What is Customer Lifetime Value and how to calculate it

Any business in today's world needs the proper data on various metrics to understand how much to spend on an average customer’s retention and acquisition.

Customer Lifetime Value (CLV) makes this process simpler since it helps us understand how much a customer is worth to a business over the course of their relationship.

Knowing the Customer's Lifetime Value also helps businesses divide their customers into various segments. This basically helps businesses differentiate between the high-value and low-value CLV segments of their existing base.

This strategy helps businesses properly understand to which customer base they have to pay more attention and what areas they need to focus on. In short, it helps businesses create a strategy that can optimize their customer retention and growth efforts.

There are many businesses that have used Customer Lifetime Value in the above ways to their advantage.

The most notable company to use Customer Lifetime Value data of its customer to attract and retain its high-value customers is Amazon. The average Amazon prime customer spends $1400 per year on products, compared to just $600 for non-prime customers.

The most important thing is that Amazon can retain and increase the portion of these high-value customers consistently through prime subscriptions (which provide the customers with additional benefits).

What is Customer Lifetime Value?

Customer Lifetime Value (CLV) is the total amount of money you expect your customer to spend during their entire relationship with your company.

This is an important figure to know because it determines what kind of return on investment you can expect from your marketing efforts.

If you have a high Customer Lifetime Value, then it means that your customers will spend a lot of money with you over time. They’re worth investing in because they’ll make up for their initial cost many times over.

As an example, let’s say you sell custom-tailored suits to men and women. Your average customer spends about $1500 on their first suit and purchases two suits annually. Each customer will probably have a relationship with us for 4 years.

Now let us calculate CLV for the above:

CLV = Average value of a purchase average purchase rate per year Average customer Lifespan

CLV = $1500 (Per Suit) 2 (Suits per year) 4 (years) = $12000

This is the simplest way to calculate Customer Lifetime Value. There are many more ways to calculate Customer Lifetime Value and a host of other unseen factors that have a direct impact on CLV. We will talk about this later in the article.

Why is Customer Lifetime Value so important?

Following are some reasons why knowing your Customer's Lifetime value is important to the success of your business:

1. It affects the profitability of the business

A high Customer Lifetime Value (CLV) means that each customer is worth a lot to you. If your business does not have a steady stream of repeat customers, you may be spending more on advertising and promotion than you earn by each sale.

2. It ensures the flow of steady cash in the business

A steady stream of repeat orders from existing customers helps keep your business financially sound and stable. Your cash flow projections will be much easier to maintain if you know with certainty that a certain amount of money is coming in regularly.

3. It allows you to attract more high-value customers

By understanding the Customer Lifetime Value of your customers, you can customize your marketing efforts to appeal to people who will spend more money with you.

4. It allows you to grow your business at a steady pace

Having an unbreakable stream of predictable income is a powerful way to grow your business. It allows you to predict future income and expenses.

This makes it easier for you to plan ahead and make sure that your financial projections are accurate. This predictability ultimately helps bring efficiency and scale to the business in the long term.

5. It helps you identify customer segments with different spending behaviors

By understanding how much each of your customers spends, you can analyze their behavior patterns and tailor your marketing strategy accordingly. This allows your business to effectively set aside a budget for the service of each customer segment based on their respective Customer Lifetime Value.

6. It allows you to better predict future business

Forecasting Customer Lifetime Value can help you make decisions that affect your business's bottom line, such as how much inventory to carry, and how many people to hire.

By knowing the Customer Lifetime Value of your customers, you can make more informed decisions about how much to spend on marketing and sales. This can help keep your business from spending too much or too little money on customer acquisition.

7. It provides a better understanding of managing customer acquisition costs

Knowing how much money you can expect to receive from a typical customer will help you forecast your future revenue—and decide how much money is best spent attracting new customers. If, for example, you are trying to decide whether it would be better to invest in paid search advertising or content marketing (both of which can help increase traffic), knowing how much money customers make you can help you determine which type of marketing has a higher return on investment.

8. It can help in improving customer retention and loyalty

A Consistent review of Customer Lifetime Value will provide a general idea as to whether the business is able to retain its customers longer than its competitors.

If the Customer Lifetime Value of a business is lower than the industry standard, then there is an increased need to spend more effort and capital on marketing and support teams to improve the retention and loyalty of its customers.

How to calculate the Customer Lifetime Value?

