The reading level for this article is Novice
After you’ve finished this article, be sure to read the accompanying article “Four Steps to Increasing the Lifetime Value of Your Customers.”
Note: This article is a bit mathematically dense. To make it a lot easier to calculate your lifetime value, be sure to download the companion Excel spreadsheet. The four worksheets in the spreadsheet make it as simple as plugging in a few variables and the lifetime value and lifetime profit is computed for you. Feel free to distribute this file to your friends and associates.
Determining the Lifetime Value of and Lifetime Profit From Your Customers
When many businesses look at a customer they see the value of the first sale. If Sue bought a product worth $39 many companies would see Sue as being worth $39 in revenue. Then if, and only if, later on Sue buys, say, another $39 product from you will she be seen as worth $78 in revenue. Let’s assume S Company looks at customer value this way.
Other businesses, with managers perhaps a bit more experienced that S Company’s know better than to follow the above model. They know that the true value of Sue is the value of all the purchases she has made plus the value of all the purchases she is likely to make in the future (discounted to the present). This is called the lifetime value (LTV).
The essence of what you must know here is that to obtain the lifetime value of an average customer multiply your average sales by the average number of times they come back. You can estimate these figures to come up with a rough lifetime value figure.
So, to estimate your lifetime value of an average customer
Estimated Average Lifetime Value = (Average Sale) x (Estimated Number of times customers reorder)
Go ahead and calculate this figure right now.
1. Your estimated average sale is _______________.
2. The estimated number of times customers reorder is ________________.
Now, multiple figure one by figure two to get _________________. This is your estimate for the average LTV of a customer.
Now, to determine how much you can spend to acquire each customer, you must determine the lifetime profit (LTP) you receive from an average customer. To do that multiply your average profit per sale by the estimated number of times customer reorder.
Now, what does lifetime profit mean. Well, two things. First, it means the average amount of profit you are going to receive from each customer. Secondly, however, it means how much more you can spend to acquire each customer and still make a profit in the long run. To determine how much in total you can spend simply add back your average customer acquisition cost to this figure. Follow these steps to determine this very valuable information.
1. Average profit per sale is ________.
2. Estimated number of times customers reorder is __________.
3. Figure one multiplied by figure two is __________. This is average lifetime profit.
4. Figure three plus your average customer acquisition cost is _________. This is how much more you can spend to acquire each customer and still turn a profit.
Estimated Average Lifetime Profit = (Average Profit Per Sale) x (Estimated Number of times customers reorder)
If all you are looking for is an approximation of your average lifetime value and lifetime profit from a customer then you can stop with this article here. Simply know that this lifetime profit plus your current per customer acquisition cost will be the maximum amount you can afford to spend to obtain a customer and still break even, in the long run. It should be your goal to spend less to acquire a customer than this figure, so you can turn a profit.
Do not be afraid to spend more than the profit on the first sale to acquire a customer, however. In review, As long as you cash flow is healthy enough to support it, spend whatever you need to acquire that customer, as long as it is less than the average lifetime profit plus your current customer acquisition cost.
As you can see, however, this lifetime value and lifetime profit figures are very important numbers to know. Therefore, let’s look at a way to obtain a much closer approximation.
In case you missed the message at top, I’d very much recommend downloading the Excel companion worksheets at this point. It will make the following much easier to understand. Just scroll to the top to download them.
Once again, the following is a bit mathematically dense. You may wish to just download the Excel worksheets to compute more accurate numbers and leave the reasoning and formulas to others. However, do go forward if you wish.
Finding A Closer Approximation of the Lifetime Value of and Lifetime Profit From an Average Customer
As stated above, it is important to know your customers’ lifetime value as closely as possible so that you can make informed decisions about your marketing costs and budget.
While you should be able to determine your average sale fairly easily (divide total sales by number of sales), in some cases it may be difficult to estimate the the number of times customers reorder.
So first, let’s get a ballpark figure of the number of times customers reorder and refine our figure from there.
What we are doing: Getting a closer approximation of the number of times customers reorder so we can have a more accurate average lifetime value figure.
