Imagine a hypothetical scenario where you’re forced to make a choice between innovating for Customer A or Customer B. Which one would you choose?
Well, it depends on how much they buy from you. If Customer A spends more money on your products than Customer B, you’d select that one. But wait a minute. What if Customer A costs you more in terms of selling and customer service. She may spend more, but you actually earn less on her than on the other customer. So then, you would switch because the net profit is higher.
But hold on. There’s one more factor you have to consider. You make less profit on Customer A, but what if you expect to retain her for a longer period of time than you retain Customer B? You make more profit on one sale from him, but if you can continue selling to this lady for the next ten years, then you’ll do much better.
The way you make this type of decision in reality is with a tool called Customer Lifetime Value, or CLV for short. CLV is a formula that helps an innovation manager arrive at the dollar value associated with the long-term relationship with any given customer. It tells you just how much a customer relationship is worth over a period of time.
There are various formulas to calculate CLV, and some are more complex than others. The simplest way to estimate lifetime value for a typical customer is the following equation:
(unit selling price – variable costs) X (number of repeat purchases per year) X (average retention time in years)
Let’s do an example. Imagine you’re selling men’s wallets. Your wallet sells for $89 and it costs you $29 to make a sell it. The typical customer buys a new wallet every three years, and you expect to retain him for an average of 20 years. The CLV formula gives us:
($89-$29) X (.333) X (20 years) = $400
So what? Well, calculating the CLV helps in several ways. First, it tells us that we wouldn’t want to spend more than $400 acquiring and retaining any one customer. Spending more than that and we start losing money. It also helps you decide which customers are more valuable to acquire and retain, like our example earlier.
CLV encourages innovators to focus on the long-term value of customers instead of investing resources in customers of lower value. And it makes you sensitive to how much you’re spending on acquiring and retaining customers and whether it’s effective.