Why Customer Lifetime Value is the Most Important Measurement in Your Business
When I ask, all the people that I meet in business, if they know their top 10 customers, most proudly announce that they do. Then, when I then ask who their top 10 most profitable customers are, it is normally a very different look. Do you know? And why would you care? This article explores the importance of knowing the lifetime value of your customers and how to calculate it. This way, you can spot trends as they happen, and make the most from them.
How do you calculate your profitability?
You will need to apply some simple accounting rules in relation to fixed and variable costs. Stop yawning and stick with me, since this is important. OK, maybe you have a good accountant; they will be able to help you out – if not, get a new one!
To calculate your fixed costs, look at all the items that you spend money on every year. Things like; rent, light, telephone, salary costs, etc. When you have the total, then divide that by the amount of customers you have, and that is the amount you will assign as the fixed cost to each customer.
To calculate your variable costs, you will need to add up the cost of goods sold. Items such as; material costs, variable manufacturing costs, sales commissions, lead generation costs, service costs, etc.
This will give you a total cost of doing business, and what most companies do, is apply the variable costs the same way as the fixed costs and calculate an average margin. For example if you had turnover of €100, and your fixed costs were €30 and the variable costs for the year were €40, your margin would be €30 or 30%.
How do you calculate individual customer profitability?
You have your average margin, what you now need to do is to divide your customers into groups. Suggestions would be as follows;
* Top 5 revenue earning customers
* Middle 5 revenue earning customers
* Bottom 5 revenue earning customers
* 5 customers in each industry
* Additional metrics may include
o Location
o Number of employees
o Sales representative looking after them
o Products they buy
Once you have your rankings, then try and apply the above calculations to each segment. Apply your fixed costs as a proportion of revenue each customer generates.
Now apply the variable costs to each customer segment. Some products may cost more to produce. Some locations may cost more to service, and some of your larger customers may seek larger discounts, which can all eat into your margin.
Calculating the lifetime value of a customer
Once you have an average profit per segment, you can create the average profit per segment. Just by getting this far you will have obtained huge insights you’re your customer base.
You will finally need to look at how long your average customer stays with you, and how much they buy. So say customer X, has been with you for 6 years, has spent €500 with you, and the margin has been 20%. That means the customer has generated €100 for your bottom line.
That is the secret to successful business – knowing the lifetime value of a customer.
Now you know the Lifetime Value – what next?
Whatever the answer you come up with, you now will have the secret to multiplying your profits. Select the groups that deliver you the most lifetime value. With this information you can do the following.
* Work out how much you are prepared to spend to get a new customer that will deliver you €100. Use this as the basis of your marketing plan
* Love your existing customers in those segments, and continue to sell to them.
* Identify the least profitable ones, and either relinquish your attention on them, or find ways to increase the value they deliver to you.
* Use the information gained, to target your marketing and lead generation activities on similar types of prospects.
* Ask each one of them for two referrals, after all, since they are giving you so much profit, they must be happy!
The above exercise is one that should yield you massive returns on the time spent. However, once completed, you should seriously consider putting in a system, which tracks this information as you go on. This way, you can spot trends as they happen, and make the most from them.
In their efforts to become more customer-focused, companies everywhere find themselves entangled in outmoded systems, metrics, and strategies rooted in their product-centered view of the world. Now, to ease this shift to a customer focus, marketing strategy experts Roland T. Rust, Valarie A. Zeithaml, and Katherine N. Lemon have created a dynamic new model they call “Customer Equity,” a strategic framework designed to maximize every firm’s most important asset, the total lifetime value of its c
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