Setting a Marketing Budget: Lifetime Customer Value
At Kinesis, the #1 question I get is, “How much will it cost?”
To which I say, “What’s your budget?”
I know this sounds a tad flip, but the reality is the driving force behind a marketing effort should not be the price of the project. On the contrary: the emphasis behind any marketing effort should be the potential return on that project.
What I mean is this: most businesses see a marketing project, like a website, as an expense. They use emotion (or “best guess”) to pre-determine what that expense is worth, then start the process of shopping around for a firm that meets their expected budget number.
Sadly, 9 times out of 10, this strategy is doomed to fail. The business owner either overspends or buys a lemon (I’ll write more on this in another post).
You see, the very first step in establishing a budget for a project is determining the potential return on that project. You NEED to know what you’ll get out of the effort in order to determine how much you can afford to put into the effort.
Marketing experts often refer to “Lifetime Customer Value” (LCV). In short, this is the total amount of money a client spends with your business over the period of days, months, or years. In some businesses, the LCV is low – customers buy only once and then move on to a different provider. In other businesses the LCV is high (think cell phone plans). The trick, then, is to first figure the value of a customer so you can determine how much you can afford to spend to acquire and keep that customer.
To begin the process of creating a realistic budget, you need some data. Here are the variables you need to collect:
Average (or median) lifespan of a customer within each business segment How long do clients stay with your company? 1 day? 2 years? 12 years? Many businesses have multiple service or product offerings, so it can be especially helpful to segment customers based on offerings. The more granular the data, the smarter you can be in your decision-making.
Gross Revenue and Profit (Margin) for each customer within each business segment. This is a critical figure – if we know how much profit you make each year, then we can develop marketing, sales, and client retention strategies that maximize return on investment. For example: Let’s say a client spends $2000 per year with your company. Of that figure, $1500 is allocated to general operating expenses (keeping the lights on, rent, payroll, technology, and other fixed-cost items). The remaining $500 is profit. The profit can be distributed for any number of things – firm growth, marketing, retention, distributions, savings, etc. These are generally executive-level decisions, but my point here is that you need to determine the expense and profit related to each customer transaction.
Conversion Rates: This can be a little trickier, but it’s extremely helpful to know what percentage of prospects you convert to actual customers. So, for every 100 leads, how many prospects turn into paying customers? Knowing your success rate is critical for future efforts. At Kinesis, for example, I know that we will convert roughly 80%-90% of the clients that come to us via referrals. Prospects that arrive via our web contact form, on the other hand, trend much lower. So, when I’m looking at return on my effort, I put a great deal of time and energy into cultivating new business through my network of referrers and existing clients.
Here’s how this all comes together:
I have a client who sells a very custom product that sells for roughly $150. For sake of discussion and confidentiality, let’s call these “widgets.” For every widget made, the client spends approximately $50 in labor and materials, leaving a $100 profit.
The client runs a direct-mail campaign. They have a list of 20,000 suspects that they are going to mail to twice, followed up by telemarketing. Initial tests indicate a 2% response rate (in other words, of the 20,000 people who receive mailings and calls, 400 are viable leads). After following up with the 400 prospects, my client qualifies and eventually sells 30% of the pool of 400 for a total of 120 new customers. Since my client makes $100 on each widget they sell, that’s $12,000 in NEW revenue from the effort.
Except the profits don’t stop there. Like many businesses, my client gets revenue from their widgets on a recurring basis. Because history shows that widgets need to be replaced at least 4 times per year, each new client is worth $400 per year.
To recap: 120 New Customers X $400 = $48,000 per year in PROFIT.
To extend this story a little further, the average life of a customer is 5 years. This means the LCV for this new group of customers is actually $240,000!
At this point, the client has more than enough data to determine how much money and effort to expend on their direct-mail campaigns. If they want a 1-year return on their investment, they can spend UP TO $48,0000 on the initial effort, knowing that all the money made after year one will be pure profit. If they are willing to have a little longer payback time, they can opt to spend more money on the campaign, knowing that they’ll get a return on their investment in year 2 or 3.
What’s REALLY fun about this sort of data modeling is to look at how tiny little tweaks can have profound effects on profitability. For example, what if we took the above model and used a really compelling sales strategy to increase our conversion rate to 40%?
400 Prospects x 40% = 160 New Customers.
160 Customers x $400/Year Profit x 5 Year Lifespan = $320,000 in new revenue
See how powerful that is? Simply by converting an additional 10% of the prospects, we’ve increased the firm’s 5-year profit by nearly $100,000! Similar results can be had by increasing the lifespan of the client, the amount the client purchases each year, or the response rate on marketing efforts. Once you know what people are worth, and how effectively you can convert sales, you can really dictate effective long-term strategy.
In truth, this model is somewhat simplistic. Executives understand that there are good and bad ramifications to adding all that new business. You’ll need more infrastructure to meet the increased demand, which could mean lower margins. On the other hand, the new business will produce increased word-of-mouth advertising and referrals. This added “marketing” can add significantly to your overall market presence and revenue, leading to even more growth and profit.
So, the next time you’re thinking about profits, customers, and marketing efforts, start by figuring out the potential return on your effort. You’ll spend your money more wisely, select the right firm to help with your efforts, and have a better understanding of how marketing relates to bottom-line profitability
PS: If you need help calculating your LCV or setting up a marketing program budget, give me a call at Kinesis: 503-922-2289.