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How much should I spend on advertising?
How much should you spend on advertising? How do you decide on your advertising budget? How much of your total spend should be on advertising? Well actually the calculation is not too hard once you understand the concept of 'Lifetime Value' of a customer - but the concept of an advertising 'budget' is nonsense!
The 'Lifetime Value' of a customer is a very simple concept. Rather than looking at the value of sales that you make to a customer over a week or month or year - Lifetime Value, as it's name implies, looks at the whole period that person or company is buying from you.
Think about it - You have a customer that spends £20 per week with you. How do you value them? As a £20 customer out of total sales per week of (say) £2000 they don't seem very important. But in a year, that customer spends over £1000. Say that your average customer stays with you for 3 years. The lifetime value of that £20 customer is now £3120 - that's over one and a half weeks sales!
Lose that customer and you have lost one and a half weeks of business. Makes it more worthwhile giving good customer service doesn't it? (If you don't get repeat business from your customers - i.e. you have a 'one shot' sale - you need to develop a 'back end' - we will talk about this some more in a later article.)
So how does this impact on an advertising budget? Well, lets calculate the average lifetime value of your customers. It's best to work on averages - so first calculate your average monthly sales per active customer (don't include customers that have not bought for a long time - you have probably lost them). You will then need to look at an 'active' customer list from some time ago (the longer the better). What percentage of the customers from the earlier period are still buying?
Let's say that 40% of customers from two years ago are still buying. Your average lifetime will be the point at which 50% of customers are still buying - so in this case it is less than 2 years - In fact 60% of customers will have gone after 2 years so 50% will have gone after 50 x 2/60 = 1.67 years. Lifetime value of a customer is therefore the average monthly sales calculated above multiplied by 20 months (1.67 years) in this case.
You now have the lifetime sales value of each customer. From that you need to deduct your 'direct' costs. Direct costs are the costs that you will not incur if you do not sell to that customer - things like:
a.. Cost price of the goods that you sell to them
b.. Distribution (delivery costs)
c.. Card processing costs (if you sell via credit cards) Do not include costs that you incur just to be in business (web site hosting costs, office accomodation, warehousing) as you will need to pay these whether you sell to the customer or not. You end up with the average gross contribution that each customer will bring you during the lifetime of their doing business with you.
This 'Average Gross Contribution' (AvGC) is the MAXIMUM amount that you can spend on advertising to acquire a new customer. If you spend more per new customer, you will have lost money. This is why the concept of an advertising budget is a nonsense. No matter how much you spend, if you spend more than the AvGC per customer, your business loses money, if you spend less, you make money.
The secret is to minimise how much you need to spend to acquire each new customer - and that's where testing comes in - but that's another article...
So, to summarise with an example:
You calculate your customers average monthly spend by dividing your average monthly sales by the total number of active customers - Say that comes out at £40.
You calculate the average lifetime a customer has with you by comparing active customers from a certain past period, see how many are still customers today - Then find after what time period you would have lost 50% of the original customers - that's the average lifetime of your customers (say 1.67 years).
- Multiply Lifetime by sales (40 x 12 (months) x 1.67) gives 'Lifetime Value' - in this case £800.
- Deduct 'Direct costs' from that figure (cost price, delivery and so on) in this case assume -
- Cost of goods sold = £500 Delivery Costs = £80 Credit card cost = £16
- Average Gross Contribution (AvGC) is therefore 800-596 = £204.
- You can spend up to a maximum of £204 to acquire each new customer and still improve your business' profits.
Simple! ...and no budgets to worry about!
© 2010 Dave Broadway. All Rights Reserved.
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