Lifetime Value of a Customer, Part 1

All businesses on some level require the same evaluation. There must be a developed interest in their goods or service through business development activities, fulfill on sales that result from the business development activities, and administrate the underlying and resulting activity.

For the most part, most businesses are comfortable with the idea of measuring fulfillment activities by starting with some variation of margin analysis at a minimum. General & Administrative activities are generally analyzed based on budget to actual analysis, benchmarking, and/or cost audits. But how should business development activities be analyzed?

One such method of understanding and analyzing business development activity is to consider the lifetime value of a given customer to the business relative to business development activities.

As is typically acknowledged, developing and closing new business is one of the most challenging things for any business to do. The process includes branding, messaging, advertising, promotion, reaching out to new prospects, engaging prospects to convert them to sales leads and then, closing the sales. In short, marketing activities combined with sales activities account for the cost to acquire a new customer.

Most business’ initial perspective underestimates the initial cost to acquire a new customer. Once all marketing and sales expenses are considered, the true cost to acquire a customer is a critical figure. It also helps to understand the company’s sales cycle; some acquisition costs span multiple months because of a prolonged sales cycle. The length of the sales cycle will help determine the timeframe over which the applicable data will be used.

Depending on the nature of a business’ goods or services, the lifetime of a customer can vary drastically. Some businesses engage with customers based on a singular transaction while others seek to engage with a customer through multiple channels and over a prolonged period of time. The nature of the business to consumer relationship may add complexity to the determination of the lifetime value of a client.

It is important that businesses understand and appreciate the relationship between the cost to acquire a customer and their lifetime value. Measured as a ratio of Lifetime Value of a Customer against Cost to Acquire a Customer, the target ratio is dependent on the industry. Let’s assume a target ratio of 10:1 or “10 times.” This means that for every $10 of “value” provided by a customer costs the business $1 to acquire.

“Value” is a relative term but it is my perspective that Gross Margin should be used to calculate “value.” The idea is that business development activities result in “good sales” or “high value sales.” Discounting price, for example, for the sake of netting a singular transaction from a customer delivers less value in the form of contributory margin than a comparable sale that has not been discounted. As a result, I recommend using contributory margin for calculating the Lifetime Value of a Customer.

See my future blogs to increase your understanding of this concept. If you want help today, contact your TGG Accounting professional.

It is important and recommended that business start to track this ratio and review the trend analysis, at a minimum. The trend analysis of this ratio will provide a renewed sense of effectiveness of a Company’s business development activities.

Written by:
Andrew Ruff
TGG Accounting

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