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Customer lifetime value was born out of the need for businesses to attract and retain the most valuable clients. Acquiring and retaining customers is hard, so you want to be sure that you are concentrating your efforts on clients who present the highest ROI for your organization.
By tracking CLV, businesses can predict consumers’ purchasing behaviors and map out strategies to increase their value to existing clients and acquire new ones. This article will discuss the common factors affecting customer lifetime value and how to increase CLV for your business.
Customer lifetime represents the total monetary worth of a customer to a business throughout their interactions and relationship with the organization in question. In other words, it is how much a customer is projected to spend on your product or service, from the moment they make their first purchase until they stop patronizing your business.
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Common factors considered for Customer Lifetime Value (CLV) include:
Here’s a simple scenario that explains this point.
Let’s say Customer A is projected to spend $1,000 per purchase at a 2-year interval over ten years, and Customer B is expected to make a one-time purchase worth $3,000. In this case, Customer A has a higher value than B.
Organizations fuss over customer lifetime value because it has several implications for business growth, revenue, and profit—you can think of it as a cheat sheet for business success. The most obvious impact is it helps businesses to identify the customers with the highest value prospect. With this, you can decide how much money to invest in customer acquisition and customer retention.
For example, if a hot lead is estimated to spend $75,000 on your business over 15 years, investing in that relationship might be a wise call for your organization.
Customer Lifetime Value can be historical or predictive depending on the approach of your organization.
Historical lifetime value refers to how much profit a business has made from a customer’s previous purchases. It also accounts for different direct costs incurred as part of the services provided for the customer, including the cost of returns, acquisition costs, and marketing spend. You can measure the percentage of net profit accruable to a customer’s purchases from historical lifetime value.
How to Determine Historical Lifetime Value for Your Business
Historical Lifetime Value Formula
Historical Lifetime Value = (Sum of past transactions) ÷ Average Gross Margin
Here, the Average Gross Margin is the result of dividing the difference between total revenue and costs of goods sold by total revenue and converting the result to a percentage.
When To Use Historical Lifetime Value
If you want to know how much profit your company has made from an individual customer, then historical lifetime value is your best bet.
Predictive customer lifetime value depends on the historical data of customer behaviors to predict the actions they’d take in the future. It aims to generate a precise CLV based on the transactional behaviors of your customers.
If you’re looking to estimate a customer’s ROI as accurately as possible, you should depend on predictive customer lifetime value.
Predictive Customer Lifetime Value = T × AOV × AGM × ALT
Where;
T = Average Monthly Transactions
AOV = Average Order Value
ALT = Average Customer Lifespan (in months)
AGM = Average Gross Margin
The most important factors that influence CLV are:
As the name suggests, Customer Acquisition Cost refers to how much money a company spends on acquiring a customer. CAC varies based on the number of touchpoints (think advertising, marketing, promos, and offers) that a potential client came in contact with before making their first purchase.
In this sense, a customer’s CLV must be higher than their acquisition cost; else, your business runs at a loss. If you spend $1,000 to acquire a customer with a CLV of $300, you are losing money.
To know a customer’s acquisition cost, simply divide the total money spent on marketing and sales by the number of first-time customers acquired in that same period. This means:
CAC= (Total Marketing Expenses + Total Sales Expenses) ÷ The Total Number of Customers Acquired
Here’s how this pans out in real-time.
If an organization spent $5,000 to acquire 50 customers, their customer acquisition cost for that period is $100.
A customer’s annual profit is the average amount of money they help your business generate. If your company provides multiple services or has various products on sale, you should consider the total amount of purchases a customer has made across your catalog. For example, a content marketing agency providing both SEO services and thought-leadership writing services would score customer revenue based on how much a client has invested in both products.
To calculate customer annual profit, subtract any direct costs such as the money spent on providing a service to the customer and any retention costs from the total revenue generated from the customer’s purchases. In other words;
Customer Annual Profit = Total Customer Revenue – Direct Costs
So, if a company generates $4,000 in sales from a client and incurs direct costs worth $1,000, the Customer’s Annual Profit is $3,000.
The lifetime of a customer to the firm means the amount of time you expect them to keep patronizing your business. Often, this depends on the type of product or service provided and other factors like the geographical location of your business and the accessibility of your product or service.