As I mentioned earlier in the article, we will discuss different ways to calculate Customer Lifetime Value.

Let's take an example. Suppose you are running a restaurant and have 1000 customers on average per year. You know that each customer spends about $10 on average for lunch or dinner. The average customer stays in touch with your restaurant for 5 years. The profit of the restaurant business is 40%.

Now, this is a bit more advanced formula for Customer Lifetime Value than the previous one.

CLV = LTV * Profit margin

LTV stands for Lifetime Value

The formula for Lifetime Value calculation is:

LTV = Average value of a purchase average purchase rate per year Average customer Lifespan

LTV = $10 (per meal) 1000 (meals per year) * 5 (years) = $50000

CLV = $50000 * 40% = $20000

If you look closely at the formula the main difference is the inclusion of the profit margin.

Lifetime value is the amount of revenue a customer brings during its entire relationship with your company. It does not take profit margins into consideration. Customer Lifetime Value stands for the lifetime value of the customer multiplied by the profit margin of the business.

Customer lifetime value model

When companies calculate Customer Lifetime Value, they have two main models to choose from. The first relies on past performance to predict future trends, while the second considers present circumstances in order to forecast what might happen.

1. Predictive customer lifetime value

The Predictive Customer Lifetime Value model uses regression or machine learning to forecast the buying behavior of customers who are already active and those whom organizations would like to acquire.

Predictive models can help you forecast which customers are likely to buy, how your product or service will perform in the marketplace and what retention tactics should be implemented.

This dynamic method allows you to create regression models that can predict the Customer Lifetime Value of existing or new clients based on their latest purchasing behavior. This means the value of this metric relies heavily on analytical data, which must be recent and also accurately reflect customer purchasing behavior.

To fully realize the predictive power of Customer Lifetime Value, companies need to gather complex data sets that can determine the monetary benefits attached to each customer's purchases during each of their first three months on board for all other current customers.

2. Historical customer lifetime value

The historical model considers only the past to predict future customer value, not whether that customer will continue using your product or service. In this method, you determine the value of a customer on the basis of their average order size.

This model is especially useful for businesses that interact with customers over a certain period of time.

However, the historical model has one major drawback that is it doesn't account for customers who might become inactive. If a large number of your most recent customers are no longer buying from you and skew the data on which new prospects base their buying decisions, this will affect how you market to them. Inactive customers might come back to purchase from you, but because they’re listed as inactive in your database, you might overlook them.

Customer Lifetime Value Variables

This increased understanding of Customer Lifetime Value is valuable for businesses in many ways. Businesses can use Customer Lifetime Value to get a better understanding of their finances and improve retention rates by understanding what customers already find valuable.

We will examine a little advanced Customer Lifetime Value formula and analyze what makes these variables important to a company.

1. Average Purchase Value
As we can understand from all the above Customer Lifetime Value formulas discussed earlier an increase in the Average Purchase Value leads to an increase in the Customer Lifetime Value of the company.

Through an understanding of Average Purchase Value, companies are better able to design strategies that increase revenue. For example, KFC has been able to drastically improve its revenues by offering combo meals—a strategy that other fast food chains also wisely emulate. This has also helped them retain their customers as they get more value for money on their purchases.

2. Average Purchase Frequency Rate
The Average Purchase Frequency of customers plays a very important role in the business, especially in sectors like FMCG. The reason is that customer loyalty is low in the FMCG sectors.

By properly understanding this data, many different large corporations were able to increase their purchase frequency above industry standards. For example companies like Coca-Cola and PepsiCo have been able to increase the purchase frequency of their customers through an extensive distribution strategy enabling their customers to get access to their products literally anywhere in the world.

3. Customer Value

Customer Value basically means the amount a customer spends on a business annually. This is a very important metric to track because it can tell you how much money each customer is actually worth.

By tracking this data, many companies have been able to increase their profit margins by targeting high-value customers and offering them additional services or products at a premium. This becomes even more apparent when data shows that repeat and high-value customers account for just 8% of an average eCommerce store audience but generate 41% of its revenue.

4. Average Customer Lifespan
It is a known fact in the business world that the longer a customer stays with the business the more value it generates for it. By tracking this data you can get an idea of how many customers are leaving and what kind of value they bring to the business.

High rates of customer turnover may indicate a flaw in your product or sales strategy. However, if your business has a high percentage of loyal customers who spend more than the average customer — and maintains that loyalty long after the purchase is made — then it shows that you are doing well.

