Increase Profits with Customer Lifetime Value

While endless conversion ratios and Key Performance Metrics (KPI) are available for advertising performance analysis, Customer Lifetime Value (CLV) is one of the key metrics I recommend for retaining your Ideal Clients, increasing your profit margins, and establishing advertising budgets.

Key Performance Indicators (metrics)

Marketing strategy and advertising campaigns are regularly evaluated with KPIs, including:

• Cost Per Click (CPC)
• Cost Per Unique Landing Page View (CPULPV)
• Operating Margin (per unit)
• Return on Investment (ROI)
• Customer Acquisition Cost (CAC)

While each of these can be useful in marketing and advertising, determining a product or service’s revenue and profit margin is the ultimate metric for a business. The challenge with most metrics is that they don’t tell the whole story.

What’s worse? They sometimes provide an outlook that is too optimistic.

Let’s take a look at the three common KPIs:

Operating Margin

For an advertising cost analysis, I define Operating Margin as Operating Cost subtracted from Revenue and divided by each unit of product or service.

• Operating Margin ($) = (Revenue – Operating Cost) / each unit of product or service
• Operating Margin (%) = Operating Margin ($) / Revenue)

Operating Margin Example

Note: To simplify this financial illustration, all examples assume you have one customer.

• Assumptions:
  • Revenue per unit: $50.
  • Operating Cost per unit: $40.
• Calculation:
  • Operating Margin = (Revenue – Operating Cost) / each unit of product or service.
  • Operating Margin ($) = ($50 – $40) / 1 = $10.
  • Operating Margin (%) = $10 / $50 = 0.20 or 20%.

For some businesses, a 20% Operating Margin may be well out of reach; for others, it must be higher. Also, suppose your Operating Margin has been negative for a substantial time: If that’s the case, then there’s a fundamental problem with a particular service or product–unless you’re in the launch phase. 

What’s a Reasonable Operating Margin?

One way to think about what level of Operating Margin you need is to consider your margin compared to the average stock market return of an index representing your business sector or vertical. While it may seem like a strange comparison, it will help you ask yourself: are we better off investing money in the stock market or your business? Which will provide us with a better return?

For example, suppose a particular stock market index has an average annual return of 5% (net after investment expenses and taxes), and your Operating Margin is close to or below this level. In that case, it’s time to rethink your product or service. Since Operating Margin doesn’t include additional expenses, when you include interest and taxes in your analysis, adding the total cost of doing business will lower your Net Margin. 

If this is the case for you, then the next question is: Can we increase our Operating Margin by reducing Operating Costs and growing Revenue?  

It seems simple, but substantially reducing Operating Costs while maintaining quality is always challenging. Incremental reductions in Operating Costs make sense for relatively mature products and services. But if you’re still in the launch phase, incremental reductions are usually a waste of time since other unanticipated costs frequently arise that wipe out the savings.

From a Revenue perspective, a significant increase in unit revenue will likely require rebranding or developing a new brand for a higher-revenue product or service, with a subsequent new marketing strategy and series of advertising campaigns. This strategy can be successful if your marketing research indicates that your current or target customers are interested in a premium brand and are price-insensitive.

Suppose increasing Revenue and decreasing Operating Costs don’t provide a reasonable Operating Margin. The next step is to re-evaluate the product or service with an eye toward either a significant change or sunsetting it.

Return On Investment (ROI)

ROI is your Operating Margin divided by Operating Cost on a per-unit basis.

ROI Example

Note: To simplify this financial illustration, all examples assume you have one customer.

• Assumptions (from Operating Margin example):
  • Operating Cost per unit: $40.
  • Operating Margin per unit: $10.
• Calculation:
  • ROI = Operating Margin / Operating Cost.
  • ROI (%) = $10 / $40 = 0.25 or 25%

The benefit of using ROI is that it allows you to compare your product, service, or business more easily to competitors.

Customer Acquisition Cost (CAC)

Drilling down into marketing and advertising costs: how much can you afford or need to budget for acquiring a new customer? It should be easy to calculate if you assume that once a person buys your product or service, they’re a customer for life. But this isn’t true.

• CAC ($) = Advertising Expenses / Customer Retention Rate.

CAC Example

Note: To simplify this financial illustration, all examples assume you have one customer.

• Assumptions:
  • Operating Cost per unit: $40. (from Operating Margin example)
• Advertising Expenses (per customer, per year): $5.
  • Note: This is part of the Operating Costs from the ROI and Operating Margin examples.
  • Customer Retention Rate: 50%.
• Calculation:
  • CAC ($) = Advertising Expenses / Customer Retention Rate.
  • CAC ($) = $5 / 50% = $10.

Note: in this example, your Operating Margin per unit decreases to $5 (10%) from $10 (20%), and your ROI drops from 25% to 11%.

