How to calculate Customer Lifetime Value (and why you shouldn't rely too hard on this KPI)
Calculating Customer Lifetime Value (CLV) is more than just a strategic advantage. It's a necessity for thriving in an ever-competitive landscape.
Understanding CLV can transform the way you approach business growth and customer engagement.
But what is CLV and how is it calculated?
Why is it so important? And why does it have to be so important?
Let's find out.
What is a Customer Lifetime Value?
Customer lifetime value represents the total amount of money a customer is expected to spend in your business during their lifetime.
It's not just a fancy metric. It's a cornerstone of your brand’s success.
Understanding CLV helps you grasp not only how valuable a customer is now, but how valuable they're likely to be in the future.
It's like having a crystal ball that shows you the potential value of each customer relationship.
This insight is invaluable. Why is it so?
Because they enable you to make informed decisions about marketing spend, sales strategies and customer service initiatives.
It tells you how much you need to invest to retain a customer and acquire new ones.
After all, if you know that a customer's lifetime value is $1,000, you wouldn't want to spend $1,500 to acquire or retain them, would you?
It's all about finding the right balance between the customer's value and the company's investment.
How to calculate Customer Lifetime Value ?
There are two main methods for calculating CLV: by sales and by margin. Each offers its own perspective on customer value.
Let's dive into the specifics of each method.
The Customer Lifetime Value by turnover : the revenue perspective
It's the most commonly used formula for calculating CLV.
Here, you're looking at the revenue a customer brings to your business.
It's a simple approach that lays the foundations for understanding customer value.
To calculate Customer Lifetime Value, multiply the average order value by the average purchase frequency rate, and then multiply the result by the average customer lifespan.
Customer Lifetime Value = (Average Order Value × Average Purchase Frequency Rate) × Average Customer Lifespan
Let's look at each CLV component in detail:
Average Order Value
This is the average amount your customers spend per purchase.
You calculate it by dividing your total revenue over a set period by the total number of purchases during that period.
AOV = Total Revenue / Total Number of Purchases
Purchase Frequency Rate
This measures how often customers buy from you.
It's the ratio of the total number of purchases to the number of unique customers who made those purchases in the same timeframe.
PFR = Total Number of Purchases / Number of Unique Customers
Average Customer Lifespan
This is the average time a customer continues to purchase from your business.
You calculate it by summing up the lifespan of each customer relationship and dividing it by the total number of customers.
ACL = Sum of Customer Lifespans / Number of Customers
The Customer Lifetime Value by margin: the profitability angle
Calculating CLV by margin takes into account not just sales, but the profitability of each customer.
It gives a better understanding of how much real value customers bring.
To do this, simply replace the monetary figure (previously expressed as turnover) with the profit generated per purchase.
Customer Lifetime Value by margin = (CLV by turnover) - (marketing costs × customer lifetime)
Here, by marketing costs, we mean all the costs related to acquiring and retaining a customer.
It includes a wide range of expenses such as advertising costs, promotional materials, social media marketing, email campaigns, SEO, content marketing expenses, and even salaries of marketing staff.
They also encompass expenses involved in customer retention strategies, like loyalty programs, customer service, and engagement activities.
It's essential to capture all these costs accurately to determine the true profitability per customer.
1 Customer Lifetime Value calculation example
Now that we've covered the theory behind calculating Customer Lifetime Value (CLV) through sales, let's see how it works in practice.
We'll use a fictional e-commerce brand, "GreenLeaf Outdoors," to illustrate this, an e-commerce store specializing in eco-friendly outdoor gear.
Let's say they want to calculate their CLV by turnover.
Here’s how they’d do it:
In 2023, GreenLeaf Outdoors had a total revenue of 500,000€ from 10,000 purchases.
→ Average Order Value (AOV) = 500,000€ / 10,000 = 50€ per purchase.
In the same year, these purchases were made by 4,000 unique customers.
→ Purchase Frequency Rate (PFR) = 10,000 / 4,000 = 2.5 purchases per customer per year.
Analysis of customer purchase history shows that customers typically continue purchasing from GreenLeaf Outdoors for an average of 3 years.
→ Average Customer Lifespan (ACL) = 3 years
Putting it all together:
CLV = APV × APFR × ACL = (50€ × 2.5) × 3 = 375€
So, this means, on average, each customer is expected to bring in 375€ over their relationship with the brand.
Understanding this number helps GreenLeaf Outdoors determine how much they can reasonably spend on acquiring and retaining customers.
For instance, if they spend less than 375€ to acquire and keep a customer, they're likely making a profit on that customer.
Why calculate Customer Lifetime Value?
Calculating Customer Lifetime Value (CLV) is more than just crunching numbers. It's a strategic tool that has a profound impact on various aspects of your e-commerce business.
Let's delve into the key benefits that come with understanding and utilizing CLV effectively.
Target customers more precisely
Understanding CLV allows you to identify different customer segments based on their value.
And this can help to implement more targeted marketing strategies.
For example, customers with a higher CLV may receive more personalized attention or exclusive offers, which can strengthen their loyalty and potentially further increase their lifetime value.
Make smarter spending decisions
Knowing your CLV is crucial to making informed decisions about the allocation of marketing resources.
It enables the marketing budget to be adjusted to focus more on acquiring high-value customers, thus guaranteeing a better return on investment.
Set prices for maximum profitability
The results of CLV calculations can guide your pricing strategy.
They provide an understanding of how much customers are willing to spend over time, enabling the development of more effective pricing models that maximize profits without the risk of alienating customers.
