The Lifetime Value of Money
What is the lifetime value of a customer? It is the most important piece of information that you need to know, if you want to be a successful business owner. If you are starting a business, you need to know what your cost to acquire a customer should be…and don’t overspend. If you spend more money to acquire a customer than they would ever bring in, you will soon go bankrupt.
Why should we care about the lifetime value of a customer? Because your “regular” customers are the lifeblood of any business. The customers that come back week after week, month after month, and buy your products are your profit centers. They make you rich.
Let’s whip out the formula, ok? The lifetime value of a customer can be determined by a very simple formula.
(Average Value of a Sale) X (Number of Repeat Transactions) X (Average Retention Time in Months or Years for a Typical Customer).
Take your average sale, multiply it by your profit margin. (Let’s use 10% for a profit margin), That $20 sale has a value of $2 (profit). Multiply that by the number of repeat transactions per year, and then multiply that by the number of years.
Example: If you have a dry cleaner, and a customer spends $20 per week, and they will stay with you for five years, then it is very simple how much that customer is worth.
$20 (average sale) X 10% profit margin = $2 average value per sale
52 weeks per year X 5 years
$2 average value X 52 weeks X 5 years =$520 lifetime value of a customer
However, a dollar today is much more valuable than a dollar five years from now, so we have to assign it a discount factor. (Time value of money, or, “inflation factor”) Just to keep things simple, let’s use 3 years, rather than five years for the lifetime value of the customer.
$2 X 52 weeks X 3 years = $312 lifetime value of a customer in today's dollars.
What Does This Mean to You?
If you realize that every time that you acquire a customer, you have just received a $312 asset. So, if you spend less than $312 to acquire that asset, you are doing well. If you spend MORE than $312 to acquire that asset, you are losing money.
Once you realize the lifetime value of a customer, you have just created a marketing budget. You can go negative on the first sale, because you are making money long term. (Assuming that you can afford to go negative on the first sale, and are not in a dire cash crunch.)
There are many variations of this formula, and some of them are quite sophisticated, but they all boil down to the same thing. You have to know the cost to acquire a customer. Once you know that, you can do marketing projections, and cost estimations.
Your job, as an entrepreneur, is to know the lifetime value of a customer, and keep increasing that value, so that your customers become more valuable over time.