The True Value of a Customer, Part 1: Customer Lifetime Value
Whether marketing professional, business proprietor, or something in-between or related, those familiar with formal business growth strategy are almost certain to also be intimately familiar with the concept of customer lifetime value. A critically important metric for establishing growth strategies with optimal (or at least reasonable) customer acquisition and retention costs, customer lifetime value is a term that refers to the total value that a customer contributes to a business over the entire duration of their relationship with that business. Formally, Wikipedia defines customer lifetime value as “a prediction of the net profit attributed to the entire future relationship with a customer.''
Conventional thought holds that a customer’s lifetime value (“LTV”) can be derived from a relatively straightforward function that involves the customer’s spending patterns. In other words, the traditional perspective on customer LTV is that a business can understand a customer’s value by accurately understanding how much that customer is likely to purchase over the lifetime of their relationship with that business. While there are some slight variations from one source to the other --with some formulas taking into account customer acquisition costs, the time value of money, and other metrics-- ultimately customer LTV is calculated through some version of the following equation:
Customer LTV = [average purchase amount] * [average contribution margin] * [average purchase frequency] * [average customer lifespan]
Now let’s use an example to help to clarify how the above equation works in practice. Let’s assume that we are marketing or revenue agents for a national coffee chain called Buckstar's Coffee and we’re looking to understand the average lifetime value of our customers overall. Let’s use the following assumptions:
Our average customer purchase amount is $5
Our average contribution margin per sale (revenue - variable costs) is 75%
The average purchase frequency of our customers is 3x per month, which equates to 36x per year
Our average customer relationship lasts for 3 years
To calculate our average customer LTV, we simply need to use the formula above with the information we have on our customers:
Average customer LTV = $5 * 75% * 36 purchases per year * 3 years = $405
Now that we know our average customer LTV, we are empowered with a critical customer metric that enables us to make a variety of informed decisions and determine whether or not certain costs are actually driving a viable return. For example, some critical growth strategy questions that an understanding of average customer LTV helps to answer include:
How many customers need to be acquired in order to justify a given marketing budget?
How many more customers would we need to serve each day in order to justify the costs associated with a given expansion project?
How much money should be spent on placating dissatisfied customers?
Relating this to our hypothetical example company, Buckstar's Coffee, suppose we’re approached by Jim of Allstar Ads, a TV commercial agency, who is trying to sell us commercial ad space. Jim makes us an offer for $450,000 to secure a 30-second commercial slot during the national VXYZ nightly news to air 3x per week for the next 12 weeks. Since we need someone to professionally film and edit a commercial for us, he also offers to refer us to a filmographer who is willing to shoot, cast, and edit our 30-second commercial for $360,000. Altogether, we would need to spend $450,000 + $360,000 = $810,000 total in order to film a commercial and air it for the next 12 weeks.
Assuming that the LTV of the customers we would acquire from this TV ad campaign are consistent with the average customer LTV we’ve already calculated previously, we would need to acquire at least 2,000 customers just to financially break even ($810,000 marketing spend $405 average customer LTV = 2,000 customers needed to break even). Given the time and effort involved in executing and managing the whole process, we may decide that we need to acquire at least 2,500 customers in order to make this TV commercial worth it for our purposes. Now that we know how many customers we need to acquire in order for Jim’s offer to be viable for our business, we can do our best to determine whether or not such a target is realistic based on how many people watch the national VXYZ nightly news and what sorts of conversion rates can be expected from the viewers.
In the above example, we’ve made things relatively convenient for ourselves by working in terms of average customer LTV across our entire customer base. However, it can also be helpful to calculate customer LTV for a specific segment of our customers, or even for individual customers. For example, another salesman may come and approach us to advertise on a digital coupon site called “Crazy Discount Mania”. This coupon site may have high visitor traffic with many potential customers located in our regional markets as well as a relatively high conversion rate among those potential customers, making it a rather attractive option at first glance. However, if a large proportion of the “Crazy Discount Mania” customers who would convert as a result of seeing our coupon happens to be “hit and run” shoppers with little chance of returning after they’ve used their coupon, this becomes a much less attractive opportunity.
Although our average customer LTV across our entire customer base at Buckstar's Coffee is $405, the customers that we receive as a result of advertising with coupons on the "Crazy Discount Mania” site may have a much lower LTV. In fact, if the coupons we include in the advertisement don’t quite allow us to break even (which is often the case with coupons intended to drive first-time foot traffic), these customers may even have a negative LTV, costing our company more in expenses than those customers will bring in through purchase revenue. Many coupon shoppers, after all, are exactly that: shoppers looking exclusively for coupons and crazy bargains, moving from one to the next with no intention of returning in the future to pay full price1,2. Clearly, decisions in marketing and growth strategy aren’t always as simple as audience size and conversion rates. The ability to account for customer LTV enables for significantly more well-informed decisions that enable a much more accurate view of an action’s effect on the health of our company's financials.
