Very few business owners know exactly how much a new customer is worth to their business. Not knowing this piece of information is a great handicap in several ways. First, it means that when it comes time to evaluate an advertising opportunity, the final decision is based on guessing and hunches rather than on real numbers. Secondly, and perhaps most importantly of all, studies have shown that business owners who know how much their customers are worth have a much higher customer value than those that don’t. In other words, knowing what your customers are worth allows you to make smarter, data-driven decisions, and enables your business to be more profitable. Let’s look at how you can determine quickly, and with certainty, exactly how much a new customer is worth to your business.
Calculate Average Customer Lifetime Value
In its most basic form, the formula for calculating the value of a customer is simply this:
Customer Lifetime Value = Sale Price – Cost of Goods Sold.
Now if you only sell one thing one time to a single customer, this makes your calculation really easy. In most businesses, you’ll need to add a little bit to this.
How long does a customer typically buy from you? How many purchases would you anticipate from that customer during that period of time? The purchases over this span of time get added into the sale price and cost of goods sold in the formula above.
Customer Referrals and Customer Lifetime Value
How much of your business is from word of mouth referrals? If you receive a substantial amount of business as a result of the recommendations given by current / previous customers, then this needs to be reflected in your Customer Lifetime Value (CLTV or sometimes known as LTV) calculation.
How frequently do your customers refer other customers to you? How many new customer referrals would you expect to receive from one customer? Ideally, you are tracking this information, but if you’re not yet doing this, just guestimate it. If 1 out of every 3 customers gives you a referral, then your customer referral rate is 33%. The percentage of customers who will refer new business to you gets added into the CLTV formula as follows:
Customer Lifetime Value = ((Sale Price – Cost of Goods Sold) x (1 + Referral Rate)).
Example – Joe’s Gutter Business
In Joe’s Gutter Business, Joe’s customers buy only once from him. His typical sale ranges from $300 – $1,000. This works out to an average sale price of $650. His labor and materials is usually around 36% of the sale price. This works out to $234 for cost of goods sold on an average sale price of $650. Joe’s customers are very pleased with his work and 1 out of every 2 customers refers another customer. His customer referral rate is 50%. With this information we can now calculate that the lifetime value for Joe’s customer is $624.
CLTV = (($650-$234) x (1+.50))
Once you know your customer value, you can begin making advertising decisions based on hard data – not on guesses and hunches. Once you know your customer value, you can begin working to track it more closely and increase the value that you are providing to your customers. Remember – what you give comes back to you. As you increase the value that you’re providing to your customers, your customer value will also increase. Knowing the value of a new customer is essential for accurately measuring and increasing the return you receive on your advertising investment.