Customer lifetime value (CLV) is a critical metric used by businesses to assess the value of their customers over time. It provides insight into the total worth of a customer throughout their relationship with a business, including the revenue they generate and the costs associated with acquiring and servicing them.
In this article, we will explore the concept of customer lifetime value, its importance to businesses, and how it can be calculated. We will also discuss how CLV can be used to inform marketing strategies, customer retention efforts, and other key business decisions. By the end of this article, you will have a deeper understanding of CLV and its potential impact on your organisation’s success.
Customer Lifetime Value (CLV) is one of the metrics that any growing company should be measuring.
You can measure how long it takes to recoup the investment required to earn a new customer by measuring customer lifetime value in relation to cost of customer acquisition (CAC).
It’s essential that your business learns what customer lifetime value is and how to calculate it if you want your business to acquire and retain highly valuable customers. Additionally it allows you to establish the cost and value of your marketing and sales.
So what is Customer Lifetime Value
Customer lifetime value identifies the total revenue a business can reasonably expect from a single customer account throughout the business relationship. The metric compares a customers potential revenue value and compares to the company’s predicted customer lifespan.
The longer a customer continues to purchase from a company, the greater their lifetime value becomes. Therefore businesses use customer lifetime value to identify customer segments that are most valuable to the company.
CLV is a metric that anyone customer focussed can directly influence during the customer’s journey. Those in the business who play critical roles in solving problems and offering recommendations that increase customer loyalty and reduce churn can significantly impact CLV.
Two important Factors in CLV
Customer Acquisition Cost (CAC)
Customer acquisition cost, or CAC, is the amount of money spent on marketing and sales required to close a sale. In its simplest form it’s calculated by summing a company’s total sales and marketing spend and dividing it by the number of new customers.
Companies can calculate CAC for a given time period or all time, and is helpful to compare the effectiveness of different marketing tactics and strategies. A lower CAC is better, as it suggests your marketing and sales teams are efficient and properly scaled. So if your marketing budget is zero and customers place orders without you having to sell you will have a super low CAC
CAC Example: Amount Spent on Sales & Marketing (£10,000) / Number of new customers acquired (4) = Customer Acquisition cost (£2,500)
Customer Lifetime Value (CLV)
Customer lifetime value equates to revenue an average customer will provide a company before they stop using you ( for whatever reason – they might choose to purchase elsewhere / they might cease trading). There are a number of different equations used to calculate CLV, but for this purpose, we’ll be using the simple CLV formula to multiply average annual revenue by the average lifespan of a customer.
CLV Example: Average annual revenue per customer (£10,000) x Average lifetime of customer ( 4 years) = Customer Lifetime Value (£40,000)
The important element CAC to CLV
This metric compares the customer’s acquisition cost to the revenue that customer will provide over time. It helps businesses know if customers churn before they start contributing profit to the company. Depending on the sector and the products / services provided it might be many years before a customers acquisition cost is recovered. Not an issue as long as you can cash flow and ensure that the customer stays with you for the long term
Example CAC to CLV: Customer Acquisition Cost (£2,500) – Customer Lifetime Value (£40,000) = CAC to CLV of (£37,500)
Why Customer Lifetime Value Is Important To Your Business
There are a number of reasons why understanding CLV is important to your marketing and sales
1. It helps you target your ideal customers.
When you know the lifetime value of a customer, you also know how much money they spend with your business over a period of time — whether it’s £100, £1,000, or £1,000,000. You can develop a customer acquisition strategy that targets customers who will spend the most at your business armed with this knowledge, .
2. It reduces customer acquisition costs.
In an article published by Harvard Business Review they found that gaining a new customer can cost anywhere between five and 25 times more than retaining an existing one. Acquiring a new customer can be a costly affair.
Other research conducted by Bain & Co found that a 5% increase in retention rate can lead to a rise in profit between 25% to 95%.
These two statistics illustrate how important it is that your business identifies and nurtures the most valuable customers who purchase from your business. The benefits of doing this include
- Having higher profit margins,
- Increased customer lifetime values,
- Ultimately reducing customer acquisition costs.
3. CLV improves customer loyalty and retention.
When a business optimises its CLV and consistently provides value. This can be delivered through excellent customer support, products, or a loyalty program then customer loyalty and retention tend to increase .
As a business gains more loyal customers so churn rate reduces and positive reviews, referrals and sales will increase.
4. It directly affects your revenue.
The CLV identifies the specific customers that contribute the most revenue to your business. This allows you to serve these existing customers with products/services they like and make them happier, resulting in them spending more money at your company.
