Working out what your customers are worth
It’s normal for businesses to audit the worth of their stock, products, equipment and so on. It’s pretty rare, though, that businesses assess the worth of their customers – yet this is a valuable piece of marketing information.
- by Peter Labrow
The ‘worth’ of a customer is typically assessed in terms of ‘customer lifetime value’ – or CLV for those of you who love acronyms. Simply put, the CLV is the estimated worth (profit, not turnover) of a customer from the first order to the last. The key word here is estimated because it’s clearly impossible to put an accurate number on this in advance of a trading history. Not being 100% spot on doesn’t make calculating a CLV a less valuable exercise, though.
Why is it worthwhile to understand a customer’s lifetime value?
Without a CLV estimate, it’s harder to plan and target your marketing, because you’re focusing on initial sales rather than overall sales. Here’s an example. You run a direct mail campaign which costs you £2,000. The campaign pulls in £500 in sales. The first reaction is to write this off as a failed campaign – but you could be wrong. Although the campaign could be a duff one, it might actually be the best thing you’ve ever done, but you simply don’t have the information yet to be able to assess it.
You should measure that £500 in terms of CLV – not total order value. If the £500 represents one-off purchases from customers who will never, ever come back, then you’re right – the campaign bombed. But if you’ve just acquired some customers who are going to spend £500 (or more) every year for three years, then the equation is totally different. In fact, you might grow a new customer into being your top account, in which case it’s the best £2,000 you’ve ever spent!
There are three important types of CLV.
First, each customer will have its own unique CLV. Assessing this up-front is nigh-on impossible, because you’ve not built any kind of relationship or trading history. However, with time, it’s relatively easy to work out a CLV for each of your customers.
For marketing purposes, you need an average number, so that you can predict the likely CLV of a new customer. I’m sure you don’t need too much help with the maths for this one: you divide your annual profits by the number of your customers and multiply this by the number of years over which you typically retain customers.
This can be a real eye-opener and immediately changes how you view your customer-acquisition marketing/advertising.
Of course there’s a flaw in the second type of CLV. It’s a one-size fits all solution. At the point of acquiring a customer, we can’t give a wholly accurate assessment of CLV, but neither can we say confidently that all new customers will measure up to our average CLV. Therefore, it makes sense to break customers down into CLV bands – averages of levels of profitability. Most organisations can break customers down into a very small number of CLV bands, perhaps as few as three. The top band represents that valued 20% of customers which typically brings in around 80% of your income. The next band is the solid but modest spenders. The lowest band is the occasional buyers.
Using these methods, you can estimate reasonably accurately what customers are worth. As you build relationships, you can move customers up to the higher bands or perhaps give them their own unique CLV estimates.
This gives you a clearer picture of where to focus sales and marketing. Remember CLV is about profit, not turnover – where sensible businesses invest. It also gives you a far more realistic picture of the worth of sales and marketing activity. Measuring response against initial sales alone is myopic, and leads to an organisation not recognising its investments in marketing or not building as effectively on its customer base.
The general rule is that most customers’ initial purchases may be modest, but over time you will realise significant sales and profit if those customers are managed well. In fact, you’d have to be doing something really wrong if those profits don’t significantly exceed the initial outlay. This is why large companies can be so confident about loss-leaders. The initial sale isn’t the issue: it’s winning the customer and getting sales over a defined period, which is.
Another concept aligned to CLV is that of customer share. We’re used to thinking in terms of market share, but actually customer share is far more important.
Market share is easy to grasp. If you’re doing half the available business for a specific product or service, you have 50% of the market share. With customer share, you’re not thinking about what all customers are spending on one service, but what each customer is spending on every service (and not just what they spend with you). It’s the size of each customer’s overall spend.
Since the biggest sales and marketing issue is to acquire a customer, once you’ve got the customer, it makes commercial sense to expand your share of that customer’s spend. Selling new products and services to current customers can be significantly easier than acquiring new customers for your current products and services.
Here are a couple of examples. Supermarkets have no real business selling petrol, but doing so is smart because almost everyone arrives at the supermarket in their car. It’s an easy sale: and you can sell petrol cheaper because you’ve got far more ‘passing traffic’ than the average petrol station. Second example: Amazon started by selling books, but Amazon is not a bookstore. It is actually a terrific logistics business with an easy-to-use on-line shopping basket and unprecedented market share. If you can ship it, Amazon can sell it. From books to CDs, DVDs, electronics and now DIY tools, Amazon wants your business. Both of these are great examples of how to expand customer share.
Neither CLV nor customer share are mercenary topics. They just make good marketing – and business – sense. You’re not out to tip your customers upside down and empty their pockets, but you do want their business. In our supermarket and Amazon examples, it’s easier for the customer to buy from a company with which they already do business, so it’s a good old win-win. It does make it harder to spot ‘the competition’, though, with organisations expanding into each others’ core activities.
Estimating a customer’s lifetime value is the only sensible way to understand the return on your sales and marketing spend.
CLV focuses your efforts on your most profitable accounts and helps you ‘trade-up’ accounts from low spend to higher.
Customer share can be a terrific way of expanding your activities, because it’s usually cheaper to sell to those customers with whom you already have a relationship than it is to acquire new ones. It’s also as good a strategy defensively as it is offensively.