How to Calculate the True Value of your Customers
According to the Pareto Principle, 80% of your revenue can be attributed to 20% of your customers. Paying close attention to these ‘all-star’ customers can help you make decisions about where you should be spending your ad dollars. Because wouldn’t you rather be spending money on a single customer who spends $1000 than 10 people who spend $10?
If only you knew where you should be focusing your efforts and which channels were bringing you in the highest return. If you could determine your most valuable customers you could invest your ad dollars wisely and have money flowing in with minimal effort.
In this article I’m going to focus on determining the value of a customer and how you can choose which channels are resulting in the best customers.
Specifically i’ll be going over:
- The cost of acquiring new customers
- Cost versus Value
- What is customer lifetime value (CLV)
- How to calculate customer lifetime value (CLV) - Historic Lifetime Value
The cost of acquiring new customers
There are many channels you can use to acquire new customers to your business. Three of the most common ways are through search engine results, social media and paid advertisements. For the purposes of this article I’m going to be focusing on paid ads as they’re the quickest in terms of calculating costs.
Paid advertisements are shown across search, display and social networks and are one of the best ways to acquire new customers when starting out. The problem lies in the types of customers you get from these advertisements.
Let’s make it super simple. Let’s say that you have a $1000 marketing budget to spend on paid ads to attract new customers. You invest $200 in Facebook, $300 in Bing and $500 in Google.
As you can see in the chart below, Facebook costs the least to advertise on and resulted in the lowest cost per customer. Using Facebook ads we spent $200, which sent 340 people (at $.70/click) to a landing page that converts traffic at 10%. The resulting cost per customer was $5.88.
Now, at first glance it looks like you should be taking your money out of Bing and Google and putting it into Facebook because Facebook is giving you the lowest Cost-Per-Click.
Not so fast. It’s entirely likely that would be a bad decision for your business.
There are other factors you need to consider when determining whether switching platforms is a good investment or not. The types of customers you get from different channels can affect whether they spend more or less; whether they stay with you for one purchase or are a lifelong buyer, and more. It’s often an altogether different story once you calculate the actual value of the customers you’re getting.
Cost Versus Value
In the previous section we saw that Facebook Ads were the cheapest way to acquire a new customer. Each new customer acquired through Facebook only cost $5.88 per customer as opposed to $20.70 in Google Ads but I mentioned that you can’t just look at the cost.
You do need to take into account how much it costs to acquire a customer but it has to be balanced with the true value of that customer.
If you simply look at the cost of acquiring a customer through ads without factoring in their value you could be missing out on a prime opportunity, and wasting some serious dollars doing it.
Take a look at the following chart. As you can see, in this case, spending extra money on Google Ads as opposed to Facebook Ads resulted in a higher ROI.
Although ad spend for Facebook was the most affordable and initially looked to be most promising, the quality/purchase value of traffic from Google resulted in a higher ROI than the other platforms. This will not always be the case, and it’s essential to calculate this yourself and see which ad channels are bringing in your most valuable customers.
What is customer lifetime value (CLV)?
Now that I’ve shown you how important it is to look at the cost of acquiring customers in terms of raw value, I’m going to introduce you to the term customer lifetime value (CLV). CLV is any revenue that is accumulated from an individual over the length of time they’re a customer of your business.
In simplest terms, you’re taking the revenue generated from a customer, subtracting the money spent on marketing, sales, and etc., and adjusting it for the duration they’re a customer with you.
Lifetime value allows you to look beyond the cost of acquisition and initial purchase amount to show a more holistic assessment of true value.
Calculating the lifetime value of a customer can be tricky but is important as it will help you determine how much you should spend on customer acquisition and retention. Although the CLV you calculate will never be 100% accurate (as you never know for sure how long someone will be a customer), it will give you a rough estimate of how much you can spend.
How to calculate customer lifetime value (CLV) - Historic Lifetime Value
There are two ways you can calculate customer lifetime value, historically and predictively. In this section I will show you how to calculate historical value and in the next section I’ll go over predictive lifetime value.
Historical CLV - Average Revenue Per User
When you’re calculating historical CLV you need to look at the average revenue per user (ARPU) and divide it by the number of months they’ve been a customer with you. Once you’ve determined this value, multiply it by 12 or 24, to see how this translates over a 1 or 2 year calendar period. This will help you estimate how much a customer is worth and how much you should be spending to acquire them.
Equation looks like this….
Total revenue (per customer) ÷ number of months since the customer joined X 12 = 1 year historical CLV
Customer 1 spends: $40 + $75 + $25 + $60 and has been a customer for 9 months
$200 ÷ 9 months x 12 months = $266 per year
Customer 2 spends: $10 + $290 and has been a customer for 16 months
$300 ÷ 16 months x 12 months = $225 per year
You can now estimate (quite roughly) that over the course of their time as a customer with you (so long as marketing efforts remain the same) customer 1 is likely going to spend approximately $266/year where as customer 2 will spend approximately $252/year.
As you can see, the results can at times be skewed when larger purchases are made. This is more likely to happen with new customers as the longer a person is a customer, the less they’ll spend over time. One way to avoid this problem is by looking at cohorts of customers…
Historical Lifetime Value - Cohorts
A cohort is a group of people that have the same characteristics. In this case, it would be a time-based segment: the people who first bought from you at the same time. You can examine the amount of money this cohort spent over the course of the year and average it out. Doing this gives you a larger pool of data points, allowing you to estimate how much they’ll be spending in the future far more accurately.
The major challenge that happens when looking at historical lifetime value is if you’ve made any major changes to your business model. Such as, if you’re a newer company, the majority of your customers may be the result of a large promotion or a change in your company dynamics. Keep these things in mind and monitor your customers closely to ensure your CLV isn’t changing too much.
Once you’ve determined the CLV of your customers it’s easy to make predictions about how they will spend in the future. If you determine some customers are more valuable than others then you may want to spend more money in acquiring similar customers as well as more money in retaining those existing customers.
In the next six months Wishpond (and other awesome software providers in this market) will allow you to set values on your existing customers and see those values when you interact with them through email, customer support, and more. Pretty cool!
It’s easy to know how to spend your marketing budget if you know where your most profitable customers are coming from. You can’t just be looking at how much it costs to acquire a customer, you need to look at how valuable that customer is in the long run. There is no one perfect way to measure this but I hope this article has given you some insight into how you can calculate the customers that are worth the most.
Have you tried incorporating some of these metrics into how you allocate your marketing budget? Have you noticed an increase in the amount of profits your business has been receiving? Please, comment below!
- Written by Samantha Mykyte
When Samantha isn’t crushing content at Wishpond she performs with her burlesque troupe, casts spells in dungeons and dragons and enjoys baking and eating cookies.