How to Measure the Value of your Customers

So last week we talked about buckets of water, leaks, refilling and plugging the holes, it was thirsty work so whilst rewarding myself with refreshing, a chilled pint… of water (well, it was a “school” night) I started thinking about another form of customer measurement – their value.

This week we will look at how to measure the worth of your customers in relation to your business, or to hark back to last weeks theme, how good and effective is the water within your bucket?

The real measurement of customer worth is not a short term one, but more measured over time using the parameter of  how much the customer contributes, or is “worth” to your business in the long term…or as they call it in Marketing terms, the Lifetime Value of a customer (LTV).

The business definition of  Lifetime Value of a customer states:

“Total profit (or loss) estimated to result from an ongoing business relationship with a customer over the life of relationship. Goods or services with high lifetime value may justify comparatively higher marketing expenditure and/or salesperson compensation.” (BusinessDictionary.com)

If like me, sometimes business jargon more bamboozles than helps then I will simplify the above definition…

To put it simply, the Lifetime Value of a customer is the amount of profit they will generate over a longer period of time, or their lifetime as a customer. This brings into focus the importance of the longer term performance and value of a customer, as opposed to the initial narrow analysis of a customers performance in the short term. This has huge implications of how much you can afford to spend to gain new customers.

In other words, it is important for a business to understand the overall profitable contribution of a customer in the longer term future in order to see how much it can afford to spend on recruiting new customers.

The key to working out lifetime value is to know the following:

1)     How much it costs to recruit a new customer

2)     how many of your customers will make repeat purchases over the lifetime you are measuring (e.g. next 2 years)

3)     How much their average order value (AOV) will be when they return

4)     How frequently they will purchase per annum on average

5)     The average profit margin for repeat customers

6)     The overall cost of fulfilling the order of your product/service

For example, if a business loses £20 on its first transaction with a customer (including the marketing cost, the discount/promotion cost and the cost of fulfilling the product and service) but that customer goes on to buy 10 more times in the next 2 years and makes £5 profit for each of these 10 times, then you can say for the cost of the initial £20, that the customer will provide £50 of profit subsequently with the net  effect being a £30 profit. This would technically allow the business in question spend up to £49 on a new customer acquisition and still be profitable within 2 years.

Businesses are all different though so the industry and market you are in will determine the LTV of your customer and the implications on your business. For example, we don’t buy cars often, or redecorate our homes often, so the initial profitability of a customer is far more important to these types of infrequent purchases. However with consumable goods like food, fuel, clothing and other repeat purchase products, it may be possible to take a longer-term view to profitability.

To conclude, knowing when a customer will become profitable is vital and will help your business be able to determine how much you can spend to recruit, but also to allow your business to budget for growth and help with forecasting and budgeting. No two businesses are the same, and therefore there is no right or wrong answers regarding on how to use LTV to run your business, but as an information tool it is of huge importance to measure this value of your customer.

Next week we will look at how to gauge your customers’ potential LTV through creating buyer personas.