Calculating Customer Value
It’s well documented that it’s easier to sell something to an existing customer than it is to find new customers. An existing customer has already given his trust (and money) to you, so it’s easier to persuade him to buy again than it is to convince someone to buy who has never heard of you or your business before.
When you are allocating funds for marketing, you should consider more than just the initial purchase when you look at your cost of acquiring customers. You should also look at the future revenue you might derive from that customer. This concept is called calculating the “lifetime value” of a customer. Although the calculations vary, the lifetime value of the average customer (LVC) is essentially an estimate of your average sale (AS) amount multiplied by the estimated number (EN) of times a customer reorders:
LVC = AS x EN
As an example, suppose you sell light bulbs for $2 each. Your customer Fred buys at least three light bulbs for his house every year from you. He lives in the area for 10 years and gets new light bulbs every year. The lifetime value of Fred as a customer is:
$60 = $6 x 10
Of course, this calculation is far easier if you have been in business for many years. Determine your average customer order amount by dividing your total sales by the number of sales you have. Calculating how often customers reorder is a little trickier because you have to remove the customers that haven’t ended their relationship with you from the equation. If you have been in business for a while, you can take a random sample of customers who haven’t ordered in the last year and look at their first order date and their last order date.
Once you have determined the LVC, you can subtract out your costs and get a feel for what you can spend to acquire a new customer. Of course, you’ll need to take your cash flow and other budgeting considerations into account as well, but figuring out the LVC is a good starting point.
Performing these calculations also acts as a wake-up call when it comes to customer service. Retaining your existing customers by treating them well and communicating with them effectively increases the length of time customers do business with you (that is, it increases their lifetime value). Using the light bulb example again, suppose Fred only buys light bulbs for two years, instead of 10. Now his lifetime value is:
$12 = $6 x 2
Multiply that $48 loss by an entire customer base and you can see why it’s important for a business to retain customers for as long as possible. Retaining customers involves keeping them aware and active with your business. Newsletters and promotions encourage interaction and communication. Even if you just send out a thank you note or a birthday card, you remind those customers that you exist and that you are happy to have them as customers. A few small efforts like these can yield big results in your bottom line.