DOWNLOAD THE FREE EBOOK: DRIVING CUSTOMER LIFETIME VALUE
The DilemmaImagine you know the following about your average retail (direct channel) and wholesale (indirect channel) customers: Your retail price is $100 per product, so you have to sell it wholesale at a 50% discount, or $50. Your direct costs include the net costs you incur to get your product to your customers. Bulk packaging and shipping offers some cost advantage in selling to wholesale customers, so your direct cost per product is $25 for a retail customer and $22 for a wholesale customer. You figure your average retail customer will buy two of your products per year. Let’s say your wholesale buyers tend to be fairly small, niche retailers, themselves. So, they don’t buy enormous quantities of your product. Nevertheless, the average wholesale customer still buys 164 items per year. On the one hand, that retail margin is really attractive: ($100 price per product – $25 direct cost per product) / $100 price per product = 75%. That said, even with an apparent profit of $75 per product, that only translates to $75 per product x 2 products per year per customer = $150 per customer per year. On the other hand, the apparent wholesale margin is significantly lower at 56%. However, the profit per year per wholesale customer is $4,592, which is 30 times the annual apparent profit from a retail customer. Which would you choose?
Insufficient InformationIt’s a trick question. The preceding simply isn’t enough information upon which to make a fully informed decision about how to value your customers across those two channels. Your intuition might point you in the right direct…but, then again, it might not. As Jeff Batton of HomeStake Strategic Finance explains, Customer Lifetime Value (“CLTV”) offers a way to make an apples-to-apples comparison of seemingly disparate choices. CLTV is a method for placing a dollar value on a customer relationship. It’s an inclusive measure of the net profit of a customer relationship over time that acknowledges a dollar today is preferable to a dollar tomorrow.
As Jeff says, CLTV helps you make better decisions, faster about how to prioritize the wide and growing array of opportunities that creative, small businesses generate.
The Drivers of Customer Lifetime ValueThe information presented in Table 1 above is necessary, but insufficient, to calculate CLTV. In the following video, I’ll walk you through the factors that drive customer lifetime value in a graphical way (best viewed on a larger screen):
Filling in the BlanksAfter watching the preceding, you know you need a few other bits of information in order to calculate customer lifetime values for your average retail and wholesale customers. Once you fill in those blanks, you’ll have benchmarks with which to make informed decisions.
Retail Customer ProfileThe following table includes an update to the retail customer profile presented in Table 1.
- Because you make efficient use of technology, the direct marketing and support costs for your retail customers are pretty low on average – just $5 per customer per year for each type of cost. So, your customer contribution margin on retail sales is still a very healthy 70%.
- Let’s say your Google Adwords cost per click (CPC) runs about $2.00, and your customer conversion rate on clicks is about 2.5%. So, your customer acquisition cost averages $2.00 per click/2.5% customers per click = $80 per customer.
- Assume your retail relationships aren’t that long-lived. You estimate a 50% annual retention rate, which corresponds to an average customer lifetime of 2 years.
- Your average cost of capital and, thus, your discount rate is around 15% per year.
Wholesale Customer ProfileHere’s a more complete profile of your average wholesale customer:
- You find that your wholesale customers require much more handholding and personal attention. As a consequence, you estimate your average direct marketing and support costs are $500 and $2,000 per customer per year, respectively. Given that, your wholesale customer contribution margin is a much lower 26%. Even so, the contribution rate from a wholesale customer is $2,092 per year versus $140 per year for a retail customer.
- You acquire new wholesale customers through face-to-face interactions at trade shows. Let’s say you figure that the customer acquisition cost of a wholesale customer is $5,000.
- However, all that face-to-face and support pays off in the form of a 75% retention rate. That means the average duration of a wholesale customer relationship is twice that of your average retail relationship. In other words, wholesale customers generate much more profit contribution than a retail customer for twice as long.
The Customer Lifetime Value CalculatorThe CLTV calculations aren’t difficult, but they do require a fair amount of grinding and crunching. A quicker and easier way to run the numbers is to create a simple spreadsheet to do the work. We’ve got your back – we’ve created one for you: DOWNLOAD THE FREE CLTV CALCULATOR I don’t like “black box” models. So, here’s a video that explains how the calculator works:
Which Channel is the Most Valuable?Dropping the retail customer data into the calculator yields a customer lifetime value of $135: Guess what? Notwithstanding its very different revenue and cost profile, the average wholesale customer has a customer lifetime value of $135, as well: I confess. I rigged the game to make a point. That is, even experienced intuition can lead us astray when confronted with evaluating the tradeoffs of markedly different marketing strategies and customer segments. The customer lifetime value calculation offers a relatively painless way of making more informed judgments. The numbers won’t tell you what to do, but the valuation benchmarks will help you better understand the tradeoffs you’re facing.
Next StepsBoth of these hypothetical marketing channels offer a positive CLTV, which means they are both worth pursuing from a financial standpoint. Financially, you’re indifferent, but there may be qualitative factors that tip you one way or the other. For example, you may love face-to-face selling at trade shows but dread search engine optimization tweaking. With the CLTV concept and calculator in hand, you’re equipped to ask more pointed questions that will help you increase the lifetime value of your customers:
- How much does my customer’s purchase rate have to increase to justify an increased direct marketing budget?
- How much more can I pay per click to acquire a retail customer?
- If I increase my product price, how much can the purchase rate drop given my current customer acquisition costs?
- How much can I afford to pay in additional support costs to increase my customer retention rate?
- How do the answers to the preceding questions change when examined by customer segment?