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HOW MUCH ARE YOUR CUSTOMERS WORTH? Many people -- marketers, managers, investors, and bankers -- need to know the answer to this question. So do business owners who are sellling their company and those who might buy the company. |
The answer to this question determines budget and resources for acquiring new customers. For a business owners, sellers or buyers, the answer to this question is a major factor in determining the worth of a business. For lenders and investors, the answer to this question impacts the availablity and cost of capital financing for the company.
To answer this question, we use Life Time Value ("LTV") calculations. LTV objectively answers two critical business survival questions, "What are our customers really worth?" and "How much should we be spending on advertising and retention efforts?"
WHAT IS LIFE TIME VALUE?
Life Time Value is the present value of the stream of future profits generated by a customer's purchases, reduced by the cost of acquiring and servicing the customer, calculated over the life of the customer. For several reasons, this is more easily stated than calculated!
First, remember that "present value" is the time-discounted value of future payments. Think of it as interest in reverse. Simply, it is a mathematical way to recognize that a dollar in hand today is more valuable than a dollar that we will not have until some time in the future. For example, if a company needs to earn 20% return on their investment, then $1 of revenue today is worth $1 -- but $1 of revenue a year from now is only worth $0.83. (The calculation is $1/($1*1.20) = $0.83) So to start calculating LTV, we need to know (or at least make an assumption about) the earnings rate we need to earn to stay in business.
Second, LTV calculations require that we know how much we spend on acquiring a new customer. These costs include...
- Fixed costs like sales staff (excluding commissions) and other advertising costs that do not change much regardless of the number of customers or revenues of the business.
- Variable costs such as media purchases, offer redemptions, contact and mailing costs, etc.
Third, LTV calculations require that we know how much we can expect to earn on each customer over time. This means we also need to know...
- How long they are likely to remain a customer (customer retention)
- How much they are likely to spend while they are a customer (customer spending)
- How much profit we are likely to make on what they buy (product profitability).
It is simply not possible to know all of this information with certainty. Fortunately, "educated estimates" are usually enough for the LTV calculation to be useful. The key to making educated estimates is to understand how to take advantage of customer segmentation techniques. Many of the data-driven analytical reports prepared by Management Analytics Group can help answer these questions objectively.
HOW DO YOU CALCULATE LIFE TIME VALUE?
To answer this question, we need to take a step-by-step approach. Calculating LTV isn't too hard if we have a good Management Analytics Database or marketing database.
The first step is to determine how much it costs to acquire a new customer. In this example, let's assume we are spending $0.60 per catalog (total in-the-mail-cost, including list rental and postage) and getting a 1.1% average response rate from the rental files. (This is equivalent to a "response factor" of 0.011.) So, stated as a simple formula:
| ACQUISITION COST OF A NEW CUSTOMER: |
(Cost
to acquire a customer) = (Cost to reach a prospect) ÷ (Average
Response Rate) |
Next we need to determine how much profit is earned on the average initial sale. Let's assume an average initial order of $70.00 and an average margin of 40% after fulfillment costs. Again, stated as a simple formula,
| PROFIT ON AVERAGE INITIAL SALE: |
(Initial
Order Profit) = (Average Initial Order) x (Average Profit Margin) |
Finally, to know the net amount we must invest to acquire a new customer, we simply subtract the Initial Order Profit from the cost of acquiring the customer. Once again, a simple formula:
| NET INVESTMENT TO ACQUIRE A NEW CUSTOMER: |
(Initial
Investment for a new customer) = (Cost to acquire a customer)
- (Initial Order Profit)) |
At this point we have determined the net initial investment to acquire a new customer. In this example, the amount is $26.55. To know whether this investment is wise, we need to know the net future profits that are likely to result from this investment. Here is how we do this.
We start by calculating how much gross profit we expect to make from future sales to the customer. This differs from the profit on initial sales but is calculated the same way. We just use the Average Repeat Order amount. For our example, we will assume that the average repeat order amount is $75.00. So, displaying this again as a table,
| PROFIT ON AVERAGE REPEAT SALE: |
(Repeat
Order Profit) = (Average Repeat Order) x (Average Profit Margin) |
There are future costs associated with obtaining these future orders, however. We must subtract the future costs of recontacting the customer.
Let's assume that we are mailing four catalogs per year to existing customers at a cost of $0.50 each. (The cost is lower than that for catalogs to prospects since there is no list rental expense associated with mailing to existing customers.)
We also need to make some assumptions about what response rates we should expect from our future campaigns. To do this, we look at what the response of customers has been during each of the past three years. Note that this is not based upon the most recent purchase (recency), but rather upon the amount of time since their first purchases.
For this example, we will assume that a group of customers who made their first purchases in the past year responds at a rate of 16% to each of the four offers. A customer who made his or her first purchase two years ago responds at 13% and a three-year customer group responds at 11%. The numbers drop off just as customers tend to drop off over time and fewer are recent buyers.
