When I ran my own business, I had lots of customers. Truth be told, some were better than others, not just in terms of our working relationship, but their value to my company.
Customers cost money, and while you may think that new customers are the way to build a business, the math doesn’t necessarily prove this to be true. Sometimes, your most loyal, long-term customers are the most valuable, even if they purchase from you less frequently or place smaller orders.
Successful companies consider this all the time. Two metrics, Customer Lifetime Value (LTV) and Customer Acquisition Cost (CAC), are the north star of calculating the value of a customer relationship.
I had to learn this the hard way through trial and error. I didn’t know anything about these two metrics, and even after 20 years in business, the math plum evaded me when it came to understanding that the lifetime value of a customer can be far greater than the cost of acquiring a new one.
Customer Lifetime Value (LTV) measures the amount a company can expect to make from a single customer. Customer Acquisition Cost (CAC) measures the amount a company spends to turn a lead into a customer. This includes the cost of marketing, advertising, sales, social media campaigns, staff salaries, cold calling, collateral, signage and more.
To calculate your company’s Customer Acquisition Cost (CAC), add all these costs and divide it by the new customers you gained through these attraction strategies. If you’re mathematically challenged like me, the formula looks like this:
Total advertising costs + payroll costs + design costs + other associated costs ÷ number of customers gained = CAC
Now, let’s look at the Customer Lifetime Value (LTV) side of the equation. LTV is the value of a customer over the course of a lifetime. Start the calculation by averaging your customer’s orders minus shipping fees, transaction costs, refunds and taxes due on any profit. Then, multiply the remaining profit by the actual number of purchases from that customer in a specific timeframe.
The math looks like this:
(Average transaction profit x average number of transactions) x average customer lifetime = LTV
Of course, it’s far easier to find the Customer Acquisition Cost since these are hard costs. The Customer Lifetime Value can only, at best, be an estimate since customers, no matter how loyal they are or how well you treat them, tend to change their buying preferences over time, meaning they won’t be your customers forever.
Even so, this exercise can show you some important things about your business. It can show you if you’re spending too much to acquire a new customer or if you’re not doing enough to keep an existing customer and get them to buy more from you. CAC is cost. LTV is profit.
If you love numbers, you can even create a ratio that will help you compare these two variables. The equation in its raw form looks like an alphabet soup, but once you drop real numbers into it, you can use it to drive decisions about where to spend your money.
LTV ÷ CAC= LTV:CAC
If the ratio is one or less, you’re taking in a dollar or less for every dollar you spend to get that customer. That doesn’t make any sense, now, does it? So, you may want to either lower your acquisition cost or improve your current customer retention rates to generate more profits. A ratio of 3:1 or higher is ideal. This means you’re taking in three times the cost to acquire and keep a customer.
This brings us back to the value of a customer over time. In the beginning, a business tends to focus a lot on bringing in new customers. You want a lot of customers so that cash flow remains strong and isn’t affected by the whims of a single large customer.
But that doesn’t mean you should take your current customers for granted. They don’t have to buy from you. They may want to be loyal, but if you’re always paying more attention to new customers, they may find another supplier.
Over time, they may be more profitable than any new customer you can acquire.
Say you get that new customer with an initial sale of $10,000. You do the happy dance because that’s good money. Years go by, and that same customer makes two other purchases, one for $2,000 and $5,000. Compared to your average customer who buys $300 from you regularly, these are big moments in the life of your business.
Now, look five years down the line. That new customer bought $17,000 from you during that time, but you had to do a lot of handholding with that customer because they are important. On the other hand, the small customer bought $18,000 during that same timeframe, and you never really had to do anything to remain in their good graces.
But what if you had spent a little extra time on that existing customer? Perhaps you added a new product line or service they weren’t aware of? So they bought from someone else. What if you had a customer retention program in place to stay in contact with all of your current, smaller customers? And what if you could get them to either buy more from you or more frequently?
In the example above, you start emailing your customers about a sale you’re having, a free shipping offer, or a new product or service with an introductory price. That same $18,000 customer increases orders by $500 every other month. That’s an extra $15,000 for a total customer value of $32,000 over five years.
And that’s just one existing customer. The acquisition ratio remains low, sales increase, and customers become more loyal to you because they feel important and appreciated. It’s a win-win all around.
Going back to my own business, I did eventually learn this lesson. I had a client who was on a $5,000 monthly retainer and, over time, began to ask for more and more from my consulting firm at the cost of time I could spend with other, smaller customers. I finally did the math. I fired that client, even though they had initially been a cash cow when we were smaller. Best thing I ever did.
– Robb