For businesses its very important to invest in customer retention processes
Businesses that are actively working towards customer’s success should experience higher revenue because of increased customer satisfaction.
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Customer Lifetime Value Calculation
To calculate customer lifetime value, you need to calculate the average purchase value and then multiply that number by the average number of purchases to determine customer value.
Once you have calculated the average customer lifespan, you can multiply that by customer value to determine customer lifetime value.
Customer Lifetime Value = (Customer Value * Average Customer Lifespan)
where Customer Value = Average Purchase Value * Average Number of Purchases
Customer Lifetime Value Approaches
Below, we have showcased two models that companies will use to measure customer lifetime value.
Historical Customer Lifetime Value
The historical model uses past data to predict the value of a customer without considering whether the existing customer will continue with the company or not.
With the historical model, the average order value is used to determine the value of your customers.
The historic model is especially useful if the majority of your customers only interact with your business over a certain period of time.
This model has certain drawbacks however, as most customer journeys are not identical. There is the chance that active customers (deemed valuable by the historical model) might become inactive and skew your data.
Equally, inactive customers might begin to purchase from you again, and you might overlook them because they’ve been labelled “inactive.”
Predictive Customer Lifetime Value
Unlike the historical customer lifetime value model focusing on past data, the predictive CLV model forecasts the buying behaviour of existing and new customers.
Using the predictive model for customer lifetime value helps you better identify your most valuable customers, the product or service that brings in the most sales, and how you can improve customer retention.
This approach requires a large amount of insight, so is of limited use if you are new to the market.
Analysing Customer Lifetime Value
Average Purchase Value (APV)
Calculate this number by dividing your company’s total revenue in a period (usually one year) by the number of purchases throughout that same period.
APV = Total Revenue / Number of Orders
Average Purchase Frequency Rate (APFR)
Calculate this number by dividing the number of purchases by the number of unique customers who made purchases during that period.
APFR = Number of purchases / number of customers
Customer Value (CV)
Calculate this number by multiplying the average purchase value by the average purchase frequency rate.
CV = Average Purchase Value x Average Purchase Frequency Rate
Average Customer Lifespan (ACL)
Calculate this number by averaging the number of years a customer continues purchasing from your company.
ACL = sum of customer lifespans / number of customers
Customer Lifetime Value (CLV)
Multiply customer value by the average customer lifespan. The multiplication will give you the revenue you can reasonably expect an average customer to generate for your company throughout their relationship with you.
CLV = Customer value x Average customer lifespan
Using “Coffee” To Explain Customer Lifetime Value
Using a coffee shop as an example and considering the weekly purchasing habits of five customers. We can use this information to calculate the average lifetime value of a Coffee shop customer.
1. Calculate the average purchase value.
First step, is to measure the average purchase value. Lets assume, the average coffee shop customer spends about £4 each visit. We can calculate this by averaging the money spent by a customer in each visit during the week. For example, if I went to the coffee shop 3 times and spent £12 in total, my average purchase value would be £4.
Once we calculate the average purchase value for one customer, we can repeat the process for the other five. After that, add each average together, divide that value by the number of customers surveyed (five) to get the average purchase value.
2. Calculate the average purchase frequency rate.
The next step to calculating CLTV is to measure the average purchase frequency rate.
In the case of the coffee shop, we need to know how many visits the average customer makes to one of its Peterborough locations within a week.
The average observed across the five customers was established to be 3 visits. This makes our average purchase frequency rate 3.
3. Calculate the average customer’s value.
Now that we know what the average customer spends and how many times they visit in a week, we can determine their customer value. To do this, we have to look at all five customers individually and then multiply their average purchase value by their average purchase frequency rate. This lets us know how much revenue the customer is worth to the coffee shop within a week.
Once we repeat this calculation for all five customers, we average their values to get the average customer’s value of £12.
4. Calculate the average customer’s lifetime span.
So now we need to know the average customer lifetime span, lets assume its 5 years years. If we were to calculate the coffee shops average customer lifespan, we would have to look at the number of years each customer frequented Starbucks, Costa, Nero, Bewiched or any of the various other coffee shops .
5. Calculate your customer’s lifetime value.
Once we have determined the average customer value and the average customer lifespan, we can use this data to calculate CLV. In this case, we first need to multiply the average customer value by 52. Since we measured customers on their weekly habits, we need to multiply their customer value by 52 to reflect an annual average. After that, multiply this number by the customer lifespan value (5) to get CLTV.
