In its most basic sense, lifetime value represents the amount of money a customer will spend on a product during the course of their lifetime. This is significant, and often overlooked in transactional approaches to marketing because they focus only on a single sale, which in turn leads them to employ tactics that are geared to getting a single sale – and discourage repurchasing. I could elaborate on this quite a bit, but it would be a diversion from the present topic.
The relationship company does not seek to make a quick buck through a single sale, but instead seeks to establish a lifetime relationship with a customer and capture all sales over the course of their lifetime. As such its basis for determining the value of the customer should not be the revenue of a single sale, but the revenue of all sales that can be made to the customer over the course of their lifetime.
Example: Spectacles
Let’s take spectacles (glasses) as an example: it’s plausible to assume that a customer will purchase a new pair of spectacles every two years from age 18 to 80. And yes, this is a “plausible assumption” as will be all figures in these examples – research could derive a more precise number, but for now I’m merely ballparking, so a plausible assumption should suffice.
And so, a pair of spectacles every two years for a period of 62 years (ages 18 to 80) results in the purchase of 31 pairs – which I’ll round down to 30. If the average price of a pair of spectacles is currently $400, the customer represents $12,000 in lifetime value to the company that succeeds in forming a lifelong relationship with him, such that he returns to them for every pair of spectacles he will ever need.
That is a basis for his lifetime value to the vendor – and it should already become clear that a firm that considers the customer to represent a $12,000 stream of revenue should value him more and be willing to invest more in cultivating a relationship than does a firm that sees this customer’s value as a single $400 transaction and ignores the lifetime value of the customer.
The Basic Elements
I’ll pull the basic elements of the equation together in a general sense, which is a bit tedious but necessary to applying it to various products:
- Duration of use – How many years will the customer purchase the product?
- Frequency of use – How often will the customer purchase the product?
- Unit price – The current price of the product
That’s all you really need to know (or estimate) to calculate lifetime value of a customer for a given product. A few examples show how it can be applied to various products:
- Automobiles – If the average customer purchases a new car every four years from ages 18 to 80, this means they will buy 15.5 cars in their lifetime. And if the average price of a car is $30,000 then customers have a lifetime value of $465,000. The equation is: ((80-18)/4) * 30,000
- Coffee – If the average office worker purchases two cups of coffee from the cafeteria in their workplace each working day (200 per year) from ages 22 to 65 at a price of $1.89, then the lifetime value of their coffee purchases to the cafeteria is $32,508. The equation is: (65-22) * 2 * 200 * 1.89)
- Diapers – If the average household has two children, for whom they purchase 24 diapers per week for the first two years of their lives, and a 24-count package of diapers costs $12.50, then the lifetime value of that household to a diaper brand is $2,600. The equation is 2 * 2 * 52 * 12.5
Adjustments to Duration
From these examples, it’s already plain that certain products require adjustments to the basic equation. For example, the office cafeteria captures only 43 years worth of business (because people don’t begin work until age 22 and retire at age 65) and the diaper brand sells to a household for only four years (because the product is only purchased during the first two years of life for each of the two children).
The duration of use is somewhat hazy and is the most influential factor in the outcome of the equation, so it’s worth a bit of nitpicking to get it right because small differences in duration can result in significant differences in the estimated lifetime value.
Primarily, when a firm seeks to acquire new customers, their full lifetime value is less germane than their remaining lifetime value – as any purchased made in the past cannot be won. So if a premium automobile brand accepts that most people can’t afford its products until age 40, it must start its equation at that age rather than at age 18.
I would be more cautious about adjusting the age at which a customer ceases using a product, as many firms look to current customer behavior to conclude that they only keep a customer for a limited time – if your current customers stay with you for eight years, then switch to another brand, that should not be accepted as inevitable in all cases. Unless there is a plausible reason that a customer will stop using the product altogether, you should not passively accept that you will eventually disappoint them into switching to another brand, but instead work very hard to prevent that from happening.
Adjustments to Frequency
Frequency of purchasing is another factor in the calculation of lifetime value that is based on the assumption of constant and consistent use. For a ballpark estimate, it is likely sufficient to look at customer behavior in aggregate – e.g., a person purchases a new car every four years is an estimate based on all car buyers.
In some instances, this can be adjusted by market segment: by definition, the average customer exercises average behavior – but if the customers that a given brand attracts are skewed to purchase more or less frequently than the customers of other brands, then the equation must be adjusted.
There are also overall trends in society that can be observed. For example, the recent economic downturn has people holding onto their cars for longer, and it is now more typical to purchase a new car every six years rather than every four. There is some debate over whether behavior will return to normal after the economic crisis has passed, or if six will be the new standard – but at least for the present, the frequency of purchasing should be adjusted.
Share of wallet is another factor that affects frequency, and it is adjustable. For example, a customer may dine in restaurants 150 times a year, but only visit your restaurant 25 times a year. A marketing initiative to get them to come to your business more often can have a dramatic effect on their lifetime value to your brand.
There are even initiatives that can increase frequency of use for a product category – convincing customers to change their purchasing behavior in general, such as to dine in restaurants more frequently in total and not just at a specific location. But both this and share-of-wallet are factors that can be changed, so the difference in lifetime value is only germane to a project if the goal of the project is to increase frequency of consumption.
And finally, frequency may not be perfectly linear. A customer may purchase more frequently at different times in their life. Sticking to restaurants as an example, people in their early twenties may not have the financial resources to dine out as often, when they get married and settle down they tend to dine out less often, when their children leave the nest they may dine out more often, and once they are retired and living on a fixed budget they may dine out less often. If these variances are significant, they should be accounted for.
Adjustments to Unit Price
For the sake of comprehensiveness, I’ll mull over the adjustment to the last factor: price. This does not seem to be quite as significant, because prices do not tend to fluctuate much from a point of equilibrium with the market – and though poor pricing strategy can be harmful to the revenue of a given brand, it generally does not affect consumption.
While it is true that nominal prices tend to increase gradually over time, this is generally in pace with the decrease in the value of money over time. Accountants use discounting rates to reflect that a dollar that will be earned in five years is worth less than a dollar that will be earned today. But if you expect that increases in price and debasement of money are more or less in balance, the difference ought to be negligible.
It is likely far more important to consider not merely the lifetime revenue to be received from a customer, but the lifetime profit that will be derived from this revenue. For example, it’s all good and well to predict that customers will spend $400,000 to purchase all of a given product they will ever consume, but the suppliers will generate different levels of profit from that amount based on their cost of providing the product to the customer. One firm might make a net profit of 8% ($32,000) from that revenue whereas another might make only 6% ($24,000).
Ironically, cost accounting is an idea with which most firms are already familiar, and they project their costs and revenues into the future when determining ROI and making efficiency improvements … to cut costs by 2% means generating a specific amount of revenue per year. For projects whose primary benefit is decreasing costs rather than increasing revenue, this becomes very important.
And That’s About Enough
I’m going to stop grinding on this for now – and possibly for ever – because there is a great deal of elaborate and intricate detail that can be applied to perfecting the calculation of lifetime value of a customer, and it’s really something that accountants should be enlisted to help with if you need your figures to be precise.
But insofar as deriving a figure that’s reasonably accurate for the purpose of considering whether the investment in customer experience is worth the cost, this will likely give CX professionals a good way to derive a ballpark estimate as a quick test as to whether a proposal is worth undertaking.
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