The profit formula: what is your customer lifetime value?
Determine Your Customer Value and Acquisition Cost
You're on this journey because you believe you have the potential to put something of value into the world through your product or service. That belief is a critical first step and motivator as you begin your entrepreneurial journey.
Your excitement to get your product/service in the hands of customers is continuing to build, but it's essential that you take the time to answer this fundamental question:
Can I make a profit with this business?
The answer depends on a very important part of your business model: the profit formula. There are three important components to the profit formula for any business:
The price you charge to your customers
The cost of providing your product
The cost of acquiring your customers
The first two components determine your customer lifetime value (CLV). Whether your CLV is sufficiently greater than your customer acquisition cost (CAC) will determine your profitability. These calculations are sometimes referred to as the unit economics of your business because they are focused on a single individual customer/purchase. Of course, there are also fixed costs and overhead associated with running a business, but we will keep our focus at the unit level for this activity.
We will walk you through creating a model to ensure the numbers make sense and profitability is possible. Let’s dig in!
You will need:
Price of your product
Ballpark estimate of the costs that go into producing your product
Understanding of your go-to-market system
If this list makes you question whether you’re ready to move on, consider going back and revisiting some of the earlier activities. You can return when you feel more confident and after you’ve done the groundwork to determine your customer value and acquisition cost.
Estimate your Customer lifetime Value (CLV)
Before you can determine how much you have available to spend to acquire your customer, you need you have to understand what you can expect to earn from each customer who purchases your solution. You do this through determining your Customer Lifetime Value (CLV).
Customer Lifetime Value:
Is a forward-looking concept. It is an expectation of all the future net cash flow (revenue we get from selling the solution minus the cost of providing the solution) associated with a particular customer.
Requires a model to capture assumptions. Because it is a prediction, businesses need to use a model to capture assumptions of future customer behavior in order to calculate CLV. We will explore two simple business model scenarios and provide a formula for calculating CLV for each.
Consider the following scenarios and decide which model best fits your business.
Scenario 1: You expect your customer to buy from you only once. In this case, the calculation of customer lifetime is simple. It extends only as long as it takes to make the first purchase. If this scenario fits your business, this is a "One and Done Scenario."
Scenario 2: You expect your customer to return and buy from you several times. This might be a contractual arrangement (like a subscription to a cable TV service) or a non-contractual arrangement (like visiting a favorite restaurant). In this case, the determination of customer lifetime is more involved. If this scenario fits your business, A "Repeat Purchase."
One and Done Scenario Calculation
If customers will buy your product once, without returning regularly to make additional purchases or payments, determining your CLV is pretty straightforward. Essentially, your CLV is equal to your Gross Margin (GM) Simple as that. Your GM must be high enough per customers to cover CAC's and the fixed costs associated with running a business
Your Gross Margin refers to the amount you have left after paying the cost of goods sold
COGS = What are you spending per unit to manufacture each unit
CLV = Customer lifetime value
GM = PRICE - COGS
CLV = GM
Example: We sell a product for $100. The COGS are $40, leaving us with a GM contribution of $60. If the CAC is $50, this leaves us with $10 from each customer to cover our overhead and generate any remaining profit. These numbers point out the potential limitations of a "one-and-done" model. After all the investment in acquiring the customer, there is no further opportunity to receive a return on that investment. However, if we had the opportunity to sell a second product to each customer and they all purchased, CLV would increase to $120 (EX: a GM of $60 for each product) relative to the same customer acquisition cost of $50
This formula works best if your customers are subscribers or contractual customers. If your business fits this model, and if you know enough about your customers to do so, go ahead and complete the formula on a scrap piece of paper.
CLV = Customer lifetime Value
GM = Generated gross margin contribution from each customer in each period. This is different than the contribution margin, which is customer revenue less variable cost associated with customer demand.
Example: A family eats in a restaurant four times each year, for a total GM contribution of $300. The restaurant notices that they retain about 80% of their customers each year (EX: 20% church ), leading to an expected customer lifetime of 0.8 / (1 - 0.8) = 4 years. So CLV = 300 x 4, which is $1200