5. Profit Margin

All businesses are concerned with keeping expenses low and maximizing revenue generation in order to earn profits.

The Profit Margins of a business can be a useful data point if businesses can use it to their advantage based on their industry. For example, Microsoft sells Xbox at a steep loss to make people buy them, then sells accessories and games at huge margins. This not only helps them retain customers but also have a healthy margin in the overall business.

Customer Lifetime Value Example

Let's take a look at a Customer Lifetime Value example of a brand to help clarify the concept.

Let's take the example of Starbucks using the data of Kissmetrics to determine the Customer Lifetime Value of Starbucks.

Here the purchasing habits of 5 customers are taken on a weekly basis. Now let us calculate the above in a step-by-step manner.

1. Calculate the average purchase value

Kissmetrics, a customer analytics company, reports that the average Starbucks customer spends about $5.90 per visit. We can figure out Average Purchase Values by adding up how much people spent during their visits and dividing it by the number of trips they took that week. For instance, if you went five times and spent 25 total dollars on those visits your average purchaser value would be 5.

2. Calculate the average purchase frequency rate

The Average Purchase Frequency Rate can be calculated by dividing the total number of visits made per week by the total number of customers observed. Across all 5 customers in the report, 4.2 visits was found to be the average. Thus, the Average Purchase Frequency Rate is 4.2.

3. Calculate the average customer value

In order to calculate the Average Customer's Value you need to multiply the average purchase rate of all Starbucks customers by their average purchase frequency.

Average Customer Value = Average Purchase Value * Average Purchase Frequency

Average Customer Value = $5.9 * 4.2 = $24.3

4. Calculate the average customer's lifespan

The report by Kissmetrics does not present how it calculated the Average Customer Lifespan, but it states the value as 20 years.

You can calculate the Average Customer Lifespan by these two formulas:

Average Customer Lifespan = Sum of Customer Lifespan/Number of Customers

Average Customer Lifespan = 1 / Churn Rate

The formula for Churn Rate is as follows

Churn Rate = (Customers at the beginning of the period - Customers at the end of the period) / customers at the beginning of the period

5. Calculate your customer's lifetime value

In this problem, you need to multiply the customer value by 52. This is because we have calculated the customer value for each week—but these figures are annual averages so they need to be converted from a weekly measurement.

Customer Lifetime Value = Average Customer Value * Average Customer Lifespan

CLV = $24.3 52 * 20 = $ 25272

How to Measure Customer Lifetime Value?

Here's how to calculate Customer Lifetime Value in a step-by-step process.

Step 1

The average order value of a company can be calculated by adding up the total revenue earned during a period and dividing it by the number of orders placed in that same time frame.

Average Order Value = Total revenue in a given period / Total number of purchases in a given period

For example, if your business brought in $10000 from 200 sales in a year, the average order value is $10000 / 200 = $50.

Step 2

To calculate the average number of transactions per period, divide the total number of purchases made by your customer base (i.e., unique customers who bought something).

Average Number of transactions per period = Total number of purchases / Total number of unique customer

Let's say your business currently serves 100 customers and they have made 200 purchases in total in a year.

Average number of transactions per period = 200 / 100 = 2

Step 3

Average Customer Lifespan is the average amount of time, in years, that your customers stay with you. It can be calculated by adding all Customers' Lifespans and dividing them by the total number of customers.

Average Customer Lifespan = Sum of customer lifespans / Total number of unique customers

In order to generate an accurate Average Customer Lifespan calculation, you may need a sufficient sample size of customers. If this is not the case (your business has just started and you do not have many customers), then it might be possible to derive your Average Customer Lifespan from your churn rate.

Average Customer Lifespan = 1 / Churn rate

Let us assume that the retention rate of the business is mentioned instead of the churn rate.

We can find the churn rate of the company using the following formula.

Customer Retention Rate = 80%

Churn Rate = 1 - Customer Retention Rate = 1 - .8 = .2

Churn Rate = 20%

( The above formula is applicable only when two rates add up to 100% or the churn rate is positive)

Average Customer Lifespan = 1 / .2 = 5 years

Step 4

The profit margin of any business can be measured by using the following formula:

Profit Margin = [( Total Revenue - Cost of Goods Sold) / Total Revenue] * 100

Total Revenue = $10000

Cost of Goods Sold = $5000

Profit Margin = [(10000 - 5000) / 10000] * 100 = 50%

Step 5

Now that we have all the data required to calculate Customer Lifetime Value, we can multiply them together.