Expanding on this general concept, let’s now suppose that we are the on-site managers of a Buckstar's Coffee location, and a customer named “Tabitha” comes in and makes a purchase. Let’s suppose that we can reliably predict Tabitha to have a lower-than-average value of $25 over her remaining customer lifetime given that, over the entire remaining course of her relationship with our business, she will only visit our business a handful of times in order to stage a new Instagram selfie. On this current occasion of Tabitha’s visit, while in the process of snapping a stylized Instagram photo of herself sipping on her medium rainbow mocha chai boba unicorn latte, Tabitha accidentally spills her drink all over her brand-new, trendy jacket which she just recently purchased for $150. Tabitha is visibly and audibly upset about her mishap, and she complains to the management that the lid on her coffee wasn’t secured properly. In other words, Tabitha blames the establishment itself for ruining her new jacket. It is quite clear to us that the only way we can make Tabitha happy and maintain her patronage is to reimburse her for the cost of the jacket that was ruined.
Now there are several approaches we could take in our decision-making process here. However, for the sake of maintaining a customer value-focused discussion, we’re going to avoid any subject matter regarding social commentary or professional responsibility and simply stick with the financially-relevant facts of the matter. If we are simply to compare Tabitha’s value over her remaining customer lifetime ($25) to the cost of maintaining her patronage ($150 to cover the cost of the ruined jacket), it makes no financial sense to spend the money necessary to satisfy her and maintain the customer relationship. In order to maintain Tabitha as a customer, it is going to cost us substantially more money than she will bring in through her purchasing habits. However, there are other significant implications worthy of our financial consideration at play here beyond just what we expect Tabitha to spend:
Will Tabitha leave us bad reviews online if we don’t agree to reimburse her for the cost of her jacket?
Will Tabitha make a negative post about her experience on Instagram and possibly other social media platforms? For that matter, what is the size of Tabitha’s reach on social media?
If we agree to reimburse Tabitha, will she instead advocate for us to her audience and within her social community?
If we salvage our customer relationship with Tabitha and she continues to visit now-and-then to take Instagram selfies, will these posts help to drive customer traffic and sales?
Generally, how big is the impact of Tabitha’s digital reviews and social media posts about our business?
Times are changing -- in the modern world of smartphones, social media, and mobile internet, the above considerations have become critical for understanding the impact of customer relationships. Today, with 82% of Americans using social media3 (for 18-29 year olds, the figure is even higher at 90%4) and 99% of Americans owning a smartphone5, no company is capable of avoiding such considerations without drastic risks and consequences to its financial health. If we don’t agree to reimburse Tabitha and just consider her to be a lost customer, we may save ourselves the $150 reimbursement cost, but what we stand to lose goes far beyond the $25 in remaining value she would have contributed as a continuing customer. Today, 90% of potential customers make their purchasing decisions by first consulting online reviews6, and observing 1-3 negative posts from customers on a business’s digital footprint will deter 66% of potential customers from making a purchase7. In fact, 86% of potential customers feel reluctant to make a purchase after seeing just one negative post from customers7, and it takes 10-12 positive posts just to make up for the impact of a single negative one8!
On the other hand, if we agree to pony up the $150 to cover the cost of Tabitha’s ruined jacket, we actually stand to potentially gain quite a bit financially. If we placate Tabitha and turn the experience into a positive one for her, her digital advocacy on social media for Buckstar's Coffee could have a substantial impact on driving customer acquisition. In fact, peer-to-peer advocacy today drives up to half of all consumer purchases9 and $6 trillion in annual consumer spending10, and this happens in spite of the fact that 80% of brands still don't leverage word-of-mouth strategies of any kind11. Considering how influential the opinions of our peers are on our own perspectives (95% of people consider friends and family to be the most credible source of information on commercial products or services12), the astonishing power of word-of-mouth among customers shouldn’t be terribly surprising to note. Additionally, people are 16x more likely to read and digest content created by friends and family as compared to content created by a business or organization13. If Tabitha were a real customer and Buckstar's Coffee were a real company, resolving Tabitha’s complaint would also likely have a positive impact on Tabitha’s own future purchasing habits at our business (e.g. raising it beyond the $25 that it was prior to this incident) given that 97% of customers are likely to increase how much they spend at a business if they simply feel that their feedback and concerns are valued14.
Whatever our decision is regarding Tabitha, it is crystal clear that we stand to gain or lose far more than solely Tabitha’s future purchases. In spite of Tabitha’s inconsequential purchasing habits at Buckstar's Coffee, the consequences of our decision here stands to have an impact in the thousands of dollars or more given the modern reality of consumer interconnectedness. These types of considerations are massively significant, yet traditional means of understanding the value of a customer fails to account for such realities. In the modern era of constant mobile interconnectivity through social media and smartphones, the traditional means of understanding customer LTV captures only a fraction of the full picture of what a customer is able to contribute and the impact they are able to generate through their daily habits.
While traditional perspectives on customer value account solely for the customer’s purchasing habits, our present era necessitates a paradigm shift in our understanding of customer value that is consistent with the lifestyles of modern customers and the ways in which they now relate to businesses and to each other. As demonstrated in our example with Buckstar's Coffee and Tabitha, a customer’s purchasing habits represent only one among multiple ways a customer is capable of impacting a business’s financial health. Business professionals today would be well-served by adopting a more holistic view of the customer relationship and the various ways that these relationships are capable of generating value for a business.