In the second episode of The Bell Bytes Value Equation series, Bell Media CEO Scott Bell walks you through how to determine your Customer Lifetime Value. Video transcription can be read below.
Hey folks! Welcome to Bell Bytes. My name is Scott Bell. This is the second session to our three-part series of quantifying and understanding the Value Equation. In this second part, we’re going to be talking about the customer lifetime value (LTV). If you remember in the last session, we talked about the customer acquisition cost (CAC). So, we understand now how to calculate and hopefully have calculated our customer acquisition cost. Now let’s move on.
What does Customer Lifetime Value mean?
We need to understand the customer lifetime value. What does that mean? Let’s just say that you’re a retailer. Someone walks into your front door and they buy something. Over the course of a year, or two years, or five or ten, how much are they going to spend with you over that period of time? That’s where we need to start when you’re quantifying your return on ad spend.
Far too often in this business, working with small and mid-size businesses, we ask, “what is your expectation in terms of your return on investment?” They say, “I’d like to see a return on investment in the first or second month,” but they’re not necessarily taking into consideration what the value of that single customer is over a period of several months or several years. So, that’s where we’re going to start.
Understanding Gross Profit
The best place to start is understanding gross profit. Most of you out there probably know what this is. You understand this concept, so let’s go through that really quick. Your gross profit is basically taking the average revenue per customer, or if you want to get even more granular, you can look at your average revenue per customer per product. It’s totally up to you.
In this case, the average revenue for a particular business is $1,000 per customer. Then you reduce that by your cost of goods sold (COGS). Your cost of goods sold is $200, therefore you’re looking at a gross profit number of $800. Again, you can get very specific and granular with your gross profit understanding, and really looking at this on a per-product-basis is something I definitely urge you to do. But, if you’ve never really understood or quantified your gross profit, that’s a really good place to start.
Another tip with gross profit and understanding the lifetime value of a customer is you can actually start taking other expenses from your top-line revenue to understand the LTV. So, what do I mean by that? Let’s just say you also pay your sales team 10% on every dollar that they sell. Maybe you want to get more refined with understanding the average profit per customer. You can start layering in other expenses. My only recommendation, is to be as consistent as possible over your calculating period. So, once you understand your gross profit, you’re ready to move on.
Establishing Time Period and Type of Reporting
You want to establish a reporting time period and a type of reporting. What do I mean by that? First, you have to understand the snapshot and time in what you want to start quantifying and understanding the LTV of a customer. My recommendation if you’re a retailer, let’s take take 2015 as a reporting time period and compare it to 2016.
The first questions that you have to ask is “do I use an annual retention rate? If I have a customer two years ago, what is the likelihood that they were a customer again the following year?”
The second question to ask is “do I use monthly churn rate?” Monthly churn rate is usually reserved for recurring revenue business. Think about a SaaS business, that’s a great example.
Establish Type of Business and Metrics
So let’s establish what type of business and what type of metrics we’re going to be tracking and how. Here’s some recommendations.
If you’re a retailer, maybe you have a brick and mortar, maybe you have an online store. I would take a snapshot to start with of year one versus year two. Let’s go back to 2015. Let’s look at all of those customers in 2015 and how many of those same customers that spent money with you in ’15 spent money with you in ’16 as well. You’ll understand your retention rate at that point.
Next is SaaS, or maybe you sell a recurring sales model business to your customers. I would take a month-to-month approach. So understanding, last month, I had this many customers. Of that same grouping of customers, how many customers were with me this month? Then you start getting your monthly churn rate.
Something else that I think is relevant today’s environment is a hybrid. Let’s just say, for example, you’re a heating and air company. You sell units every three to five years, but that’s not necessarily a recurring revenue model, but you ALSO sell a subscription-based service package for every quarter for all of your customers. Maybe you want to look at both, year over year and a month over month, based on the products that you sell. So, that’s what I would call a hybrid model.
Examples of understanding the LTV
Example One – Retailer
Let’s look at 2015. This specific retailer has 100 customers that spent money with them in 2015. They then looked at 2016 and they established that out of those 100 customers, 78 of those customers spent money with them in 2016. It’s simple, 78% retention rate, but what does that really tell you in terms of your LTV of a customer. This is the equation:
LTV = 1/(1-.78) = 4.54 years
Lifetime value is 1 divided by 1 minus your retention rate. 1 minus your retention rate is actually your churn rate. So, think about that. 1 minus the retention rate, is actually the amount of customers that you’re losing over that time period. Again, LTV equals 1 divided by 1 minus your retention rate.
Next step, take this number (4.54) and you can multiply it by your gross profit ($800) to establish some baselines to understand the average customer LTV.
Example Two – SaaS / Recurring Business Model
I recommend looking at this on a month over month basis because you’re really wanting to understand on average that customers that you have this month, how many of those same customers will I potentially have next month based on trends.
This particular business had 100 customers in month one and in the following month, out of those 100 customers, they still had 98 of them still billing on the books. They had a 98% retention rate. So, if they had a 98% retention rate, what is their monthly churn rate? It’s 2%. Then, we can take that and look at the LTV of a customer. The LTV of a customer when you’re talking about monthly churn is 1 divided by your monthly churn, which is .02, and then divide that by 12. What that gets you is a LTV in this example of 4.167 years.
LTV = (1/.02)/12 = 4.167 years
I know we’ve gone over a lot of data and a lot of equations, but when you really look at it, you really just have to boil it down to a few main critical components that you can track every month or every quarter or every year, so you can establish what the average lifetime value of a customer is, which is really how we need to be thinking in our investment about what we expect out of it when we talk about digital marketing.
So the next topic that we’ll approach is understanding and bringing all of this together to go through an example of the quantification of a customer’s ad spend. Until next time, thank y’all.
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