It’s a rare business that operates on a “one-and-done” model when it comes to customer transactions. “Most companies now realize that the value of a customer transcends a single transaction,” says Ken Homa, a professor at Georgetown University’s McDonough School of Business. Managed effectively, the “right” customers can provide a lifetime of transactions and an extended stream of sales and profits, he says.
Customer lifetime value (CLTV) represents the profit you can expect to realize from sales to a particular customer starting from the time he or she begins doing business with your company. Calculating CLTV requires the use of historical data, which in and of itself is backward-looking, but the exercise is all about looking to the future. Determining CLTV can help you shift your focus from short-term results to a longer-term perspective on the overall health of your business. It also provides important guidelines on how much you should spend on acquiring new customers versus retaining existing ones.
Homa breaks down CLTV as a function of four variables: customer acquisition costs; projected sales, profits, and cash flows; customer defection and retention rates; and company discount rate (the cost of capital). So, the general formula for calculating CLTV is:
CLTV = (M/d + i) – AC
- M represents the annual profit margin generated by a customer
- d is the annualized defection rate (sometimes referred to as “churn”)
- i is the annual discount rate (cost of capital)
- AC is the cost of acquiring the customer.
Using a highly simplified hypothetical example of the above formula where:
- M = $175 (net profit realized on final day of fiscal year)
- d = 20 percent
- i = 10 percent
- AC = $250
CLTV = $333.
CLTV is essential to generating an effective customer relationship management (CRM) strategy, says Graham Cooke, CEO of Qubit, a retail technology company focused on CRM and automating tag management. “As marketers, we need to focus on the high-value customers, or customers with the potential to become high-value, to maximize our bang for the buck. By calculating CLTV you can do more effective segmentation of customers and then tailor your CRM strategy accordingly,” he says. Effective segmentation using CLTV allows you to lower customer acquisition costs by improving your ability to focus marketing resources on the most valuable targets. “If you can identify consumers with the highest propensity to convert and the highest potential value, your ROI from these paid channels will be much higher,” Cooke says.
While the concept of CLTV is equally applicable regardless of company size, smaller businesses may not have the information systems in place to capture and report all the data needed, especially for more sophisticated modeling approaches, Homa acknowledges. “These companies have to decide if building the systems to collect and analyze the data is worth the investment. Usually, it is,” he says. Mark Gayle, founder of 5K MVP, a developer of Web applications for businesses, points out that smaller businesses with limited data resources can use low-cost technology such as social media to identify customer segments with the greatest potential CLTV. They can then combine good insight and business agility to reap the benefits of CLTV on a minimal budget.
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