Let’s say your product has $50 worth of Gross Profit in it. When a customer makes a purchase, most business people tend to say “I’ve just make $50.”
Fair enough, but consider this:
What if the typical customer needs to buy that good or service every 5 weeks? And what if they’ll need to keep re-buying that product for the next 4 years?
If that was the case, then the sale might have been worth $50 … but the ‘lifetime value’ of the customer is $50 x 10 x 4 = $2,000.
In other words, instead of ‘closing’ a sale worth $50 in Gross Profit, we’re actually looking at ‘opening’ a relationship with a client who will spend a further $1,950 on products which we can provide. The only question is whether they’ll spend the balance of that ‘lifetime value’ with us, or with our competitors.
And that will largely be decided by how well we deal with the ‘delight’ and ‘repeat custom’ issues which we looked at earlier.
Now factor in the ‘lifetime value’ of new customers who’ve been referred to you by the existing delighted customer … and it starts to get really interesting.
So …, make sure you and your team look at every customer contact in the context of ‘lifetime value’. If you lose a customer (or fail to impress them enough to ensure they’ll come back), you don’t just miss the sale in question – but also the others which were yet to occur. Worse still, your competitor will pick that business up instead – so you’ve lost twice, because you’re strengthening the opposition at the same time as you reduced your own profitability.
And if you’re not busy, then invest your time in opening and building relationships with potential clients. Concentrate on building a relationship with them now, before you do business, rather than waiting until afterwards. When they’re ready to do business your name will spring to mind.
Don’t take the typical approach of contacting the customer only when you’re ready to sell, because the chances are that they won’t be ready to buy at that same point in time.
If relationship-building with potential customers doesn’t suit your business, then at least begin planning your promotional activities, again with the ‘lifetime value’ in mind. In particular, do some serious thinking about how much you’re prepared to spend on acquiring your new customers.
The rough formula for determining the number of sales required to break-even on your promotional expenditure is: Number of Orders (0) = Promotional Expense (P) ÷ Anticipated Gross Profit Margin (M).
So, if our promotion (P) was going to cost $1,000 and the Anticipated Profit Margin (M) was $50GP, then:
O = $1,000 ÷ $50
Therefore O = 20.
Importantly, if we squint our eyes and use two mirrors and a little sticky tape, this formula can be inverted to determine how much we can afford to spend on acquiring clients. The adjusted formula looks like this: Promotional Expense = Number of Orders x Anticipated Profit.
So, if our target Number of Orders is 20 and the Anticipated Profit Margin is still $50GP, then:
P = 20 x $50
Therefore P = $1,000.
In other words, if we spent the full $1,000 on promotions and promotional offers and picked up our 20 x $50GP transactions, we’d break-even. A higher number of sales, or higher value transactions, would make it a profitable campaign. Lower numbers would result in the campaign not being independently profitable.
But note that these calculations are based only on the value of a single transaction, rather than the ‘lifetime value’ of the customer. If we factor the anticipated profit from the customer’s full buying life into the equation, we arrive at a very different allowable Promotional Expense.
Specifically, if we keep our target number at 20 (recognising that we are now talking about a target ‘Number of New Clients’ rather than just a target number of single orders) and if the Anticipated Profit Margin is $2,000GP as determined earlier ($50GP x 10 transactions x 4 years), then:
P = 20 x $2,000
Therefore P = $40,000.
That’s obviously a MASSIVE difference in what you could consider spending. From a promotional budget of $1,000 you’ve just gone to a promotional budget of $40,000.
Of course we’re not recommending that you should spend that amount on winning your 20 new clients. (In fact, let us state that this would be unwise – because this calculation determines the ‘break-even’ levels. That is, if you invested your $40,000 in promotions you would have to acquire the 20 clients AND earn $2,000 worth of Gross Profit from each of them (being 10 x $50GP transactions per year for 4 years, as in our earlier example) simply to recoup the $40,000 you spent. (And before anyone complains, I realise that this is without allowing for ‘cost of capital’, the inflation rate and other factors which require a whole new and more complex formula. We don’t have the space to look at it in this issue – and this rough calculation is enough for us to see the point.)
What we’re trying to demonstrate is that a better understanding of ‘lifetime value’ puts you in a much stronger position to acquire customers and hang on to them. Even if, based on this understanding, you were to invest only a fraction of the amount calculated, you’d still be spending vastly more than most of your competitors. They’ll think you’ve gone mad and will be convinced that you won’t be able to sustain the generosity of your offers and the level of promotional activity, but you’ll be acquiring more customers than them.
And (if you delight those new customers enough to earn their repeat custom) you’ll harvest a bumper crop of profits over the life of each customer.
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