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NEW CUSTOMERS ARE THE LIFE BLOOD OF ANY BUSINESS. Most marketers agree that while it costs money to gain new customers and profits come from existing ones, without new customers a business will soon have no customers at all. |
The question is, how much can you prudently spend to gain a customer? To answer this question, we need to take a step-by-step approach. We will start with some basic marketing math and then combine it with information that should be in any good database. Then we will also look at the company's capital position. That is, we also need to consider how much money the company has for prospecting and what is the rate of return that the company must earn on the money it uses.
ACQUISITION
Prospecting can be viewed as a simple matter of making a financial investment. Money is invested at the beginning and time passes before the investment is recovered. Once the investment is recovered, additional income is profit. For example, the cost of producing and mailing a catalog is borne before the first sale from that catalog is made. It may be some time before new customers acquired through that catalog spend enough to more than cover the initial cost of acquiring them.
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)) |
LIFETIME VALUE
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." The Time Value of Money Discount Factor or "TVMDF" helps us do this.
The TVMDF is based upon a rate of interest that we require to be earned on our investment, including what we demand as a result of risk. Using this factor will give us the customer's Lifetime Value in terms of net present dollars. That is, what the future stream of profits from this customer are worth in today's dollars. (We need to make this adjustment because we are spending "today's dollars" to prospect for new customers.)
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% TVMDF 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.
|
||||||
THE FINDINGS
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.
Lifetime value calculations show the importance of mining your customer base. If the company under-mails its own list, it will not achieve the future profits necessary to gain new customers. If the sample company were to mail customers only three times a year, it would not make a profit. On the other hand, if it could get similar response rates from five mailings per year, it would make more profit and new customers would have a greater lifetime value.
Try these formulas with your own customers. By using this approach, you will be able to determine if you are prospecting too much or too little. You will also see how improvements in marketing to your existing customers allow you to attract new customers who would otherwise be unprofitable.
USE YOUR OWN NUMBERS
Use this worksheet to collect your own numbers for your marketing costs, customer acquisition and response rates:
| LIFETIME VALUE INPUT DATA WORKSHEET | ||||||
| Input Data | Our Numbers | Your Numbers | ||||
| Cost to reach a prospect | $ 0.60 | |||||
| Average Response | 1.10 % | |||||
| Average Initial Order | $ 70.00 | |||||
| Average Profit Margin | 40 % | |||||
| Cost to Contact A Customer | $ 0.50 | |||||
| Number of Mailings per Year | 4 | |||||
| Mailing Response Rate, Year 1 | 16 % | |||||
| Mailing Response Rate, Year 2 | 13 % | |||||
| Mailing Response Rate, Year 3 | 11 % | |||||
| Time Value of Money Discount Rate | 20 % | |||||
| Average Repeat Order Amount | $ 75.00 | |||||
| Average Repeat Order Profit Margin | 40 % | |||||
Using the numbers you collected in the above worksheet, it's time to determine the lifetime value of your customers. Using the equations below, plug in your numbers and fine tune your prospecting plans accordingly.
LIFETIME
VALUE CALCULATION WORKSHEET |
||||||
| CALCULATION | Our Numbers | Your Numbers | ||||
| Advertising Cost to Acquire a Customer: (Cost to Reach a Prospect) ÷ (Average Response Rate) |
$ 54.55 |
|||||
| Average Profit on Initial Sale: (Average Initial Order Amount) x (Average Profit Margin) |
$ 28.00 | |||||
| Initial Investment per Customer: (Advertising Cost to Acquire a Customer) - (Average Profit on Initial Sale) |
$ 26.55 | |||||
| Annual Response Rate, Year 1: (# of Mailings, Year 1) x (Average Response Rate for Year 1) |
64 % | |||||
| Annual Response Rate, Year 2: (# of Mailings, Year 2) x (Average Response Rate for Year 2) > |
52 % | |||||
| Annual Response Rate, Year 3: (# of Mailings, Year 3) x (Average Response Rate for Year 3) |
44 % | |||||
| Annual Contact Cost per Customer: (# of Mailings per year) x (Average Cost of Mailing) |
$ 2.00 | |||||
| Average Profit on Repeat Sales: (Average Repeat Order Amount) x (Average Profit Margin) |
$ 40.00 | |||||
| Average Profit, Year 1: [(Average Profit on Repeat Sales) x (Annual Response Rate, Year 1)] - (Contact Cost, Year 1) |
$ 17.20 | |||||
| Average Profit, Year 2: [(Average Profit on Repeat Sales) x (Annual Response Rate, Year 2)] - (Contact Cost, Year 2) |
$ 13.60 | |||||
| Average Profit, Year 3: [(Average Profit on Repeat Sales) x (Annual Response Rate, Year 3)] - (Contact Cost, Year 3) |
$ 11.20 | |||||
| Time Value of Money Discount Factor, Year
1: (1 + Discount Rate) |
1.20 | |||||
| Time Value of Money Discount Factor, Year
2: (1 + Discount Rate) x (1 + Discount Rate) |
1.44 | |||||
| Time Value of Money Discount Factor, Year
3: (1 + Discount Rate) x (1 + Discount Rate) x (1 + Discount Rate) |
1.73 | |||||
| Present Value of Future Profits : (Sum of Discounted Values of Future Annual Profits) |
$ 30.26 | |||||
| Lifetime Value (Return on Investment): (Present Value of Future Profits) - (Initial Investment per Customer) |
$ 3.71 | |||||
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