What is Average Customer Lifetime Value?
Traditional business philosophy is that "it is often more expensive to acquire new customers than it is to generate repeat sales from existing ones and that existing sales are more profitable due to the reduced marketing expense." This strategy is very effective for offsetting the affects of rising pay-per-click costs.
While most businesses consider only the value generated from a customer's first purchase, a business using an average customer lifetime value considers the value generated from all of a customer's purchases.
Customer lifetime value is the average time period a customer has a relationship with your business and the total revenue generated during that relationship. A relationship is defined as the time between the customer's initial purchase and their final purchase from your business.
For newer businesses, the "life-time" number is estimated based on loyalty expectations while older businesses with years of customer purchasing history can generate loyalty measures from their actual internal statistics. In either case, understanding your customer lifetime value is important regardless if you rely on relative estimates or historical stats.
How Do You Calculate Your Average Customer Lifetime Value?
To calculate your average customer lifetime value you will need to gather the following:
? How long you have been in business.
? Your best estimate of the time between an initial customer purchase and their final purchase. (Typically a year or two but ideally based on your unique business cycle.)
? Your total sales.
? Your total number of customers.
Although not covered in this article, you may also want to gather the costs you incurred so that your customer lifetime value shows your breakeven point.
The basic formula for calculating your average customer lifetime value is:
Average Lifetime Value = (Total value of all sales) / (Total number of customers)
For new businesses without ample customer purchasing history, your formula may be more like:
(Time length estimate for how long your average first time customer will remain a customer) (Length of time you have been in business)
Example of an Older Business With Vast Customer Purchasing History:
For example, you have been in business for three years and through studying your customer purchasing history you have discovered that on average, your customers make their first and final purchase within one year. So, one year is your "customer lifetime".
Over the past three years you have generated $760,000 in revenue from 2,300 customers. Before moving forward, you ideally want to remove any new customers who have not yet exceeded one-year "customer lifetime." To do this, just take your average sales value times all less than one-year customers and deduct it from your total revenue. Then deduct the less than one-year customers from your total customers.
Let's say your average sales value is $175 and there were 500 "less than one-year" customers. Now take your adjusted revenue of $672,500 ($760,000 - $105,000) and your adjusted total customers of 1,800 (2,300 ? 500) and perform the calculation.
Average Lifetime Value is $672,500 / 1,800 = $373.61
Your average customer lifetime value is $373.61! So while many businesses under this example may consider their customer value at $175 (the average value of a sale), a business using average customer lifetime value considers a customer worth $373.61. This perspective opens new strategic opportunities.
Example of a New Business Without Vast Customer Purchasing History:
Unlike the first example, let's say you have only been in business for one year and you have little customer purchasing history; therefore, you are not confident that your initial customers have made their final purchases.
In this situation, you need to estimate how long you expect a customer will remain loyal and continue purchasing from your business.
In this example, assume that your customers will remain loyal and continue making purchases for three years. You have generated $250,000 in revenue during your first year from 800 customers.
First, calculate your average customer lifetime value using your known one-year revenue and customers data.
Average Lifetime Value is $250,000 / 800 = $312.50
Now, you need to calculate the approximate value based on your expected customer lifetime of 3 years. Convert your years into months and divide the number of months an average customer continues buying from you by the number of months you have been in business.
36 months / 12 months = 3
Now, multiply this number "3" by your average customer lifetime value of $312.50 to generate your expected customer lifetime value: $312.50 x 3 = $937.50.
Although this number is not as reliable as the one generated by a business with years of actual customer purchasing history, it does provide essential information for a marketer to determine customer lifetime value. The risk is losing your average customer before they reach the three year lifetime expectation ? so be conservative when estimating this!
How is Your Average Customer Lifetime Value Used for Pay-per-Click Bidding?
Similar to how large businesses approach capital investments through calculating payback and return on investment - understanding your average customer lifetime value enables you to make decisions today based on longer term payback and returns forecasts.
Let's look at an example that really shows the power of using your average customer lifetime value.
There are two companies: Company A. and Company B.
Both have been in business for the same period of time, 3 years and both sell the same product at an average sales price of $175.
Both companies perform pay-per-click using Overture (a.k.a. Yahoo Search Marketing Solutions) and want to bid on their primary but expensive keyword, "brand X." The first eight bid positions in Overture for keyword "Brand X" are between $2.75 and $1.85 per click.
Further, Company A. does not consider average customer lifetime value while Company B. does. Let's define the parameters for Company A. and B.:
Company A. Company B.
(Uses Avg. Customer LTV)
Average Sales Price $175 $175
Customers in Past 3 Years 4,000 4,000
Revenue in Past 3 Years $2.1 million $2.1 million
Lifetime Period Unknown, doesn't calculate 2 years
Website Sales Conversion Rate 1% 1%
Company A. pulls out their calculators and figures out that for every 100 website visitors they generate $175 in revenue. At the current bid prices, an eighth bid position at $1.85 per click would cost them $185 to generate $175 sale. They decide that keyword, "Brand X" is too expensive and they drop out of the bidding competition.
Company B. though calculates their average customer lifetime value.
They researched and discovered that their customer lifetime is two years. They first remove any new customers that have not completed their two-year "lifetime" and calculate their average customer lifetime value. Assume there are 600 "less than two-year" customers and they represent $105,000 in revenue. They deduct these numbers from their totals and calculate the following?
Average Lifetime Value is $1,995,000 / 3,400 = $586.76
Company B. assesses their ability to bid for Brand X using their average customer lifetime value. Like Company A. they figure that for every 100 website visitors they generate a $175 sale. At the current bid prices, first position at $2.75 per click would cost them $275 to generate just a $175 sale. BUT, it's OK! Their average customer lifetime value is $586.76 so they know they will make over $311.76 from that customer over their lifetime. Impressive!
This is a simple example however it proves the power of understanding your average customer lifetime value. The critical step for Company B. now is to implement customer retention strategies that increase their average customer lifetime value.
Do YOU Know What to Do as Your Pay-per-Click Bid Costs Increase?
If you have read all three articles, you have discovered three powerful strategies for offsetting the affect of raising pay-per-click costs. In summary, they include: (1) Understanding your Performance Metrics (2) Maximizing Your Website Conversion and (3) Calculating your Average Customer Lifetime Value.
Now as your competition shies away from increasing pay-per-click bid costs, you are armed with the strategies to confidently dive right into the empty pool of wanting customers. And while your competition is ignorantly chuckling about how much money you must be losing by bidding on such high cost per click keywords, you'll be laughing on your way to the bank with an overflowing pocket of cash!
Kevin Gold is a Founder of Enhanced Concepts and a published author. If you're interested in increasing your leads or sales, get a free copy of "Understanding Your Conversion Rate" and "12 Surefire Ways to Increase Your Website Conversion" by visiting http://www.enhancedconcepts.com