Before deploying acquisition and retention strategies, business leaders must know how to calculate the true value of customers.
As business leaders, we transact with a wide range of customers, and the revenues and profits from each of them are different. It is therefore important for us to know where exactly we stand in terms of profit from each customer (set). We need to know the true value of the customers we are dealing with.
Often we have heard that “it is more costly to acquire new customers than to retain the existing ones.” But sometimes we get apprehensive as, according to simple logic, having more customers is better than having fewer ones.
Actually, it’s not always the case. Not all customers are good for our business; some are always more profitable and more strategic in value than others. The key is to evaluate how the profit margins compare; how easy are they to work with; how important are they for our future business.
Customer Lifetime Value (CLV) and Customer Profitability Analysis (CPA) are two useful metrics for shaping sales, marketing and service strategies.
CLV is the measure of how much our customers are worth over the time they buy our products and services. It’s a primary metric for understanding customers. It’s a prediction of the value our relationship with a customer can bring to the business. In fact, it’s a process of tracking how valuable the customer is to our company, not only on purchase but across the whole period of the relationship.
CPA is essentially a measure of how profitable a customer is for the revenue generated, and what the company spends on acquiring that customer in terms of time, resources and other costs.
One of the most common tactics applied by management to attract and retain customers is offering discounts directly or indirectly. Customers love discounts. But the point of concern is – what is the optimal discount amount that should be offered, to not affect or disturb CLV? Research has shown that different levels of discounts, at times, influence CLV and customer behaviour patterns. The task, therefore, is to determine the discount which will deliver optimal CLV in the long run.
In consumer businesses, the steps to calculating CLV are:
- Identify a discrete group of customers for tracking
- Identify the touchpoints where the customers create value
- Measure revenue at each touchpoint
- Sum up the data over the lifetime of the customers
Other factors may also be included to make the calculations more relevant, especially in a B2B environment.
There are two approaches for calculating CLV, depending on the data available. One is based on historical sales data and the other on averages.
CLV = average value of sales X number of transactions X retention time period X profit margin
While not going into details of the methods of calculations, we need to understand that CLV is important for the management because it:
1. Impacts profitability
2. Helps in growth
3. Improves cash flow
4. Indicates customer’s brand affinity and preference
To improve CLV, organisations need to invest in optimising customer service, rewarding with special offers, having a robust feedback mechanism, and improving communication to inspire loyalty.
However, there are a few misconceptions about CLV, such as:
- What’s the difference between Customer Loyalty Programme (CLP) and Customer Lifetime Value (CLV)?
- Is customer retention more important than acquisition?
In practice, CLP is designed to retain more and more customers regardless of their real value. On the other hand, CLV indicates the contribution of individual customers to the organisation’s profitability. Although the acquisition of new customers is extremely important and should not be neglected, spending too much or overemphasising the same may not be profitable in the long run.
CLV gives a picture of the net profit gained from a customer over the time he has done business with us. However, this metric doesn’t consider the cost behind the initial acquisition, and it also doesn’t give much insight into why the customer is stuck with us or what we gain going forward with him.
In contrast, CPA looks at the various activities undertaken and expenses incurred for servicing a particular customer. It’s a financial management tool that shifts the focus from ‘product line profitability’ to ‘individual customer profitability’.
Managing and tracking CPA is vital for many reasons, as it not only improves the company’s revenues but also enables it to provide more value to its valuable customers. Once you analyse your customer base and pick out the most profitable ones, the CPA metric helps in allocating effort towards them, thereby ensuring that the most profitable customers become your TG.
Businesses calculate the annual per-customer profit by determining the annual profit they generate per customer and subtracting the total expenses incurred to serve the customer over a period, generally a year.
There are different ways of computing CPA but I found this to be the simplest:
CPA = (total annual revenue the customer generates – total annual expenses incurred to serve the customer) X number of years customer remains with the company
CPA helps businesses evaluate whether the effort (cost) of providing services to gain and keep customers generates enough profits for the business.
It is evident that calculating CPA helps in:
- Identifying cost factors related to attracting and retaining customers
- Identifying the most profitable customers and markets
- Optimising customer retention strategy
Customer profitability is more than just the revenue that the customer brings in. Mapping and evaluating each area of a customer’s journey with the company can reveal insights that can have a meaningful impact on the bottom line and business strategy. Determining the true value of the customer (CLV) will aid in deploying technology resources in offline and online sales channels. By assessing what the customer is really worth (CPA), we will be able to focus on attracting and keeping the right type of customers. This focus in turn will lead to improved productivity and help in innovation and growth.
However, one needs to be aware that profits are not always the only value of a customer relationship. After all, there are customers you earn from and there are customers you learn from.
In industries where the network is fragmented, products are complex, and customer consumption is dependent on influencers, there are usually a set of knowledgeable customers who offer valuable feedback on marketplace trends etc. Also, some customers are valuable not only because of their CLV, but because they are opinion builders or influencers in their domain. Therefore while developing an effective marketing and CRM strategy, management must make sure they do not exclude influencers from the list of valuable customers.