For example, if you run a rental service for college students, each customer’s lifetime would be the duration they spend in college, let’s say three or four years. On the flip side, if you sell a consumable distributed across geographical locations, you will retain your customers for a longer time, all things being equal.
Before calculating customer lifetime value, you need to determine lifetime value for your organization. Lifetime value represents the total cash flow from customers over a specific period.
To arrive at the lifetime value for your organization, simply multiply the average order value by purchase frequency and retention time period. In other words;
LTV = Average Value of Sale × Number of Transactions × Retention Time Period
CLV = Lifetime Value × Profit Margin
Where;
Average Value of Sale is equal to the average amount of money a customer spends per purchase. To know this, divide the total revenue generated over time by the number of orders the client placed in that period.
Number of Transactions refers to the total amount of purchases a customer has made over a given period.
Retention Time Period refers to how long a customer has patronized your business.
Profit Margin represents the percentage of profit made from every dollar of sale in your business. You can arrive at your profit margin by subtracting total expenses from sales, dividing the result by the revenue generated over the specific period, and multiplying the result by 100.
Once you know the lifetime value, multiply it by the business profit margin to determine the Customer Lifetime Value.
Here’s how to put all of these to work.
Let’s say a customer has an average value of sale worth $100, a total number of 10 transactions, a 2-year retention time period, and a 0.5% profit margin. This means;
LV = $100 × 10 × 2 = $2,000
Now multiply $2,000 by the 0.5% profit margin. This gives you a CLV of $10.
If you prefer not to bug yourself with calculations, you can use the Formplus Free LTV calculator to determine customer lifetime value.
As you calculate customer lifetime value for your business, you’d likely come across several other metrics. These metrics have some degree of effect on the figures you arrive at in the end. Let’s examine a handful of them in this section.
As the name suggests, average purchase value measures the average value of every sales transaction.
It is calculated by dividing the company’s total revenue over a period by the total purchases made by its customers during that same timeframe.
Average Purchase Value Formula
Average Purchase Value = Total Revenue ÷ Total Number of Purchases.
So, if an organization generated $100,000 in sales from 50 purchases, its average purchase value is $2,000.
The average purchase frequency rate measures the number of times a customer patronizes your business over a specific time frame. It is the result of dividing the total purchases made over time by the individual customers who made those purchases during that time.
Average Purchase Frequency Rate Formula
Average Purchase Frequency Rate = Total Number of Purchases ÷ Total Number of Unique Customers
Let’s say a company recorded 1,000 purchases from 100 customers. Its average purchase frequency rate, based on the formula stated earlier, is 10.
Average customer value measures the average revenue value from each customer within a given timeframe. It is the result of multiplying the average value of the purchase by the number of times the purchase is made.
Average Customer Value Formula
Average Customer Value = Average Purchase Value × Average Purchase Frequency Rate
This means that a business with an average purchase value of $3,000 and an average purchase frequency rate of 10 will have $30,000 as its average customer value.
Average customer lifespan is the average number of years that a customer continues to buy a company’s goods and services. It is equal to the average number of days between a customer’s first and last purchases from your business.
Average Customer Lifespan Formula
Average Customer Lifespan = [1st Order Date – Last Order Date (in days)] ÷ 365 days
For example, if the difference between the first and last order dates is 2,555 days, the average customer lifespan is seven years.
Share of wallet refers to the amount of money a customer spends on your business regularly rather than buying from your competitors. You can also think of it as the percentage of a customer’s budget dedicated to patronizing your business.
Calculating the share of wallet for a business is quite complex. You need to draw up an industry list of direct competitors and see how your brand ranks in this list. Since you cannot do the ranking, you need to conduct a customer feedback survey to gather helpful responses from your existing clients.
Share of Wallet Formula
(1– Rank/Number of Brands +1) × (2/Number of Brands)
For example, let’s say your brand ranks second place in a list consisting of 4 competitors. Based on this formula, your share of wallet is:
(1– ⅖) × (⅖)
⅗ × ⅖ = 6/25 or 24%
Share of Wallet = 24%
From all we’ve discovered so far, it should be somewhat clear that customer lifetime value isn’t a linear metric. As your organization scales, you’d pay increasing attention to factors like churn rate and brand loyalty that significantly affect customer lifetime value.
Churn rate or rate of attrition refers to the percentage of existing customers who stop purchasing your product or using your service for one reason or the other. No matter how excellent your services and customer experience are, your business must record some percentage of churn over time. For example, if a customer experiences a dip in purchasing power, they might stop subscribing to your product.
