Have you ever heard of the divine ratio? It is a sequence of numbers that is found repeatedly throughout nature. The number 1.618 referred to as phi, can be found in flower petals, hurricanes, fingers, arms, shells, galaxies and tree trunks to name a few. Once discovered and popularised in the fifteenth century it shaped entire disciplines; mathematics, arts and science were inherently changed. It was used by the likes of Di Vinci to guide him in painting and by the architects of the Egyptian pyramids.
There is an equation that is not dissimilar to phi, in its importance to the business world. It’s simple and enlightening in equal part, but rarely measured and tracked. It’s called Customer Life Time Value $ (LTV). It is a measure of the value that each customer brings in financial terms.
Without knowing their LTV, owners fly blind in a thick blanket of fog. They make decisions without understanding the fundamental economics of their business. They acquire customers and focus sales and marketing efforts on segments and channels that may or may not be profitable. They make investment decisions through a murky lens, not knowing whether the decision is likely to add value or detract value from their business. My mind boggles at how many owners don’t know their customer life time value. Granted, I’m a finance guy and my view of the world is biased towards numbers. But I’m yet to meet an owner of a business who isn’t interested in being profitable, so it stands to reason that understanding a customers worth is critical. Without it how do you know if your business model is sustainable or profitable?
If you pitch your business to an investor one of the first questions they will ask is “What is the Life Time Value of a customer of yours.” They ask this for a few reasons, to make sure the economics of the business model work, but also to gain comfort around the commercial acumen of the owner.
The LTV Equation
Life Time Value $ (LTV) = the cumulative Gross Margin $ (GM) of a customer (over their lifetime), less the Cost Per Acquisition $ (CPA) and lifetime Cost To Serve $ (CTS)
The formulas for the components of LTV are below;
Gross margin $ (GM) = the direct profit a customer generates. Sales less your cost of goods sold, over the lifetime of the customer.
Cost per acquisition $(CPA*) = all sales and marketing costs invested to acquire a customer. This is a one off cost.
Cost to serve $ (CTS**) = the cost of serving this customer once acquired this includes overheads and support teams. This is calculated as an ongoing cost over a customers lifetime.
Click the link for an example of how to work out LTV
Okay, so once you have a view of LTV how can you use this to make better decisions?
Understanding LTV gives owners insight into how profitable a customer is, or isn’t. Understanding this will help shape your strategy and should focus effort to more profitable segments.
LTV allows you to assess whether a sales or marketing channel is profitable or not. If your cost per acquisition is higher than your gross margin less your cost to serve then you have an unprofitable customer.
It gives you the ability to assess and compare the profitability of different products. If product A is twice as profitable as product B, then it would make sense to focus on product A wouldn’t it?
If your high churn rate is impacting your GM, then maybe its worth employing a retention or re-engagement strategy to reduce churn and increase the average GM and LTV.
You might find that your cost to serve (your overheads per customer) are too high for what your making in GM per customer. That silver service Australian based call centre might not be viable, offshoring may be a smarter option.
Understanding lifetime value is critical to making well thought out strategic decisions. Many businesses, are stabbing in the dark, not understanding the basic metrics that drive value, profit and ultimately a higher business valuation.
Do you understand your businesses life time value?
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Follow this link for a quick example of life time value.
*CPA – this is probably the hardest number to calculate. How do you apportion the cost of brand, PR and activities which are not directly attributable to acquiring a customer? It’s hard. To simplify this (sum your last twelve months of sales and marketing costs, then divide it by the number of new customers acquired during this period). This will give you a rough idea of how much each customer costs to acquire. This is a one-off cost.
**CTS – this represents your ongoing costs to retain a customer. This includes customer service costs, account management, discounts / offers used to upsell or drive repeat purchase, hosting if you’re a software business etc. This is an ongoing cost.