Understanding Customer Lifetime Values

The vital importance of Customer Lifetime Value

It is always preferable to develop an ongoing relationship with repeat customers rather than depend on costly promotions to attract fresh custom. You should calculate your Customer Lifetime Value to highlight just how important this factor is.

To calculate your Customer Lifetime Value, take the average transaction size that you deal with. Multiply this by the number of purchases an average customer makes from you each year to calculate the average annual sales volume of each customer you have.

e.g. I determine that an average transaction is £50, and that an average customer buys from me just once each year, so the average annual sales volume per customer is (50 x 1) £50.

How many years does your average customer keep buying from you? Multiply the annual sales volume per customer by that number of years to calculate their direct lifetime value.

I have determined from looking at billing details that my average customer keeps buying from my company for around 3 years, so their direct lifetime value is 3 yrs multiplied by £50/yr = £150

How many additional customers are referred to you each year by your average customer? Multiply that number by the number of years that your average customer keeps buying from you.

I've ascertained that an average customer refers 2 new customers to me each year, so in the 3 years that they are customers, they refer (2 x 3) 6 additional customers.

Finally multiply the direct lifetime value of the customer by the number of total referrals that your average customer brings, and add the direct lifetime value to the result. This is the total customer lifetime value.

Since an average customer has a direct lifetime value of £150, the 6 referrals bring (£150 x 6) £600 and then adding the customer's own lifetime value of £150 means an average customer is worth a total of £750 (and more when you consider that the six referrals they brought may each in turn bring six more).

This shows precisely why some companies will choose to use loss-leaders - a deal they actually lose money on - in order to open up a new customer relationship. Losing a little on that first transaction can easily be made up over the course of the lifetime relationship with each customer.

However, there is a far more important aspect to customer lifetime values that you should be considering. Once you can measure something, you can start to manage it. Managing and optimising your customer lifetime values can reap huge benefits.

Here's exactly why Customer Lifetime Value matters

Take a look at those figures and calculate how much more you would make if you could encourage a customer to make just one extra referral each year, and also to remain a customer for just one extra year. It makes a big difference doesn't it?

3 referrals a year for 4 years mean a total of 12 referrals, with each having a direct lifetime value of (4yrs x £50) £200, so the total lifetime value of the average customer would be (12 x £200 + £200) £2,600

If that doesn't show you exactly why gaining customer loyalty and building ongoing customer relationships is so incredibly important, then you are probably not cut out for business. Customer relationships are absolutely vital to any business.