Let’s say you have 1,000 steady customers and these customers have been with you for the last two years. Your net profit in these two years was $500,000. Thus, your customer lifetime value is $250 (500,000 ÷ 1,000 ÷ 2) per customer. Simple, isn’t it.
There are three key factors in calculating the customer lifetime value: customer profitability, the value of future purchases, and the customer lifecycle. You already know how to calculate customer profitability. Calculating future purchases is not difficult; for all the dormant accounts, average the purchases they made during their lifecycle and you will have the average value for future purchases. The lifecycle, however, requires some explanation.
A customer’s life—with respect to your business—starts when she buys your product. If the buying and use experience was exceptional, she may come back to buy more of the same or associated products, which could happen the next day or in six months. However, if for some reason she decides not to buy anything from you for an extended period of time, usually a year, then we say that the customer life cycle has ended—the account has defected.
The active life of your customers is simply the difference in months or years between the last purchase-date and the initial purchase-date. Let’s suppose Jane made a first purchase on January 18, 2006. She made repeated purchases worth $2,000 over the next six months, but after that she suddenly stopped buying and hasn’t bought since August 2006. Jane’s lifecycle is six months long and her lifetime value is $2,000. Each of your customers will have a different lifecycle, so average them to come up with a single figure for your business or for a market segment.
By the way, Ms. Jane can come back after a year, which is normal, cool, and dandy with us. We welcome her with open arms. From a market modeling perspective, however, we should treat her as a new client. Otherwise, we will lose the relevance of the customer lifetime value (CLTV) calculation because our customers will have an infinite life.
In order to calculate the customer lifetime value, take the customer lifetime and multiply it with the potential purchases in that period. This will give you potential sales from a customer. Then multiply it with your profitability margin to get the net worth of the customer for your business.
Some experts also suggest adding income through potential referral while calculating the net worth. This makes calculation quite complex. There is a place for this kind of thoroughness. However, if you are a beginner, you must first learn to walk before trying to run. This situation is similar to Newton's theory of gravitation. It works perfectly fine for calculating the forces acting on a falling apple. However, when you are ready to discover a black hole, you have to pay a visit to Einstein’s theory of relativity.
The final step is to estimate how much a customer is worth in today’s dollar; for that, use a net present value (NPV) of today's dollar.
By the way, many experts argue that NPV is not a perfect measure because it doesn’t take into account many factors. These perfectionists have developed a more accurate measurement tool using the Real Options theory. Along with all that accuracy, however, comes unnecessary complexity. For now, I suggest you politely tell them, I have to make some dough, man! Let me use a simpler way to unearth some treasure.
The next section "Unearthing the Treasure" puts all this together in one coherent system for growing your business through existing customer base.
Related:
- Table of Content
- Red Queen Effect – An Introduction
- The Billionaire Code
- Cracking the Code
- Implementation Plan