In a previous post I explained how to calculate the gross revenue generated by one customer over its lifetime.
In order to calculate the Customer Lifetime Value we need to subtract the direct costs incurred in order to acquire and serve that customer.
Let’s continue with the example of an eCommerce site that sells shoes.
How to compute the costs to acquire and serve a new customer?
In the list of costs you need to include any costs that are incurred to get a new customer or to serve an order. You should compute the variable costs, those that increase with every new customer you acquire and serve and hence can be directly attributed to the customer.
Below is a list of the most common costs you should include:
- Acquisition costs: how much we have to pay for the marketing campaigns required to get a new customer. It is recommended to analyse acquisition costs by lead source since they are usually very different. This will help you understand which lead sources are profitable and which ones are not. You can work with averages to get the whole picture, but look at each source individually and eliminate those that are unprofitable and increase the investments on those that are profitable. You will have to look at all parameters individually since some sources may be more expensive but may also bring customers with a higher CLV.
- Cost of Materials: for an ecommerce business that sells shoes, this is how much you paid to manufacture or acquire the shoes a customer has purchased. The usual way to compute this is a percentage of sales. If you operate with a 40% margin on the sale of a product, your cost of materials will be 60% of the price of the product.
- Payment Processing Fee: usually you will have to pay a commission for a payment gateway to process payments from your customers. If you combine different payment options, here you will have to compute the weighted average costs. Many times this is a % of the order value.
- Shipping Costs: if you have to deliver actual products you have to include the shipping costs. In general and to make things easier, shipping costs payed by customers are also included in the average revenue you make per customer. If you offer free delivery then you will be assuming the shipping costs in its entirety.
The total costs incurred to acquire and serve a customer are just the addition of the 4 above. We assume that you once you acquire a customer and they buy from you, you will not need to acquire them again for the next purchase, so we are assuming a degree of loyalty that may not be true in your case. Also note that because when we calculated revenues we discounted returns from sales, we also need to discount them in the Cost of Materials
CAC + ( COGS x O x (1 - RR) ) + ( (PAY x OV) + SHIP ) x O
CAC = Customer Acquisition Costs
COGS = Average Order Cost of Materials
O = Orders per Customer
RR = Return Rate
PAY = Payment Processing Fees
OV = Order Value
SHIP = Shipping Cost Per Order
So for example, if you spend $20 to acquire a customer, you operate with a 40% margin on the sale of a product, your payment processing fee is 2% and your average shipping costs $3, the total cost to serve and acquire a customer would be:
$25 + $60 x (1 – 0.4) x 2.4 x (1 – 0.07) + ( (2% x $60) + $6 ) x 2.4 = $122.632
Hence the Customer Lifetime Value would look like this
CLV = $133.92 – $122.632 = $11.288
Since in this case it is positive, acquiring new customers is profitable and hence you should invest heavily in acquiring them. That said, the CLV does not tell you the whole picture. Be sure to look at operational costs as well which usually grow with the sales volume as well and check that the you can serve enough customers without increasing your operating costs to be profitable.