Calculating Customer Lifetime Value (and why it’s crucial to profitability)
There are many vital metrics that govern the success of a business. Customer lifetime value, CLV, is perhaps at the top of the list. CLV refers to the financial projection of the average profitability during the lifetime relationship between a customer and a business. Business owners can significantly improve customer retention rates by implementing strategic sales and marketing efforts according to the value of their CLV.
The CLV concept is calculated based on various business metrics. We will apply the CLV model from an annual perspective.
Average Purchase Value (APV)
The first step involves the calculation of the average purchase value, APV, which determines the average amount of money spent by customers during a given time-frame. This is calculated by dividing a company’s total revenue (in a year according to our example) divided by the total number of sales during that time.
Average Purchase Frequency (APF)
The next step involves calculating the average frequency of sales experienced by a company. This refers to how often customers make purchases during a given time-frame. We can acquire the average purchase frequency by dividing the total number of purchases in a year with the total number of unique customers during that time.
Customer Value (CV)
Customer value must be calculated before determining the CLV. This refers to how much a customer spends during a given time frame (as opposed to the entire lifespan of the business-customer relationship). Customer value can be calculated by multiplying the APV with the APF.
APV × APF = CV
Average Customer Lifespan (ACL)
ACL is the final metric required for CLV calculation. It refers to the average number of years that a customer purchases actively from a business before settling into a dormant business relationship.
There are various ways to calculate ACL, however, as a quick reference, industry experts such as analyst Avinash Kaushik places this at about 1–3 years for most companies. Startups are more likely to experience lower ACL values compared to well-established brands in the industry.
Customer Lifetime Value (CLV)
Business owners will be able to calculate the CLV of their company once they have established the CV and ACL values. This is achieved by multiplying the CV with the ACL. The acquired value is the expected revenue from an average customer during the entirety of a business-customer relationship. CLV plays a major role in determining business strategies as it determines the urgency of customer retention rates and when to act.
There are variants to the formula of CLV calculation, which results in accurate values for more effective business responses.
The first variant involves the factoring in of business-related costs, which includes overheads, customer acquisition costs such as ongoing marketing and sales expenses, operating expenses, and manufacturing fees. For example, this might result in an average profit margin of about 25%.
Thus, the true CLV under this method of calculation is multiplied against 25% to achieve a much humbler value. This method will help business owners accurately calculate current cash flow and determine the number of customers required in reaching profitability targets.
In other words, this method helps to separate the profits from the total revenue to determine how much a company earns.
CV × ACL × Profit Margin = CLV
The second variant involves calculating CLV according to market segments. In this variation, CLV is calculated according to the type of customer. For example, a company might come up with separate values by dividing customers into channels (offline vs online customers), location (domestic vs international customers), or customer behavior (customers subscribed to newsletter vs non-subscriptions). This will help business owners determine where the aggregate of customer revenue is streaming from and which segment works best.
Putting it all Together
We will be referring to a hypothetical bubble tea business to demonstrate the calculations of the CLV model.
For example, if the CV of the bubble tea business (on an annual basis) is $780 and ACL is at two years, this amount to a CLV of $1560.
However, to calculate profitability, business owners need to factor in the profit margin value. We will be applying a 25% profit margin for our example. Thus, 25% of $1560 gives us a CLV at only $390. This provides business owners with an average projection of their profits with each customer on a long-term basis and determines the budget to be invested in customer acquisition efforts.
Ways to Improve Customer Lifetime Value
Customer lifetime value is essential in assessing the success of a business. Although the acquisition of new customers is a necessary process in the future of a business, customer retention is equally, if not more crucial. Keeping the right customers/regulars has been proven to strengthen business revenues. Research shows that a 5% increase in customer retention has been known to raise profitability as much as 95%.
There are various strategies to improve the CLV of a business. These include:
- Paying careful attention to the initial customer experience, and providing exceptional onboarding processes. This means that brands need to ensure that customer queries are swiftly attended to while products and services are of the highest quality. The first impression on a customer is a major factor for CLV results.
- Retaining customer relationships by fostering brand loyalty through personalized services, and loyalty programs that offer incentivized services.
- Retargetting past customers who have become inactive. Provide a reminder of the brand’s offerings with a soft approach. Businesses dealing with perishables will have an easier time convincing customers to replace expired items via renewed patronage.
An estimated 76% of companies strongly believe in the importance of customer lifetime values. Yet, only 42% of companies are able to accurately measure CLV. It is important for business owners to be better aware of CLV metrics to calculate the most accurate assessment of their revenue to optimize the financial health of their brands.
Seeking Professional Support
Lift Digital Marketing is a specialist in the field that provides businesses with effective marketing solutions for their branding needs. Our team is ever ready to optimize strategies that will raise the profitability of your marketing campaigns. Contact us to learn how we can improve your customer lifetime value for long-term results.