How to Calculate Customer Lifetime Value

By November 13, 2017Uncategorized

Business is booming! New customers are rolling through every week, or so you thought. After taking a further look at your financials, your bottom line hasn’t budged one bit. What could be the reason for this?

One may suggest that it could be attributed to the lack of customer retention. Many businesses quickly come to find that no matter how much spend they allocate to acquiring new customers, it is often much cheaper to build loyalty and retain existing customers. In fact – depending on the industry – it could cost 5 to 25 times more to acquire a new customer than to retain an existing one. 

Or perhaps the business is targeting the wrong customer segments. Poor customer acquisition strategy inevitably results in low qualified conversions – the type of customer that does not truly understand the value your business provides. As such, they are in and out of your sales pipeline like a revolving door.

Ultimately, this problem may also signal that customer satisfaction is down. Although you are attracting customers to your business, there is a flaw in your product or service that discourages customers from continuing your relationship together.

To determine the cause of your growing pains, we look to calculating the Lifetime Value of your Customers. Often overlooked, this metric can accurately measure how much your customers are truly worth, detail the health of your business, and is an important requirement to sustainably grow your customer base in the long run.

Understanding Your Customer Relationships

Loyalty, Loyalty, Loyalty

In its simplest form, Customer Lifetime Value tells you the value customers have brought to your company during your relationship. But it can reveal so much more about your business that you would not have otherwise uncovered. The lifetime value of a customer is a lagging indicator of overall customer satisfaction and directly correlates with customer loyalty. If existing customers are satisfied with their experience, they are 50% more likely to try new offerings and spend 31% more in doing so.

In conjunction with other marketing metrics, such as churn rate, Customer Lifetime Value can be used to create demand forecasts as a means to project revenue and future prospects.

DNA of Marketing

Customer Lifetime Value is often seen as the ‘true north’ metric – an all-encompassing figure that can guide your business to longevity by discovering which customers you should be targeting in your content marketing. Consequently, it is an important consideration when developing your ideal customer profiles. The value depicted by these findings offer a concrete reason as to why you should optimize your processes to focus on certain customers.

Keeping in mind Pareto’s Principle, 80% of your revenue comes from 20% of your customers. If you were able to identify the customer segments where value is both mutually shared and maximized, Customer Lifetime Value can help you optimize your acquisition spendings to determine maximum value rather than minimum cost.

Calculating Customer Lifetime Value

Calculating Your Customer Lifetime Value

Depending on your business model, there can be various approaches when calculating for Customer Lifetime Value that ranges in complexity as it accounts for different factors and customer behaviors. In this article, we lay out a straightforward but effective calculations that would best move the needle for you to take actionable next steps. This calculation has three associated variables. It should also be noted that when calculating for any of these formulas, each variable should be within the same timeframe (either in months or years).

Value of a Sale

Whether it’s the average order value of your products or subscription price to your service, this value points to the profits generated after a sale. However, it is critical to differentiate between a contractual and non-contractual business such as an e-commerce business.

As a subscription-based service, this figure may have to take into account the average length of a contract customers have with you.

Value of a Sale = Average Order Value (Profit)

In contrast, a product-focused business would include repeat purchases and the frequency in which they make another purchase. If this is the case, the value of a sale:

Value of a Sale = Average Order Value (Profit) × Number of Repeat Transactions

Customer Lifetime

This variable takes into account how long a customer has been conducting business with you.  If your business keeps track of this data via a CRM platform, you can simply extract the figures from there. Alternatively, it can be determined by your business’ churn rate.

Churn rate refers to the percentage of customers that discontinue working with you. If your growth rate is greater than your churn rate, your customer base is expanding. To calculate churn rate:

Monthly Churn = # of customers who discontinue working with you per month  ⁄ # of customers at the beginning of the period

As a result, the lifetime of a customer is as follows:

Customer Lifetime in months = 1 ⁄ Monthly Churn

For example, if you had 150 customers last month and 9 chose to end their contract without renewal by the end of the month, your churn would equate to 0.06. Consequently, your average customer lifetime is 16.67 months:

16.67 months = 1 ⁄ (9/150)

Acquisition cost

The total cost accrued to acquire a prospective customer. As with Customer Lifetime Value, the formula can differ depending on what costs you would want to account for. Typically, businesses use their marketing spend and divide it by the number of customers acquired to determine an average cost of acquisition.

Acquisition Cost = Lead Generation Costs ⁄ Number of Acquired Customers Per Month

Customer Lifetime Value

Once you have gathered the necessary information, you can determine your CLV. Simply put:

Customer Lifetime Value = (Value of a Sale Customer Lifetime) – Acquisition Costs

It costs $300 via inbound marketing channels to acquire a B2B customer. They generate an average monthly profit of $900 on its SaaS solution. In the previous month, 4 customers churned out of 50. As a result:

Churn

450 =0.08

Customer Lifetime (Months)

10.08=12.5

Customer Lifetime Value

($800/month 12.5 months) -$300 =$9,700

Customer Lifetime Value is a powerful metric that represents the profitability across all periods of the relationship. This is best applied to different customer segments to compare their value generated for your business to help you maximize your overall ROI. Lastly, it will ultimately allow you to:

  • Acquire more qualified customers that perceive greater value from your product or service offerings
  • Improve customer satisfaction and loyalty
  • Reduce churn rate and increase bottom line profitability
  • Predict future sales and demand