers acquired through paid search have returned for their second visit while other customers have not. So, they may shift more of their marketing budget to paid search.
Lifetime Value is an important weapon in every Internet marketer’s arsenal. If you know what prospects are worth, but your competitors don’t, you have the advantage in any marketing situation.
