What is Lifetime Value of a Customer?

Have you ever used a term when speaking to a certain audience with the assumption that they knew what that term meant, only later to find out most of them had no clue what you were talking about?

That happened to me recently when I realized that many local small business owners don’t know the meaning of the term “lifetime value of a customer”, or at least don’t understand it as much as they need to.  It’s actually one of the most important concepts to understand when it comes to marketing, so in case you are one of those business owners who are a little unsure what exactly that means, I took the time to explain it in a recent podcast episode.

Use the player below to listen to the episode, or scroll down to read the article.

When I say “lifetime value of a customer”, what I mean is the amount of money that a customer spends in your business from the time they become a customer to the time they stop becoming a customer permanently. While the implications of this number are the same for all businesses (we’ll get to that in a second), the calculation of this number might look dramatically different for different types of businesses.

For example, if you’re a real estate agent and you sold someone a $150,000 house, the commission you got for selling that one house would most likely be the lifetime value of that customer (unless the person used you as his agent years later when he bought a second home).    Commissions for real estate agents average around 3%, so let’s say the lifetime customer value in this case is $4,500.

On the other hand, if you own a bar, someone may come into your bar once a week for happy hour and have a beer and some food.  A person might do this for months or even years, until she experiences some type of life event that changes her routine.  In that example, the lifetime value of a customer is the sum of all the money the customer spends in your bar for all the years that she eats there.  So, if she spends on average $20 a week at your bar, and eats there for five years, the lifetime value of that customer would be $5,200.  In other words, her lifetime value as a customer would actually be higher than that of the real estate agent’s client in our first example.

Why Lifetime Value of a Customer is Important

Why is this important?  Well, all too often, business owners only think about the value of their customers in terms of the first transaction.  This is especially true for businesses with a fairly low average transaction value (like a $10 hamburger, for example) that are in industries where subscription-based services are not the norm (like restaurants).

This mindset leaves business owners to assume—either consciously or subconsciously—that the customer is only worth as much as the first transaction.  This, in turn, makes them very hesitant to spend money on marketing, since—in their minds—they would be spending more money on marketing than the customers they get from it would be worth to them.

The end result of this entire thought process is that a business is so afraid to spend money on marketing—even when it comes to things like a professionally designed logo, website, and other marketing materials—that they end up with a public presence that makes them look unprofessional or incompetent.  This actually drives away customers, which makes it more likely that the business will fail or at least struggle mightily.

Now, on the other hand, if a business owner was thinking of their customers in terms of lifetime value, it changes the entire equation.

Right off the bat, he would realize that he can actually afford to spend more money to acquire new customers, which opens up a lot more marketing tactics to him.  It also makes him start thinking about how to increase the lifetime value of a customer, so that he can spend even more on marketing—or even outsource his marketing to someone like myself, thus freeing up his time to focus on other areas of his business.  In other words, a business owner who knows the average lifetime value of his customers and is constantly looking for ways to increase it will be much more likely to succeed.

How to Increase Lifetime Value

So, now that we know increasing the average lifetime value of your customers is important, let’s talk about how to do that. There are basically two ways to increase the lifetime value of a customer—increasing the number of transactions per customer and increasing the average value of a transaction.

By far the easiest way to increase the number of transactions per customer is to make repeat transactions automatic—in other words, to create subscription-based service offerings.  In some industries this is the norm, but unfortunately for most it is not.  This means that you might have to get creative when creating your subscription-based service.  If you can’t think of any ideas, just read The Automatic Customer by John Warrillow, which is about how to create subscription businesses in any industry.  Trust me, if Amazon can turn “free” 2-day shipping into a subscription service worth billions of dollars to their bottom line, you can create a subscription model for your business as well.

As far as increasing the average value of a transaction, that comes down to thinking of what cross-sells and up-sells you can offer your customers to compliment your core offering.  Think about the last time you went into a fast-food restaurant.  Chances are, the pimpled teenager behind the counter asked you something like “would you like fries with that burger” and/or “would you like to supersize that meal”.  Well, guess what?  If you aren’t asking your customers those questions, then that teenage fast-food employee is doing a better job at increasing lifetime customer value than you are!

Now, of course I don’t mean that you should literally be asking your customers if they want fries when they buy something from you (unless, of course, you own that bar we were talking about).  You need to decide what your cross-sells and up-sells will be, and then build a step in your sales process that ensures every single customer will have the opportunity to take advantage of those things—just like at a fast-food restaurant.

If you follow the two steps outlined above, your lifetime customer value—and your business’s profitability—will skyrocket in no time.