Disclaimer: The content of these articles is to be used as a general guide only. Professional advice should be sought before taking any action relating to the points discussed in these articles.

LIFETIME VALUE OF A CUSTOMER

  Those of you who read my articles regularly would know there are three fundamental ideas that I believe in strongly. These are:

1) Exceed your customers' expectations.
2) Aim for the long term rather than the short term.
3) Your reputation is more important than any individual sale.

  I believe strongly in these concepts because it is our aim at Australian Credit Stationers to continually increase the lifetime value of a customer. Put simply, the lifetime value of a customer is the profit generated by a particular customer from the first time that customer makes a purchase from your business until the day your customer does not use your products or services any more. So the lifetime value of a customer is the product of:

a) average profit generated per order
b) number of orders per annum per customer
c) number of years a customer buys your products or services

  The first part of the calculation is the most difficult to determine. It is important to calculate the profit rather than the sales. You need to deduct from your sales, the cost of goods sold, the costs in processing the order and an allocation of your fixed costs. 
The best way to calculate the number of customers is to add the number of customers on your database at the beginning of the year to the number at the end of the year and divide by two. To get the number of orders per annum per customer, simply take the number of orders you have received in a year and divide by the average number of customers on your database. 
  The number of years a customer buys your products or services is very difficult to calculate, even if you have detailed computer records. Firstly, you need to determine when a customer has lapsed. This is different for different industries. A car dealership may sell a motor vehicle to a customer every five years so if that customer has not placed an order with you after say, seven years, then you may assume that that customer has lapsed. But if you own a local supermarket and your customers visit your store once a week, then your may consider a lapsed customer is one that has not visited your store in say, two months.
  Every customer will have a different life span with your business. What we need to do is calculate an average life span. Consider a company with 10,000 customers at the beginning of the year, 3,000 new customers obtained during the year, but only 11,000 customers at the end of the year, instead of 13,000 as we would expect. We say that from the 10,000 customers at the beginning of the year 2,000 have lapsed, so the average life span of a customer is five years. This is calculated by: (customers at beginning of year/customers lapsed during year).
  The lifetime value of a customer is a powerful concept because small changes can make a large difference to your profit.
Consider a company with the following details:

a) average profit per order is $100
b) two orders per annum per customer
c) average life span per customer is four years

  In this example the lifetime value of a customer is $800 ($100 x 2 x 4). This figure is very important in determining your marketing plan. Put simply, it means you can actually afford to spend up to $800 to obtain a new customer because once your have obtained a new customer, then on average you will expect that customer to generate $800 profit during that customer's time with your company. The other implication that the lifetime value of a customer has on your company is that once you realise how valuable each customer is to your business this will encourage you to obtain as many new customers as possible. In the above example, you can see that 1,000 new customers would generate an extra $800,000 long term profit. However, the main purpose in obtaining new customers is to replace your lapsed customers. For your company to continue to grow, you need to ensure that the number of new customers you obtain each year is greater than the number of lapsed customers.
  Consider again the above example. If these customers generated a profit of $150 per order instead of $100 per order, then the lifetime value of the customer would increase to $1200 ($150 x 2 x 4). Similarly, if the customer ordered three times a year instead of two, $800 would increase to $1200 ($100 x 3 x 4). And if the customer stayed five years instead of four, $800 would increase to $1000 ($100 x 2 x 5).
  The mathematics involved in the calculation of the lifetime value of a customer is important, but what's more important is your strategy to increase the lifetime value of a customer.
  The hardest thing to do is to increase the average profit per order. Some of your options here include increasing prices, improving efficiency by reducing your order processing costs, selling higher margin goods and services, and reducing your fixed costs.
One of the best ways to increase the number of orders per annum is to market to your own customers. Your options here are endless, You can develop a loyalty program, have a sale, do one or better still, several direct marketing campaigns to your own customers during the year or develop more products or services, especially those to supplement the initial sale.
  To increase the average life span of a customer you need to reduce the time it takes for a customer to lapse. Ideally, you would like your customers to continue to do business with you until they definitely have no reason to use your products or services any more. Your customers may have sold their businesses or moved to another area.
  In reality, most customers stop doing business with you to do business with your competitors or to buy similar goods or services from another supplier. Your customers may have several reasons for choosing another supplier. They may perceive your products to be of inferior quality, your service to be substandard or your price to be too high. However, often it is none of the above. It is just that your customer decided to respond to your competitor's marketing for no particular reason.
  Obviously, it is important to contact your lapsed customers and find out why they no longer use your products or services. This may expose some flaws in your business which when fixed may reduce the number of lapsed customers and increase the lifetime value of a customer. Secondly, you should contact your lapsed customers and make them an offer to entice them back to your business. It is usually easier to convince lapsed customers to reorder from you than it is to entice new customers to order from you for the first time.
  To maximise the lifetime value of a customer, you really want your customers to stay with you for life. You want your customers to continue to purchase your goods or services from you, even if your competitors are offering lower prices. Ideally, you want your customers to show you the same level of loyalty your friends or relatives would show you. To do this you need to do everything right.
  Have a strong guarantee, make it easy to do business with you, be friendly, be personal, and most importantly exceed your customers' expectations. If you do, the rewards will be a greater lifetime value of a customer and larger long term profits for your business.

This article is reprinted from Rentons' Business Tips No. 10
© Copyright February 2001 ACS