Powerful customer value multiplier kicks profit
Many businesses fail to understand the tremendous multiplier effect on their profit that properly grooming their clients can offer. One of the most powerful multipliers on your profit can be the Lifetime Value (LTV) of a customer.
We can paraphrase the old biblical quotation "if you give a person a fish you feed them for a day, if you teach them how to fish you feed them for life" and turn it into "if you sell to a customer today you make one sale, if you convert them to a Lifetime Client you achieve a greater number of sales".
The Lifetime Value (LTV) of any customer is:
Average Purchase x Frequency of Purchase x Purchasing Lifetime.
A restaurant offering quality dining - A customer coming in once may pay $100 per head for a good meal. The same customer coming in once a month would, over a year, contribute $1,200 to the restaurant. If we expect these customers to continue to dine for a period of 5 years, they are now worth $6,000. The first time they walked into the restaurant you may have been thinking of them as $100 whereas you could have been thinking of them as $6,000.
As another example:
If you buy a daily coffee, we could consider that a $4 purchase or alternatively we could consider it a $4 x 5 day per week x 52 weeks per year = $1,040 purchase.
When you start to think of your customers by their LTV, they instantly become considerably more valuable to you than thinking of them as just someone to dine at your restaurant in a one-time transaction.
Therefore, the smart marketer will be continually thinking of ways to improve the Lifetime Value of the customer.
To do this, you can work on increasing each of the component parts of the LTV equation above.
You want to work on how to:
- Increase the average expenditure at each visit.
- Increase the number of times they visit in a period (say per year).
- Increase the period of time they stay with you.
By way of example let us go back to our restaurant.
Increase the Average Spend
Rather than repeat work that has been done elsewhere in the Profit Savvy, we encourage you to read our article on Pricing (see Pricing article). This will demonstrate that there are 3 variables in your pricing which you may be able to bring to bear on any customer. Research has shown that, of 1,200 businesses studied, they would have received an average profit boost of 11% for just a 1% increase in price.
In the restaurant game your customers may break into, roughly speaking, frequent diners and infrequent diners. The frequent diners are the most valuable to you because they give you the biggest impact on your LTV.
When people are choosing a venue to dine they may consider you but there is a lot of other choice available to them.
You need to break through the clutter of choice with something memorable.
To start with, you need to remain in their short-term memory so that when they are considering the next dining opportunity they have your business in mind. To do this, you might give some thought to a weekly email that lists out this week’s specials on food or wine or some other entertaining aspect of dining out. You cannot expect people to dine on a weekly basis with your restaurant but if they see something tantalising coming past on your weekly specials or some other inducement, for example a fiesta format, they may be attracted by the novelty. If this is emailed to them weekly they can always elect to unsubscribe but while they remain subscribed they are getting a weekly reminder of your business.
Take a moment to think of the ways that you can encourage people to revisit your establishment more frequently.
Increasing the Customer’s Lifetime
It is very difficult to know how long a customer might remain with you.
They will certainly drop off if they have a poor experience or your quality is perceived to slide. This might happen if a competing business starts to offer a more compelling value proposition than you do.
Keeping a customer is what loyalty programs are intended to do. You already have had a lot of exposure to loyalty programs yourself so you can probably easily imagine ones that might work in your situation.
Typical methods to prolong Lifetime might include:
- Giving them personal attention so they feel part of the “family”. Think how nice it is that your coffee shop remembers your “usual” or your name.
- Make them stretch a little to get a reward. Offer a free meal at your restaurant for every x many meals that the customer buys. With the prospect of a free meal dangling out in front of them, they may well attend the restaurant several more times to qualify for the free meal. Certainly, there is the risk that you will lose them after the free meal but at least you have had the several dining events prior to the free meal.
- Offer an inducement to re-sign with you. You sometimes see this type of thing with magazine subscriptions where they will give you a free gift when you renew the subscription.
- Say thanks for their business. If you are, for example, an accounting professional, you might offer a one hour professional consultation for free for each set of annual taxation documents that you do. If this has value in the minds of the customer then they may choose you to do their next annual accounts to qualify for the free hour of advice.
- Offer them some other service they might value or which appeals to their curiosity. If you sell cars, you might make offer them a free valuation on the resale value of their car in case they may sell that and buy a new one.
Any incentive is likely to have a cost. If you know what that cost is to you, and if you can estimate how likely they are to continue to trade with you, you can guesstimate the cost of your incentive as:
Actual cost divided by the probability they stay with you
If your incentive costs you $10 and one in 5 who take advantage of it stay with you (20%), the cost is $10/20% = $50.
That is what the incentive will cost to get the next sales from that customer. If you subtract that from how much you make during that customer’s lifetime with you, you can see if your incentive is worthwhile. Ideally, the profit from the expected sales (income less the expense of the product times the expected number of sales) should considerably exceed the cost of the incentive; or you are paying too much for the incentive.
