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Every organization, no matter the size, would love to know the cost to acquire a new customer and the value of that customer over a period of time. One way of calculating the profitability of one customer within a given segment is through Customer Lifetime Value (CLV). With this calculation, an organization can identify which segments generate the most revenue, allocate organizational resources more efficiently and tailor a comprehensive data-driven marketing strategy.
Prior to the calculation of CLV, an organization must have a quality tracking system in place in order to know the cost of solicitation, response rate, number of purchases per a period and average spend for the typical customer belonging to a given segment. In addition, the profit margin, cost of ongoing marketing, retention rate and discount over time must be known. Once all of this information is accessible, an accurate analysis of the customer lifetime value may be measured. All of the previously mentioned pieces will be critical to a set of formulas necessary to the calculations for the present value of the contribution. Below is a simplified version of the formula plus a step-by-step list of steps for calculating the CLV.
1. The first step towards calculating the CLV of a given segment is to figure out the one-time acquisition cost. This is calculated by dividing the cost of solicitation by the response rate (Note: All these figures should be placed into a spreadsheet for careful calculation).
2. Then, you must calculate the yearly revenue from the customer. This is done by multiplying the average purchase spend by the number of purchases per a year.
3. Next, the customer gross profit is calculated by multiplying the yearly revenue by the profit margin.
4. Following this step, the contribution (if retained) is calculated by subtracting the gross profit from the ongoing marketing costs (not included in the chart but could be added).
5. Then, the expected contribution for the average customer is determined by multiplying the contribution if retained by the likelihood of being retained.
6. Lastly, the present value of the contribution is calculated with this formula: expected contribution * [ 1 / (1 + discount rate)t ]. Once you have the present value of the contribution over a given time period (i.e 3-5 years), you subtract the total of the present value of the contribution (over the given time period) from the initial acquisition cost.
Although a given segment generates revenue it may not be as profitable as a different segment and in some cases targeting a specific segment may result in a financial loss rather than a gain. Therefore, CLV evaluates several data points and assists in figuring out if targeting a specific segment is an efficient use of resources.
Now, let's put this into context with a "real-world" example!
Crazy Aaron's is well-known toy company with one product: Thinking Putty. Founded in 1998, Crazy Aaron's Thinking Putty comes in over 60 colors and includes putty that glows in the dark, changes colors with the heat of your hands, and even functions as a magnet!
In the last 21 years, Crazy Aaron's has grown exponentially from a small mom and pop operation to a multimillion dollar corporation with more than 100 employees. Initially their silly putty was designed as stress-relieving toy for working adults, however the product line has expanded substantially. Similar to other niche trends, children around the world are now collecting every new color and limited edition versions are released every year. At the same time educators are purchasing the product in bulk to teach their students about science, color theory, and physical therapy. Elderly consumers are also purchasing the putty to perform hand exercises that help with ailments like carpal tunnel and arthritis. It's a product for everyone!
Available in over 60 colors and effects including, but not limited to:
- Glow in the Dark
- Heat Sensitive Color-Changing
Aids in hand exercises that help with motor skills:
- Autism Therapy
- Occupational Therapy & Physical Therapy for Arthritis, Carpal Tunnel Syndrome and other conditions
Better quality product than competitors:
- Long lasting; does not dry out or crumble
- Non-Sticky and Odorless
- CPSIA Compliant
There are obviously a lot of reasons why someone might be interested in Crazy Aaron's silly putty, however which of these segments is going to yield the highest return on investment?
This is a fictitious and fun exercise that will assist an organization in determining the most profitable consumers.
First we need to think about what we know about each segment. For this exercise, I've picked educators and parents with children and added in some guess-timations on how many tins each segment might hypothetically purchase. In addition, the market assumptions listed below will be critical to the calculations. I made up figures for this example however your organization should use real data.
Segment 1: Parents
Children want Thinking Putty in all colors and effects, and usually build their collection through their parents. Parents buy on average 5 small tins 6 times a year, for a total of $90. Parents are likely to continue buying Thinking Putty for their children for a few years as new colors are released, but may not return as their children get older.
*Each small tin costs $3.
Market Assumptions for Segment #1:
Cost of Solicitation - $10
Response Rate - 15%
Number of Purchases Per a Year - 3
Average Spend/Customer Purchase - $30
Margin - 50%
Ongoing Marketing Costs - $15
Retention Rate - 70%
Discount Rate - 10%
Segment 2: Educators
Educators buy Thinking Putty in bulk for instructional purposes. On a yearly basis, an educator generally makes 1 purchase of 50 small tins. This purchase accounts for all of the educator’s students, plus backups, and totals $150 on average . An educator will likely return year after year to purchase new tins of putty for their new students.
*Each small tin costs $3.
Market Assumptions for Segment #2:
Cost of Solicitation - $15
Response Rate - 20%
Number of Purchases Per a Year - 1
Average Spend/Customer Purchase - $150
Margin - 50%
Ongoing Marketing Costs - $10
Retention Rate - 80%
Discount Rate - 10%
Once you've done the calculations, you will add the the present value of the contribution over a given period (3 years in this example) together and subtract the initial acquisition cost. This will give you the CLV for each segment.
Insights: Although the acquisition cost for Segment 2 (Educators) is higher than that of Segment 1 (Parents), Segment 2 maintains a positive CLV, whereas Segment 1 is actually returning a negative value.
Recommendation: Based on this example, it would be best to increase the marketing efforts to Segment 2. This segment not only drives profits, but is likely to do so for a much greater length of time and each additional acquisition would provide solid long-term benefits. On a more personal note, as a former educator, I know from experience that lesson plans are used year after year. Not only do educators have a higher CLV, they are also more likely replenish their putty stock on yearly basis. In contrast, children age-out of toys and there's always the next new innovation on the market.
As a final suggestion, when I did this exercise in my marketing course we recommended a re-evaluation of the parent market. Since this segment rendered a negative CLV, adjustments need to be made in order to yield positive results. The company could either re-calibrate their pricing and marketing costs, or re-position the product to be for “Working Adults.”.