I’m going to take a crazy, wild stab and assume you don’t adore math.
Most entrepreneurial folks like us think of math less as a “fun activity” and more as a necessary evil.
When I was a young lad in school, I could easily pay attention in classes like history and English because there was something human to wrap my brain around in those topics. There were stories, people, ACTION.
But math was not the same. Fortunately, for me, I found math quite easy as I had one of those brains that just got the numbers.
But, even then, no amount of enthusiasm from my (geeky) teachers could get me to care about formulas and fractions. There was no romance or excitement to numbers. They just sat there on the page as something that had to be done but gave me no warm fuzzy feelings.
Fast forward a few decades and, thanks to the world of small business, I can now say that I like math.
It’s still not my favorite thing in the world but once I understood the concept (and the importance!) of finding out the Lifetime Value of my customers, I started to look forward to math a bit more. Because where there are calculations, there is data. And where there is data, there are trackable metrics. And where there are metrics, there are goals.
And where there are goals – achievable goals – there is profit.
And profit I do like. Quite a bit.
So let me explain why calculating the lifetime value of your clients is really important, and how it can help you make more money.
Our old pal Wikipedia defines the Lifetime Value (LTV) as “…a prediction of the net profit attributed to the entire future relationship with a customer. The prediction model can have varying levels of sophistication and accuracy, ranging from a crude heuristic to the use of complex predictive analytics techniques.
Customer lifetime value (CLV) can also be defined as the dollar value of a customer relationship, based on the present value of the projected future cash flows from the customer relationship.”
Let’s hold the heuristics for now and focus on the second part. The CLV is really very simple. It’s how much each customer’s lifetime relationship with you is worth, in dollars and cents. Its what your future cash flow will be from that customer.
Now, don’t you think that would be handy to know? How can you possibly decide how much to spend acquiring a customer, until you know how much they will ‘yield?’
If you are spending $50 a person in marketing budget, what would you change if you found out that you are only making $20 on customers that are in Segment A. And if you’re making $75 per customer who is in Segment B?
Armed with those numbers, you can start moving your sales and marketing dollars around to where they will make you the most money. Maybe lay off a bit on marketing to Segment A and amp up your efforts attracting Segment B-ers?
See? Now are you itching to do a little math?
Okay, let’s do this. Remember, you’ll be doing this more than once, since you are likely to have various groups of customers. So you might as well get good at this.
We’ll break this down but for now, I want to show you this incredibly helpful infographic from KissMetrics. It will give you a good overview on how to get this calculation done.
Now, let’s talk about this in plain English. Note that this is a very simplified version and one that assumes all customers incur the same delivery cost. If one customer buys from you in person, it will cost you nothing to deliver your product to them. If another customer buys $50 worth of product and it costs you $25 to deliver it to them, then you’re really not making the same $50 sale.
But again, for the sake of simplicity, we’ll just assume all customers are created more or less equal here and the only difference between them is their spending habit.
Step One: Determine your average customer expenditure.
Say you sell birdseed online. Some bags of birdseed cost $12, some cost $75. Your average order will vary wildly. Depends on the size of the order and the brand of seed. Pick 5 of your most common order sizes and average them out.
So if you have 5 orders that each spend: $12, $23, $150, $45 and $60, you would do this:
12 + 23 + 150 + 45 + 60 = $290/5 = $58 is your average individual
Step Two: Determine your average customer purchase cycle.
Now determine what the average purchase cycle. This just means how often do your customers come back to spend money with you again. Is it a week? A month? A year? In the infographic shown, they use Starbucks as an example. Most of their customers buy daily, so they calculate ‘visits per week.’
But that’s fairly unusual and I doubt many of you have multiple orders from the same customer per week. (If you do, tell me what you sell!) For now, we’ll use orders per year. So go back to those same five customers and look at how many times they placed an order from you in one year.
Maybe they bought 8 times, 6 times, 12 times, 3 times and 7 times per year.
8 + 6 + 12 + 3 + 7 = 36 / 7.2 times per year is your average purchase cycle
Step Three: Determine your average customer value per year
Now put those two individual customer numbers together and let’s get a firm average customer value per year.
- So if Mr. $12 buys from you 8 times a year (12×8), he’s worth $96 per year
- So if Mr. $23 buys from you 6 times a year, he’s worth $138 per year
- So if Mr. $150 buys from you 12 times a year, he’s worth $1800 per year
- So if Mr. $45 buys from you 3 times a year , he’s worth $135 per year
- So if Mr. $60 buys from you 7 times a year, he’s worth $420 per year
96 + 138 + 1800 + 135 + 420 = $2589/ 5 = $517.80 is your average customer value per year.
Now all you have to do is plug in how many years you think your average lifespan is. Is it 5 years? 15? 25?
Once you determine how long you expect that customer to keep coming back to you, you have your LTV. For the sake of easy math, let’s say your average customer stays with you and reorders your birdseed for 10 years. That brings your average customer LTV to $5,178.
You now can get much closer to calculating true ROI on customer acquisition. If you have a marketing plan that is costing you roughly $2k per customer for a lifetime, you’re in great shape.
If however you’re spending $2k PER YEAR to acquire and retain that person…you are losing money on them hand over fist.
Math! It’s enlightening!
One last note – I purposely threw Mr. $150 in there as an example of why, once you have this concept mastered, you might want to segment your customers into even finer categories.
If you have one customer who is spending $45 with you three times a year and another one who’s spending $150 each and every month…those are apples and oranges. The first one is probably a homeowner who loves his backyard birds. The second smells more commercial to me. Perhaps he’s a landlord with a lot of properties and a lot of birds to feed. Or maybe he works at a nature preserve.
Either way, it would be smart of you to parse that down and do some averaging of your residential vs. commercial consumers and to determine how much each of these segments are bringing you year, after year.
So Here’s Your Challenge:
Pick up your last year’s spreadsheet and customer data. Pick up a calculator. And go to town. Knowledge is power, people. And when it comes to LTV, knowledge could be the difference between peril…and profit.
Calculate your LTV and let me know if you found any surprises. Or if you intend on tweaking your spending at all because of what you’ve found out! I want to hear all about it, so email me the results at info at marketingforowners.com (just hit “reply” to this email).
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