We live in an information-intensive era. The news cycle runs 24/7. With a click on a tab, we can instantly find our favorite team’s scores, as well as our own credit scores.
Today, more information is always preferred to less and ignorance is never bliss. We want to know everything and we want to know it now. We don’t like surprises and we don’t like being the last to know. You probably know the value of your home, the value of your 401(k) and maybe the value of your car. You could probably make a pretty good guess as to the value of your company.
But consider this: Do you, as a business owner or manager, know the true value of a customer? That’s not a trick question. And just to clarify, true value means value as in actual revenue, or dollars to your top line.
Previous posts have emphasized that retaining current customers is more cost-effective than finding new ones. That’s because established customers don’t require as much sales and marketing effort, they’re less sensitive to price increases and they can be lucrative sources of new customers via referral.
That’s all true, but it’s also vague. Putting an actual dollar value on the lifetime value of a customer will make a compelling, crystal-clear case for putting processes in place that make customer retention a company-wide priority.
Coming Up with a Number
Marketing, sales and product development specialists have used lifetime value to help formulate strategy since the 1960s. Determining how much a customer is worth to your company – the customer’s lifetime value – is a mix of art and science.
There are several ways to calculate the lifetime value of a customer. High-level database marketing professionals use complex formulas that might even have NASA’s best rocket scientists double-checking their math. But don’t get bogged-down worrying about how sophisticated your analysis looks. It is, after all, an estimate. (In reality, you wouldn’t know the actual lifetime value of a customer until that customer stops buying from you, you stop selling to him, your company goes out of business, one of you dies, or the world ends.)
The point is, producing a specific dollar figure gives you a tangible point around which to design retention strategies, marketing campaigns, and other customer-focused initiatives.
Here’s a quick way to estimate the lifetime value of your customers.
- What is the dollar amount your average customer spends in a year? (Divide total dollar sales for the previous year – or trailing 12 months – by the total number of customer accounts.)Example: Annual sales = $1,375,000
Customer Accounts = 855Amount Average Customer Spends = $1,608
- What is the expected number of years a customer will use your services?Example: You run a landscaping company in a stable area where homeowners tend to stay in the same residence for six years on average. Expected number of years = 6.
- How many people per year does your average customer tell about your company? You may have to guess or you might have a very good idea, if you use a fairly effective referral program and track results. Number of referrals = 4.
- What percentage of referrals actually become customers? You probably have a pretty good notion. Let’s call it 50%. Referral conversion = 50%
So the average lifetime value of a customer, before referrals, equals $1608 (average annual sale) x 6 (average number of years as a customer), or:
We also estimated that each customer would tell and average of 4 people about your services and that 50%, or 2, would become customers. This puts the probable gross sales from referrals at $19,296, ($9,648 x 2) and the lifetime value of the original customer at:
This makes the lifetime value of a customer just under $30,000.
Two notes: First, a more sophisticated analysis of a customer’s lifetime value would have incorporated a “discount rate” when calculating the cash expected in future years. That’s with respect to the time value of money, which means that getting a dollar in year six is less valuable than having the dollar today. Also, other factors including probable price changes, additional service offerings and the like, are not considered here.
Second, clearly some customers are more valuable than others. The 80/20 rule (80% of your revenue comes from 20% of your customers) tends to hold up in the real world. The expected value of specific customers can certainly be calculated, and in many instances that would be informative and productive. But the objective here is to illustrate the value of the average customer, and to promote effective customer relations across the board.
With those disclaimers in mind, the lifetime value calculation still makes the point that it is extremely vital that every manager and employee think long-term, and not merely focus on the current transaction or contract. Customer retention should be among any company’s most vital priorities.
Corporate sales consultants, when talking about the importance of client relations and building trust, will often encourage companies to, “think about the fourth sale, not the first.” Thinking about “Year 6” is even more important.
MP Star Financial’s invoice factoring services can help make your cash flow more predictable, enabling you to spend more time serving your customers. Call MP Star Financial for more information at (800) 833-3765, ext. 150.