Calculating customer lifetime value
When George Orwell advised that “All animals are created equal, but some are
more equal than others” in his classic book Animal Farm, he was referring to
communists, not customers. Nevertheless, the statement holds true. There is a
difference between customers. And it makes little sense to provide the same high
level of service to everyone, when not all customers have the ability or
willingness to reciprocate in kind. In most businesses, there is an opportunity
to increase both sales and profits by gearing offerings to meet the needs of
different customer segments.
The idea of a tiered-service model is not new, by any means. The airlines
have done it for years by providing better seats and service in the first class
section than in coach. And if you've ever sipped Espresso in Venice, you know
that you'll pay more to enjoy a cup at a table than you will if you take it
standing up. They key is to divide our customers into groups or “service
brackets” according to the goods or services they want, and charge them a price
appropriate to the value they receive, and the services we provide.
Whatever discriminating brackets we use to segment our markets, we must be
careful to provide the “right” amount of service to each segment at the “right”
cost. Of course, to make these decisions, one must understand the value of a
customer.
Simply put, Customer Lifetime Value is defined as “the amount of profit that
a customer will generate during their lifetime of doing business with you,
discounted back to its net present value.” What is a customer “lifetime?” If you
are a baby food manufacturer, that lifetime might be a woman's child-bearing
years. If you're a CRM software company, you might find that the average client
buys systems, upgrades and maintenance from a vendor for an average of six years
before moving to a competing platform. The right customer lifetime horizon for
your business depends entirely on the markets you serve.
The dynamics of customer relationships change over time. Acquisition costs
are allocated and recovered early on, and retention costs decrease gradually as
customers stay with you longer and “train” themselves to become more loyal. In
addition, loyal customers are more likely to purchase more from you, as well as
to refer other potential customers.
There are three generic strategies for increasing a customer's lifetime
value: 1) Increase their spending rate, 2) increase their retention rate, and 3)
increase their referral rate. Savvy marketers are constantly monitoring these
key metrics, and putting strategies in place to improve performance in each
area.
Note: The information in this short article is merely a primer that covers
the basics. Go to the Downloads section
of this web site to download our Customer Lifetime Value calculator.
Back to free resources list » |
