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How to Calculate and Increase Lifetime Customer Value

haircut_scissors 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.

LCV1

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.

LCV2

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.”

LCV5

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.

Segmentation of the customer base by lifetime value groups, and different marketing programs designed for each segment.

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  1. U.B., DK
    November 9th, 2009 at 06:48 | #1

    How nice for Sondra to have such helpful clients.

    It is not 100% clear to me if she has her own salon. But since you are describing how her clients are “coming in”, I assume she has some sort of fixed location which is her base of operations.

    Travelling to her clients, she will be wasting a lot of time on the bus. Perhaps she should rather considder how alternative business hours could be applied to her business. For instance, she could open for one or two nights a week. Then she could explore the possibility of charging higher prices from working customers instead of giving discounts to unemployed costumers as you suggest.

    Moving her salon to a “high street” area would most likely increase her fixed costs, but might improve visibility and might also increase the number of spontaneous clients, thus decreasing acquisition costs.

    Good luck to both of you

  2. November 9th, 2009 at 10:04 | #2

    Hi, U.B.

    Thank you for your comments. It is not her salon, she’s renting a chair. She has a car and does make herself available in the evenings. I do agree with you that she may want to consider renting another chair in an area with greater foot traffic. That is one of the problems.

    Best,
    Rebekah

  3. November 10th, 2009 at 01:27 | #3

    Thanks for such a detailed example Rebekah.

    I think it is important not to get too bogged down in details U.B.

    I see this as a great example that can be expanded and amended for your own personal situation (thanks Rebekah for the links through to the relevant calculators as well). Thinking about different ways of improving retention rates, average spend or frequency are all important, but this is an exercise in finding the results which will give you something to build on and not the solutions.

    You need to find the right metrics and measure them accurately before you can really move on and plan for the future. In this example, finding out your lifetime customer value gives you a good idea of how much you can spend on customer acquisition and retention.

  4. November 11th, 2009 at 21:28 | #4

    If you do re branding it help you to increase the potential lifetime value of a customer, you will see your loyal customers start behaving like new customers and become regular buyers once again.

  5. U.B., DK
    November 13th, 2009 at 05:57 | #5

    Hi,

    I agree with Nigel that for any LCV-analysis to be useful the metrics must be as accurate as possible. I do not see how that could be different – although there are degrees to the magnitude of the potential mistakes to be made. In banking for instance, where the ratio between the interest margin and the loss rate of any given customer segment can be very small, an LCV-analysis is more sensitive to data accuracy.
    It is true that the purpose of this type of analysis is to look ahead and not backwards, and therefore excessive attention to details might take our focus away from the opportunities.
    But to really make a difference for her, I believe we must try to look beyond the LCV of Sondra’s customers, and look at the properties (details) of her business. Chitraguptas mentions rebranding. It seems to me that Sondra’s brand is her skill, her personality, her relationship with her clients, and her location. Although it seems that she values her freedom, she should perhaps consider increasing her commitment a bit. My suggestion would be to talk to the bank about buying a stake in a salon with a good location. This would make her much more “tangible” for her clients, as she would be easier to see and easier to contact. It would even allow her to keep a staff, and then her profits would no longer depend solely on her own “scissors-time”. And she could take a vacation with less fear of her customers making relationships with other hair stylists while she is away.

  6. November 13th, 2009 at 10:03 | #6

    Hi, U.B.

    Thank you again for your follow up comments. As a matter of fact, she was considering buying the salon she is currently working in with the help of an investor-friend (a bank would not consider it, I’m sure). The issues that I raised for her is that the foot traffic of the current salon may make it not a good investment, as well as, she doesn’t have the experience running a business, so would need a great deal of training and hand-holding by a consultant (or her investor-friend) for at least the first 6-12 months. I would like to see her gain more experience with her current business and with marketing before she makes such a leap.

    Rebekah

  7. Ulrik
    November 22nd, 2009 at 09:49 | #7

    @Rebekah
    Hi Rebekah

    It sounds to me like you have given her excellent advice and I repeat that she is lucky to have you as a client. And she must be talented too, as I suppose she must be partly responsible for your LinkedIn-profile photo (I hope you will forgive me for making this subtle compliment here).
    In most of the world, a beauty salon is not so complicated to run if you have some starting capital and some good-will to build on. I do not know much about managing beauty salons in Venice. But although I suspect, with the limited knowledge I have about Greater L.A., that that line of business around those parts is a “mature market”, I am sure that with some guidance she would have no problem. But location is Paramount – as always.

    The best of luck to her

    Ulrik

  1. November 23rd, 2009 at 10:04 | #1
  2. March 14th, 2010 at 18:11 | #2
  3. June 13th, 2010 at 19:26 | #3

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