Monday, August 22, 2011

Lesson #79: Determining Customer Lifetime Value

Customer lifetime value (LTV) is the net present value of dollars attributed to one customer over their entire life as a customer.  LTV is a critical calculation in your marketing efforts, in determining an appropriate customer cost of acquisition (COA).  With the ever rising costs of customer acquisition, LTV is playing a more important role in determining the ROI efforts from your marketing spend.

The formula for calculating LTV is: (i) your average transaction size; (ii) times your average gross margin; (iii) times your average number of transactions per year; (iv) times the number of years a customer buys product from you; (v) times your retention rate of customers from one year to the next; (vi) less any marketing costs required to retain your customer over time; (vii) discounted back to present day dollars.   For number of years, I wouldn't model anything greater than five years.  For retention rate, I wouldn't model anything greater than 80% of the preceding year's customer base.  And, for your discount rate, that should be your weighted average cost of capital (somewhere around 10%--blending 5% cost on your debt and 15% required return on your equity, in one example).

As you can imagine, these inputs can wildly vary from one business to the next.  So, let's run through a couple examples.  In the first example, we have restaurant business, whose average transaction size is $50 and customers come to the restaurant about 4x per year.  That suggests $200 in revenues in year one, and then attritioning down (at 80% a year) to $160 in year two, $128 in year three, $102 in year four and $82 in year five.  So, total five year revenues per customer of $672, on average, and total gross profit of $224, assuming this restaurant averages a 33% gross margin. 

If the average company spends 10% of their lifetime customer revenues to acquire the customer in the first place, that suggests this restaurant could spend up to $67 in initial COA marketing.  As you can see, that would be a big loss looking at the first transaction in isolation ($50 revenues less $67 marketing).  But, you make up for the initial shortfall within the first year given the high frequency of purchase.  And, on a five year basis, this example will yield a profitable customer ($224 in gross profit less $67K in acquisition marketing less $97 in retention marketing in years two through five).  To estimate retention marketing, assume retention marketing costs in year two are up to half of the original $67 acquisition cost, or up to $33 in year two.  Which then attritions down with the smaller customer base (the same 80% of the prior year level) to $26 in year three, $21 in year four and $17 in year five, for a total of $97 in years two through five. 

So, net, at the end of five years, the customer drove $672K in revenues (or $224 in gross profit), less $67K in original COA marketing, less $97 for four years of retention marketing for a total profit of $60, prior to discounting these cash flow back to their net present value.  The net present value of these cash flows using a 10% discount rate, is $44, the LTV in this example.

In a second example, let's say we are a manufacturer of vacuum cleaners, whose average transaction size is $250 and customers only buy one vacuum cleaner in the entire five year period.  That doesn't leave a lot of room for error in your marketing efforts, as you need to drive your entire LTV and a solid ROI on your marketing COA all at once.  With a 30% gross margin, or $75 gross profit, this company needs to keep its marketing COA under $50, to have a chance to drive a $25, or 10%, profit.  And, even then, that doesn't take into account any back office and overhead costs, so it is probably better to cap COA at $40 to cover those items.  So, your LTV in this example is $250 in revenue (or $75 in gross profit), less $40 in acquistion cost, for a profit of $35, your LTV. 

Theoretically we could have modeled this customer over forty years, buying a new vacuum cleaner every ten years.  But, given the infrequent purchase behavior over a very long period of time, I would be conservative and make sure you drive a healthy profit from the first transaction, as who knows if you or your customer are going to be around ten years from now, waiting for that second transaction to close.

So, incorporate LTV into your thinking for all marketing activities and build your LTV model according to the specifics of your business.

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