How to Calculate and Increase Lifetime Customer Value

Understanding Lifetime Customer Value is a key factor in evaluating the health of a business.  In this post, I look at how to calculate and increase LCV.

Yesterday I was helping a friend work on a marketing plan for her business.  While she is an excellent hair stylist, she has not put any effort so far into monitoring metrics in her business so she can determine how to affect them, nor has she yet conducted any formal advertising, having relied exclusively on word of mouth.  We’re working on changing that.

The first thing I suggested is that she build a simple spreadsheet to log, backwards and forwards, who are her clients, when they are coming in by month/date and how much they are spending.  When completed, she can then make some important calculations.

I have been her client for nearly 14 years, but I don’t know if this is common for her.  In fact, my devotion to her talents may be an outlier that skews her average.  Therefore, we want to first calculate the mean (average) and median (middle figure) in the number of months that her customers have been with her.  Excel makes it really easy using the formulas: =average(starting_cell:ending_cell) and =median(starting_cell:ending_cell).  If the average is much higher than the median, then we know that the results are being skewed.  For a more visual representation, we can create a scatterplot by using Excel’s Chart Wizard tool.  Highlight all the months, click the Chart Wizard, select Scatter, hit Finish and voila!  A helpful chart that lets you see outliers at a glance.

Let’s say that the results of her analysis shows that the majority of her customers are with her for 20 months.  We then have to connect that value with the amount they are spending.  By adding a second column next to the months for dollars spent, we can do similar calculations to derive average and median dollar values.  Taking a look at my own spending with her, on average I’m seeing her every 6 weeks and spending $60 each time.  I’m getting my hair done about 9 times per year, which means over nearly 14 years, I’ve spent $7,560.  So for every new customer that spends $60 a visit, she now knows that’s $540 over a year’s time.

However, that’s not entirely true.  Another thing she has to look at is how much she’s spending to acquire and keep her customers.  If she spends $200 a month on advertising, she has to deduct those costs of $2,400 in the first year towards those clients’ acquisition costs.  Additional monies in subsequent years spent on mailings to encourage those clients to come back will also reduce her profit per customer in those years.  Then there’s the product costs – color, gels, hairsprays, shampoos and conditioners, scissors, scissor sharpening, brushes, blow dryers – which adds up.  Those costs have to also be applied to each client.  Some of those costs can be spread out over all clients using an average and some she may want to do on a more granular level, e.g. color products she may want to apply on a per-person basis since longer/thicker hair requires more product.

Then there’s the cost of inflation to consider.  My $60 paid today is worth less than the $60 given to her nearly 14 years ago.  Using the inflation rate calculator I can see from January 1996 to September 2009 (the most recent month provided), inflation rose 39.88%.  So therefore, my $60 can buy $23.93 less than it did in January 1996 (=60 x 0.3988).  For each of her current customers, she can calculate on an annual basis how much to adjust for inflation.

A really nifty spreadsheet from Harvard Business School makes doing all this pretty easy: Download the Lifetime Customer Value Calculator tool. Clicking on the “Basic Model-Assumptions” tab, I can input:

• Time between purchases.  Every six weeks would be =1.5/12.
• Retention Rate or likelihood that a customer will buy again in the next period.  Let’s use a guesstimate of 80%.
• Average Purchase value.  Let’s use $70.
• Net Profit Margin.  Assuming product costs of $15 per visit and 9.25% taxes, Net Profit After Taxes = $48.53 ($70 – $15 – ($70 x .0925)).  $48.53 divided by Revenue of $70 x 100 = 69.33% Net Profit Margin.
• Profit Per Purchase is calculated for you at $48.53.
• Discount Rate is currently 0.75% as of November 8, 2009 (it rounds to 1%) – think of the discount rate as a forward-looking inflation rate.
• Product (or Service) Inflation Per Year.  Using the inflation rate calculator again, we can see the inflation rate from September 2008 to 2009 has actually decreased -1.29% (it rounds to -1%).
• Cost of Reaching a Potential Customer.  As she plans to spend $2400 a year to reach potential customers, targeting 10,000 customers, her cost per potential customer is $0.24  ($2,400 / 10,000).
• Response Rate.  This is the percentage of respondents to her advertising efforts.  Let’s say 2% until we know for sure.
• Cost of Attracting a Customer is calculated for you at $12.
• Coupon or Other One-Off Costs.  This is the cost to obtain that particular customer, for example, a 10% off coupon for first visit.  The cost to her would be $7 ($70 x 0.10).
• Total Customer Acquisition Cost is calculated for you at $19.