Customer Lifetime Value = Profit Margin Average Order Value Average Number of Transactions Per Period * Average Customer Lifespan

Customer Lifetime Value = .5 50 2 * 5 = $250

How to increase or boost the Customer Lifetime Value?

Here are some strategies companies can adopt to increase their Customer Lifetime Value.

1. Make your onboarding process seamless

Optimize your onboarding process by identifying its touch points (the moments when users come into contact with it), prioritizing those that are most important, and then focusing on getting each one right.

Zendesk's research found that 70% of consumers base their purchasing decisions on how they felt when dealing with a company's customer service department. For each new feature or tool that you add, think about how it will fit into your overall user experience, and make sure that your onboarding process reflects this.

Why This Works

A well-designed customer onboarding process can help retain customers and increase their Customer Lifetime Value over time.

2. Increase the amount customers spend on each order.

If you can get customers to spend more, your revenues will increase and so will profits.

By offering tiered pricing plans or other differentiators around the price, you can increase customer spending. For example, in the European Market movie chains are increasing prices for premium seats and charging more when blockbuster films come out. This helps them keep their customers coming back while also improving revenues per visit.

Why This Works

The example above illustrates how a small increase in average order value can translate into greater revenue and Customer Lifetime Value over time.

3. Develop lasting relationships with customers

Businesses often make the mistake of focusing on short-term gains rather than long-term success.

Consider offering your customers incentives and discounts for repeat purchases. For example, if a customer buys a new computer from Dell today, he or she might receive an additional discount on their next purchase in two years' time.

Why This Works

When a customer feels connected to a brand, they will purchase more often. This increases the Customer's Lifetime Value over time.

4. Empower customers to give you advice.

This one is a bit more advanced, but it can be very effective. You can incentivize customers to fill out surveys about their experience with your brand and then use their feedback to improve your products or services. Feedback from customers can help you identify weaknesses in your business that need to be addressed.

Why This Works

The more customers feel like they belong to a company and the more loyal they become, the higher those Customers' Lifetime Value.

5. Connect with customers easily.

If you want to create customer loyalty, make it easier for your target audience to find and follow you by setting up a social media page.

You can also use email marketing software, like MailChimp, to send out promotional emails so you stay in touch with customers on a more personal level.

Why This Works

A recent analysis by McKinsey & Company predicts that organizations will increase their digital interactions by 1.5x between now and 2024. Customer Lifetime Value is now based on the relationships you build with customers, and building such relationships requires constant interaction.

6. Improve the way you treat your customers

The way you treat your customers impacts their loyalty and willingness to recommend you.

A recent study found that 43% of new customers found out about Zappos through word of mouth. This finding indicates that a focus on customer centricity leads to long-term growth in revenues.

Why This Works

Improving your overall customer service not only helps you attract new customers but also helps in reducing the customer acquisition costs of the business. This leads to an increase in the Customer's Lifetime Value over time.

7. Content Marketing

Content marketing is a way to attract and retain customers by providing them with valuable information. It can be in the form of e-books, blog posts, and videos. According to Demand Metric, content marketing generates leads at a cost of 62% less than traditional marketing channels and produces about 3 times as many leads.

Though it may take time for your content to generate leads, it has a long-term impact on the customer's purchase decision.

Why This Works

Content marketing increases brand awareness and reputation which helps you attract new customers over time. It also has higher rates of return on investment compared to other channels of marketing. This helps in saving money on the marketing budget while also increasing Customer Lifetime Value in the long term.

Advantages of Customer Lifetime Value

Emphasizing your Customers' Lifetime Value will cultivate loyalty and provide a steady stream of revenue. Here are some of the ways that Customer Lifetime Value benefits companies.

1. It is cost-effective for the business

Focusing on retaining your current customers—instead of spending money to attract new ones makes it easier for you to keep operating costs low.

2. Promotes Brand Loyalty

As loyal customers, high-value target segments tend to promote your brand through word of mouth and social media. This improves the reputation of your company among prospective consumers who weren't sure until then whether what you were offering was worth their hard-earned money—and initiates the sale process with people who didn't know if they wanted whatever exactly you were selling.

