How to find the customers, products and services that make you the most money

Part two: The power of lifetime value

Have you ever wondered why some companies seem to offer unbeatable deals to sell you their products and services? Or why book, music and video clubs can offer such fabulous products for such remarkably low prices?

The answer is that they are exploiting the concept of lifetime value. The lifetime value is what your average customer contributes directly and indirectly to your bottom line over a few years.

All too often, businesses concentrate on the immediate returns from a sale. But, assuming your products and services are good, customers will usually buy more than once from you. These follow-on sales are far more profitable since they involve little or no marketing costs. Also, by looking at a customer’s requirements in greater depth, servicing their needs better and actively seeking referrals from them, a customer’s value to your business soars.

Knowing your customers’ average lifetime value will help you decide how much you can afford to spend on marketing to catch new customers and how to increase what you earn from existing customers.

The concept is probably more relevant to mail order, business-to-business, or service sales where there is the opportunity to build an ongoing relationship, rather than over-the-counter retail sales. However, lifetime value is so important that one big US burger chain drills this concept into all new recruits. Using the calculations shown opposite, the burger chain discovered that upsetting a customer over a 99¢ burger could result in $18,000 of lost business.

If you have many customers, you will probably want to consider average figures overall, or in segments according to customer or product type. If you have relatively few customers, you might want to consider the figures case by case.

How to calculate a customer’s lifetime value

A customer’s lifetime value is the amount they can be expected to contribute to your bottom line over the period of your business relationship with them. So you need to analyse the profitability of your customers over several years.

First find out:

• The value of an average sale. Divide total annual sales (products and/or services) by the number of sales in a year. Let’s say it is £500. (A)
• Your profit margin. Let’s say it is 20 percent. (B)
• Customers’ purchase frequency. The total number of annual sales divided by the number of customers in a year. Let’s say the average customer buys from you four times a year. (C)
• Average customer lifespan. How long does the average relationship last? Let’s say three years. (D)

Here’s how to assess these values for a typical customer:

• Average annual profit per customer: (A x B) x C = (£500 x 20 percent) x 4 = £400.
• Average lifetime value: £400 x D = £1,200.

Additional business

Not included in this calculation is the amount of referral business customers generate. Most clients will be happy to give you referrals if you ask for them. The number of leads you get and how many you convert will vary with each type of business. However, it is fair to estimate that the referral business generated by each customer is at least 50 percent of their own contribution – that is, £600.

Why a short-term view is so unproductive

If you had concentrated your efforts on one-off sales, you would have had to make 12 sales just to achieve the same level of profit (18 if you add in the value of the referrals).

What’s more, you have to spend a fortune marketing to reach and capture each new sale, which is wasted if the customer doesn’t buy again.

How to calculate lifetime values for service industries

Where you sell an annual service, say preparing year-end accounts, you can calculate a customer’s expected value in a similar way.

You cannot be sure a customer will stay, but you can estimate the chances of them renewing their contract each year, and so work out the probable or expected earnings over, say, a four-year period. The calculation is actually really simple once you get the hang of it.

All you need to know is your average annual profit per sale, and the percentage of customers who renewed their contacts last year – or are likely to next year if you are new to business.

For example, if your annual average profit per sale is £1,000 and each year you expect to retain 85 percent of last year’s customers, whose average lifespan is four years, a customer’s lifetime value is:

• £1,000 x (1 + 0.85 + [0.85 x 0.85] + [0.85 x 0.85 x 0.85]) = £3,187

However, if the chance of customers renewing their annual contract falls to 30 percent, the figures now look like this:

• £1,000 x (1 + 0.3 + [0.3 x 0.3] + [0.3 x 0.3 x 0.3]) = £1,417

From this you can see the importance of keeping customers more than happy.

The sprat to catch a mackerel

Your lifetime value calculation will also show you how much you can afford to spend on winning a new customer. In our first example, you could afford to spend up to £400 (the first year's profits) to win a new customer, even though the value of a typical sale was only £500, and the margin only £100.

Six ways to boost profits

The lifetime value calculation shows how you could dramatically boost your bottom line by changing the key figures used to derive it. So:

1. Increase the net profit. Raising prices by as little as 5 percent would have a dramatic effect. Similarly cutting costs by the same amount would increase lifetime value disproportionately.
2. Increase the value of each order with special bulk offers or by selling extra or complementary products. Usually the hard part is the first sell (the burger). The add-ons (the drink and chips) are easier and often more profitable.
3. Increase the number of sales per customer per year by a single sale. Consider special offers to make customers feel warm towards you.
4. Extend the lifespan of your customers. Review your customer service procedures. Find out what they want and never take good customers for granted. Contacts can change or rivals appear.
5. Increase the number of customer referrals. Few businesses do this systematically and so waste a great marketing opportunity.
6. Review your customer list for the past three years. Rekindle relationships you have allowed to wither. At the very least, touch base and ask for some referrals.

To see what effect these measures could have, let’s say you increase sales value (A) by 10 percent to £550; profit margin (B) by 10 percent to 22 percent; frequency (C) by one to five purchases a year, while keeping the average lifespan (D) the same. The average lifetime value leaps up as follows:

• Average lifetime value = (A x B) x C x D = (550 x 22 percent) x 5 x 4 = £2,420

The figure has more than doubled for very little extra effort.