High churn rates can upturn an organization’s customer lifetime value.
If you expect a customer to patronize your business for two years, but they drop off abruptly at the sixth month, it will have a far-reaching impact on your customer retention rate. It also means you have to invest more money in acquiring new customers to meet projected cash flow and profit.
How to Calculate Churn Rate
Churn Rate = (Total Number of Lost Customers ÷ Number of Initial Customers within the timeframe) × 100
Let’s say a business kicked off 2020 with 1,000 customers and lost 250 along the way; its churn rate is 25%.
Brand loyalty is a qualitative characteristic representing the extent to which existing customers are devoted to your business. It manifests through several behaviors such as repeated patronage and word-of-mouth marketing.
Net Promoter Score and Customer Satisfaction Score are standard methods for tracking brand loyalty in an organization. If many of your customers leave positive reviews and are willing to recommend your business to others, this shows that they are loyal to your organization.
Loyal customers have a higher lifetime value because they are willing to spend more money for your business over a more extended period. A sure-fire way to boost brand loyalty is by investing in customer experience and customer satisfaction across multiple touchpoints.
Example 1
A car manufacturer has records the following in a business year:
Average Value of Sale = $1,000,000
Total Number of Transactions = 200
Profit Margin = 2%
Retention Time Period = 4 years
First, we calculate the company’s lifetime value.
Lifetime Value = Average Value of Sale × Number of Transactions × Retention Time Period
$1,000,000 × 200 × 4 = $800,000,000
Next, we multiply lifetime value by the 2% profit margin.
Customer Lifetime Value = $16,000,000
Example 2
A college-based hospitality business records the following numbers for its meal subscription service:
Average Value of Sale = $40,000
Total Number of Transactions = 1,000
Profit Margin = 1%
Retention Time Period = 2 years
Based on these data sets, the lifetime value of the business is;
$40,000 × 1,000 × 2 = $80,000,000
Customer Lifetime Value = $80,000,000 × 1% = $800,000
Customer lifetime value is a critical part of decision-making for both customer-facing teams and executives in the workplace.
Unlike NPS and CSAT, CLV doesn’t measure customer satisfaction, customer experience, or word of mouth marketing, although these factors influence how long people are willing to patronize your business. Instead, it draws a straight line from the customer’s purchasing power to the financial value it provides for your business.
Customer lifetime value helps business executives to develop the right strategies for acquiring and retaining customers. While on that, customer lifetime value enables you to prioritize investments objectively—you’d know when you increase marketing and sales spend to convert a lead.
Product teams consider customer lifetime value as they make product improvements for the market. Sales teams use CLV to decide on the types of customers they should spend time acquiring. In addition, customer support teams depend on CLV to know how much money needs to be spent hiring talented customer support staff to provide impeccable customer service.
If a business doubles down on retaining high-value customers, it can unlock a new phase in its prosperity. So, how do you go about this? Here, we’ll walk you through 4 practical steps for improving CLV for your organization.
The accuracy of your CLV calculation depends on the quality of data you work with. This means you need to gather first-hand information from your existing customers regarding their experience with your organization and suggestions for improvements.
With Formplus, you can create effective surveys, questionnaires, and polls for CLV data collection for free. You also have access to more than 1,000 customizable templates, which speeds up the data-gathering process.
Sign up for a free Formplus account here.
If you want to outclass the competition, you must treat your customers differently. This means you should invest in creating exciting and positive experiences for people; from their first point of contact with your business right until they become repeat customers.
Create an impartial reward system for outstanding customers. This is an intelligent way to show them that you appreciate their patronage while nurturing deeper relationships. You should consider a customer loyalty program as part of your acquisition costs.
More than rewarding happy customers, you should also pay attention to clients dissatisfied with your product or service. You can set up feedback channels with which unhappy customers can swiftly report any issues they’ve faced with your product.
Consider sending out pilot surveys for quick check-ins. More importantly, make sure you act on the issues customers raise via these surveys. This way, you can reduce your churn rate and increase the business LTV.
Conclusion
Ultimately, the goal of CLV is to help you create lasting and rewarding relationships with your customers. This is why you should prioritize creating the right experiences for your clients across different touchpoints. Make your customers feel like an essential part of your business, and you would have them around for a longer time.
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