For our coffee shop example customers, that value turns out to be £3,120 (52 x 12 x 5= 3,120).
How To Improve Customer Lifetime Value
Make it as easy as possible for customers to buy.
Customer onboarding is one of the first interactions your audience would have with your business after they decide to become customers. It’s also the first chance you have to impress them. You only get one chance to make a first impression
Therefore if dont you want to lose your customers in the early stages, you need to optimise your onboarding process to make these customers familiar with your products and services.
When done correctly, onboarding encourages customers to come back to your products time and time again, thus increasing their lifetime value.
Best practices for customer onboarding include:
- Making it quick and straightforward
- Use walk-through or tutorial videos
Under promise but over-deliver.
You can increase your customer lifetime value by overdelivering on your product / service promise. Many brands already make bold claims they can’t meet, so it comes as a welcome surprise to customers when they come across a brand that over-delivers on its promise.
Increase your average order value.
One of the smartest ways to improve your CLV is to increase your average order value.
When a customer is about to check out, you can offer relevant complementary products to those they’re about to buy.
Businesses like Argos, Amazon and McDonald’s are examples of companies that use the upsell and cross-sell method extremely well. Argos in store will offer you leads / batteries when any electrical good is purchased. Amazon online will offer you related products and bundle them into a group price offering (often with no pricing benefit).
McDonald’s will offer you “are you going large” “would you like a drink” before you finished your order. I’m an absolute sucker for the “would you like an apple pie with that?” approach.
If you’re a subscription-based company, you can increase your average order and customer lifetime value by encouraging your customers to switch to an annual billing cycle.
Engage and build your relationship with your customers
Customers spend on products because they’re trying to fulfil a need. To boost your customer lifetime value and reduce your churn rate, you need to think beyond the immediate need a customer is trying to satisfy.
As such, you’ll need to engage and build a relationship with your customers. Standard practices around relationship-building include:
Improve your customer service
Pay attention to your customer service and look for ways to make it excellent. if you want to improve your customer lifetime value.
You can improve your customer service by offering existing customers personalised services, specialist customer support, extended guarantees / warranties and a proper return or refund policy.
The Benefit of Customer Lifetime Value
Customer lifetime value (CLV) is an essential metric for businesses because it helps to quantify the long-term value of a customer relationship. Understanding CLV provides a wealth of information that can be used to make informed business decisions and maximize profitability. Here are a few key reasons why CLV is important:
- Helps with customer acquisition: By knowing the average value of a customer over their lifetime, businesses can make more informed decisions about how much to spend on customer acquisition. This allows companies to optimize their marketing spend, ensuring they are acquiring the right types of customers at a reasonable cost.
- Aids in customer retention: Businesses can use CLV to identify high-value customers who are worth investing in to retain. Understanding which customers have a higher CLV can help companies design retention strategies that keep these valuable customers engaged and loyal.
- Helps with pricing decisions: CLV can also be used to inform pricing decisions. By understanding the total value a customer is likely to bring over their lifetime, businesses can price their products or services more effectively. For example, if a product has a high CLV, a business may be able to charge a premium price.
- Guides business strategy: CLV is a valuable tool for guiding overall business strategy. By analyzing CLV data, businesses can identify areas for improvement, optimize their operations, and focus on initiatives that will generate the greatest return over the long term.
In short, CLV is a critical metric that provides businesses with a comprehensive understanding of the value of their customers. By leveraging this data, businesses can make informed decisions about marketing, pricing, customer retention, and overall business strategy.
Use the formulas and model provided above and start calculating CLV for your business today. Customer lifetime value is an incredibly useful metric. It tells you which customers spend the most at your business and which ones will remain loyal to you for the longest amount of time.
In conclusion, understanding customer lifetime value (CLV) can bring many benefits to a business. CLV provides a prediction of the net profit attributed to the entire future relationship with a customer. This can help businesses to understand the value of different customer segments and to make strategic decisions about where to allocate resources.
Knowing CLV can help businesses to identify and target high-value customers, allocate marketing budget more efficiently, prioritize customer retention and loyalty programs, create personalized and targeted marketing campaigns, and forecast revenue and plan for future growth.
CLV also helps businesses to understand which customers are most valuable to them, and to make informed decisions about where to allocate resources, such as sales and marketing efforts, to maximize the return on investment. In short, understanding CLV is a powerful way for businesses to improve their performance and achieve long-term success.
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