Having inputted these values, I now click over to the “Basic Model-Calculations” tab and see that the Net Present Value of Acquiring a Customer (taking into consideration the stream of a customer’s income, ongoing costs, and cost of acquisition) is $221.

Now I click over to another handy Harvard Business Screen tool, the Customer Lifetime Value Calculator, which does something a bit different than the downloaded one.  First, I clicked in the top right side Reset Inputs to Zero.  I then entered my inputs:

• Average Spend Per Purchase = $70
• Average Number of Purchases Per Year = 9
• Direct Marketing Costs Per Customer Per Year = $0.24 ($2,400 / 10,000 mailing) + $7 coupon = $7.24.
• Average Gross Margin = 69%
• Average Customer Retention Rate = 80%
• Annual Discount Rate = 1% (rounded from 0.75%).

In summary of the below grid:

• The cost of acquiring a new customer is $362 = (cost of mailing / response rate) = $7.24 / 0.02.  What this doesn’t allow me to do is change the mailing costs where in the first year they receive the 10% coupon and in subsequent years they don’t, so I will assume they receive an annual coupon.
• Expected Net Present Value in the 6th year is only $132 because it looks at the value of a dollar today compared to the value of that same dollar in the future, taking inflation (based on the discount rate) and returns into account.  If the NPV is positive, it should be accepted.
• The cumulative Net Present Value (taking into consideration expected inflation, based on the discount rate) of a new customer in the 6th year is $1,171.
• The cumulative Retention Rate shows that in the 6th year, with an 80% retention rate, there is only a 33% chance of making another appointment.  The longer they are a customer the more likely they are to “expire.”

Lastly, those things that she can affect to increase Lifetime Customer Value:

• Work to improve retention rate above 80%.  Be on top of how often her customers come in.  Call customers a week in advance of their normal scheduling to ask if they are ready to make an appointment.
• Send welcome and thank you cards.
• If a customer leaves, be sure to find out why and work to improve those areas she can (if someone moves away, there’s not much that can be done).
• If a customer is not coming in due to financial reasons, make a discount offer for their next session to keep them on schedule. The longer someone is away the more likely they are to look for someone else to do their hair next time.  They will appreciate her understanding their situation and become a more loyal customer.
• Get creative in her approach in obtaining new customers.  For example, she could evaluate the least she could charge someone and still maintain profitability.  She could then offer this discounted rate to the unemployed as a “get back to work” special.  As long as they show her evidence of unemployment, such as a recent pink slip or unemployment income receipt, they can receive their discount.  When they do get back to work, she can then raise her rates to normal and have a new loyal customer.
• Offer a loyalty card, such as buy 9 get the 10th haircut free (color, highlights and other services not included).
• Ask for referrals, which eliminates much of her acquisition costs.
• Offer a discount for purchasing several sessions in advance.
• Survey her customers to better understand who they are, what’s important to them, how satisfied they are, and areas she can improve.  Follow up with calls and letters.
• Segment her customers by lifetime value group.  Conduct different marketing programs designed for each segment.
• Monitor inflation and adjust prices accordingly.
• Reduce product costs where she can, and charge more for people who require more products.
• Offer additional services that bring in higher-paying customers.
• Sell products that will increase her revenue per customer.
• Improve response rate on mailings with messaging that better resonates with potential customers.
• Test mailings’ response rate with and without the 10% coupon.  If she receives a similar response rate without the coupon, eliminate it for cost savings.
• Test different advertising vehicles to determine which provides a better response rate, then focus on those with the highest return and provide unique audiences.
• Determine if other promotions instead of a 10% coupon would yield a better response rate, such as bring a friend with your first booking and receive half off (on the cheaper service of the two).  The LCV of the friend would cover the upfront cost on the other person.
• Don’t just focus on the response rate, but also on the return received (number of new customers times lifetime value) for the advertising investment made. Suddenly she may find she can justify a much greater promotion investment when looking at returns in this way.
• Advertise in higher-income neighborhoods where she can command a better price.  If this is outside where she works, she can make an arrangement with another salon to rent a chair on an as-needed basis when she obtains customers in that area.  She can schedule appointments in that area together to minimize travel and chair-rental costs.
• Use as many free advertising vehicles as she can, such as LinkedIn, Facebook and Myspace.
• Conduct co-operative advertising with related businesses such as spas and nail shops in her area, to reduce advertising costs.

Anyone else have suggestions I can pass on to my friend to improve her LCV?  And if you’re in the Venice Beach, California area and are looking for a great stylist, please call Sondra at 310.780.0290 to make an appointment.