How to Calculate Customer Lifetime Value: A Guide for Beginners

Guest Contributor -

For any business, customers are gained & lost over a period. Any organization looking to grow keeps adding new customers, leaving behind its old clientele. However, an excellent and successful business will deliver the best of its services and products to the clientele and keep them hooked.

To scale your business, you need to measure specific metrics of your business for a period. This is where customer lifetime value comes into the picture. Let’s learn what customer lifetime value is and how to calculate it correctly.

What is customer lifetime value?

Customer Lifetime Value or CLV measures how much buying power you can expect from a customer throughout the lifetime or working of a company. CLV is the profit margin that any organization expects from a customer throughout the tenure of the business.

At any point in your business, be it the writing of your business plan or the inception of your business, you will need certain metrics to carry out the operation. This is where CLV helps the organization provide measurable insight into the business. Moreover, it goes beyond traditional marketing practices and works around,

  • Purchase history of the customer
  • Customer behavior
  • Brand interaction

How does CLV help a business to grow and in decision-making?

CLV becomes one of the best metrics to measure your business as it considers the long-term value for every customer. It gives you a straight-line view of your customer value instead of a trough and crest for profit margins. Here are some ways CLV helps you make essential decisions and enhance your business.

  • It impacts every business area, from branding and awareness to customer loyalty.
  • It also provides you with an outline for getting enhanced profits for your organization.
  • It helps businesses to segment their clientele based on the value they deliver to the company.
  • It helps organizations set optimum prices for their products and services. This enables you to avoid under-pricing and overpricing your products & services.
  • You may also be able to gauge the customer acquisition cost or CAC through CLV.

Factors influencing customer lifetime value

There are various factors affecting the Customer Lifetime Value or CLV. Some of these are:

  • Average bill value

The average order value of each purchase will affect the CLV. So, a better average order value will enhance the CLV.

  • Customer retention

The more the amount of time the customer stays loyal to the business, the more would be the number of repeat purchases. This will improve the overall CLV.

  • Purchase frequency

It may seem obvious but getting customers to make repeat purchases, thereby increasing the purchase frequency will directly affect the CLV.

  • Churn rate

The churn rate refers to the rate of customers who leave a business. So, higher churn rate would have an adverse effect on your CLV.

  • Cost of customer acquisition

We all know that it’s cheaper to retain a customer than to gain a new one. So, the higher the Cost of Customer Acquisition, the less would be the CLV.

  • Market condition and loyalty

Market conditions and loyalty also directly or indirectly affect the overall customer lifetime value. Loyal customers tend to purchase more from you than your competitors, increasing average purchase frequency. While market conditions will dictate consumer behavior.

How to calculate customer lifetime value?

Customer lifetime value is one of the core aspects of any stable and thriving business. It is also one of the most important metrics for reducing customer churn rate. There are some methods by which you can calculate customer lifetime value.

But before we can get the result of customer lifetime value, we need to know the formula for it, which is,

  • Customer lifetime value or CLV = (Customer Value*Average lifespan of a customer)
  • Customer Value = (Average Number of Purchases* Average Purchase Value)

So, to find CLV, we must know the average purchase value.

Step 1: Calculate the average purchase value

To find the average purchase value, divide the total revenue for a given period by the overall amount or number of purchases in that period.

APV = Total Revenue/Total number of orders

Note: Both values should be for the same period.

Step 2: Determine purchase frequency

We can calculate the total number of purchases made in a given period by the total number of customers.

So,

Average purchase frequency = amount of purchases/number of unique customers.

Ensure that the number of customers calculated is unique and not repetitive.

Step 3: Calculate customer lifespan

Also called an average customer lifespan, you can calculate it by taking a sum of the total number of customer lifespans and then dividing it by the total number of customers.

So,

  • Customer lifespan = Sum of customer lifespan/ Total Number of customers

You must also note that the Lifespan of a customer is reciprocal of the churn rate.

  • Lifespan= 1/churn rate
  • Churn rate= (customer at the start-customer at the end)/Customers at the start

Step 4: Calculate the customer lifetime value

Considering that you have the customer value and average lifespan, you can calculate the customer lifetime value by using the formula below.

  • Customer lifetime value or CLV = (Customer Value*Average lifespan of a customer)

Step 5: Adjust for customer acquisition costs and churn

Churn rate and customer acquisition cost (CAC) are directly linked with CLV. With them, you can adjust CLV by calculating the total customer lifetime, then determining the gross margin. We then calculate CLV without taking CAC into account. Now we calculate CLV by incorporating CAC.

So, for example,

If the customer produces 5000 USD as revenue, and 2000 USD is the cost associated. Then the gross margin would be 3000 USD.

Now, if the customer has been there for five years, so,

3000*5= 15000 USD

Now, subtract 5000 USD from 15000 USD.

So, 15000-5000= 10000 USD.

Step 6: Analyze and interpret the results

You might see customer lifetime value as a single number, but it has great significance. You can design and test various strategies that may help us determine the best way to work with your customers. It is a great financial metric for many small-scale businesses.

It also helps us measure and improve upon the results while helping us make better decisions and forecasting.

For example, if a customer spends 50 USD an average of every two weeks at a store,that means he’ll spend 50 USD 26 times a year. .

So, the CLV for seven years would be 50*26*7= 9100 USD.

So, now you know that the customer will provide you with 9100 USD in 7 years. But, if you improve the average purchase value, the CLV will increase too.

How to interpret and use CLV in your business?

CLV provides a customer-centric approach that helps build long-term relationships with customers.