To estimate the number of times customers reorder, divide the number of customers you have by the number of sales you have made.
Number of Times Customers Reorder = Number of sales you have made / Number of customers you have
So to get this approximation of the number of times customers reorder
1. The number of sales you have made (not the number of products you’ve sold, but the number of orders you’ve filled) is __________________.
2. The number of customers you have is _________________.
Now, divide figure one by figure two to get ________________. This is an approximation of the number of times customers reorder. Is this figure close to your estimate above?
Now, you may notice that there is a bit of problem in this formula. Customers that you have acquired recently will not have ordered as many times as a normal customer would. Therefore this figure you just calculated will off. Therefore we must make the following adjustment.
To come up with a more accurate figure for the number of times customers reorder, you must remove the data from all the customers who, on average, have not yet finished their relationship with you.
What we are doing: Removing data from recently acquired customers as these relationships will not have come to a conclusion.
This calls for a crucial estimation. You must estimate the length of time a customer stays with you.
If you are an older company you can obtain a pretty accurate estimation by taking a random sample of 50 customers who have not ordered from you in at least 12 months. The larger your sample is, the more accurate this estimation will be. Simply determine the last data they ordered from you and the first date. Determine the number of days (or months if your average relationship is longer) between these figures. Add up all the days for each of the fifty customers, then divide by 50. This will be a very good approximation of the average length of a customer relationship.
Now, simply remove all the sales and customers you have gained during this period and repeat the formula above, number of sales times number of customers.
Closer Approximation of Number of Times Customers Reorder = Adjusted Number of sales you have made / Adjusted Number of customers you have
Now, if you are a younger company, you may not have been in business as long as the average length of a customer relationship.
If this is the case, you must estimate as closely as you can the length of an average customer relationship. Take a look at the sales data you do have to verify your estimation. Now, remove all the sales and customers you have gained during this period and repeat the formula above, number of sales times number of customers.
So to get a closer approximation of the number of times an average customer will reorder do the following.
Assume X is the length of an average customer relationship.
1. Total number of sales you have made is _________________
2. Number of sales made during the previous X number of days is _______________.
3. Figure one minus figure two is ______________.
4. Total number of customers you have is ______________.
5. Number of customers you have acquired during the previous X number of days is _________.
6. Figure four minus figure five is _______________.
7. Figure three divided by figure six is _____________. This is the adjusted number of times an average customer orders.
Now, that you have a closer approximation of the number of times an average customer orders you can plug it back into our original lifetime value formula and get a very accurate figure.
Do the following.
1. Average Sale is ____________.
2. Adjusted number of times an average customer orders is ______________.
3. Figure one divided by figure two is ________________.
This is a much closer approximation to the true lifetime of value of an average customer. Is it far from your original value?
Average LTV = (Average Sale) x (Adjusted number of times customers reorder)
And there you have it. You now have a very accurate figure for the average lifetime value of your customers. To get the amount you can spend to acquire each customer simply subtract the per customer cost of goods sold and per customer operating expenses.
Alternatively, you could find Average lifetime profit by multiplying adjusted average profit by the adjusted number of times an average customer reorders.
The one note I must make here is that average lifetime profit is not the total amount you can spend to acquire a customer. Rather, it is the additional amount you can spend to acquire a customer above and beyond what you are currently spending. Add back what you are currently spending to get the actual total amount of what you can spend to acquire a customer and still turn a profit.
In summary, every business wants as many new customers as they can get, but very few business owners know exactly what they will receive ultimately from each customer nor how much they can spend to acquire each customer. This is very important information, and if you know it you will have a marked advantage over your competitor. As long as your cash flow is healthy, spend as much as you must to acquire a new customer, as long as it is less than the present value of average lifetime profit.
Now, if you have not yet downloaded the Excel spreadsheet and you do want to calculate your actual lifetime value and lifetime profit, here it is again.
|Download Companion Excel Spreadsheet|
Now that you have quantified your Average LTV, make it a goal of yours to increase it. How can you do this? Read my article Four Steps to Increasing the Lifetime Value of your Customers.