Customer Lifetime Value (CLV) – how to calculate and measure
Calculating Customer Lifetime Value is a widespread practice among both e-commerce business owners and marketers. However, not everyone approaches this metric with the same mindset.
The value of the CLV doesn’t lie in finding ways to acquire customers, cheaper. It lies in optimizing customer acquisition costs.
If you’re in the eCommerce game, you can’t afford to go on without understanding the impact of your Customer Lifetime Value.
What is the Customer Lifetime Value
The CLV is defined as the prediction of the net profit attributed to the entire future relationship with a customer.
CLV is one of the key metrics which needs to be monitored as part of the customer experience program as it reveals how valuable a customer is to a business for an unlimited period of time as opposed to referring to their first purchase solely.
How to calculate the customer lifetime value
The simplest formula would be:
CLV = customer revenue – the cost of acquiring and serving that customer
Let’s say every year, for Mother’s Day, you send your mother the same $70 flower bouquet. If you’ve been doing this for the past 5 years, your lifetime value for your florist is $350. However, this simple formula does not always apply as most businesses are more complicated than that. So two other methods have been proposed: historical and predictive CLV.
The historical CLV is the sum of the gross profit from all historical purchases for an individual customer. Determining the customer lifetime value based on profit shows you the actual profit a customer is bringing to your store. To determine the historical CLV, first you need to:
- Identify the touchpoints where your customer creates value;
- Integrate records and create a customer journey;
- Measure your revenue at each touchpoint;
- Add everything over the lifetime of that customer.
Then, you can use the formula below:
Historical CLV = (Transaction 1 + Transaction 2 + … + Last transaction) * Average gross margin
The historical CLV takes into account customer service costs (cost of returns, acquisition costs, cost of marketing tools, etc.). The problem with this method is that it can be complicated to calculate on an individual basis, especially if you want the figures to constantly be up to date.
A more efficient way to determine the customer lifetime value is through predictive CLV. The predictive CLV is built based on predictive analysis and takes into account previous transactions plus various behavioral indicators that forecast the lifetime value of an individual. This value becomes more accurate with every purchase and interaction, so this is a better method to calculate customer lifetime value.
To calculate the predictive CLV you need to:
- Identify the touchpoints where your customer creates value;
- Find out what determines that value and if it differs from customer to segment;
- Identify why a customer has moved from one moment to the next.
Then, you can determine the predictive CLV in two ways:
Simple predictive CLV:
CLV = ((Average monthly transactions * Average order value) * Average gross margin) * Average customer lifespan
*where the average customer lifespan is calculated in months. This formula is also used to determine the detailed predictive CLV.
Detailed predictive CLV:
CLV = CLVs * Monthly retention rate1 + Monthly discount rate – Monthly retention rate
One thing to keep in mind when calculating the predictive CLV is that it will never be 100% accurate as this is just a forecast. However, if you personalize the formula for your business, you can determine a highly-accurate customer lifetime value.
Also, note that the equations above don’t take into account the cost associated with retaining a customer. To get a net value for your CLV, you will also need to calculate this. And if you really want to be accurate, you may also want to consider interaction and transactional information for each customer, as every individual is unique.
Lifetime value to Customer Acquisition Cost Ratio
The ratio between CLV and CoCA (customer acquisition cost) is one of the most important aspects that a VC will look at before investing in your company.
You simply can’t acquire customers forever. So finding the right customer acquisition and retention mix is the key for a sustainable for eCommerce growth.
A good ratio would be 2, a bad one would be below 2 and the best ratio is 3.
If it is below 2, that means your either doing this consciously in order to gain market share, either your business is bleeding money.
If it’s above 3, it usually means you’re either harvesting cash because your business can’t grow anymore as you are the market leader and don’t want to diversify. Another possible explanation for this value could be the fact you’re too prudent and don’t want to grow faster, or you’re not aware of this and you don’t want to go faster.
Customer lifetime value benchmarks
After all the effort you put in to determine your CLV you might also want to know where you stand compared to your competitors. Although each e-commerce business is different and their customer lifetime value varies, there are some benchmarks you can use to roughly estimate your position.
Customer lifetime value analysis (Case Studies)
Starbucks is always opening new stores around the world, its acquisition strategy being frequently copied. For this case study, I am going to use data from 2004. The numbers do not reflect the company’s current status, but they can be used to exemplify how you should determine your customer lifetime value.
