What is Customer Lifetime Value (CLV)

Want to know how to gain clients, boost profits, and save your budget? Among all metrics, there’s a special one that can tell you what value a buyer brings to your company during the customer life cycle. Let’s unwrap the customer lifetime value (CLV or LTV) meaning and make the most of this metric for your business.

Customer lifetime value (CLV, CLTV or LTV for “lifetime value”) helps you predict future revenue and measure long-term business success. CLV tells you how much profit your company can expect from a typical client over the course of the relationship. More to the point, CLTV meaning is to help you estimate how much you should invest in order to retain a regular shopper.

Actually, that amount depends on your margins. One company may spend up to $1 to retain a buyer while another spends up to $50. To figure out how much you should invest, you need to know how to estimate the lifetime value of a customer for your business.

According to Marketing Metrics, there’s a 5–20% probability that you’ll sell your product or service to a new consumer, whereas the chance of selling it to an existing client is about 60–70%. Retention is a lot cheaper than acquisition. Thus, successful marketers don’t focus only on strategies for acquiring new clients. They also work out tactics to retain shoppers and stimulate them to make more purchases. CLTV gives an understanding of your promotion spendings, based on which you can further optimize and plan your budget. What’s more, CLV provides useful insights for how to encourage buyers to spend more.

Knowing the lifetime value of a consumer allows you to answer these questions:

There are many ways to measure customer lifetime value, and the choice depends on your resources and your business. Of course, the harder it is to get information to include, the harder it is to calculate CLV. A complex product, segregated teams, and untargeted marketing are the main reasons why it’s difficult for large companies to estimate CLTV.

There are 3 approaches to calculating CLV — historical, cohort, and predictive.

The historical approach is based on the gross profit sum from purchases your shoppers have made in the past. It’s not difficult to do this calculation, since you only need data on previous purchases. The historical approach is valid only if your clients have similar preferences and stay with your company for the same period of time. They don’t consider changes in customer behavior. So if your buyers change their interests and the way they purchase, it will affect the outcome.

Cohort analysis takes the average revenue per user (ARPU) approach further. A cohort is a group of clients who have similar characteristics and made their first purchase during the same month in their customer journeys. Using cohort analysis, you calculate the average revenue per cohort instead of per user.

In addition to calculating customer lifetime value, cohort analysis can help you find the number of loyal clients, improve lifetime value by finding the points where purchasing drops off, and accurately assess ad campaign performance.

The historical and cohort methods are simple, but they can’t be used for predictions.

A predictive approach to calculating CLTV aims to model a customer’s transactional behavior and predict what they’re likely to do in the future. It’s more precise than historical CLV because it applies algorithms that can predict the total value of a buyer. Along with past purchases, this approach accounts for a client’s actions.

Although this approach is better than the historical model, you still need to consider that the predictions may be misleading. We’re just guessing the customer lifespan based on monthly data. For a more accurate result, you should adjust the CLTV formula to your industry and business strategies.

Let’s suppose 20 shoppers brought $1,240 in profit over a three-month period.

ARPU (3 months) = $1240 / 20 = $62

Let’s see what these clients will bring us in one year.

ARPU (12 months) = ARPU (3 months) × 4 = $62 × 4 = $248 per year per buyer

The historical CLV equals the ARPU for one year, which is $248 based on our data.

Taking the above example, we’ll calculate the ARPU per month for the cohort named Customers from January 2018 that joined in January 2018 and the cohort Customers from March 2018 that joined in March 2018.

This table shows that purchases differ from month to month. Suppose your cohorts are not that different. In this case, the March cohort will likely also go silent for some period of time.

The most complicated but accurate method for calculating CLTV. You’ll need to calculate some metrics to plug into this formula:

Now we’ll figure out how to calculate the metrics you need to plug into this formula.

