How Much Are Your Customers Worth?

January 20, 2022

Successfully managing customer relationships is an art form business owners struggle with on a daily basis. Given each company operates with limited time and resources, how do you determine which customers to focus on to maximize your return on effort?

Successfully managing customer relationships is an art form business owners struggle with on a daily basis. Given each company operates with limited time and resources, how do you determine which customers to focus on to maximize your return on effort? CLV, or Customer Lifetime Value, and the concept of quantifying your customer relationships, is a finely kept secret I’ve recently stumbled upon while in business school. It’s a power tool that enables you to attribute a dollar amount to each customer so that you can then prioritize how you manage your customer base. What’s exciting about CLV is that no matter where your customer falls on the priority list, it helps you create a plan to manage that relationship in a way that’s best for your company.

Wikipedia defines CLV as “a prediction of the net profit attributed to the entire future relationship with a customer”. The actual calculation, however, is a bit harder to define as it can vary from simplistic to much more complex, depending on the industry in which your company operates. In this post, I’ll use a basic version of the CLV model which is used as a foundation for the more complex versions.

Where:

  • CMi = Customer Contribution Margin
  • Rr = Retention rate for customers
  • (δ) = Discount rate (Cost of capital)
  • ACi = Customer acquisition cost

There are three main components of CLV that I wanted to highlight further from an application standpoint; the contribution margin (CM), the retention rate (R), and the acquisition cost (AC). For more details on the math behind each variable, the article by Greg LaRose from Simafore does great job of going more in depth on the mechanics of the formula.

  • Contribution margin is a measure of the profitability of that customer or customer group. It essentially tells you how much profit this customer contributes to your company. Depending on your company’s goals, you may prioritize customers with higher contributions margins over those with lower. However, don’t count out the lower contributors as they may not directly contribute to profitability, but they may be contributing in other ways. For example, they may not fit into your target market so they don’t buy your product frequently, but they refer you to those in their network who do.
  • Retention rate is a way of measuring how often your customers purchase your goods and/or services and is the metric that has the greatest impact to the overall change in CLV. Why is that important? Business owners often focus on expanding their customer base by acquiring new customers when CLV shows that improving how you retain the customers you have currently will contribute more to your company’s overall profitability. Essentially, “the grass is greener where you water it.” (Neil Barringham)
  • Acquisition cost is how much it costs you to make that customer, a customer. This is where you’d factor in costs associated with advertising campaigns, product demos, direct-to-customer contact, etc. It’s often hard to associate these broad costs to one customer, so averages are usually used to calculate this metric.

Now that you’ve been able to quantify your customers’ value, you can then determine how you manage them. If you compare the value you generate to your customers to the value you derive from your customers, you can map out where they fall in the Two Sides of Customer Value chart below.

The strategy you use for each customer value group will be different as they require different attention to ultimately move them to a “star customer”. To learn more about each customer group and how they impact your company, check out the textbook chapter entitled Customer-Based Strategy.

How does your company manage customer relationships? If you haven’t leveraged CLV before, what are your thoughts on now being able to quantify your customers’ value to your company?