Understanding Customer Lifetime Value
Brian Reaves, CEO of Factris
In writing about customer value, I am looking at the financial side of the equation that is only part of the overall company journey, but often does not receive enough attention. In businesses depending on recurring revenues, there is a common mistake made in financial planning and business case analysis, i.e. not every good idea is supported by business logic. In other words, some ideas should be hobbies and not turned into businesses unless the founder has money to burn. I have on multiple occasions met with representatives of companies - and start-ups in particular – that try to scale a business or product line with no positive gross margin. For every euro they spent, they earned back less than their investment. I have occasionally pointed this out and been met with the answer that scale will solve the issue, which highlights a lack of financial prowess.
A great way to avoid falling into the value trap is to plan your business from the bottom up, starting with the customer. If you can be profitable at the customer level, then you can be assured that with scale, you can eventually generate a profit at the operating level and overall, with some cost management.
Understanding customer lifetime value (CLTV) is crucial to building, scaling and managing your business. My first experience with CLTV was with telephone companies that were figuring out whether there was a profit to be made in installing fixed or mobile phone lines for a customer or group of customers. This business concept consists of three main parts: the acquisition cost, the service cost and the revenue generated over the estimated period of the customer paying for the service.
Customer Acquisition Cost (CAC)
The cost associated with acquiring a new customer varies by business. Normally, however, the customer acquisition cost includes (i) the marketing cost, consisting mostly of promotion and advertising; (ii) the sales cost, which is mostly made up of salespeople and commissions for direct and indirect sales; and (iii) the cost of boarding the customer or delivering the product or service.
The higher the amount spent to add customers, the lower the customer profitability and the greater the likelihood of having a negative gross margin overall. It is important to identify early on which acquisition channels offer the most profitable customers for the lowest acquisition cost. Normally, implementing a varied distribution program of will give you the best chance of quickly identifying where to put your marketing and sales efforts. If possible, it is also helpful to try and defray as much of the acquisition cost over time, e.g., paying the commissions for customers added in instalments.
Marketing departments should be as numbers-driven as the finance department to hone in on their true purpose, which is to generate quality customer leads that eventually become quality customers. Measuring the spend relative to the lead generation by channel will go a long way to identifying the cost-effective variable spend on acquisition cost.
The last opportunity in acquisition cost is a bit trickier: building what I call acquisition infrastructure, if possible in your industry. This means making one-off investments into things that generate ongoing leads for a low recurring cost. This can be referral websites, affiliate networks, partner agreements and memberships in organizations that introduce you to potential customers. This has the clear advantage of enabling you to scale your marketing investment.
The cost of servicing customers is the fixed and variable cost of delivering the product or service. This includes the customer support team, software licenses, operations activities, etc. Service cost is normally based on units allocated by processes and timing. In the financial service business industry, there is a high degree of automation that drives down unit cost per service or per product offered.
For the last decade, innovations in automation have focused on the cost of maintaining and serving customers. Just about all aspects of servicing customers has moved online, either completely or in part, and, more recently, to mobile. This has increased the productivity of small teams by enabling them to provide better service and to serve more customers per team member. At Factris too, we automate what can be automated so our team can spend more valuable time on personal contact with our clients.
If your business is still primarily people-based, then you need to see what your operations lends itself to automation and make the investment based on your expected return on investment. In this case, the ROI is often reallocating people to do more fun things. A number of software as a service (SAAS) providers are making things much easier across a wide spectrum of industries.
Net Customer Profits
Actually figuring out how much your business is earning on a per customer basis (or not) is the fun part, if you are into numbers. If you have optimized your acquisition cost and automated a large portion of the cost of serving your customers, the most important variables left are how long you maintain your customer relationship, how often they use your service and how much net revenue (the revenue left after subtracting the cost to provide and service your customer) you can generate.
Your customers are your greatest assets. In order for your business to succeed, you need to focus on them and take the greatest possible care of them possible within a reasonable service cost. Happy customers provide referrals, which lowers the average acquisition cost. Happy customers do more business with you and generate more revenue. Most importantly, they stick with you for a long time. In a recurring revenue environment, there is a huge difference between the net present value of a customer over 12 months and over 48 months. You can amortize the acquisition cost over a long period of time and give yourself a much better return per customer.
In many industries, you can take averages to see over time how long customers stay. In our business, we have the benefit certainty, with contracts of up to 48 months. Contracts enable us to pass on extra benefits to our customers - mostly in the form of discounts - to encourage customers to sign up for a longer term.
Churn can kill
In a recurring revenue business, churn represents a potentially huge cost and a threat to the sustainability of your business. Churn is the loss of existing customers actively using your services. Churned customers are a great loss because you have already incurred the cost of acquiring them, so their future profitability is quite high if the cost to serve them is the same as other customers. In addition, you now have to incur the cost replacing not only the churned customer but another customer to keep the company growing.
There is a natural level of churn in every business, for a variety of reasons, but it is very important to ensure that when calculating the cost to service, there is a provision for customer retention that’s focused on the high value of your existing customers. While churn is a part of business life, you should actively manage the risk of losing your most coveted customers.
Managing by measuring
A lot of this will make sense to entrepreneurs who are managing a business day to day. The trick is to make this a part of your business culture, so your company constantly measures and improves. It is worthwhile to set up your key metrics once and then to track them over time. Try to make improvements as you go along and see how they impact your financial performance. At the end of the day, it is tough to manage what you are not measuring, as gut feel will only take you so far.