Customers, the source of profits for companies, have different profiles and their value to the business can vary according to different factors such as demographics, levels of income or the highest levels of education attained. For example, a gaming industry startup is more likely to gain more profits from wealthy millennials and their children, while a share economy-based app may benefit more from a middle income demographic. Customer acquisition costs money. These costs include advertising, promotions and other marketing costs. Startups have limited abilities to generate cash and, thus, limited marketing budgets. In order to succeed, a business needs to identify the segment of its overall market which brings the most value to the company and concentrate its marketing efforts on that segment.
The best customers for a business make relatively frequent purchases or products or services over an extended period of time, thus generating substantial profits for a company. These kind of customers are essential for any startup, particularly if one considers that, sometimes due financial and cash flow issues, only 80% of startups survive their first year while about half make it to their fifth. However, startups may attract customers who use their products and services temporarily, be it on a trial or an initial subscription basis, but then abandon the company. Startups, including those in financial services, utilities, communication, insurance are susceptible to losing valuable customers, customers which would have cost the company to acquire.
Customer lifetime value is a measure of how valuable an individual customer is to a business, which makes it a useful tool to help a business identify its most valuable customers. Specifically, it looks to measure the profit which can be generated for the company for the duration of the relationship a customer has with the business. Customer lifetime value is essentially the present value of expected future profits from the customers dealings with a business. This value can then be compared to average acquisition cost per new customer. As discussed, customer acquisition is a significant cost to the business. While it may be desirable to minimise customer acquisition cost, the cheapest option is not always the best. Take an industry with two marketing avenues, television and social media, for example. Television might cost more than social media marketing. However, if the customer lifetime value for customers acquired through television advertising campaigns is significantly more than that of those acquired through social media marketing, then the company should prioritise television advertising. As such, customer lifetime value is a metric which is used to determine how effectively a company acquires, grows and retains ideal customers for its business. Measuring CLTV depends on the business model applied by a startup.
Basic Components of Customer Lifetime Value
Calculating CLTV in order to make marketing decisions is just one of many key startup KPIs and requires the consideration of several variables. Each component will be analyzed in this section.
Average Purchases per Period
Average purchases refers to the number of times an average customer transacts with the business. For the sake of this calculation, the base period is a year. However, CLTV can be calculated for shorter periods, like a quarter or a month.
Net Margins per Purchase (Excluding Fixed and Sunk Costs)
Each transaction with a customer generates revenue however, some of the revenue generated may go towards variable costs. These could include costs of goods sold and delivery costs. As such, the value added by the customer would be revenues less any cost of sales. Some startups, such as Software as a Service (SaaS) companies do not accumulate cost of sales as they do not manufacture or deliver physical goods, and their overhead costs are fixed. In such a scenario, the entire revenue less any transactional costs is the value added by an additional customer.
Customer Life Time Value vs. Retention
This refers to the average time that customers spend with a business. This is not always an easy calculation to establish however, there is a suitable proxy which essentially results in an equally useful measure. Instead of establishing how long any individual customer stays with the organization, it may be more convenient to establish how many existing customers are lost by the business in a given period (in this case, a year). This metric is known as a startup’s churn rate.
With these variables defined, CLTV can be calculated by multiplying all three values. For a given average customer life time, CLTV = average number of purchases X net margins per purchase X average customer lifetime. For example, if customers make 3 purchases per month, net margins per purchase are $1.00 and customers last 3 years on average, then CLTV = (3 purchases X 12 months) X $1.00 net margin X 3 Years = $108 or $36 per year.
For a given retention rate, lets say the company loses about 20% of its customers each year, CLTV can be calculated as ((3 purchases X 12 months) X $1.00 net margin X 80% = $28.80 per year. This calculation differs from the first as it factors in the probability that a customer stays with the company during the period rather than the actual time the customer retains business with the company.
Customer Base Fragmentation
The point of calculating customer lifetime value is to establish which segment of the market base is more valuable to the company. As such, it may not be very useful for a company to merely calculate CLTV for its entire customer base. Instead, it would make sense to split its customers by certain characteristics. A startup could differentiate by age group, gender, income group, geographical location or other factors to determine if there are significant differences in lifetime value. Additionally, businesses increasingly keep track of how the customers were acquired – hence the popularity of questionnaires which enquire how a customer may have heard about a product or service. This is an attempt to figure out which marketing method draws in the most valuable customers.
Advanced Factors of Customer Lifetime Value
The aim of calculating CLTV is in the context of the costs of acquiring new customers. A marketing campaign, for example running television ads for a fixed time, may have a fixed cost upfront. The estimated cost of acquisition per customer for a television campaign that costs $1 000,000 and brings in 25 000 customers would be $40 per customer. If there is a lower than expected response to the campaign and only 20 000 customers are brought on, then the acquisition cost per customer rises to $50. Such is the nature of uncertainty of customer acquisition costs. Similarly, online marketing campaigns, like those on social media or google typically have fixed costs per view or click – say $0.20 for a view and an additional $0.30 for a click. However, not all people who click through to a company’s landing page will make a purchase. If only 100 000 customers view an ad, yet only 2% click through to the landing page and only half of new customers who click an online ad sign up as a customer of the business, the cost of acquisition is as follows:
Total cost: (100 000 people X $0.20 per view) + (2000 people X $0.30 per click) = $20 600
New customers: 20 000 clicks X 50% sign up = 1 000 new customers
Cost of acquisition per customer = $20 600 / 1 000 = $20.60
With cost of acquisition established, only the present value of all expected purchases would then be compared to the cost of acquisition. For known average customer life times, the customer lifetime values are calculated using the present values of expected net margins. For the earlier example with a discount rate of 10%, CLTV would be the sum of discounted net margins for the duration of the expected life time i.e. 3 years:
Year 1: $36 X 90%
Year 2: $36 X 90% X 90%
Year 3: $36 X 90% X 90% etc.
If customer retention is used there is an additional calculation. There is no fixed time limit but retention rates are factored in. In this case, it would be:
Year 1: $36 X 80% (retention rate) X 90% OR $36 X 72%
Year 2: $36 X 72% X 72% and so on
The present value is calculated using a perpetuity formula.
In order to improve the standing of a startup, the decision makers should focus on their most valuable customers using CLTV as a metric in conjunction with cost of acquisition. Additionally, they should aim to retain the most valuable customers.