Whether you sell products or services and whether you work with one-time sales or subscriptions, attracting new customers will take time, effort and of course, money. You would think that after all this hard work you deserved a little party when a new customer has presented itself, right? Well, not quite. First you need to ask yourself how much profit this particular customer has actually given you. And is this profit enough to make up for all the hard work you did? The Customer Lifetime Value (CLV) will give you the answer to this question. And is not only helpful for the statistics, it’ll also give you an insight into what strategy and budget would be best for your business.
In this blog we will discuss the perks of the Customer Lifetime Value. We will use a simple mathematical example to show you how your company can determine its CLV. Of course we’ll also tell you how that information can help you and your business by deciding what kind of customers you should focus on. When you have the answer to this question we can determine fitting marketing strategies and budgets. Lastly we will take a look at one of the most important Key Performance Indicators (KPI), the Customer Acquiring Const (CAC). At the end of this blog it will be perfectly clear what role the CLV can play in the long term planning of your business.
What is the Customer Lifetime Value?
How much revenue one customer generates is exactly the amount of money you’ll find on the invoice, simple right? True, but there are a lot more factors that should be taken into account. Most companies have regular customers who will buy from them more than once. Regulars will always come back to make new purchases. Sometimes at irregular times (like with clothing stores), sometimes regularly (like with companies that work with subscriptions). You can’t just assume every new customer will become a regular, so how will you know how much a customer is really worth to you?
Well, this is exactly where the CLV comes in. The CLV estimates, very accurately, all future revenues one customer is going to give to you. The CLV, or CLTV (Customer Life Time Value) or even just the LTV (Life Time Value), gives you a prospect of the totality of purchases a customer will do during his lifetime. This makes the CLV a very important new KPI, especially for the long term.
How to calculate the Customer Lifetime Value?
There are multiple ways to calculate the CLV. There are some extremely difficult formulas, which are really hard to master, but of course, they are very accurate. But for starters the CLV is nothing more than multiplying the purchase revenue with the number of purchases a particular customer has done. By using the net profit, the CLV will automatically show you the net worth of the customer.
The formula for calculating the CLV:
CLV = average net profit per purchase (P) X average number of purchases per customer (N)
For instance: U have a website on which you sell printed t-shirts. On every shirt you sell you make an average of €15 net profit. Some customers will only buy one t-shirt, others will buy three at one, and then you also have the ones who’ll come back regularly to purchase more t-shirts. On average a customer will buy 8 t-shirts during his entire lifetime. Which means the CLV will be €15 x 8 = €120.
This simple formula can be adjusted depending on the company, the branch of products and/or services and the kind of customer. We’ll take you through it step by step:
- Average purchase price: calculate the average purchase price of customers by dividing the total profit over a specific period of time by the number of sales during that same period of time.
- Average purchase frequency: calculate how often customers make a purchase by dividing the total number of sales in a specific period of time by the number of unique customers during that same period of time.
- Average customer value: calculate the average customer value by multiplying the average purchase price per customer by the average purchase frequency.
- Average customer lifespan: calculate how long a customer will stay with your company by dividing the average lifespan of all customers in years by the number of unique customers.
- CLV: calculate the CLV by multiplying the average customer value by the average customer lifespan.
We’ll use the same example as above, but this time we’ll show you how to calculate the CLV concretely.
- The total net profit of your webshop in 2019 was €100.000. In the same year you have made a total of 2500 sales. The average purchase price is: €100.000 / 2.500 = €40.
- The total amount of sales is not the same as the number of unique customers though. You had only 1250 unique customers. Which means that the average purchase frequency is: 2.500 / 1.250 = 2.
- This means that the average customer value is €40 X 2 = €80.
- Check how many years your customers have been faithful to your company and add those numbers. Let’s say the total amount is 10.500 years. If the total of customers since the start of your customers for instance 7000 is. The average customer lifespan is 10.500 / 7.000 = 1,5 years.