1. First, we’ll calculate the average number of transactions (T):

Period: 6 months

Total transactions: 120

T = 120 / 6 = 20

2. AOV is the average value of an order or the average revenue from each order.

Total revenue (November): $12,000

Number of orders: 20

AOV = $12,000 / 20 = $600

3. AGM is the average gross margin, which tells you what part of each sale is your actual profit and what part is the cost (expressed as a percentage). We need to perform a two-step calculation to get AGM.

Determine the gross margin (GM) percentage per month:

Example:

Total revenue (November): $12,000

Cost of sales: $8,000

Gross margin (%) = (($12,000 — $8,000) / $12,000) × 100 = 33%

Let’s take a six-month period to get the average:

Total gross margin: 1.64

AGV = 1.64 / 6 = 0.27, or 27%

4. ALT represents the average lifespan of a customer, which tells you how long the average shopper has been with your company.

To get this figure, use this formula:

To measure your churn rate, use this formula:

Suppose you had 200 clients at the beginning of November and 150 buyers at the end of November.

Churn rate (%) = (200 — 150) / 200 = 50 / 200 = 0.25, or 25%

ALT = 1 / 25% = 1 / 0.25 = 4 months

Finally, we have all the metrics for our CLTV prediction formula:

• Average number of transactions per month (T) = 20
• Average order value (AOV) = $600
• Average gross margin (AGM) = 27%
• Average customer lifespan in months (ALT) = 4 months

CLV (total) = 20 × $600 × 27% × 4 = $12,960

Now, we should take into account the total number of existing buyers at the end of the latest month, November, which was 150.

Predicted CLV = $12,960 / 150 = $86,40

If you don’t have flat yearly sales, you can rely on a traditional CLV formula. It’s possible to consider the discount rate, average gross margin per lifespan of a single customer, and retention rate.

The formula is:

1. GML is the average profit you receive from a customer during their lifespan.

GML = Gross Margin (%) × Average Total Revenue per Customer

Gross margin: 27% (from the example above)

Average total revenue: $900 (from the example above)

GML = 0.27 × $900 = $243

2. R is the monthly retention rate.

The retention rate, R, is the percentage of clients who made a repeat purchase over a particular period, compared to the previous period. To calculate your monthly R, you’ll need these numbers:

CE = 250

CN = 50

CB = 220

R = ((250 — 50) / 220) × 100 = (200 / 220) × 100 = 0.9 × 100 = 90%

3. D is the discount rate. We’ll take a standard 10% discount rate.

Now we have all the figures needed to calculate traditional CLV:

CLV = $243 × (0.9 / (1 + 0.1 — 0.9)) = $243 × (0.9 / 0.2) = $243 × 4.5 = $1,093.50

This formula covers all possible changes in revenue during a particular period. In order to take into account inflation, each subsequent year should be adjusted by a discount rate.

Is my CLV normal? There’s nothing like “normal” for CLTV. Any CLV is normal if your business stays alive. You should concentrate on how to improve this metric at any stage of your business development. And if you want a sign from above, here are some interesting statistics: if your CLV is three times your CAC, everything is going well. If not, you have a lot of things to do to improve the situation.

To boost your CLV figures, you should continuously work to improve your customer-brand connection. Here are a few options for how to achieve a lasting and positive customer relationship:

• Launch a loyalty program. You can use different forms: client cards or mobile applications, earning points only by customer phone number, and much more. The main thing remains unchanged. You offer customers personal discounts and other benefits.
• Improve your customer experience. All touchpoints with customers (online and offline stores, support centers, social networks, etc.) should be monitored continuously. Listen to your customers and make the necessary changes if needed.
• Work with disappointed customers. Prevent potential customer discontent, work through objections, and offer alternative solutions.

Customer lifetime value helps you find the balance. You can figure out how much to invest in order to retain your existing customers and to acquire new ones. You’ll get an idea from CLV investigations of how to build customer loyalty and increase sales. If you keep your clients satisfied, they’ll stay longer and continue to purchase from you. Simply by calculating CLTV, you can improve your business in all directions.

In this article, we’ve shared shortcuts to finding your CLV. If you have any questions or would like the OWOX BI team to help you figure out how to improve the lifetime value for your business, contact us today.