Customer lifetime value (CLTV, or CLV) is a measure of the total income a business can expect to bring in from a typical customer for as long as that person or account remains a client. It’s an important metric because it’s a measurement of how valuable a customer is to your company, not just on a purchase-by-purchase basis but across the entire lifetime of the relationship.
Knowing that it costs less to keep existing customers than it does to acquire new ones, increasing the value of your existing customers is a great way to drive revenue growth and profits.
By knowing your CLV on an account or customer by customer basis allows you to determine which customers or accounts contribute the most revenue to your business. This allows you to serve these existing with products/services they like and make them happier, resulting in them spending more money at your company.
CLV can also be used to 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. With that knowledge, you can develop a customer acquisition strategy that targets similar customers.
To get started calculating 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. Then, once you calculate the average customer lifespan, you can multiply that by customer value to determine the total customer lifetime value.
Simply put, the formula for Customer Lifetime Value = (Customer Value * Average Customer Lifespan) where Customer Value = Average Purchase Value * Average Number of Purchases.
For example, a fictitious coffee shop chain called EZ Bean has three locations and has an average sale of $5 per customer. The typical customer is a local worker who visits two times per week, 50 weeks per year, over an average of 5 years.
With the above information we now have all the variables needed to calculate the CLV for EZ Bean.
CLV = $5 (average sale) x 100 (annual visits) x 5 years (lifespan) = $2,500
A metric that usually comes along with CLV is Customer Acquisition Cost (CAC). CAC considers the costs of acquiring a new customer, such as sales and marketing expenditures. The purpose is to compare the lifetime value of a customer and the expense of getting a new customer for decision-making related to business viability.
The formula for CAC is sales and marketing costs divided by the total number of new customers during the same period. Sales and marketing costs include salaries, advertisements, campaigns, and promotions. The number of new customers is the total headcount of new customers you have at a specific length of time.
Customer Acquisition Cost = Sales and Marketing Costs / New Customers
For example, if a retailer has a CLV of $100 while CAC is $150, it means that the business is not profitable due to the high CAC. In this case, the retailer should review its costs for sales and marketing because it doesn’t generate any profits from getting new customers. Based on the above example, we can see how breaking down CLV and CAC offers insights into financial conditions and future profitability.
Examining the relationship between CLV and CAC reveals the significance of a customer to your business. If a customer's CLV is unusually higher than others, are the costs of getting that specific customer the same? In contrast, if a customer costs you a lot more to acquire than the others, does it affect that customer's CLV? Understanding CLV and CAC metrics allows you to investigate these questions.
Businesses also examine Cost to Serve (CTS), which associates with all the cost factors to deliver the products or services to a customer. The calculation of CTS may involve allocating fixed costs to servicing a customer, such as transportation, warehouse, product returns, and call center expenses. Looking into CTS helps you reduce servicing costs and improve internal processes.
CTS is a long-term cost system over the entire customer lifespan instead of a one-time acquisition cost. Therefore, CTS might shift simultaneously, directly affecting financial performance. For example, if a customer constantly returns purchased products, the CTS will soar, resulting in decreased profits.
In short, as you track how much customers are costing your business on a granular basis, you can get to the bottom line of profitability. CLV and CTS are effective metrics for evaluating the cost of acquisition and servicing a customer. Again, maintaining a good balance of revenue and expense is essential to business viability and profitability.
To increase CLV, you need to pay close attention to the components of the CLV formula. Indeed, the calculation of CLV comprises the average purchase value, the average number of purchases, and the average customer lifespan. Thus, boosting these factors altogether improves your CLV ultimately.
There are multiple methods to make your CLV rise, but they all come hand in hand with fostering customer relationships. In other words, customers with positive experiences tend to revisit more frequently and purchase more items in the long run. Consider the following tips to boost your CLV metric and generate more profits for your business:
In this section, let's analyze the contributing variables of CLV. From a data-driven approach, understanding the components allows you to identify which factors affect the overall customer lifespan value. As mentioned above, the CLV formula is the average purchase value multiplied by the average number of purchases per year and the average customer lifespan.
Customer Lifetime Value = Average purchase value * Average number of purchases per year * Average customer lifespan
Average purchase value = Total revenue / Total number of purchases
Average number of purchases = Number of purchases / Number of customers
Customer value = Average purchase value * Average number of purchases
Average customer lifespan = Sum of customer lifespans / Number of customers
A local coffee shop collects data to investigate customer purchase habits and calculate the Customer Lifetime Value. The total revenue of the shop over the past year is $100,000 from 20,000 purchase orders. The number of customers the coffee shop serves during the same period is 400. Since the shop has operated for a long time in the neighborhood, the sum of customer lifespans is 4,000 years.
Following the steps to calculating CLV, we first apply the formula to get the average purchase value. The result shows that each customer spends $5 per visit.
Average purchase value = $100,000 / 20,000 = $5
Next, we continue finding the average number of purchases during the year by dividing the number of purchases by the number of customers. The result suggests each customer makes 50 purchases per year on average.
Average number of purchases per year = 20,000 / 400 = 50
The customer value for the coffee shop is the average purchase value multiplied by the average number of purchases. The metric displays how much money a customer brings to the business in one year.
Customer value = $5 * 50 = $250
To get the average customer lifespan in this scenario, we divide the sum of customer lifespans by the number of customers.
Average customer lifespan = 4,000 years / 400 = 10 years
Finally, using the formula for CLV and the above metrics, we get a value of $2,500.
CLV = $5 * 50 * 10 = $2,500
To improve Customer Lifetime Value (CLV), businesses can use various strategies such as changing pricing, upselling, cross-selling, investing in a loyalty program or referral program, and improving their brand image. For instance, changing pricing or increasing the average purchase value can directly impact CLV. Investing in a loyalty or referral program can indirectly improve CLV by increasing the number of purchases per customer. However, these methods may come with additional costs. Another way to improve CLV is by establishing a strong brand image and providing exceptional customer experiences and high-quality products. This can lead to increased customer retention and better lifetime relationships.