Step 1: Find out your average
To simplify calculations, let’s say you only have three customers. Customer 1 spends $4 per visit. Customer 2 spends $6 per visit. And customer 3 spends $9 per visit. The average will be $6.33 (I’ll call this value ‘s’, the average spend per customer).
Now, for the purchase cycle, customer 1 visits you 5 times a week, customer 2 visits you 3 times a week, and customer 3 does it 6 times a week. The average number of visits is 4.66 (I’ll call this ‘c’).
Last but not least, your average customer value per week (expenditures * visits) is $20 for customer 1, $18 for customer 2, and $54 for customer 3. The average across the three customers is $30.66 (I’ll call this value ‘a’).
Step 2: Calculate the CLV
To determine the customer lifetime value, I will also use some constants:
Average customer lifespan (t) = how long an individual remains a customer. For Starbucks, that’s 20 years.
Customer retention rate (r) = the percentage of customers who repurchase over a given period of time when compared to an equal preceding period. Starbucks’ retention rate is 75%.
Profit margin per customer (p) = For Starbucks that’s 21.3%.
Rate of discount (i) = the interest rate used in discounted cash flow analysis to determine the present value of future cash flows. Usually, the rate of discount is between 8% and 15%. For Starbucks, it’s 10%.
Average gross margin per customer lifetime (m) = Starbucks has a profit margin of 21.3% (p). If the average customer spends $31.886 (52 * a * t) during their life as a customer (t), Starbucks has a gross margin per customer lifespan of $6.791 (profit margin * expected customer lifetime expenditure).
A large corporation like Starbucks will use several methods to determine the customer lifetime value, as well as marketing budgets and acquisition costs.
Determining your customer lifetime value is just the beginning. What you do with that information is what will determine your business’ success. Because now you know how much you should be spending to acquire a customer, from overhead to marketing.
Let’s look at Netflix. An average Netflix subscriber stays on board for 25 months and has a lifetime value of $291.25.
If you’d subscribe to Netflix right now, you would pay around $8.97 per month (that’s the cheapest price plan), which means $107.64 per year. If you were Netflix, would you spend $150 to acquire a customer?
It seems counterintuitive to spend more to acquire a customer and still be profitable, but that’s why determining your customer lifetime value is important. Yes, Netflix would lose $42.36 in the first year, but as I mentioned earlier, the average Netflix user stays a customer for 25 months. So even if the company doesn’t make an immediate profit, it doesn’t mean it remains unprofitable.
You shouldn’t be afraid to lose money in the short run if that can boost your revenue in the long run. In order to determine how much you can afford to lose in the short run, you need to know the lifetime value of your customers. Without that number, it’s impossible to optimize your revenue.
Maximizing the customer lifetime value
Each customer is unique. Some will not pay for Netflix; not even for a month. Some might remain customers for several years, while some might never want to cancel their subscription. Not to mention that Netflix offers three different price plans – a premium user who remains a customer for three years is more valuable than a customer who has the cheapest price plan for four years.
By tracking each customer individually, Netflix can optimize their lifetime value. For example, if you stop watching movies, they know you might cancel your subscription sooner or later. So, they can start persuading you into remaining a customer long before you even think of canceling your subscription. By tracking stats and behavior of users, Netflix is reducing its churn rate.
To maximize your revenue per customer you need to track each individual. By monitoring the specific events and actions your customers are taking on your website, you can determine the steps or features that will influence people to engage more. Users that engage more are happy customers, and happy customers will remain with your company for longer.
Maximizing customer acquisition
Netflix knows their customer lifetime value and has fine-tuned their product to reduce churn so they can afford to spend more on marketing. For example, they pay affiliates $16 for every customer they bring in. It might not seem that much, but take into consideration the fact that Netflix offers the first month for free and many users don’t turn into paying customers after that. So, affiliates are paid $16 for each user no matter if those users become profitable or not.
However, a percentage of those users actually do turn into paying customers. Otherwise, Netflix wouldn’t be able to keep paying affiliates $16 or spend $2 for every click from their Google AdWords campaign. The point I want to make is you can’t keep dumping money into marketing if you don’t know your lifetime value metrics well.