To increase their customer base and loyalty of its customers, companies should focus on meeting with high-value customers to find out what areas they can improve upon and which products or services they should focus on. A tool like Airgram can be used by companies to take notes during important meetings, making sure no topic is left uncovered.

3. It assists in the scalability of the business

If a business knows that its customers will spend a certain amount of money and it can estimate the number of potential daily buyers, then there is a chance to plan for scalability.

Surprises in the business world are nice when they result in profit, but if a company needs to quickly scale from 10,000 to 100,000 orders without warning that might not be pleasant. By incorporating Customer Lifetime Value into their strategic planning, companies can make better decisions about the future.

4. Predicts churn rate

Customer Lifetime Value also helps in predicting the churn rates of a company. This is an effective data point that companies can use in their overall marketing strategies to better retain customers and reduce the number of lost sales.

Challenges of Customer Lifetime Value

While Customer Lifetime Value (CLV) has many benefits, it also presents its own set of challenges.

1. Results May Be Misleading for the company

While it’s important to consider a Customer Lifetime Value, breaking down the data into smaller segments may offer more specific insights about which groups are valuable and how they should be treated. It may be more useful to break down your customer data by size of business, location, and other key demographics.

2. It is difficult to measure

Companies without quality tracking systems in place may have difficulty calculating Customer Lifetime Value (CLV). An Enterprise Resource Planning (ERP) or Customer Relationship Management (CRM) system provides access to this information on an automated dashboard that tracks key performance indicators—making it easier for managers and marketers to make decisions about which customers are most valuable.

3. It is just one of many variables in the business

Many factors affect CLV, and many of those are outside marketers' control. For example, customers might be enticed by a marketing campaign but then have an unpleasant experience with customer service that leads them away from the brand. There are many variables that could influence a customer's decision to keep spending money on your brand. It can be challenging to determine which interactions with the company matter most and how they should be managed.

4. It requires a decent investment of time and capital

The major drawback of Customer Lifetime Value is that it requires a significant investment of time and money to correctly calculate—and continue to analyze. Organizations with extensive customer data will have no problem coming up with an estimate.

Startups and small companies that lack funds and skilled manpower often have difficulty calculating the accurate Customer Lifetime Value.

Frequently Asked Questions

What is LTV in marketing?

Many people think of marketing as the process used to sell a product or service. They believe that marketers need only get their products into the hands of potential customers and convince them to buy it—and then move on once that sale has been made.

While it's important to make sales, long-term marketers know that single transactions don't help you hit your marketing goals. So they focus on the Lifetime Value of their customers (LTV). The Lifetime Value of a customer refers to the total amount of revenue that they will bring in over their entire period as a consumer.

It's important to know your Lifetime Value because it helps you set realistic goals and strategies. If you don't know how much value a customer will bring in, you may waste time and money on marketing efforts that don't actually make sense for your business.

The best way to determine your Lifetime Value is through the use of customer analytics tools. These are programs that track your customers' behavior, from how they browse your site to what they buy and how often. They also help you identify which marketing channels are working best for you, so you can focus on those instead of wasting money on ones that aren't producing results.

The Lifetime Value of a customer can be calculated by taking the average purchase value of a consumer and multiplying it by the number of years they are expected to stay with your company and average purchase frequency. This will give you an estimate of how much money you will make from each customer over time.

What is customer lifetime value model?

The Customer Lifetime Value model calculates how much a customer is worth over the course of their relationship with a company.

Lifetime Value predictions are based on multiple touch points such as customer profile data, past history of transactions, the monetary value of the transactions, and the frequency of transactions. These predictions help you to determine the cost/benefit of pursuing a particular acquisition, retaining an existing customer, or targeting them with personalized offers.

There are two types of Customer Lifetime Value Models used by companies to calculate the CLV of a customer. These two models are Predictive Customer Lifetime Value and Historical Customer Lifetime Value.

What is the difference between CLV and LTV?

There is a minute difference between Customer Lifetime Value and Lifetime Value. Lifetime Value shows the amount of revenue that the customer will bring over the time they interact with your company. On the other hand, Customer Lifetime Value shows how much profit a customer will bring over the time they interact with your company.

Conclusion

Customer lifetime value tells you which customers spend the most money at your business, how long they tend to stay loyal, and what kinds of products or services are best suited for them.

It can be useful for determining what kinds of customers you should target and how to attract them. Customer Lifetime Value can also help you decide which products or services are worth offering, as well as how much to charge for each one.