  • With CLV, businesses can target high-value customers and allocate resources more effectively.
  • You can use CLV to target a specific segment of customers and get a better conversion rate with an enhanced return on investment.
  • CLV helps in determining the best marketing channel for every customer segment. This is important as some customers might respond to one marketing channel, while others might not.
  • Use CLV to personalize your interactions with customers. You can tailor your messaging, offers, and recommendations to enhance their experience.
  • CLV analysis helps refine customer acquisition strategies. Understand the lifetime value of different customer segments to optimize your acquisition efforts.

How to maximize CLV?

One of the easiest ways to maximize CLV would be to create a loyal customer base and improve customer retention. Here are other proven ways that can help in maximixing CLV.

1. Cross-selling

When you sell a service or product to an already existing customer, you open up new channels of business with them. This affects CLV significantly. Identify high CLV customers who have the potential to spend more with your business. Offer complementary products or services that align with their interests and purchasing history.

When customers are loyal to the brand, they do not back down to upgrade their products and try new ones. The Apple iPhone is a classic example of it.

2. Word of mouth

When you do well for your customers, they will market your products and services. They would want others to get a similar experience, and they will become a free-marketing asset for the business.

3. Cut costs

If you are trying to acquire new customers, there would be a higher cost than entertaining the old ones. So, increasing customer retention should always be the priority.

4. Enhance long-term revenue channels

With loyal customers, you will have a long-term revenue stream. This also means you might have better purchase frequency, increasing CLV.

5. Get a competitive advantage

When customers feel they are getting a better connection with a brand, they do not switch to other brands in the same market.

You will have enhanced customer loyalty and retention in these ways. However, you may improve customer experience to get better CLV, directly or indirectly. Some of these ways are,

  • Loyalty programs and incentives
  • Fast customer service
  • Seamless omnichannel experience
  • Customization
  • Customer mapping
  • Continuous feedback for improvement

Customer lifetime value and customer segmentation

Customer lifetime value helps in customer segmentation which in turn helps improve your organization's revenue. Let us see how customer segmentation is related to CLV and why it is important.

Customer segmentation is one of the most important factors for businesses because it helps them to separate their client base into discrete groups based on similar criteria.

1. Targeted marketing effort

Marketing efforts can be tailored to target a certain group by segmenting clients based on different aspects. This ensures that marketing messages and tactics are relevant, and engaging with each segment's distinct requirements, interests, & behaviors. Moreover, it also enhances campaign efficacy, enhances consumer engagement and improves conversions.

2. Resource allocation

Successful allocation of resources is possible with the help of customer segmentation. Organizations may prioritize their marketing funds, time, and efforts on high-value segments.

3. Provide personalized marketing and experiences:

Different groups have different requirements and motivations. Personalization provides a feeling of worth and uniqueness. It makes the consumer feel special. This, in turn, improves loyalty and lifetime value.

4. Consumer retention and loyalty

Businesses may identify at-risk clients and develop tailored retention efforts by knowing the characteristics & behaviors of different groups. Offering relevant offers, incentives, & assistance to certain groups provides customer loyalty and decreases the churn rate.

How to tailor your marketing strategies for different segments?

We must know that marketing starts with customer preferences. So, based on different customer preferences, we will tailor our marketing strategies for different segments.

1. Create customer personas

Create customer profiles based on different characteristics. With this, you would be able to understand the needs and desires of your customers. Customer personas are ideal customers within each segment. For example, A is in his 30s and likes to play outdoor sports.

2. Customized messages

Visualize and write. Budget brands prioritize price, whereas luxury brands promote exclusivity and quality. Write messages that address the concerns of your customers and show product advantages to them

3. Optimal channel Selection

Every customer segment reacts to different communication channels differently. Younger, tech-savvy customers may choose social media and online advertising over traditional media or direct mail.

4. Personalization is the key

Recommend products using customer data. E-commerce companies advertise and discount using browsing and purchase history. Personalized recommendations show that the company understands and values consumer preferences, improving conversion and customer experience.

5. Incentives are always better

Market-specific promotions, discounts, and loyalty schemes are always loved by everyone. High-value customers may get VIP events or limited-edition merchandise, while new customers may receive a small discount.

So, do real-world companies segment their customers? Obviously yes! Here are some companies that segment their customers based on various factors.

  • Amazon aggressively segments consumers for marketing which is based on their browsing, buying, and demographics.
  • Nike categorizes consumers. Consumer data identify athletes, fitness buffs, and fashionistas. This way, they can target consumers based on their behavior. Moreover, Nike's ads appeal to each category of customers, fostering customer loyalty.

Now you know that consumer segmentation will impact marketing as well as consumer tastes. So, it should be used properly to increase customer engagement and increase CLV.

Impact of CLV on business growth

Here are some examples of how CLV has influenced businesses across the globe. These are,

1. Netflix

It is a prime example of how CLV has driven a business to a subscription model. Moreover, by analyzing the behavioral patterns of the customers, the company provides personalized content to the users to get a better viewing experience and enhanced customer satisfaction.

2. Starbucks

You might love sipping your coffee at Starbucks, but do you know that the organization is getting better loyalty and growth by using CLV? Your behavior is tracked every time you order your favorite beverage from Starbucks. This, in turn, helps the company to provide personalized rewards, recommendations, and promotions. The company focuses on customer retention, providing an enhanced customer experience to achieve it. (Ref: www.omniconvert.com)

3. Amazon

Amazon is known to be a customer-first company. It follows a customer-centric approach, and to follow that, CLV plays a major role. By analyzing customer behavior and CLV, the company suggests products and offers to the customers. This results in higher conversions, making the company an eCommerce giant.

These are some of the real-world examples which certainly show why CLV is important for any business and how it may help your business to grow.

You have now understood why customer lifetime value is important for any business and how it may affect its day-to-day operations. With CLV, a business can change its patterns and steer towards more revenue and profits. Moreover, CLV helps with market segmentation, allowing you to identify your clientele and deliver the best results.