In summary, here are our assumptions about what it will cost us to generate future sales:
RECONTACT
COST ASSUMPTIONS: |
|
| Mailings per year: | 4 |
| Cost per mailing: | $0.50 |
| Mailing Response Rate, Year 1: | 16% |
| Mailing Response Rate, Year 2: | 13% |
| Mailing Response Rate, Year 3: | 11% |
WIth these assumptions, we can determine an expected cost per year of reaching an existing customer. We call this the Annual Contact Cost. It is $2.00 per contact, calculated this way:
ANNUAL
CONTACT COST |
|||
| (Number of Mailings) x | (Cost per Mailing) | = (Annual Marketing Cost) | |
: |
4 |
$0.50% |
$2.00 per contact |
Next, we calculate an Annual Response Rate (as opposed to the response rates for each of the campaigns shown in the table above.) To simplify the calculations, we can look at each year as if it were a single $2.00 (4 x $0.50) catalog mailing with a 64% (4 x 16%) response rate for one-year customers, a 52% (4 x 13%) response rate for two-year customers and a 44% (4 x 11%) response rate for three-year customers. This table shows how:
ANNUALIZED
RESPONSE RATE |
|||
(Number
of Mailings) x (Response Rate) = (Annualized
Response Rate) |
|||
Year 1: |
4 |
16 % |
64 % |
Year 2: |
4 |
13 % |
52 % |
Year 3: |
4 |
11 % |
44 % |
With all of these results, we next combine them as shown in the table below to calculate an Expected Future Annual Gross Profit:
| EXPECTED FUTURE ANNUAL GROSS PROFIT PER CUSTOMER | ||||||
| Year | Average Profit on Repeat Sales | Annualized Response Rate | Annual Contact Cost | Annual Profit per Customer | ||
| Year 1 | ($ 30.00 | x 64%) | - $2.00 | = $17.20 | ||
| Year 2 | ($ 30.00 | x 52%) | - $2.00 | = $13.60 | ||
| Year 3 | ($ 30.00 | x 44%) | - $2.00 | = $11.20 | ||
Finally, we need to recognize that a future dollar of profit is less valuable than a present dollar of profit. That is, we must discount the Expected Future Profits to reflect the "time value of money." In this example, we will base Lifetime Value upon three years of purchases. (The optimal number of years varies from industry to industry and should be appropriate to your specific situation.)
We will also choose 20% per year as the earnings rate we must achieve. In other words, if we can achieve a 20% or greater return, we can attract additional investment. Below 20% per year, investors will place their money elsewhere.
The 20% discount factor for year one is 1.20 which is the principal (1.00) plus the TVMDR of 20% (0.20). For year two, the factor is 1.44 (calculated as 1.20 x 1.20) and for year three the factor is 1.73 (Calculated as 1.20 x 1.20 x 1.20). So, simply listing these factors in a table:
Time Value of Money
Discount Factor (based upon a 20% discount rate) |
TVMDF Factor, Year
1: 1.20 |
TVMDF Factor, Year
2: 1.44 |
TVMDF Factor, Year
3: 1.73 |
Now we are finally ready to calculate the Discounted Total Profits per Customer. Here is how:
| DISCOUNTED TOTAL PROFIT PER CUSTOMER | ||||||
| Year | Annual Profit per Customer | TVDMF | Present Value of Future Annual Profit per Customer | |||
| Year 1 | $17.20 | ÷ 1.20 | = $14.33 | |||
| Year 2 | $13.60 | ÷ 1.44 | = $ 9.44 | |||
| Year 3 | $11.20 | ÷ 1.73 | = $ 6.47 | |||
TOTAL
DISCOUNTED PROFIT PER CUSTOMER: $30.24
|
||||||
Finally, we can know the Lifetime Value of each customer. We simply subtract the cost of obtaining a new customer from the present value of the future profits that we expect from that customer.
| LIFETIME VALUE OF EACH CUSTOMER | ||||||
| Present Value of Future Profits per Customer | Initial Investment
to Acquire Each Customer |
Lifetime Value
of Each Customer |
||||
| $ 30.24 | $ 26.55 | = $ 3.71 | ||||
The LTV of each new customer from this
campaign is positive so we should proceed.
|
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SUMMARY
In this example, we acquired customers at an almost 50% loss on the initial sale. However, by the end of the year we have recovered our investment -- with interest -- and are making a profit.
If the sample catalog company could attract investors who would demand less than a 20% return, it would be able to expand its prospecting into more marginal lists and still make a profit. This would be particularly wise if by expanding, it could lower fixed expenses as a percentage of sales.
On the other hand, if investors view the company as an increasing risk, they may demand more than a 20% return on investment. In this case, the company would be forced to prospect more selectively and increase its initial response rates.
WHAT'S THE BOTTOM LINE?
Lifetime value calculations show the importance of understanding the differences between customer segments. Some are much more valuable than others... and every company has its own unqiue mix of customers and customer segments. These differences determine not only the most cost-effective marketing strategies, but also the most attractive opportunities to boost company wealth and value.
Try these formulas with your own customers with the worksheets presented in Using Lifetime Value to Prospect.
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