- The CLV is €80 X 1,5 = €120
The calculation made with this formula is actually the same as the first, easy formula (CLV = average net profit per purchase (P) X average number of purchases per customer (N)). But because you take more factors into account, your answer will be more accurate.
What makes the Customer Lifespan Value important?
it is very important for a business to know how much your customers are worth to you in the long run. It’ll show you how much money acquisition or retention are worth. You wouldn’t spend more money to attract more customers, if you already know these customers are not worth the investment. A marketing strategy is built on this principle. A strategy can simply not cost more than the earned profit.
The CLV gives you two important insights to help you with this:
- How much money you can spend on acquisition of customers
- How much money you can spend on retention of customers.
Calculating the CLV is very important to determine a good marketing budget. If a company only looks at the number on the invoice, they’ll miss a lot of relevant information. Especially company’s with a large regular client base. For them it’s even more important to take all factors into consideration when determining a marketing budget. The CLV can help.
If you, as a webshop owner, work with a net marketing budget of €50 per new customer, you might consider lowering your budget. A new customer rarely spends more than €50 on their first purchase. In fact, if a customer only buys one shirt at their first purchase, you’ll only have a net profit of €15. With a marketing budget of €50, you’ll lose money on this customer. But when you take into account that this particular customer will come back to your webshop to make more purchases, you suddenly make a profit of €120 – €50 = €70! You can even consider increasing your budget to attract more new customers.
You get what you pay for
When focussing on the long term customer behaviour, a company can choose to increase their budget to amounts that seemed impossible at first. Besides, the CLV will focus on the optimization of attracting new customers and income rather than attracting new customers as cheap as possible.
Acquisition en retention
Moreover, the budget you set does not necessarily have to go to marketing strategies only. You can also use it to invest, product enhancements and customer service. The CLV can also help to decide on the way to spend your budget.
For instance, your webshop does not only sell printed t-shirts, but also printed hats. Like sports hats. The net profit per hat is €5. On average sports clubs order 16 hats at once. The average net profit will be 16 X €5 = €80. A lot of cases sports clubs will purchase a number of hats again every year for their new members. Sports clubs tend to keep purchasing for at least 5 years. Say you only earn €30 per customer per year, you have to add this number to your average net profit to see what the sports clubs CLV is. In this case: €80 + (€30 * 5) = €230.
A private customer and the sports club generate the same profit in the first year (€80). But the sports club will definitely gain you more profit than a private customer would. This means that simply that you should spend less money on the acquisition of private customers, and more on the acquisition of sports clubs. If you spend €150 on attracting private customers, you will lose money, but if you spend the same amount on attracting sports clubs, the money will pay for itself in the long run.
Generally only 5 to 20 percent of the potential clients actually place an order. While 60 to 70 percent of the already existing customers come back after one purchase. This means that the acquisition of new customers costs more time, effort and money than the retention of existing clients. You would think that makes retention always worth investing in. But the example above shows different.
When a company expects a lot of profit from returning customers, the obvious choice will be to spend their budget on keeping their customers around. Rather than spending it on customer acquisition. On Average the returning purchases for a t-shirt webshop are constant, private customers spend approximately €40 per purchase. The net profit from returning purchases from sports clubs is much lower than their first purchase: €30. It would be smart for you to focus on acquisition of sports clubs and the retention of private customers.
Customer Lifetime Value versus Customer Acquisition Cost
It is clear that the best thing to do is compare the CLV to the costs you make to attract new customers. The costs per customer are expressed as Customer Acquisition Cost (CAC). Of course you would want the CLV to be bigger than the CAC, otherwise you’ll be losing money. A CLV/CAC ratio of 3:1 is considered financially healthy.
When knowing the CLV/CAC-ratio, a business can determine their marketing budget. When the net CLV of a private customer of our t-shirt webshop is €120, you immediately know that it would be ideal for you to set a budget of €40 for the acquisition per customer (€120 / 3). For the sports club the budget will be €75 (€230 / 3).
