How much is a customer worth to your business?
The Why, What and How of ‘Customer Life Value’

Knowing the profit each customer adds to your bottom line enables you to decide how much to spend on finding, attracting, getting, and keeping customers.
 
Most SMEs don’t ever calculate this; usually their EXCUSES are:

“the maths can be really complicated”
or
“the input data difficult to dig out of your accounting system”

As with most things – the more detail and time you spend getting the input data accurate the clearer your information will be (we all have heard “rubbish in = rubbish out”)…
There is a very simple way you can use existing reports, or even take an educated guess, to get easily started.

The basic concept is that the average customer will make a certain number of purchases before they leave. Each purchase that customer makes while they are with you will add profit to your bottom line. (See last week’s pricing post if you are not absolutely certain every one of your products is adding profit…_

So don’t let “it’s too hard” get in your way – your ‘Life Value of Customers’ can be gained super easily with these 4 steps:

Before you start ideally you will also gather:

  • Grab a piece of paper, and a calculator if you have one as you will need to do a small amount of maths
  • Current Customer list
  • Previous Customer List
  • your Profit and Loss report for the period between Customer lists

eg if you have a customer list for at 30th Sept 2012, and one from 1 July 2012 – you need to know your profit from 1 July 2012 to 30 Sept 2012 as well – Note this will make your cycle one quarter.
Don’t give up here if some of this stuff is missing – worst case is you will need to make some educated guesstimates….

A. Customer Retention Rate (Retention Percentage)
What percentage of customers return to your business?

There are several ways of approaching this depending on what input data is available:

  • If you record each sales separately in your Accounts – look at your customer lists and count how many have returned during the period (your system will have a sales report that will generate this) – divide that number by the ‘total starting number of customers that purchased from you the year before last’ to give you your Retention Percentage
  • If you are a rapid turnover cash business (or not up to date with your accounts)- think about how many customers return each week/month/year to buy from you and ESTIMATE your Retention Percentageby guessing what percent of sales are to existing customers – the guess will do as a start, if you want to get more accurate, take a rough tally over a few hours, or days, and keep a little note of new v returning – see how closely that matches your initial guess and adjust the rest of these calcs accordingly.

eg Banana Brain Co. started last year with 100 customers, and during the year 80 of these returned. Therefore the retention percentage is 80/100 or 80%.
NOTE: If it is easier for you to think about lost customers, instead of returning ones, simply calculate your attrition percentage and then subtract it from 100% to get the retention percentage; Initial customers = returning customers plus lost customers

 

B. Customer Life
How long does a customer stay with your business?

This retention percentagecan then be used to calculate how long every customer stays with your business by using the following formula.

  • Firstly calculate your Customer Attrition Rate (Attrition Percentage) which is the inverse of your Retention Percentage ie 100% less yourRetention Percentage = Customer Attrition Percentage
  • Then (retention percentage / attrition percentage) = customer lifetime

eg From above we worked out Banana Brain Co have 80% annual retention, and therefore 20% attrition (100-80). The Customer Lifetime calculation will look like
80/20 = 4 or 0.8/0.2 = 4 ie everyone who buys from Banana Brain Co will continue to do so for roughly 4 years.
NOTE: Be really careful about the relevant CYCLE here – this ‘lifetime’ may be number of years, or weeks or months…
if you used a YEAR to calculate your Retention percentage then this will give you number of YEARS a customer stays,
BUT if you collected and calculated based on a WEEK then this calculation will relate to the number of WEEKS a customer stays in their “lifetime”
 

C. Annual Customer Profit
How much does a customer add to your bottom line each year?
  • Divide last years’ profit by total number of customers that purchased from you last year = Average Customer profit per year

eg Banana Brain Co. have a profit before tax of $35,000 and 130 customers so their Average Customer Profit is $270; ie every customer who walks through the door contributed $270 to the total profit last year.
NOTE: Again be careful about the relevant CYCLE here – this step gives you profit per year. If you are working in weeks divide your total by 52 or months divide by 12 before proceeding…
 

D. Life Value of your Customer
How much does your average customer add to your bottom line in total?
  • This is easy – multiply step B. by step C. which is multiply the customer lifetime by the average customer profit to get your lifetime value

eg Banana Bain Co’s Average Customer Lifetime is 4 years and their Average Customer Profit is $270; so 4 * $270 = $1080
that means every customer who walks in the door and purchases is worth a bit over $1000 bucks to the back pockets of the owners!

[box type=”info” style=”rounded” border=”full”] Your average customer will make a certain number of purchases before they leave due to attrition or competition.
– each customer adds this much to your profit while they are with you

Customer Spend  x Period as a Customer = Customer Life Value

[/box] Adjust the selling cycle from a year to a week, or month, if it makes more sense to your business
– but if you use another timeframe make sure you amend ALL the input data to ensure all have the same input cycle ie if it is a week then use a week for EVERY part of the calculation.
 
A cafe may find it easier to use a week as with this Starbucks example. The calculation method used in the diagram here is a more refined version of my quick and dirty one above, feel free to use it as a more accurate alternative.
 

Remember – having a general idea is far better than no clue at all!

Make an attempt to calculate your Customer Lifetime Value today, then again next month, as you become informed and see how your accuracy, and decision making, improve your bottom line.

 

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