How to Calculate the Lifetime Value of a Customer
Some seasoned entrepreneurs may say “break even” or some other number is the most important metric, but I believe “lifetime value” is perhaps the most significant measure to benchmark. I also know it’s one of the most overlooked and least understood metrics in business -- even though it’s one of the easiest to figure out.
Why is this particular number so important? Mainly because it will give you an idea of how much repeat business you can expect from a particular customer, which in turn will help you decide how much you’re willing to spend to “buy” that customer for your business.
Once you know how frequently a customer buys and how much he or she spends, you will better understand how to allocate your resources in terms of customer retention programs and other services you’ll need to keep your customers -- and keep them happy.
The simplest way to estimate lifetime value: Plug actual or estimated (if you’re in the planning stages or just starting out) numbers into the following equation:
(Average Value of a Sale) X (Number of Repeat Transactions) X (Average Retention Time in Months or Years for a Typical Customer)
An easy example would be the lifetime value of a gym member who spends $20 every month for 3 years. The value of that customer would be:
$20 X 12 months X 3 years = $720 in total revenue (or $240 per year)
Now you can see even from this hypothetical example why many gyms offer a free starter membership to help drive traffic. Gym owners know that as long as they spend less than $240 to acquire a new member, the customer will prove profitable in a short amount of time.
Related: Why Should Your Customers Trust You?
Once you have some idea of the lifetime value of your customer, you have two options in deciding how much to spend to acquire him or her:
1. Allowable acquisition cost: This is the amount you’re willing to spend per customer per campaign -- as long as the cost is less than the profit you make on your first sale. This is a shorter-term strategy that makes the most sense when cash flow is a concern.
2. Investment acquisition cost: This is the cost you’re willing to spend per customer knowing that you’ll take a loss on an initial or even subsequent purchase. But you have the cash flow and other resources to absorb your initial marketing investment with this longer-term strategy.
If you can market your free initial memberships for less than $240 in the gym example, you can afford to expand your marketing campaign, as each new customer provides a return on your efforts. This is great if you’re just starting out because you can develop the business by using cost-effective, measurable marketing programs.
On the other hand, you may take a different view if you’re an established gym or the value of your customers is higher. Think a high-end facility with premium monthly fees and value-added options such as spas or personal trainers. You may be fine spending $1,000 to get a $700-a-year customer and waiting until the first quarter of the second year of the membership to start profiting from your investment.
The point is that you’ll never know how to develop an optimal marketing budget unless you know what the return on your investment needs to be. This knowledge is vital because it will help you make marketing decisions based on the reality of your own numbers rather than the promises of some new media program.
Knowing lifetime value also lets you see how, or if, you can discount. It will help you avoid the potentially disastrous effects of discounting when your business needs cash flow to survive. In addition, you will find innovative ways to build value upfront and create offers that drive enough volume to support and eventually increase your overall lifetime value number.
So take some time to work the numbers in the very simple lifetime value equation, especially if you’re still in the planning stages for your business. Remember to build in some variation and see if your current plans support the numbers you come up with. If so, that’s great. If not, that’s also great because you’ve determined on paper what you need to change to make your numbers work.
In the end, it’s the lifetime value numbers that will determine the ultimate success of your company.