Tailor marketing for greater impact
Customer lifetime value helps determine the most effective marketing tactics for retaining the most valuable customers.
This helps refine future campaigns to improve customer retention and attract new customers similar to those with high CLV.
Develop offerings that meet customer needs
Customer lifetime value data can influence product development and service improvement.
Understanding the preferences and needs of high-value customers enables offers to be tailored to these demands, increasing customer satisfaction and added value.
Forecast with greater accuracy
Customer lifetime value is a powerful metric for predicting future revenue and growth.
Analyzing CLV trends aids in making more accurate long-term planning and strategy formulation.
Focus on keeping customers engaged
A clear understanding of CLV assists in crafting strategies to increase customer retention.
Focusing on keeping high-value customers satisfied and engaged reduces churn and ensures a steady revenue stream.
Evaluate marketing impact effectively
CLV is crucial in assessing the ROI of marketing campaigns.
Comparing the cost of acquiring and retaining customers to their lifetime value provides a clear picture of the effectiveness of marketing expenditures.
How to improve Customer Lifetime Value?
Increasing the Customer Lifetime Value (CLV) is essential for e-commerce brands aiming for growth and sustainability.
Here are more detailed strategies to effectively boost CLV.
Go beyond the basics in Customer Service
Exceptional customer service involves more than just solving problems. It's about creating an emotional connection with your customers.
Implement a proactive customer service approach by anticipating customer needs and addressing them before they become issues.
Personalize interactions and consider offering surprise upgrades or discounts to loyal customers.
Utilize customer feedback to continually improve the service experience.
Deepen relationships through tailored communications
Use data analytics to gain insights into individual customer preferences and behavior.
Develop targeted marketing campaigns that resonate on a personal level.
For example, send birthday discounts, celebrate customer milestones, and provide recommendations based on past purchases.
Personalization should be a consistent part of your communication strategy across all channels.
Create a compelling rewards system
Design a loyalty program that offers tangible value.
This could include tiered rewards, points redeemable for products or services, or special access to new releases.
Make the program simple to understand and participate in.
Regularly communicate the benefits of the program to your customers and make them feel part of an exclusive community.
Continuously improve the online shopping experience
Regularly audit your website for user experience (UX) improvements.
Simplify the checkout process, ensure high-quality product images and descriptions, and provide clear navigation.
Consider using AI-driven tools like chatbots for instant customer assistance.
A/B test different elements of your website to find the best configurations that lead to higher customer satisfaction and increased sales.
Maintain and elevate product standards
Consistently deliver products and services that meet high-quality standards.
Consider implementing quality control checks and gathering customer feedback to identify areas for improvement.
Highlight the quality and durability of your products in your marketing efforts to reinforce the value proposition to your customers.
Showcase real experiences to build credibility
Actively manage and display customer reviews and ratings on your website.
Create case studies or feature stories showcasing how customers are using and benefiting from your products.
Use user-generated content on your social media platforms to enhance credibility and attract potential customers.
Keep the conversation going
Develop a content strategy that includes regular blog posts, email newsletters, and social media updates that provide value beyond just selling products.
Share tips, industry insights, or behind-the-scenes content to create a more engaging and relatable brand presence.
Respond promptly and thoughtfully to customer interactions on social media to foster a sense of community.
Stay informed and adapt
Use surveys, customer interviews, and feedback tools to gather insights directly from your customer base.
Monitor industry trends and competitor activities to stay ahead of the market.
Use this information to inform product development, marketing strategies, and customer experience improvements.
Enhance purchase value intelligently
Train your team to recognize opportunities for upselling and cross-selling in a way that feels natural and helpful to the customer.
Use data to identify which products or services are frequently bought together and make relevant suggestions.
Ensure that these recommendations are based on the customer’s purchase history and preferences to avoid appearing pushy or irrelevant.
Why shouldn't you rely on Customer Lifetime Value alone?
Calculating Customer Lifetime Value is incredibly beneficial for e-commerce brands, but it's important to recognize its limitations.
An over-reliance on CLV can lead to a skewed perspective and missed opportunities.
Here's why a balanced approach that goes beyond just focusing on CLV is crucial.
An exclusive focus on CLV might cause brands to overlook strategies that drive short-term sales and revenue. While cultivating long-term customer relationships is valuable, it's also crucial to balance this with tactics that drive immediate sales, especially in a highly competitive e-commerce environment.
CLV calculations are often based on historical data and assume consistent customer behavior over time. However, market trends, economic shifts, and competitor actions can drastically change customer preferences and spending habits. Brands need to be agile and responsive to these changes, something that a static CLV metric might not fully capture.
Focusing primarily on high-CLV customers can lead to the neglect of other customer segments that might have potential for growth. It's important to recognize the value of diverse customer bases, including new or low-spending customers who could become more valuable over time.
CLV focuses on financial metrics and might not fully account for the broader impact of brand perception, social responsibility, and community engagement. These factors can play a significant role in attracting new customers and building a loyal customer base, even if they don't immediately translate into high CLV.
Accurately calculating CLV requires comprehensive and accurate data collection over an extended period. Small or new e-commerce brands might not have access to sufficient data, leading to potentially inaccurate CLV calculations.
A heavy focus on CLV can lead to underinvestment in acquiring new customers. Acquiring new customers is essential for business growth and helps mitigate the risk of over-reliance on a limited customer base.
In conclusion, while CLV is a valuable metric for e-commerce brands, it should not be the sole focus.
A balanced approach that considers both short-term gains and long-term relationships, new customer acquisition, and the broader brand impact is crucial for sustainable growth and success.
