The Importance of Lifetime Value

Lifetime Value defined:  

Lifetime Value is defined as the net present value of a customer over a specified period of time, discounted back to present day dollars at an appropriate rate.

By not tying proposed marketing and sales budgets back to Lifetime Value, top management in most companies rightfully considers these budgets as dollar outlays without any basis: expenses rather than investments.

Armed with this knowledge, your company will be able to determine exactly how much you should spend each year to acquire,  retain and cultivate customers, and reactivate lapsed customers.  You’ll also know how much should be budgeted to generate qualified sales leads. Best of all, you’ll be able to prepare and objectively analyze every marketing and sales budget from this time forward.

What others say about the importance of Lifetime Value:

“It follows that, if marketing expenditures can result in the acquisition of new customers who will generate value over future time, then that action is desirable even though the initial cost to obtain these customers might be higher in the short-term return on that investment.  Some might call this long-term return on investment, LTV.”                                                                               Martin Baier, Contemporary Direct Marketing.

“Step One: Figure out the lifetime value of a new customer.  Without this data it will be extremely difficult to compute what it’s worth to acquire new permission.”                                        Seth Godin, Permission Marketing

“You must know the exact cost to acquire a new customer and the exact lifetime value of that customer in order to be successful in direct marketing.”                                                                         Don Libey, Libey on Customers

“The ideal expression of actual valuation is customer lifetime value (LTV), the stream of expected future profits, net of costs, on a customer’s transactions, discounted at some appropriate rate back to it current net present value.”                                                                      Don Peppers and Martha Rogers, Enterprise One-to-One

“We believe the leaders in The Great Marketing Turnaround will be those companies that take into account the concept of Lifetime Value.  It will help justify marketing expenditures heretofore considered ‘too expensive’.”                                                                                                     Stan Rapp and Tom Collins, The Great Marketing Turnaround

“Customer-intimate companies consider the customer’s lifetime value, not just the profit and loss of a few transactions.”  Michael Treacy and Fred Wiersema, The Discipline of Market Leaders

“Gathering and analyzing your own data on all these effects — acquisition cost, base profit, revenue growth, operating costs, referrals, and price premium — will give you quite an accurate picture of the lifecycle patterns of your customers.”                                                                           Frederick Reichheld, The Loyalty Effect

Steps for correctly calculating Lifetime Value:

Before you begin the development of a lead-generation program, I strongly suggest that you calculate projected Lifetime Value (over a five-year period) for the new customers you plan to acquire.  This way you will know exactly how much you can budget for the acquisition, assimilation, and cultivation of a new customer – and when necessary, the reactivation of lapsed customers.

Let’s assume your goal (which you fully expect to achieve) is to acquire 25 new customers within the next 12 months from a targeted segment of 250 potential customers.

 

Year 1 Year 2 Year 3 Year 4

                   Year 5

New Customers

25 23 20 18 15
Retention Rate 100.00% 90.00% 80.00% 70.00% 60.00%
Revenue per Customer $150,000 $175,000 $200,000 $225,000 $250,000
Total Revenue $3,750,000 $3,937,500 $4,000,000 $3,937,500 $3,750,000
Production and Overhead Percent 83% 83% 83% 83% 83%
Production and Overhead Cost $3,112,500 $3,268,125 $3,320,000 $3,268,125 $3,112,500
Awareness & Acquisition Budget $50,000        
Assimilation Budget $25,000 $15,000      
Cultivation & Retention Budget   $25,000 $20,000 $15,000 $10,000
Customer Reactivation Budget     $7,500 $7,500 $7,500
Total Marketing Costs $75,000 $40,000 $27,500 $22,500 $17,500
Total Costs $3,187,500 $3,308,125 $3,347,500 $3,290,625 $3,130,000
Gross Profits $562,500 $669,375 $680,000 $669,375 $637,500
Discount Rate @ 10% per year 1 1.2000 1.4400 1.7280 2.0736
Net Present Value Profit $562,500 $557,813 $472,222 $387,370 $307,436
Cumulative Net Present Value $562,500 $1,120,313 $1,592,535 $1,979,905 $2,287,341
Projected Lifetime Value $22,500 $44,813 $63,701 $79,196 $91,494
  1. It’s best if you begin by looking back over the past five years, and identifying the customers your company was serving five years ago.
  2. Now, determine how many of these same customers your company has retained each year during the past five years.
  3. Next, calculate the average sales revenues for each of the past five years.
  4. Then, calculate total revenue from these customers for each of the five years by multiplying average sales revenues by the total number of customers.
  5. You can now derive gross profit from these original customers by subtracting total cost for each (including direct costs + commissions) from your annual revenues.
  6. Now look forward.
  7. Your retention rate for each year over the next five years can often be determined by looking at the number of customers your company has lost over the past five years.  Certainly, not a very comfortable situation in this example – losing 40% of the customers within five years.  Hopefully, you’ll improve on customer retention.

In building customer relationships over time, there are only five things you can affect (four of which are shown in red): 1) retention rate; 2) customer referrals (which I haven’t included in this example); 3) increased sales; 4) reduced direct costs; and 5) reduced marketing costs.

Please note in this example that I’ve broken out separate marketing budgets for each of the four probable phases of a customer’s life.  Inasmuch as you’ll employ four separate strategies and supporting tactics for each phase, your Lifetime Value calculation will be more accurate.  I usually show a Referral Budget, too.

8. Now, estimate the average sales revenue the your new customers will generate over the next five years.                                                                                                                                                     9. Multiply average expenditures by the number of new customers retained for each of the five years to determine total revenue for each year.

One reason that I cautioned you on knowing how to correctly calculate Lifetime Value is because over the past few years, I’ve attended two workshops during which the presenters did not include a discount factor.  Yet, the definition of Lifetime Value is this: the net present value of the profit your company will realize on the average new customer during a given number of years, discounted back to present day dollars.  Since profits received from customers come over several years, money received in future years is not worth as much today as money received today.

10.  To do this correctly, estimate average interest rates for each the next five years.  Use the current interest rate and multiply times the risk factor.  Risk is attributable to increasing rate of interest, product obsolescence, competitive pressures, etc.  Use any risk factor you choose; for this example, I’ve used an interest rate of 10% and risk factor of 2 (i.e., 20).  For example, to calculate discount rate for the 4th year (three years from now), use this formula: (1.20)3 = 1.7280

11.  Divide the expected gross revenue for each year by the discount rate for each year to determine Net Present Value Profit.

12.  Add each of the Net Present Value Profits over the five years to derive Cumulative Net Present Value.

13.  Lastly, divide each Net Present Value Profit Value by the number of new customers you have during the first year for each of the five years.

You now have projected Lifetime Value.

After reviewing this example, please let me know if you would like to receive more information on correctly calculating Lifetime Value.  To do so, please send me an e-mail – at earl@hogandirect.com – or by phoning me – at 913-677-4580.  I would welcome the opportunity to serve you.

Leave a Reply

Your email address will not be published. Required fields are marked *

Required * Time limit is exhausted. Please reload the CAPTCHA.