Is Your Customer Profitable?
An important customer performance metric is customer profitability. A business often spends a considerable amount of money acquiring and retaining a new customer. The customer purchases have to more than offset these expenses over the course of their customer life for that customer to be profitable. Because this happens over time, we need to discount future purchases and expenses in order to determine the Lifetime Value of the Customer. Our example focuses on an average fast-food customer.
Four-year Customer Life – Is The Average Customer Profitable?
In this example the cost of acquisition is $100. The average customer spends $100 per year as a first year customer of this fast food restaurant. The customer buys less expensive items (32 percent margin) in year one, which produces an average gross profit of $32 per year. The customer life is 4 years. As shown below, each year the average customer buys more and higher margin products. The company spends 5 percent of sales each year on the average customer to retain them. Using a 25 percent discount rate the Lifetime Value of the average customer is $15. This means the rate of return for this customer is greater than 25 percent. The rate of return for this customer cash flow is 32 percent (this is determined by varying the discount rate until the lifetime value is approximately zero).
Five-year Customer Life – Is It Worth Spending More on Customer Retention?
Using this customer performance, we can assess the profit impact of spending more on customer retention in an effort to extend the customer life one more year. As shown above, we made year 5 customer buying the same as year 4, but for each year of the customer life we increased the percent of sales spent on customer retention from 5 percent to 6 percent. This result in a Lifetime Value of $37, more than double the current Lifetime Value of $15. The rate of return for this customer cash flow is 39 percent.
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