Customer Lifetime Value per product, service or customer
To see the value that a customer can bring to your company, the CLV is a very helpful KPI. But as our webshop example shows, not every customer is the same. A big webshop does not only sell shirts and hats, but more products and maybe even services. Most of the companies sell a variety of products and services and all of these products and services bring their own clientele.
It’s no news that a lot of companies follow the famous Pareto-principle when it comes to income. This principle, also known as the 80-20-rule, says: 80 percent of your revenue is generated by 20 percent of your customers. The CLV helps differentiate the profitability of those customers. By calculating the CLV per customer group, a company can identify which customers are the most valuable. And that helps with setting your marketing budget.
CLV/CAC-ratio per customer
Before you start following the CLV blindly, it is important to consider the CAC. If it takes a large amount of time and money to attract sports clubs, you might want to reconsider.
Tools to help you calculate the Customer Lifetime Value
It will take a lot of time and work to type all of those relevant numbers like average purchase values and customer lifespan values into your calculator. Luckily, you don’t have to. There are several handy tools to help you see your CLV.
If you run a webshop, Google Analytics is thé free tool to calculate your CLV. Google Analytics has something called ‘Lifetime Value’. With this feature you can see rapports on all your unique visitors and their value to your business. It is also possible to view rapports on acquisitions in particular time periods. This is especially useful if you just ran a marketing campaign in a specific month, because you can immediately see if it did any good. You can see which customers are new, which ones repurchased and through which channels they came to your webshop.
To get everything out of Google Analytics as you possibly can, you’ll need a lot of knowledge of the tool. If you don’t, a good alternative is Oribi. Oribi is simple and clear. The software is kind of expensive, but it carries way more features than Google Analytics. Not only can you see where your customers come from, you can also see where the visitors who did not yet place an order come from. This way you can reach those who are interested in your webshop and give them the final push they need to make a purchase. This is very valuable for your Costs per Acquisition (CPA).
Another example of powerful, paid CRM-software is Simplicate. CRM means Customer Relationship Management and that is exactly what it does. It shows you everything you need to know concerning your clientele. Simplicate automatically calculates the CLV and shows it in many different ways.
How can you increase your Customer Lifetime Value?
A company could make a bigger profit, or set a larger budget for marketing and investments when the CLV increases. A customer’s CLV increases when the customer spends more money than the average customer would do, or if the customer becomes a regular. Best would be both. There are multiple options for a company to increase a CLV.
If a customer had a simple question or if something went wrong during ordering, customer service is there to the rescue. If the customer service is in order the chances of customers cancelling their orders will decrease. The better the service, the bigger the chance is the customer will return to your shop in the future. A great way to keep your customers satisfied.
Try to make a customer more than they originally wanted to. If you have a webshop for t-shirts and hats, you could try to sell a hat when someonws already intends to buy a t-shirt. Show them what else you have in stock when they place orders in their shopping cart. This way you’ll increase the chances of a larger purchase price.
A potential client visits a webshop often more than once before buying something. So it would be a good idea to keep this potential customer hooked by reminding them of your webshop. You can send them emails or personalize the ads they see scrolling through Facebook. This marketing strategy is called remarketing and helps with generating repurchases.
You can reward your loyal customers in many different ways. You can send them special offers, like vouchers or early bird access. This way you’ll stimulate repurchases.
Perks of the Customer Lifetime Value
- The CLV gives an accurate estimation of the financial value of a (existing) customer.
- The CLV takes repurchases into consideration which means it is no snapshot, it is accurate for the long term.
- With the CLV you can calculate how much money should go to acquisition or retention of customers.
- The CLV gives information about different customer groups, this way you know what is best for what group.
With Customer Lifetime Value, you can see the future
To determine the health of a company and to estimate how successful the company will be in the future, people often take a look at their quarterly figures. But quarterly figures are snapshots, calculations made with the CLV will tell you much, much more about your future performances in the long term. Especially when combined with CAC-numbers you can immediately see if you should be talking about a short term success, or persisting growth.