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Whether you’re new to paid search or it’s old hat, two things every marketer quickly realizes today is that pay-per-click costs are expensive and they are on the rise. With the current strain of finding strategies to profit from click charges ranging from $1.50 to $20.00, one becomes nostalgic for the Goto.com days of $0.05 and $0.10 bids for top keywords.
Bygone days aside, today’s high click cost environment requires a stronger strategic mindset. It requires a success structure consisting of a clear objective, powerful ad copy, detailed keyword-level tracking, split-testing methodologies, a solid grasp of landing page optimization, and an in-depth understanding of performance metrics. Yet, as the competitive landscape becomes increasingly intense and these strategies are adopted by more companies, the success structure needs to drill even deeper into the business sales process.
Under certain circumstances, winning against a “no holds barred” competitor demands the mindset of a world-class chess player pursuing short-term sacrifice for resulting long-term gain. This is the purpose behind the customer lifetime value strategy.
What is Customer Lifetime Value?
Business philosophy is that “it is more expensive to acquire new customers than it is to generate repeat sales from existing ones and that existing sales are typically more profitable than initial ones due to reduced marketing expenses.” While most businesses consider only first-time purchases when calculating their paid search performance results, a business applying “customer lifetime value” considers the value gained from all expected purchases across an individual’s relationship with their business.
By definition, customer lifetime value is the average time period a customer has a relationship with your business and the total revenue generated during that relationship. A “relationship” is defined as the time between a customer’s initial and final purchase from your business.
For newer businesses, the “lifetime” number is estimated based on loyalty expectations, while more established businesses with years of customer purchasing history generate loyalty measures from actual internal statistics. In either case, understanding your customer lifetime value is important regardless of reliance on expectations or historical results.
How Do You Calculate Your Customer Lifetime Value?
To calculate your customer lifetime value you will need to gather data easily accessible from your shopping cart or your payment gateway reports. This data includes:
- How long you have been in business;
- Your best estimate of the time between an initial purchase and a customer’s final purchase;
- Your total sales;
- Your total number of customers.
You may also want to gather costs you incurred so that your customer lifetime value shows your breakeven point (although that calculation is not part of this initial analysis).
The basic formula for calculating your customer lifetime value is:
Average Lifetime Value = Total value of all sales / Total number of customers
For new businesses lacking ample customer purchasing history, your formula may be more like:
(Estimated length of time your average first-time customer will remain a customer)
(Length of time you have been in business)
Example: Established Business with Vast Quantity of Customer Purchasing History
Let’s assume, for example, that you have been in business for three years and through studying your customer purchasing history you discover that, on average, your customers make their first and final purchase(s) within one year. So, one year is your average “customer lifetime.”
Over the past three years you have generated $760,000 in revenue from 2,300 customers. Ideally, you should remove new customers who have not yet exceeded the one-year “customer lifetime” from the equation. To do this, take the average sales value times the number of “less than one year” customers and deduct the resulting value from your total revenue. Then deduct the number of “less than one-year” customers from your total number of customers.
For our example, let’s say your average sales value is $175 and there were 500 “less than one year” customers. Take your adjusted revenue of $672,500 ($760,000 – $105,000) and your adjusted total customers of 1,800 (2,300 – 500) and perform the calculation.
Average Lifetime Value is $672,500 / 1,800 = $373.61
Now that you know your average customer lifetime value is $373.61, while the competition is making bid and keyword performance decisions based on a customer value of $175 (the average value of a sale), you can instead base decisions using your average customer lifetime value of $373.61.
Example: New Business without Vast Quantity of Customer Purchasing History
Unlike the first scenario, let’s say you have been in business for just one year and have little customer purchasing history; therefore, you are not confident that your initial customers have made their final purchases. In this situation, you need to estimate how long you expect a customer will remain loyal and continue purchasing from your business.
Let’s assume that your customers are loyal and continue making purchases for three years. In this case, you generate $250,000 in revenue during your first year from 800 customers.
First, calculate your average customer lifetime value using your known one-year revenue and customer data.
Average Lifetime Value is $250,000 / 800 = $312.50
Now, you need to calculate the approximate value based on your expected customer lifetime of three years. Convert the years into months and divide the number of months an average customer will continue buying from you by the number of months you have been in business.
36 months / 12 months = 3
Now, multiply “3″ by your average customer lifetime value of $312.50 to generate your expected customer lifetime value: $312.50 x 3 = $937.50.
Admittedly, this number is not as reliable as the one generated by years of actual customer purchasing data, but it still provides essential information for marketers to determine customer lifetime value. The risk is losing your average customer before they reach the three-year lifetime expectation – so be conservative when estimating this!
A Paid Search Strategy that Penetrates the Depth of Your Sales Process
Applying a customer lifetime value strategy for paid search requires the development of an effective customer retention program. Ultimately, the strategy leverages your unique sales process as the competitive advantage for competing in a paid search market.
As an example, one of our current e-commerce clients is engaged in a highly competitive market where paid search costs are outrageous. Through careful analysis and planning, we created a marketing plan that focused on three major strategies:
(1) Immediately building on natural search and other less expensive advertising channels to eventually offset paid search costs;
(2) Developing a high-performing e-commerce website capable of better-than-industry best practices conversion rates (e.g., targeting 7% to 10% conversion);
(3) Creating a sticky customer retention program.
By understanding the competitive forces in the client’s paid search market, we intentionally worked to develop a powerful retention program enabling us to confidently follow a customer lifetime value strategy.
Customer lifetime value forces one to think beyond the initial sale. It allows you to set aside the “sticker shock” of high click costs and settle confidently into a paid search campaign that delivers profitable results over the long run. Ultimately, it provides a deeper strategy for winning in a highly competitive market.