Did you know that acquiring a new customer can cost five times more than retaining an existing one? That's where the concept of Customer Lifetime Value (CLV) comes in.
Understanding CLV is crucial for any business looking to not only retain customers, but also maximize their profitability over the long-term. In this blog post, we'll delve into what exactly CLV is and why it should be a key metric in your company's growth strategy.
Let's see what is customer lifetime value and how to calculate it.
What is customer lifetime value
Customer lifetime value (CLV) is the metric that represents the total net revenue a company expects to earn from a customer over the entire lifetime of their relationship.
In other words, CLV is a projection of how much revenue one can expect to generate from a single customer before that customer leaves or stops doing business with the company.
There are many factors that go into calculating CLV, but the basic formula is:
CLV = (Average Order Value x Purchase Frequency)/Churn Rate
To break this down, let’s look at each component of the equation:
average order value (AOV): This is how much money, on average, a customer spends per order.
purchase frequency: This is how often, on average, a customer makes a purchase.
churn rate: This is the percentage of customers who stop doing business with a company over a given period of time.
Knowing your CLV is important because it allows you to make informed decisions about where to allocate your marketing budget and other resources.
For example, if you know that the CLV for your best customers is $1,000 and the CLV for your average customers is $100, then you know that it makes more sense to focus your efforts on attracting and retaining high-value customers rather than trying to increase conversions among low-value customers.
Lifetime Value Calculation
The lifetime value of a customer (CLV) is the net present value of the future cash flows from the customer during their entire relationship with your business and you need to evaluate to understand the business healthy.
Let’s see a couple examples of how big companies have adopted CLV results.
There are some methods how to calculate Customer lifetime value and below we're going to list a couple we define effective to apply.
How to calculate customer lifetime value, Method #1
This is Customer lifetime value clv with ARPU - Simplest method
Let’s suppose 14 customers buy €3580 in profit over a three-month period.
ARPU (3 months) = 3580€ / 14 = 255€
Let’s see what these customers will bring us in one year.
ARPU (12 months) = ARPU (3 months) × 4 = 255 × 4 = €1020 per year per customer
The historical CLV equals the ARPU for one year, which is 1020€ based on the sample data.
How to calculate customer lifetime value, Method #2
This is customer lifetime value clv – the most detailed one
- First, we’ll calculate the average purchase frequency (T):
Period: 6 months
Total transactions: 120
T = 120 / 6 = 20
2. AOV is the average value of an order, or the average revenue from each order.
Total revenue (November): $12,000
Number of orders: 20
AOV = $12,000 / 20 = $600
3. AGM is the average gross margin:
it tells you what part of each sale is your actual profit and what part is the cost (expressed as a percentage). We need to perform a two-step calculation to get AGM.
3.1 Determine the gross margin (GM) percentage per month:
Total revenue (November): $12,000
Cost of sales: $8,000
Gross margin (%) = (($12,000 — $8,000) / $12,000) × 100 = 33%
3.2 Let’s take a six-month period to get the average:
Total gross margin: 1.64
AGV = 1.64 / 6 = 0.27, or 27%
3.3 ALT represents the average lifespan of a customer, which tells you how long the average customer has been with your company.
To get this figure, use this formula:
To measure your churn rate, use this formula:
Suppose you had 200 customers at the beginning of November and 150 customers at the end of November.
Churn rate (%) = (200–150) / 200 = 50 / 200 = 0.25, or 25%
ALT = 1 / 25% = 1 / 0.25 = 4 months
Finally, we have all the metrics for our CLV prediction formula:
- Average number of transactions per month (T) = 20
- Average order value (AOV) = $600
- Average gross margin (AGM) = 27%
- Average customer lifespan in months (ALT) = 4 months
CLV (total) = 20 × $600 × 27% × 4 = $1,296,000
Now, we should take into account the total number of existing customers at the end of the latest month, November, which was 150.
Predicted CLV = $1,296,000 / 150 = $8,640
This formula can be used to help make decisions about marketing investment, pricing, product development, and more. The average customer, purchase value and average purchase frequency are the number of evaluate your customers and how much is profitable in the long term.
The number of CLV does your business, and not considering it'll make you a failure and an assist to your competitors. Start calculating the average customer lifespan in your database and how much time they click or open an email – they're indicators of how healthy your database is and how much effectiveness you have now.
You need to evaluate the lifetime value of a subset of customers using a simple survey sent to the most loyal group, a few questions about your merchandising or Customer Experience. Once you have your metrics, you can continue expanding to other groups of customers.
Considering your current purchase history, the customer lifetime value is a way to understand how to spend in your marketing campaigns and how much budget we can dedicate to acquire a new customer. The number of customers, the average purchase frequency and the value of your AOV (Average Order Value or average purchase value) are the basis of the value of a customer.
In every business, the clv changes, and it should be different, but it should be one of the North Polar Star to take into consideration in all business activities and the marketing campaigns and forecasts.
How to calculate the customer lifetime value is the difference between a solid marketing strategy and a poor one.