This method provides a quick and simple snapshot of the cost of acquiring a customer, but it does not provide the whole picture.

Customer Lifetime Value (CLV)

The previous three KPIs provide valuable business insights but don’t tell the complete story. I’ve found that understanding CLV is key to evaluating the effectiveness of your marketing strategy and advertising campaign performance and assisting in developing your advertising campaign budget.

CLV measures how much money a customer is worth to a business over a period of time. It’s one of the most critical measurements for businesses to determine their long-term profit and growth. Over the long term, a company with a high CLV is usually better able to sustain profits and continue to grow than one with a low value.

Fundamentally, CLV looks at the time value of both revenue generated by your customer and the time value of your funds using the calculation for present value in the overall analysis. Various methods are available to calculate CLV, including an introductory online calculator from Harvard Business Review.

CLV Example A: Baseline. Annual Revenue per year, per customer: $50

Note: To simplify this financial illustration, all examples assume you have one customer.

• Assumptions:
  • Annual Revenue per year, per customer: $50.
  • Note: This is from the Operating Margin example.
  • Operating Margin: 20%. 
  • Note: This is from the Operating Margin example.
  • Advertising Expenses, per customer, per year: $5. 
  • Note: This is from the Operating Margin example.
  • Customer Retention Rate: 50%. 
  • Note: This is from the CAC example.
  • Customer Acquisition Rate: 1%. 
  • Note: This rate can substantially vary based on your industry, product, service, and advertising campaign.
  • Purchases per year by a customer: 6.
  • Customer Retention: 5 years.
  • Discount Rate (e.g., Average Annual Inflation rate, internal rate of return, or loan rate for your company/sector/vertical): 25%.
  • Calculation: CLV ($) = ($464)

In the chart for Example A, I individually varied seven of the eight variables used to calculate CLV. Each increment displays improvement in relation to this example’s starting point (e.g., Assumptions).

(Continues after the image)

CLV Example B: Annual Revenue per year, per customer: $100

Note: To simplify this financial illustration, all examples assume you have one customer.

• Assumptions:
  • Annual Revenue per year, per customer: $100.
  • All other assumptions are the same as in CLV Example B.
• Calculation: CLV ($) = ($424)

While the CLV remains a loss with a relatively minor change between Examples A and B, when I double the Annual Revenue per year per customer to $100 and leave everything else the same, I get a better sense of which variables are essential and which are less critical.

(Continues after the image)

Note:  For Examples A and B, I assumed a starting Discount Rate of 25%, dropping to 0% over the 6 Increments. This assumption illustrates that changes to the Discount Rate are relatively unimportant.

The most important takeaway from these two graphs is that calculations for Operating Margin, ROI, and CAC predicted a profitable product or service. On the other hand, CLV demonstrates that these scenarios aren’t profitable.

How to Increase Profit with Customer Lifetime Value

What can be changed to improve the results significantly?

Here are the most critical factors (ranked by most important):

1. Increase Customer Acquisition Rate.
2. Decrease Advertising Expenses.
3. Increase Customer Retention Rate.

Here are the least important factors (ranked by least significant):

1. Decrease Average Annual Inflation.
2. Increase Purchase per Year.
3. Increase Average Annual Revenue.
4. Increase Operating Margin.

By starting with a Discount Rate of 5% and not changing it, what reasonable improvements can we envision to transform a product or service that may initially appear to be successful into one that is genuinely successful, leveraging the power of CLV?

(Continues after the image)

By initially focusing on the three most critical factors, I transition the Baseline to a profit in Scenario 3. After Scenario 3, I began to upgrade the product or service-related items, including Revenue and Operating Margin.

However, the key to increasing profit is improving the efficiency of acquiring a new customer by increasing your acquisition rate while reducing advertising expenses per unit.

Reducing Advertising Costs

I’m regularly asked to estimate advertising costs, but what my clients really want is to calculate the budget and profitability of a particular advertising campaign. While I do calculate Operating Margin, ROI, and CAC, my focus is on calculating a range of CLVs, which helps my clients know what to expect from an advertising campaign.

If my clients agree, we move forward. If not, we discuss the Operating Margin of their products or services and review advertising campaign alternatives. The vast majority of the time, there’s a solution that works. But in some cases, the numbers don’t work, and it becomes evident to both parties that a campaign will not be successful.

Secrets to Success

1. Conversion ratios should be used to analyze the effectiveness of your sales pipeline from the time a potential customer views your advertisement until they purchase your product or service.
2. Operating Margin, ROI, and CAC have their place in business, marketing strategy, and advertising campaign analysis.  However, your starting point for determining advertising budgets while increasing the profit of a particular product or service should be focused on Customer Lifetime Value (CLV).

Questions?  Contact me Today