General

Customer Lifetime Value: What is it and How to Calculate

September 4, 2018

What keeps a customer coming back?

Customers are gained and lost over the lifetime of any company, but a truly great product or service can keep customers well fed, yet still hungry for more—figuratively speaking. This appetite for more is what continuously adds value to the company over the span of their relationship with customers. Follow our guide to calculating customer lifetime value or jump to our infographic below. 

What is Customer Lifetime Value?

Customer lifetime value (CLV), sometimes referred to as lifetime value (LTV), is the profit margin a company expects to earn over the entirety of their business relationship with the average customer.

The customer lifetime value must account for customer acquisition costs (CAC), ongoing sales and marketing expenses, operating expenses, and, of course, the cost required to manufacture the product and services the company is selling.  

Many companies take a short-sighted approach by overlooking this valuable metric and instead optimize for a single sale in the near term. It’s still important to find new customers for the growth of the company, but optimizing the lifetime value of existing customers is also essential for a company to sustain a viable business model. 

In fact, an increase in customer retention rates by only 5% has been found to increase profits anywhere from 25% to 95%.1 With this in mind, increasing the expected customer lifetime value is essential.

Customer Lifetime Value Calculation

how to calculate lifetime value and customer lifetime value with visual icons on purple background

Since customer lifetime value is a financial projection, it requires a business to make informed assumptions. For example, in order to calculate CLV, a business owner must estimate the value of the average sale, average number of transactions, and the duration of the business relationship with a given customer. Established businesses with historical customer data can more accurately calculate their customer lifetime value.

So, how do companies calculate customer lifetime value?

First, calculate the lifetime value by multiplying the average value of a sale, the average number of transactions, and the average customer retention period.

Lifetime Value = Average Value of Sale × Number of Transactions × Retention Time Period

Since the lifetime value of a customer is calculated in gross revenue terms, it does not take operating expenses into consideration. How much did it cost to make the product, advertise, and manage operations? Take these operating expenses into account when calculating customer lifetime value.

Customer Lifetime Value = Average Value of Sale × Number of Transactions × Retention Time Period × Profit Margin

Or simply:

Customer Lifetime Value = Lifetime Value × Profit Margin

Customer Lifetime Value Example

As an example, let’s create a hypothetical company to calculate the lifetime value of a customer.  

The average sale for the boutique clothing retailer, Bellissi, is $50, and the average customer shops with them three times per year for two years. The lifetime value of this customer is calculated as follows:

    Lifetime Value = $50 × 3 × 2
                                = $300

 

After calculating the cost of goods sold (COGS), overhead, marketing, and all other administrative expenses, Bellissi’s profit margin is 20%.

   Customer Lifetime Value = $50 × 3 × 2 × 20%

                                                  = $300 × 20%

                                                  = $60

 

This calculation reveals the customer lifetime value of the average Bellissi customer is $60 — far less than the lifetime value calculated above. As a retailer, this number is used to project cash flow and to understand how many customers you must acquire and retain to reach desired profitability.

Customer Lifetime Value Contributing Factors

When considering what weighs on the customer lifetime value we must consider how the customer perceives the brand in question.

If a customer does not feel any brand loyalty or incur switching costs when transitioning their business to a competitor’s product, then it’s likely the customer lifetime value will be impacted negatively. We must also consider how scalable the sales and marketing efforts are when growing revenues and increasing customer lifetime value. Consider the following:

Churn Rate

How often do customers stop shopping with a business they’ve previously patronized? The rate of attrition, or churn rate, differs from business to business, depending on the competitive advantage a business can command. Startups, for example, experience a much larger attrition rate than a given industry’s entrenched incumbents.

Churn rate is calculated by:

  • Subtracting customers at the end of the period from customers at the beginning of the period.
  • Dividing the difference by the number of customers at the beginning of the period.

For example, if a business started the year with 1,000 loyal customers and ended the year with 750 customers, their churn rate would equal 25%. This means 25% of their customers took their business somewhere else.

Customer Loyalty

How loyal are customers? If a customer has no sense of dedication to a particular brand, they are considered brand-agnostic. Building a sense of brand loyalty is important for any business as it directly correlates to an increase in customer retention rates and a decrease in churn rate.

Brand loyalists will advocate on the company’s behalf. As champions of the brand they will drive word-of-mouth marketing. Brands with loyal customers are likely to see a higher than normal customer lifetime value.

Scalable Sales and Marketing

How scalable are your sales and marketing tactics? If a company’s revenue growth is directly correlated to sales and marketing expenses, it is important to optimize those efforts. If revenue decreases, but the sales and marketing expenses continue to expand, profit margins will be squeezed and could result in a loss.

This is why a scalable sales and marketing strategy is essential. Tracking key metrics and measuring performance will allow for quick strategic pivots when efforts are proving ineffective. Testing new channels, A/B testing strategies, and optimizing for conversions will allow you to scale your sales and marketing.

Tips to Increase Customer Lifetime Value

Customer lifetime value with money, clock, male icon

How can a company influence the customer experience, resulting in an increase in customer lifetime value?

Some companies have the luxury of a true “moat,” or an effective defense against competitor disruption. Companies leveraging economies of scale, for example, can attain a much lower price point than the competition.

Most companies, however, do not have this luxury. This means they must implement tactics to improve operational efficiencies and impress customers through targeted, personalized, and relevant communication.

Optimize Onboarding

With churn rates the highest after a single interaction with the average company, it’s important to make the first impression positive. Customers often need education on the features and benefits of your product to truly understand how the product can positively impact their lives.

In a service business, effective onboarding can be as simple as demonstrating a dedication to customer service and availability to solve customer problems. Being attentive to the needs of a first-time customer and relieving any hesitations about their decision to purchase should be top priority for this first interaction.

Effective Communication

An open line of communication between the company and customer strengthens the relationship and makes the company feel more human. In today’s environment, it’s more important than ever to respond to feedback, especially negative comments, and poor ratings.

Customers appreciate when their voices are heard. The simple acknowledgement that a company is receptive to feedback and their problems will be addressed can be a catalyst for repeat business.

Increasing the effectiveness of customer communication also applies to sales and marketing copy. You can measure the performance of communication with customers by assessing churn rate and ad conversion rate.

Loyalty Program

Implementing a loyalty program can be a great way to personalize the customer experience while incentivizing repeat purchases. Some common loyalty programs offer reward points, or the ability to unlock free and discounted product after the accumulation of purchases. For example, buy nine cups of coffee and get the tenth free.

Customers are proud of the rewards they accrue and companies are rewarded with an increase in customer lifetime value. An airline, for example, rewards customers who make purchases using their exclusive credit card with free miles that can contribute to the cost of a flight or accrue to a free flight.  

Retargeting

One of the most important tactics to improve customer lifetime value is to re-engage customers who have had a previous experience with the brand. Retargeting can be a simple reminder of the company and at the very least, increase brand recognition. Products with a shelf life can greatly benefit from retargeting efforts as their time-sensitive nature will require another purchase.

Customer lifetime value is a metric that all businesses should consider when planning for future growth and projecting profitability pro formas. Businesses should implement strategies to increase the customer lifetime value, especially since the cost to retain an existing customer is substantially less than acquiring a new customer.

Customer Lifetime Value Statistics

  1. A 5% increase in retention produces a 25% increase in profit.*
  2. Acquiring a new customer is between 5x and 25x more expensive than retaining an existing customer.*
  3. The probability of converting an existing customer is between 60%-70%.*
  4. Existing customers spend 67% more on average than new customers.*
  5. 76% of companies see CLV as an important concept for their organization.*


Calculating customer lifetime value with example food delivery company

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