The Magic of Customer Lifetime Value for Local BusinessesHow much is a customer really worth to your local business? Is that something you can know? If so, how? What information do you need? Are different types of customers worth different amounts? How does knowing these things improve profits?

Enough questions! The point is this: Understanding the value a customer has to your business over time is absolutely critical to making smart, cost-effective marketing decisions. Getting this right can light up your bank account. It will help you know:

  • What market segments to target first
  • How much you should be willing to spend to acquire a customer
  • What types of customers you DON’T want to spend money on
  • How much you should spend to retain EXISTING customers
  • Which types of current customers you may want to “fire”

Your magic bullet is something called “customer lifetime value.” CLV is one of the concepts taught in business schools that actually has real-life, make-or-break implications for small firms. Basically, CLV defines – in dollars – today’s value of the future profits your business can expect from a customer over the entire time they remain your customer. That time could be a day — or a decade. It’s important stuff; especially for local businesses that have been lured into the daily deals game and may be sacrificing long-term relationships for a few quick bucks.

CLV does take some effort. It doesn’t just happen. But it needn’t be hard. (Below, I’ll tell you about a handy online CLV calculator you can use for free.) In simplified form, here’s how you get to it:

  1. Pick a time frame; say 10 years.
  2. Take the total annual revenue you expect from a customer – including expected changes up or down each year – and add them up.
  3. Subtract your expected costs of attracting the customer in the first place, your cost of goods sold (or “COGS” in accountant-speak), and the costs of servicing the customer each year.
  4. Apply a “discount rate” (usually 10-20%) to recognize that a dollar you hold in your hand today is worth more than a buck you get in the future.

One thing you’ll quickly discover is that common sense is correct: The longer you keep a customer, the more profit they produce. That’s true most of the time. Trouble is, not all customers are the same. Oops! They cost different amounts to acquire. They produce different amounts of revenue and stay with you different lengths of time. They also require different amounts of care and feeding. If you don’t account for these differences, you’ll end up paying to acquire and keep unprofitable customers.

Bottom line: Segment your markets and spend more to acquire and keep your best customers. Think of it this way: Does it make sense to spend, say, $40 to attract a new customer (with a Groupon offer, for example) while spending nothing to keep a customer you already have? No. Your goal is to foster longevity – not create fickleness with low prices.

Many business owners know a version of this as the 80/20 rule: That 80% of the profits come from 20% of the customers. Yet, conventional wisdom tells businesses to treat all customers alike. That’s a problem because all customers are not created equal. Being CLV savvy helps you focus your marketing methods and spending on customers who bring real value to your business.

Here are three more reasons to use CLV:

1) Your marketing budget is limited. (It is, right?) It makes perfect sense to deploy limited resources where they count the most – with customers who represent the highest profit to your business over time.

2) Even small percentage changes in customer retention produce large increases in profit. “Customer equity” in a business – which is the sum of all customer CLVs – jumps 50% with just a 10% increase in retention. Repeat sales are what send profits soaring!

3) Knowing CLV helps you see things in new ways. For example, while yellow pages and other print ads may be out of favor, it might be that customers who find you there have higher CLVs than those who click a Google ad, and thus be more attractive. Knowing this would help you decide how and where to allocate your marketing money.

And keep this in mind: CLV also includes “relationship value” – additional profits that flow from customer referrals and word of mouth. It’s tough to measure, but it’s there.

Here’s the free CLV tool I promised: Customer Lifetime Value Calculator, from Harvard Business School. Don’t let the Harvard connection scare you. It’s an effective tool for small businesses.

Editor’s note: The author is a graduate of the Executive MBA program at UCLA/Anderson School of Management, one of the world’s top-ranked business schools.