Lifetime value is what a customer contributes over the whole time they deal with you, measured in gross profit rather than revenue. Most owners never calculate it, and instead 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 assumption holds small businesses back. It means you can only 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 worth over the whole relationship and can therefore outspend you on purpose.
What are the four numbers?
Multiply four numbers together, all available from systems you already have.
- 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 about 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 does it matter to an owner?
It changes three decisions: 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.
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.
A worked example
The figures are illustrative. A garden maintenance firm charges £65 a visit, and customers book eighteen visits a year, so each brings £1,170 of revenue a year. At a 55 per cent gross margin that is £644 of gross profit a year, and the average customer stays four years.
Lifetime value is £644 times four — about £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 instead. One visit at £65 generates about £36 of gross profit. Spending £75 to earn £36 looks like a loss, and that calculation 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. The question becomes how much more of this you can buy, and whether the business can deliver it.
Then pull the retention lever
Take average retention from four years to five — 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.
The cash caveat
Lifetime value is a profit measure. The acquisition cost is a cash problem. Put the payback period beside it: how many months of gross profit it takes for a customer to repay what you spent winning them. In the example above 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 money growing quickly, because it would be funding every new customer for over a year before breaking even on them.
Common mistakes
They calculate it in revenue rather than gross profit. A 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 full cost to serve.
The second mistake is inventing the retention figure. Owners guess that customers stay about five years because 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. Segment first, even crudely, into two or three groups. That is where the useful decision usually is, because one segment routinely turns out to be worth several times another while your marketing treats them identically.
How to use this in the next week
- 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.
- Calculate the four numbers in gross profit terms. Average transaction, margin, purchases a year, years retained. Write the lifetime value down where you will see it.
- Work out what you 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.
- Segment into two or three types and repeat. Then compare. If one segment is worth three times another, your budget should not be split evenly between them.
- Put one retention action in place. Examples are an eleven-month review call, a follow-up after the first job, or a reminder before the season starts.
- Set the maximum you will pay for a customer — then spend it. Agree a figure you are comfortable with against the lifetime value in advance, so the decision is not remade emotionally every month.
Questions to ask yourself
- 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 ceiling were three times higher?
- Why do customers 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?
Working out what to do with this number is Business Coaching territory.