Lifetime Value

Most owners price their marketing against the first sale. A customer is worth what they spend the first time, so anything spent winning them has to be recovered from that transaction, or it looks like a loss.

That single assumption keeps more small businesses small than any competitor ever has. It means you can only ever afford the cheapest way of finding customers, which is usually the slowest, and it means you compete against people who have worked out what a customer is actually worth over the whole relationship.

What the model is

Lifetime value is what a customer contributes over the whole time they deal with you, measured in gross profit rather than revenue.

Four numbers, multiplied.

Average transaction value. What they spend each time.

Gross margin. What is left after the direct cost of serving them.

Purchases per year. How often they come back.

Years retained. How long they stay. If you do not know, one divided by your annual churn rate gets you close: 20 per cent churn implies an average life of five years.

Multiply the four and you have the number that should govern what you are willing to spend to acquire a customer, and how hard you should work to keep one.

Why it matters to an owner

It changes three decisions at once. What you can afford to spend winning a customer. Whether you will accept a thin or free first transaction to open a relationship. And where you point your effort, because for most established businesses the retention lever is worth more than the acquisition lever and costs a fraction as much to pull.

There is one qualification worth holding alongside it, and it is a cash qualification rather than a profit one. Lifetime value arrives over years. The acquisition cost is paid this month. The number to watch beside lifetime value is the payback period: how many months of gross profit it takes for a customer to repay what you spent winning them. In the garden maintenance example it is under two months, which is comfortable. If it were fourteen months, the ratio would still look excellent and the business could still run out of cash growing quickly, because it would be funding every new customer for over a year before breaking even on them.

It also settles arguments about marketing that otherwise run on opinion. Once the number exists, a channel is either producing customers below your acceptable acquisition cost or it is not. That is a measurement, not a debate about whether the advert looked good.

A worked example

Illustrative, but the arithmetic is straightforward. A garden maintenance firm. Average visit £65. Eighteen visits a year, so £1,170 of revenue per customer per year. Gross margin 55 per cent, so £644 of gross profit a year. Average customer stays four years.

Lifetime value is £644 times four, which is £2,574 of gross profit.

Now the acquisition side. They spend £900 a month on local advertising and it produces twelve new customers. That is £75 to win a customer. Against a lifetime value of £2,574, the ratio is roughly 34 to 1.

Look at the same £75 through the first visit. One visit at £65 generates about £36 of gross profit. Spending £75 to earn £36 is obviously mad, and it is exactly the calculation that stops owners advertising. It is also the wrong calculation, because the customer does not leave after one visit.

Once you know the ratio is 34 to 1, the constraint changes completely. Cost per customer is not the problem. Volume is. The right question is no longer how do we reduce the £75, it is how much more of this can we buy, and can the business deliver it. That is a different conversation and it produces a different business.

Then the retention lever. Take average retention from four years to five, which means one more year from customers you already have. Lifetime value goes from £2,574 to £3,218, a 25 per cent increase in the value of every customer in the business, without winning a single new one. There is no marketing spend on earth that returns 25 per cent for the price of a phone call and turning up when you said you would.

The mistake most owners make

They calculate it in revenue rather than gross profit. Revenue-based lifetime value produces a number several times too big, and it will encourage you to spend money you do not have on customers who are less valuable than the spreadsheet claims. Use margin, and deduct the genuine cost to serve.

The second mistake is inventing the retention figure. Owners guess that customers stay about five years because a few of the ones they think about have been around that long. Go and look. The answer is usually shorter than the guess, and it is sitting in your sales ledger.

The third is averaging across customer types that have nothing in common. Blend a maintenance contract customer with a one-off job customer and you get a number that describes neither of them. Segment first, even crudely, into two or three groups. That is where the useful decision usually is, because it turns out one segment is worth several times another and you have been marketing to both identically.

How to apply it this week

1. Pull three years of sales by customer. Any accounting package will do this in a minute. You are looking for how much, how often, and for how long.
2. Calculate the four numbers in gross profit terms. Average transaction, margin, purchases a year, years retained. Write the lifetime value down.
3. Work out what you actually spend to win one. All marketing costs for a period, divided by new customers won in that period. Include the time, not just the invoices.
4. Segment into two or three types and repeat. Then compare. If one segment is worth three times another, your marketing budget should not be split evenly between them.
5. Put one retention action in place. The eleven-month review call. The follow-up after the first job. The reminder before the season starts. Retention work is dull and it compounds.
6. Set the maximum you will pay for a customer, and then spend it. A figure you are comfortable with against the lifetime value, agreed in advance, so the decision is not remade emotionally every month.

The questions to sit with

• Out of 10, how confident are you in what an average customer is worth to you in gross profit over the whole relationship?
• What are you currently unwilling to spend to win a customer, and what would change if that number were three times higher?
• Why do customers actually leave you, and when did you last ask one of them directly?
• If you kept every customer twelve months longer, what would that be worth this year, and what would it take to do it?

This underpins the Sales & Marketing Engine and it is one of the levers inside the Profit Accelerator. It is also the number that decides whether you get to buy growth or have to wait for it, and waiting is only free if your competitors are waiting too.