Calculating customer lifetime value

Why don't companies pay more attention to their loyal customers? Because they don't appreciate how valuable they are. Calculating the lifetime value of your customers can be an eye-opening experience. It can also help you build top management's support for customer retention initiatives.

Lifetime value can be calculated for any customer in any industry. Let's assume a business-to-business example: a small graphic design studio that buys software from a vendor.

In year 1, the owner of the design studio sees a television ad for new desktop layout software and makes a purchase. In this first year, the vendor doesn't make any money on this customer because the costs of acquiring and serving the customer are greater than the purchase price of the software program.

In year 2, the customer, happy with the layout software, buys the upgrade (which has a higher profit margin) as well as a software program for drawing and illustrating. In addition, the studio owner refers the layout software to several independent graphic designers, one of whom buys the layout software.

In year 3, the design studio buys a program for manipulating images and a clip art library from the vendor. The first referral buys the drawing software and the layout software upgrade. Another referral purchases the layout software.

In year 4, the design studio purchases a new upgrade to the layout software and an upgrade to the drawing software. The first referral purchases image manipulation software and a clip art library. The second referral purchases the drawing software and the layout software upgrade. In addition, two new referrals purchase the basic layout software.

In year 5, the design studio buys new all-in-one software combining layout, illustration, and image manipulation capabilities and also a different clip art library. The first referral buys another upgrade to the layout software and an upgrade to the drawing software. The second referral buys image manipulation software and a clip art library. The two referrals from the past year each purchase the drawing software and the upgrade to the layout software.

The purchases made in years 1 through 5 by the design studio and its referrals are tabulated below. As you can see, the initial $800 purchase in year 1 leads to an additional $12,850 of business from all sources in years 2 through 5.

Calculating Lifetime Value, Sample
	Year1	Year2	Year3	Year4	Year5
Revenue from basic goods and services	800	0	0	0	0
Revenue from new goods and services	0	500 250	500 200	250 250	3,000 200
Cost to (acquire and) serve	850	100	100	100	100
Referrals: Revenue from new loyal accounts	0	800	750 800	700 750 800 800	500 700 750 750
Profit ($)	(-)50	1,450	2,150	3,450	5,800