Estimating the increase in the life expectancy of the client is probably the most difficult statistic to measure.
There is always some attrition in successive years as customers slowly peel away from even the best run retention programs. This might be thought of as the “rate of decay”.
Reasons they may leave are:
- Change in family/business conditions (children grow up).
- Change the grade of purchase they buy (cheaper, more expensive).
- Cease needing your product as an input.
- You sell an occasional product that they don’t buy frequently (home architectural services) etc.
Growing a customer’s LTV with your business can have a very considerable impact on the profit of your business.
A Case Study
Let us say you have a business that currently generates $750,000 in annual revenue and has a 50% Gross profit.
Gross profit is:
Sales minus the Direct Cost of Sales (such as Product Cost, Marketing and Sales Costs directly related to the sales process).
It does not include those costs that are "Fixed" because they do not change according to the amount of product that you sell. Typically, "Fixed" costs would be things like rent, labour or staff costs, electricity etc. That is a bit simplistic as fixed costs might go up if your sales increase substantially but let’s keep it simple by supposing they stay at the same levels.
You have 750 clients that you service on an annual basis and the average transaction value is $500.
This means that each person makes an average of 2 purchases per year -
$750,000 in revenue / 750 clients is $1,000 each per annum divided by a price of $500 is 2 purchases a year.
We know that the gross profit is 50% -
$750,000 in revenue = a Gross Profit of $375,000.
Given 750 clients -
each client contributes a gross profit of $500.
If the fixed costs are $250,000 -
the Net Profit is $125,000 ($375,000 - $250,000) or 16% of the Total Revenue.
Impact of Increased Price
Let us assume we can increase the price by 1%.
$750,000 in sales * 1% = $7,500 in additional sales income.
50% is gross profit - $7,500 / 2 = $3,750 -
improving net profit by ($125,000 + $3750) = $128,750.
Net profit has improved by a percentage of 3% for a 1% increase in price ($3,750 / $125,000).
Fixed costs are not likely to change with just a price change.
Impact of More Sales Per Customer
Let us turn now to the impact of an increase in the average number of sales per customer from the present 2 to just 2.5 a year.
This gives us an additional -
750 customers * ½ a sale on average = 375 sales per year.
You can work through the maths but this comparatively small change adds another -
375 sales at $500 in Revenue each = $187,500 added to our Revenue.
At 50% Gross Profit this is $93,750 in additional Net Profit
Or a Total, when combined with the original Profit -
$125,000 + $93,750 = $218,750.
This improves your Net Profit by a percentage of 75% ($93,970/$125,0000).
Of course, if you sell more, you might have to gear up your fixed costs to do this. This is more likely if you are a manufacturer because you need more manufacturing capacity. It is less likely if you are a retailer and you just buy more from your wholesalers.
The Impact of Improving Customer Life
Estimating the increase in the life expectancy of the client is probably the most difficult statistic to measure as we discussed above.
By way of example:
Increase the life expectancy of 50% of customers by a further year.
In Year 2 we have:
Profit from 750 new customers each year = $125,000.
Plus Profit from 50% of Year 1 customers = $62,500.
50% percent increase in profit.
In Year 3 we have:
Profit from 750 new customers each year = $125,000.
Plus Profit from 50% of Year 2 customers = $62,500.
Plus Profit from 50% of Year 1 customers = $31,250.
Totaling $218,750 or 175% more profit than when the client was with us for just one year.
The Combined Impact of Improvement in 2 or More of the Three
Let us go back to the variables in the LTV.
Average Purchase x Frequency of Purchase x Purchasing Lifetime.
If we can increase BOTH the price and the sales per customer, we get the combined Net Profit effect of each.
In our example, this gives the extra Net Profit of:
- $3,750 in additional Net Profit from the price change.
- $93,750 in additional Net Profit from the sales per customer change giving
- $97,500 extra Net Profit or
- $97,500 / $125,000 = 78% improvement in Net Profit.
These figures are just examples and may be wildly optimistic. We have spelt out the maths, you should be able to put together a spreadsheet to work out the likely improvement in your own circumstances.
If you set up a spreadsheet with your own data, and make price, life and purchase volume variables, you will be able to model the results to see the impact of the changes.
If we channel the 80/20 Rule, we know that the impact of each of the three variables will be greater or less than the others; and likely one will stand out. You can test this (see Sensitivity Analysis article) and then consider focusing on the best candidate.
Also, or alternatively, you can give some thought to the ones that are easiest to do and knock them off first; the so called “low hanging fruit”.
You can gauge which are the best ‘low hanging fruit” by using the formula:
Amount to be gained / how long to gain it (in say weeks).
The higher the number, the quicker the return on your time so you are more likely to start with them.