value of a customer

Calculating the Financial Value of a Loyal Customer

Customers are the most important asset a company has.
They are the source from which all cash flow flows!
But how does one calculate what a customer is worth?

The following is an example of how companies calculate can the financial value of a loyal customer.

Decide on a meaningful period of time over which to do the calculations.

This will vary depending on your planning cycles and your business.
For example, a life insurer should track customers for decades, a disposable-diaper maker for just a few years.

Calculate the profit (net cash flow) customers generate each year.

To do this, track several samples–some newcomers, some old-timers–to find out how much business they gave you each year, and how much it cost to serve them.
If possible, segment them by age, income, sales channel, and so on.
For the first year, be sure to subtract the cost of acquiring the pool of customers, such as advertising, commissions, back-office costs of setting up a new account.
Get specific numbers–profit per customer in year one, year two, etc.–not averages for all customers or all years.
Long-term customers tend to buy more, pay more (newcomers are often lured by discounts), and create less bad debt.

3. Determine a customer "life expectancy"

using the samples to find out how much your customer base erodes each year.
Specific figures are better than an average such as "10% a year";
Old customers are much less likely to leave than newer ones.
In retail banking, 26% of account holders defect in the first year; the rate drops to 9% in the ninth year.

4. Calculate net present value (NPV).

Pick a discount rate: if you want a 15% annual return on assets, use that.
Apply the rate to each year’s profit, adjusted for the likelihood that the customer will leave.
In year one, the NPV will be profit ÷ 1.15.
Next year, NPV = (year-two profit × retention rate) ÷ 1.15².
In year n, the last year in your figures, the NPV is the nth year’s adjusted profit ÷ 1.15n.
The sum of years one through n is how much your customer is worth–the net present value of all the profits you can expect from his tenure.

The insights made possible by calculating the financial value of customers are invaluable.

You can now determine how much to spend to attract new customers, and which ones.
You can exploit the leverage customer satisfaction offers.
Repeat business–the ultimate measure of customer satisfaction–almost certainly merits bigger investments than you make.
Take your figures and calculate how much more customers would be worth if you increased retention by 5%.
According to researchers, for advertising agencies a 5% increase in retention rates translates into a 95% increase in customer NPV;
for credit card companies, 75%.
Even software makers, who constantly seek new business in a fast-growing industry, would see a 35% increase in customer value if they lost fewer old accounts

. __________ Source: "What’s a Loyal Customer Worth?" Fortune (December 11, 1995), p. 182; "Putting a Price on Customer Loyalty," Dallas Morning News (June 26, 1994), p. 2H.