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Measuring Customer Lifetime Value

HostPapa Blog / Analytics  / Measuring Customer Lifetime Value
9 Apr

Measuring Customer Lifetime Value
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(Last Updated On: July 28, 2016)

Customer lifetime value and customer acquisition cost are the two most significant numbers to any corporate strategy. It’s not enough to focus on single sales; a company that wants to truly build growth and stability needs to be able to build a relationship with their customer and understand the context of each sale. That being said, measuring customer lifetime value is no trivial task; it involves an incredible amount of data which needs to be meticulously tracked and analyzed.

Calculating Your Customer’s Lifetime Value

Calculating your customer’s lifetime value is fairly trivial: you take the customer’s total spending by year and then subtract the cost of the goods and services delivered. You then multiply this spending by the average retention time for your customers. From there, you then take an average across all of your customers — and at this stage you may also subtract the customer acquisition cost.

  1. Each customer spends an average of $120 a year with the company.
  2. The cost of goods sold for each customer is $30.
  3. The customer’s value to the company is $90 a year ($120 less $30).
  4. The company retains customers for an average of 5 years.
  5. The customer’s unadjusted value to the company is $450 ($90 times 5 years).
  6. The company’s acquisition cost per customer is $50.
  7. The total customer lifetime value is $400 ($450 less 50).

We now know that for each customer acquired the company will make $400. An accurate customer acquisition cost is vital for these calculations to be accurate. If a customer’s lifetime value is greater than customer acquisition cost by a significant degree, there’s absolutely no reason not to continue ramping up acquisition aggressively — provided that the liquidity is available. If a customer’s initial purchase value is greater than the customer acquisition cost, then extremely aggressive growth is possible.

Calculating Out Acquisition and Retention Costs

Acquisition cost calculations can become quite complex but the philosophy behind the calculations are very simple. The acquisition cost for a customer is the cost of all of the company’s acquisition efforts (marketing, paid advertising, sales support) divided by the amount of customers acquired, over a given period of time.

If a company spends $10,000 in advertising per year and obtains 1,000 clients, the customer acquisition cost is $10 a client. Acquisition cost analysis is extraordinarily important for all companies and without a reliable acquisition cost a customer’s lifetime value cannot be derived.

In addition to cost of acquisition, some companies may also have a cost of retention. Some companies may take direct actions to retain and market to their existing clientele; these companies should also factor in their average annual retention costs when calculating out their customer’s lifetime value.

Using Big Data to Measure Customer Lifetime Value

Statistics such as customer acquisition cost and customer lifetime value can be automatically calculated by many customer relationship management solutions today. In particular, solutions that retain big data sets are able to create extremely accurate data pictures that take into account a variety of environmental variables. The customer lifetime value and the customer acquisition cost could, for instance, vary based on demographics.

An older demographic may have a higher customer acquisition cost but a far greater customer lifetime value; without being able to separate these statistics based on the age of the market, a company may not be able to draw these comparisons. Likewise there may be specific demographics that have a greater acquisition cost but a lower customer lifetime value; focusing on these demographics may actually be harmful to the company. Big data becomes useful particularly when working with diverse clientele or in a variety of markets. Patterns can be revealed which can be used to further streamline and optimize a marketing plan.

Projecting Customer Retention and Customer Lifespan

Companies that have been in business for only a few years may not have an accurate picture of a customer’s lifetime value; they don’t yet have enough data to determine customer retention over the course of a significant period of time. But that doesn’t mean they cannot calculate a customer’s lifetime value — there is just more work that must go into these calculations. Following an initial purchase, companies can look at the likelihood of customers returning for further purchases in the next year, and can continue to extrapolate based on this rate of retention failure. The more chronological data that is available, the more precise these statistics will be.

The Importance of Customer Lifetime Value

Though customer lifetime value is an incredibly important metric, not all businesses take the time to calculate it. Customer lifetime value is useful because it gives weight to the customer relationship. Customer lifetime value shows that customer relationships are an asset to the business. Many modern companies develop customer relationships as a major marketing focus. Moreover, customer lifetime value can help companies generate more accurate revenue projections.

But by far the most important aspect of customer lifetime value is its ability to empower businesses to make educated decisions regarding their customer acquisitions. Without knowing the value of a customer — especially throughout a variety of market sections and demographic groups — the company cannot make a decision on how much they will spend for customer acquisition.

Increasing Customer Lifetime Value

Companies looking to improve their overall revenue picture may want to look towards increasing the lifetime value of their customers, in addition to scaling up their customer acquisition. Companies that have very low customer lifetime values are likely spending too much on either the cost of their goods and services or the cost of their customer acquisition.

Customer lifetime value alone cannot determine the success of a business because customer lifetime value does not take into account the overhead of the business — it only takes into account the direct cost of goods and services sold. Thus, a company that has very low customer lifetime value may still be successful if it has very low overhead, while a company that has very high customer lifetime value may struggle because its overhead is unwieldy.

The most direct and actionable relationship is the relationship between customer lifetime value and customer acquisition cost. If an acquisition cost is too great a percentage of the customer lifetime value — or over the average of a customer’s initial purchase — it’s likely that changes need to be made to a company’s marketing strategies and campaigns.

Of course, one of the easiest and most direct ways to improve customer lifetime value is to improve retention rates. By improving retention rates across the board, you can significantly improve your customer lifetime value without having to adjust your cost of goods or your cost of acquisition.

When used appropriately, customer lifetime value will allow you to model your customer relationships as an asset to your business. It will also empower you to make decisions about further customer acquisitions. A seemingly minor increase in the average lifetime value of your clientele can have widespread ramifications throughout your earning picture; similarly, a loss of customer retention could spell the demise of a less than prepared business. By continuously analyzing and optimizing the value of your customers, you can move towards stability and steady growth.

James Grey

James is an important member of the content team at HostPapa. Although he enjoys writing and web design, what he really loves is hiking with his German Shepard Lucy.

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