When it comes to assessing the effectiveness of your business’ marketing efforts, not all metrics are equally valuable. For startups, one metric that is particularly useful in measuring marketing effectiveness is customer lifetime value.
Customer lifetime value (CLV) indicates the average total revenue a business can reasonably expect a single customer to generate over the course of the business relationship. The longer a customer continues to purchase from a company, the greater their lifetime value becomes.
Understanding CLV can help a business answer these critical questions:
- How much can we profitably spend on marketing and sales for customer acquisition?
- How much should we spend on customer service to retain an existing customer?
- Who are our most valuable customers and how can we better target this demographic for future sales?
Not all customers are equally valuable. For most businesses, specific types of customers can be identified as the most profitable. Assessing CLV allows the business owner to dedicate more resources toward the acquisition and retention of high-value customers–thereby increasing profits overall.
Without measuring CLV, a business might spend too much to acquire customers whose lifetime value simply isn’t worth the cost. By identifying the most valuable group of customers, the business can focus on providing customer service tailored to their needs to ensure they stick around long-term.
Depending on the data used, CLV can be historic or predictive. Historic CLV is the sum of all profits from a customer’s past purchases. This number is based on existing customer data from a specific time period. Considered a more complete method of assessing CLV, predictive CLV uses transaction history and behavioral patterns to determine the current value of a customer and to forecast how customer value will evolve with time. As more data are collected to include in this calculation, the value will become increasingly accurate.
There are several different ways to determine CLV. The most basic is to calculate the revenue earned from a customer minus the initial cost of acquiring them, as shown in Formula 1. The revenue from a customer is the average amount of revenue generated annually multiplied times the expected number of years of the life of that customer relationship. Customer acquisition cost (CAC) is the total cost of sales and marketing efforts, including associated property and equipment, needed to convince a customer to buy a product or service (see Formula 2). This basic formula arrives at lifetime value in its simplest definition – lifetime revenue minus costs.
Formula 1. Basic Customer Lifetime Value Calculation
CLV = (Annual revenue per customer * Customer relationship in years) – CAC
Formula 2. Customer Acquisition Cost
CAC = Total sales and marketing expenditures / Number of new customers
For example, if a company generates an average of $3,000 in annual revenue per customer with an average customer lifetime of 10 years and an average CAC of $3,000 per customer, then the CLV calculation might look like this:
CLV = ($3,000 * 10) - $5,000 = $25,000
Looking at CLV through this lens makes it easier to justify the sales and marketing budgets required to land new customers in the first place. Notice that the cost of acquisition is actually higher than the revenue generated in the first year, but when lifetime value is considered, the acquisition cost is much smaller.
The simple approach works best if a customer’s annual profit contribution remains somewhat consistent. For example, if a business runs on a subscription-based model with only one or two tiers, then each of its customers can be expected to provide a relatively stable source of revenue.
On the other hand, if a company’s annual sales per customer are not relatively flat, a more in-depth CLV equation is needed. This traditional version of the formula takes rate of discount into consideration to account for future customer retention discounts or other price adjustments. It also provides a more detailed understanding of how CLV can change over the years.
The traditional CLV calculation shown in Formula 3 is more complex and should only be used for precise valuation. It breaks down the individual costs and profits of each year. Calculating it requires the following pieces of information: average gross margin (in dollars) per customer lifespan, customer retention rate, and rate of discount.
Formula 3. Traditional Customer Lifetime Value Calculation
CLV = Gross margin * (Retention rate / [1+ Rate of discount – Retention rate])
To determine a customer’s dollar value of gross margin, calculate the basic CLV using Formula 1 and then multiply the result by the gross margin rate. Taking the final result from the first example above and assuming a gross margin rate of 30%, the gross margin in dollars per customer lifespan would be 25,000 * .30, or $7,500.
This traditional method of calculation allows for fluctuations in customer revenue over time, and each year is adjusted by a rate of discount to account for inflation, price incentives or special offers. (A rate of 10% is commonly used by subscription companies.) Retention rate is the percentage of customers who continue to be customers by making a purchase in successive periods.
Continuing with this example, assume customer retention rate is 88% and the rate of discount is 10%. Our calculation would look this:
CLV = 7,500 * (0.88 / [1 + 0.10 – 0.88]) = $30,000
Regardless of which equation is used, one of the most valuable applications of CLV is using it to frame a better understanding of the business’ CAC. The CAC-to-CLV ratio reveals a lot about the health of a startup’s business model. Many startups and small businesses struggle to grow because CAC is higher than the profit contributions of a customer’s single transaction. It may in fact be higher than the estimated CLV. A high CAC-to-CLV ratio may even lead to a startup’s early demise.
After calculating CLV, the business can focus on optimizing this ratio, by targeting specific target customer segments which offer the best CAC to CLV ratio. This will ensure that the business continues to grow profitably.
For more on these and other topics, consider registering for the NaperLaunch Academy Workshop series. In addition, business librarians, NaperLaunch coaches, and SCORE mentors are available for one-to-one mentoring sessions.