What's up y'all, this is Scott Davis and my goal today is to make calculating customer
lifetime value accessible and maybe even enjoyable
for you.
I'll refer to customer lifetime value by its abbreviation CLV throughout this video.
Let's dig in.
First, why is CLV important?
CLV gets at the heart of marketing's objective to attract and keep profitable customers.
You need to understand CLV to put together effective
marketing plans and make strategic decisions.
How much money are you going to allocate to attract new customers and generate leads?
Attracting new customers might cost 3 or 4 times as much as retaining existing ones.
CLV will help you understand what kind of return to
expect on today's investments in customer acquisition and retention.
How are you going to stop customers from defecting?
What aspects of customer attrition are controllable?
An average company loses 10 percent of its customers each year.
A better understanding of CLV will help you manage these dynamics.
Think of managing customers as managing a leaky bucket.
Your customers are represented by water and the water already inside the bucket is your
customer base.
New customers added to the bucket increase your customer base.
Ah, But there's also a hole near the bottom of the bucket and the water leaking out represents
lost customers.
So in order to grow, your business needs to increase the flow into the bucket by acquiring
new customers or decrease the customer outflow
by retaining your existing customers, or both.
It's also important to note that not all customers are profitable.
Have you heard of the eighty twenty rule?
Eighty percent of company profits come from twenty percent of its customers.
Given our fight against the leaky bucket and mixed profitability amongst customers, we
need a better understanding of customer profitability
in the long term.
Enter, customer lifetime value.
CLV is calculated a number of different ways, but let's focus on the common features.
We start with the top line, the company's expected revenues or sales in dollars over
the customer's lifetime.
We are interested in profit, so we also need to subtract the expected costs including
acquisition, sales, and service costs for the customer.
Have you ever watched the TV show Shark Tank?
Notice that the investor's financial questions usually relate to the variables used in computing
CLV.
It's not easy, but you can do it.
Here comes some math.
Let's start with the most basic formula for CLV.
CLV = the annual profit contribution per customer times the average number of years they
remain a customer... minus the initial cost of acquiring a customer... profit contribution
is the margin, or the amount of the sale that is
not eaten up by variable costs.
Other CLV formulas account for fixed costs and the time value
of money, but let's start slow.
Let's walk through an example with our basic formula.
Suppose the average Starbucks customer spends six dollars per visit and visits two hundred
times per year.
That is twelve hundred dollars in annual revenue per customer.
But the contribution margin is only three dollars
per transaction because of all the variable costs that
go into making a cup of coffee.
So the annual profit contribution per customer is six hundred dollars.
We multiply the six hundred dollars times the average number of
years someone remains a customer at Starbucks.
Suppose it is twenty years.
Now have six hundred times twenty for twelve thousand bucks.
But it costs money to acquire new customers, say five thousand dollars on
average per customer for Starbucks.
We subtract that from our twelve thousand to arrive at
a seven thousand dollar customer lifetime value.
This number is going to help us figure out how much to pay to acquire and retain new
customers.
Beyond that, we can see how important it is to sell more to our existing customers.
Can we push the six dollars per transaction higher?
Can we stretch twenty years of loyalty to twenty five?
How much will that cut into our contribution margin?
We could also take a more nuanced view and look at the impact of low and high profit
customers.
Did you know that different methods for attracting customers have different CLVs?
For example, Acquiring customers through deep discounting can substantially reduce CLV.
You need to be thinking about how much potential your new customers have to become loyal
to your business.
Understanding CLV will help you set and evaluate your pricing and promotion
strategies.
This concludes our first look at Customer Lifetime Value.
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