Lifetime Customer Value (LCV) is the present value of all gains derived from a customer relationship. LCV is a key metric that big businesses understand (for the most part) and attempt to use in their decision-making process. However, too many small and medium-sized business owners and managers fail to either understand this concept or implement it in their decision making.
Here we'll briefly take you through what Lifetime Customer Value (LCV) means and then walk you through a basic step-by-step guide on how the metric is derived so that you can fully understand how deeply profound and eye-opening the concept can be.
As stated above, Lifetime Customer Value is the present value fo all gains derived from a customer relationship. This sounds simple, but it's not quite as simple as you might think. To really understand what LCV mean's let's break the definition down into its sub-components:
1. Gains: Gains are almost always monetary in final terms, but we say gains instead of money because a lot of the time the final monetary gain comes after multiple non-monetary steps. A simple example would be customer referrals - the referral is a non-monetary gain but a real gain nonetheless because it will end up bringing revenue into your business.
However, often times gains aren't as easy as intermediary steps leading to revenue. Sometimes gains occur due to cost reductions or complex non-monetary benefits. For example, if you're attempting to get your local city government to allow you to put a certain piece of signage up, having more customers come to your business might put some sort of political pressure to get this done. Another example might be the economies of scale that can be achieved by having more customers. All of these complex non-monetary gains must at some point translate into real monetary gains or else they shouldn't be included. Even things such as goodwill, reputation, lax regulatory frameworks, etc. allow for monetary gains down the road.
Now, these complex non-monetary gains are hard to understand and even more difficult to value in terms of dollars. For the vast majority of businesses, it is better to not include them. They will almost surely represent a small portion of your LCV and attempting to introduce them into the LCV calculation will only waste precious resources and potentially cause more harm (in terms of errors) than benefits (in terms of increased accuracy).
So, why would we even mention them if we're not advising including them in the LCV calculus? We mention them because the importance of LCV is beyond the actual number - the profundity of understanding LCV is that you will have a better conception of the nature of your business and your outlook will expand into the longer term. By understand the more nuanced benefits that might accrue to your business (whatever they may be) your overall view of your business - even your underlying emotional and philosophical approach to it - will benefit. Understanding LCV after not knowing it at all is like lifting your head up - while before you were looking at the ground immediate in front of your feet, now you see the entire boulevard ahead of you.
Finally, the gains must be monetary in their final form because we will need to discount them in order to have an accurate LCV. It's almost impossible to discount non-monetary benefits.
2. Customer Relationship: The gains have to come from a customer relationship - meaning someone who has given your business money in exchange for the products or services your business provides.
Of course gains can and likely will come from non-customers - people might refer your business without being a customer because your business isn't selling what they need (eg. a man telling his girlfriends about a new hair salon he's heard or a woman telling her pregnant friend about a store that sells clothes for expecting mothers). However, it is too difficult to capture enough data to be able to effectively understand how much value such people bring. Additionally, the majority of customer value is derived from the actual transactions that take place - that's the heart of LCV and that should form the base of your LCV conclusion.
By using the terms Customer Relationship we are also implying that it's not the immediate interact that is of sole importance - the overall long-term relationship with a customer is key. The main thing to think about here is repeat customers - most businesses have customers coming back two, three, or multiple times. All of these interactions subsequent to the first transaction are clearly part of the value your customer brings your business and should be included in LCV. Of course, subsequent interactions should be discounted (this is addressed below) because money tomorrow is not worth the same as money today (a fundamental principle of economics and finance).
3. Present Value: We've hinted at this above, but it's key to discount your gains in order to properly understand your LCV. For example, if you use your data to see that repeat customers come in every 5 months for repurchases, the payment 30 months from now (the sixth purchase) shouldn't count as much as a payment today dollar for dollar. As in finance and economics, future payments (future gains) must be discounted by the appropriate discount rate in order to come up with the present value of the gain.
Of course, different payments at different times need to be discounted differently - a payment in 6 mo needs to be discounted separately and at a different rate than a payment 6 years from now.
Now, discounting and calculating Net Present Value (NPV) is beyond the scope of this article, but it should be noted that you must discount at the appropriate discount rate - a rate that reflects the inherent riskiness/uncertainty of the future cash flows and the current risk-free rate for that time interval. For example, if a payment is to occur one year from now, you should probably use a discount rate higher than current savings accounts are paying (because that's a rate of a very low-risk cash flow) but something lower than an extremely risky loan (because you're more sure based on your data that the cash flow will come in). This is more complicated than this discussion, however, and any business owner or manager would serve himself/herself as well as the enterprise they are running or managing by taking some time to understand the basics of discounting.
So, we have our recipe for LCV per the above:
- we take all of the monetary gains that will arise from a customer (except those that are complex and difficult to monetize)
- we discount those gains at the apportion discount rate(s)
Going a bit deeper, the most important gain (besides actual money from transactions) is refferals - this accounts for the vast majority of non-transaction gains that most businesses will receive from customers. So, we can simply our formula (while still understanding the broader context from which we are simplifying) to just include referrals - we can literally ignore almost everything else and still come up with a fairly accurate (albeit conservative) LCV. This LCV will be conservative because we're excluding certain gains - it's better to err on the side of conservatism here rather than optimism.
So, we have:
Gains= 1st Transaction + Subsequent Transactions + Refferal Value
But, what exactly does referral value mean? It's not immediately easy to calculate referral value because:
- not every customer will refer people
- not every referral will become a customer
- each customer will usually have a different transaction amount
So, you'll need a bit of customer data to get your Referral Value. You'll need to track how many of your customers are referrals - something many businesses do already. If you don't do this, start it - it's a fundamental part of understanding your business. But just knowing which customers are referrals isn't enough - you need to know how much referrals spend.
You can assume that referrals spend the same amount as the rest of your customers and simply imply onto them the Average Transaction Value (ATV) of your business overall. This is not ideal and can be improved upon with just a little bit of effort. You'll want also get the transaction value of referrals - this is simply done by just recording one other piece of data.
So, now you'll have the number of referrals and the average transaction of refferals. You'll want to use recent data but you'll want to make sure it's a large enough data set - maybe 6 months worth of data at aa minimum. Using that data, you can see how many referrals come in a period of time (let's use a year as an example) and then understand how your referrals relate to your overall customer volume.
Using our 1-year example, say this is what your data shows:
- 1000 customer for an entire year
- 200 referrals
That means 800 (1000 - 200) customers were on-referral. So, 800 on-referrals correlate to 200 referrals for your business. That means:
- every 4 customers is correlated to 1 federal, OR
- every customer is correlated to 1/4 of a referral
Now, you can simply at 0.25*(Average Referral Transaction) to each customer - you now know that a person coming in brings in his money for his purchase PLUS 1/4 of another referral that brings in the amount you calculated for the average referral transaction.
Putting it all together we have,
Gain = Initial Transaction + Subsequent Transactions + Referral Value
To get your LCV, we simply discount this appropriately - a more complicated discussion left for another time.
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