Customer lifetime value for B2B service firms, from your own books
Lifetime value decides how much you can afford to spend winning a customer. Calculated from your own records, it is also one of the clearest signals of whether growth is healthy.
Customer lifetime value is the gross margin a typical customer produces over the whole time they buy from you. For a service firm, calculate it from your invoices as average annual revenue per client, multiplied by gross margin, multiplied by the average number of years a client stays. Compare it with what it costs to win a client to see whether growth is paying for itself.
Most discussions about growth focus on winning new customers. Fewer focus on what those customers are worth once they have been won. Yet the second question determines the answer to the first. A company whose clients stay for six years can afford to spend far more winning each one than a company whose clients stay for eighteen months, and it can outbid that competitor in every channel while still making money.
For B2B service firms in particular, lifetime value is often the most underused number in the business. It is usually sitting in the invoicing system, waiting to be calculated.
Why lifetime value matters more than it looks
Retention has a disproportionate effect on profit. Frederick Reichheld of Bain & Company, whose work on customer loyalty is widely cited, found in financial services that a five percent increase in customer retention produced more than a 25 percent increase in profit. The exact effect varies by industry, but the direction is consistent: keeping customers longer raises what each one is worth, and that raises what the company can afford to invest in growth.
The opposite is also true. A company with weak retention has to keep replacing the customers it loses before it can grow at all. In that situation, new marketing spend fills a leaking bucket, and the leak is in the third area of the growth system, retaining clients, not in the marketing.
How to calculate it
Step 1: Average annual revenue per client
From your invoicing system, take total revenue from active clients over the last twelve months and divide by the number of clients who paid you in that period. If your client base is very uneven, calculate it separately for your main client types. A single average across a few very large accounts and many small ones describes nobody.
Step 2: Gross margin
Use the margin after the direct cost of delivering the service: the people, subcontractors and materials involved. Your accountant can usually provide this by service line. Using revenue instead of margin is the most common mistake in lifetime value calculations, and it can make a marginal client look like a valuable one.
Step 3: Average years retained
Count how many of the clients active at the start of last year were still buying at the end of it. If 69 percent remained, then 31 percent left, and a simple estimate of the average client lifetime is one divided by 0.31, or about 3.2 years. If you have enough history, a more accurate method is to follow a group of clients who started in the same year and see how long they actually stayed.
Step 4: Compare with the cost of winning a client
Set lifetime value next to your real cost per new customer, and calculate how many months of margin it takes to recover that cost. The ratio tells you whether growth is profitable. The payback period tells you whether your cash flow can fund it.
The customers you keep decide what you can afford to pay for the ones you win.
Common mistakes
- Using your best clients as the average. The clients everyone remembers are rarely typical. Use every client, including the small ones who bought once.
- Counting only formal cancellations. In service businesses many clients never cancel. They simply stop calling. Count a client as lost when they have not bought for longer than your normal buying cycle.
- Ignoring the cost of serving. Some clients produce strong revenue and weak margin because they demand more time. Lifetime value in margin shows this; lifetime value in revenue hides it.
- Treating the number as fixed. Lifetime value changes as retention, pricing and margin change. Recalculate it at least once a year.
What to do with the number
Once lifetime value is known, several decisions become easier.
- Setting a ceiling on acquisition cost. If a client is worth $34,560 in margin over their lifetime, a channel that wins clients for $6,000 is a sound investment, and one that costs $20,000 needs a strong reason.
- Choosing which clients to pursue. Calculate lifetime value by client type or service line. The segments with the highest values are where marketing should be aimed.
- Deciding between winning and keeping. If retention is weak, a modest investment in keeping clients may raise lifetime value more than a large investment in winning new ones.
- Giving finance a common language. Lifetime value and payback let marketing spend be discussed the way a CFO evaluates any investment.
Retaining clients is one of the six areas we assess in every engagement, and lifetime value calculated from the client's own books is one of the figures that comes out of it. You can see the full approach on How we work.
Do you know what a client is worth?
If the answer is not on one page, a short call will tell you whether your records can produce it, and what it would change.
Request an introductory callCommon questions
Should lifetime value use revenue or gross margin?
Gross margin. Revenue overstates what a customer is worth because it ignores the cost of serving them. Using margin lets you compare lifetime value directly with what it cost to win the customer.
What is a good ratio of lifetime value to acquisition cost?
A ratio of around three to one is a common rule of thumb, particularly in subscription businesses, but it is a starting point rather than a law. The ratio that is right for you depends on your cash position, how quickly you earn the cost back, and how reliable your retention figures are.
How many years of data do I need?
Ideally enough to see a full cohort of customers through to the point where most have stopped buying. If you do not have that, use the annual retention rate from the most recent two or three years and treat the result as an estimate, with the assumption written next to it.
Does lifetime value apply to project-based businesses with no contracts?
Yes. Count repeat projects from the same client as retention. In project businesses the question is how often a client comes back and how much they spend each time, which can be read directly from invoices.