Keep clients coming back · Every business
Customer Lifetime Value for Service Businesses, Worked Out
A customer's lifetime value is the margin they bring in each year, carried forward by the chance they come back, and for most service businesses the chance they come back moves the number far more than the price of the visit.
At a glance
- Customer lifetime value is the margin a customer is expected to bring in over the whole time they stay, discounted to today's dollars; a common form is annual margin × retention rate ÷ (1 + discount rate − retention rate).
- In a study of five companies published in the Journal of Marketing Research, improving retention by 1% raised customer value by 2.45% to 6.75%, while improving margin by 1% raised it by about 1%.
- For an illustrative salon customer worth $260 a year in margin, moving yearly retention from 70% to 80% raises lifetime value from $455 to about $693.
The number and where it comes from
The formula comes from research that valued customers the way investors value a company. A study of five companies, published in the Journal of Marketing Research, discounted each customer's stream of margin by the chance they would still be a customer in later years, then compared what different improvements would do to that value. Improving retention by 1% raised customer value by 2.45% to 6.75% across the firms, improving margin by 1% raised it by about 1%, and a 1% improvement in acquisition cost raised it by only 0.02% to 0.32%.
The paper's own illustration uses a customer with $100 a year in margin, 80% retention and a 12% discount rate, which works out to a lifetime value of $250. With constant margin and retention the calculation reduces to one line: CLV = annual margin × r ÷ (1 + i − r), where r is the share of customers who return the next year and i is the discount rate.
The curve bends upward because each extra point of retention keeps the customer for more years, and every one of those years carries the next year's chance of coming back. Moving from 80% to 90% adds more value than moving from 50% to 70% does.
The worked calculation
| Average visit (Assumption) | $65 |
|---|---|
| Visits a year (Assumption) | 8 |
| Revenue a year (Calculated ($65 × 8)) | $520 |
| Margin after product and commission (Assumption) | 50% |
| Annual margin (Calculated ($520 × 50%)) | $260 |
| Discount rate (Assumption) | 10% |
| Lifetime value at 70% retention (Calculated ($260 × 0.7 ÷ (1.1 − 0.7))) | $455 |
| Lifetime value at 80% retention (Calculated ($260 × 0.8 ÷ (1.1 − 0.8))) | $693.33 |
| Gain per customer (Calculated ($693.33 − $455)) | $238.33 |
| Gain across 300 customers (Calculated (300 × $238.33)) | $71,500 |
Illustrative example; replace every assumption with your own numbers.
The same steps work for any service business. A heating and cooling plan member paying $200 a year with a 60% margin has an annual margin of $120; at 85% retention and a 10% discount rate, that member is worth $120 × 0.85 ÷ 0.25, or $408, a sensible ceiling on what to spend winning one, and more than most would guess from a single tune-up.
How you compare
- Retention rate: count the customers who visited in the year before last, then the share of them who visited again last year. That share is r.
- Acquisition cost: a summary of Bain & Company research in Harvard Business Review puts the cost of winning a new customer at five to 25 times the cost of keeping one, so compare what you spend to win a customer against the lifetime value above.
- What moves value most: the five-company study found retention outweighed margin by roughly two and a half to seven times, so a point of retention is usually worth more effort than a point of price.
Pull last year's customer list this week, compute your own retention rate and annual margin per customer and run them through the formula to see what one customer is worth.
About this research: The lifetime value formula and the retention, margin and acquisition cost findings come from a study of five companies published in the Journal of Marketing Research. The acquisition cost range comes from a Harvard Business Review summary of Bain & Company research. The worked examples are illustrative and use a 10% discount rate.
Sources
- Gupta, S., Lehmann, D. R. and Stuart, J. A. Valuing Customers. Journal of Marketing Research 41(1), 2004. Five companies.
- Gallo, A. The Value of Keeping the Right Customers. Harvard Business Review, 2014.
Related reading: What a Referred Customer Is Worth Compared With One From an Ad · How Recurring Revenue Changes What Your Business Is Worth · How Often Customers Come Back, by Type of Business · Loyalty Programs for Small Service Businesses: What Works and What Wastes Money
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