Back in the 1950s, management consultant Mr Peter Drucker declared that the purpose of any business was to create customers. Six decades later, many SMEs still don’t quite know how to determine the true value of their customers. It’s only once the customer lifetime value (CLV) is calculated that your business can ascertain the expected profit over a lifetime of transactions with each customer.
A decision on how much (if anything) you need to invest on marketing to win that customer’s business and then retain them on a long-term basis can be determined according to their CLV.
The best way to determine CLV is to take the Average Monthly Revenue per customer, multiply it by the Average Gross Margin per customer and then multiply that by the Average Retention Rate. You end up with what you think a customer will be worth in gross profit terms over the average lifetime of buying goods and services from them.
How it works
You take the average size of a customer sale and multiply that figure by the number of times you expect that customer to buy from you in a month. You then multiply that by the average gross margin, so say you sell an item for $100 that costs $60 to produce, its gross margin would be $40. That figure is then multiplied by the average number of months you’ll trade with a customer. For example, say ABC Stationery makes an average gross margin of 25 per cent per customer per average monthly spend of $100 and retains customers for an average of three years. The average customer would in this case have a CLV of $900 ($25/month x 36 months).
Assessing financial impact
It’s only once you understand the value of each customer, that you’ll be able to identify the right marketing spend and what discounts to apply to reward customer loyalty. For instance, if your CLV is $500 and your marketing costs are $5000, you know that your business needs to win at least 10 new customers just to cover the costs. Given that you’ll want to achieve a return on your investment (ROI), your company may benchmark a campaign’s success against acquiring 40 new customers, giving it a return of $15,000 ($20,000 minus its $5000 marketing spend).
Time spent on ensuring customers are satisfied is known to correlate with increased customer lifetime value, so it is important to factor such customer engagement into your business’s overall marketing spend in order to enjoy better returns down the track.
All things being equal, the longer customers are retained, the more gross profit they’re likely to generate.
For a better understanding of ROI, you need to compare the cost of any new initiative to how much it increases CLV.
Andrew Sykes, Director of Business Advisory, RSM Australia