5 Simple Ways to Calculate Customer Lifetime Value

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

 

What is customer lifetime value?

Actually, that amount depends on your margins. One company may spend up to $1 to retain a customer while another spends up to $50. To figure out how much you should invest, you need to calculate the customer lifetime value 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 customer is about 60–70%. Retention is a lot cheaper than acquisition. Thus, successful marketers don’t focus only on strategies for acquiring new customers. They also work out tactics to retain customers and stimulate them to make more purchases. CLV 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 on how to encourage customers to spend more.

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

Let’s see a couple examples of how big companies have adopted CLV results.

CLV case studies

Netflix is another good example of why you should learn how to calculate customer lifetime value. In 2007, they found that a typical subscriber stayed with them for 25 months and that CLV was $291.25. This helped them determine that viewers were impatient. After analyzing statistics, Netflix decided to implement online streaming. This kept members satisfied while they waited for new DVDs to arrive in the mail. In this way, Netflix managed to improve retention by 4% and rented its billionth DVD.

Likewise, Starbucks shows that by improving customer satisfaction you can increase lifetime value and grow profit. A study by Business Insider shows that Starbucks should spend on acquisition of no more than average CLV $14,099.

This is how measuring customer lifetime value changes businesses in real life. Ready to give it a go?

How to calculate the lifetime value of a customer

Calculating CLV

Historical and cohort approaches to calculating CLV

Method #1

 

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

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

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

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

The historical CLV equals the ARPU for one year, which is $248 based on our data. Let’s see what we can do using the other approach.

Method #2

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.

 

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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.

In addition to calculating CLV, 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. You can read more about this in our article on cohort analysis.

The drawback of these methods

A predictive approach to calculating CLV

Method #3

 

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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.

  1. Determine the gross margin (GM) percentage per month:
 

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Example:

Total revenue (November): $12,000
Cost of sales: $8,000
Gross margin (%) = (($12,000 — $8,000) / $12,000) × 100 = 33%

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

 

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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 customer has been with your company.

To get this figure, use this formula:

 

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To measure your churn rate, use this formula:

 

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Suppose you had 200 customers at the beginning of November and 150 customers 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 CLV 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 = $1,296,000

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

Predicted CLV = $1,296,000 / 150 = $8,640

The drawback of method 3

Traditional approach to calculating CLV

Method #4

The formula is:

 

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  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:

 

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Let’s suppose that in November you had:

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.

Lifetime value of a customer in Google Analytics

Method #5

 

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Things to consider:

  • Google Analytics is a cookie-based platform. If a user opts out from cookie tracking, they’ll fall out of your data.
  • Google Analytics counts leads along with subscribers across all channels. This means you won’t know for sure how much money each user spends.
  • Google Analytics can’t clearly see which customer makes a repeat purchase. There’s no way to check if a customer has spent $100 or $1,000.

Google Analytics is an effective tool for data collection, but calculating CLV requires data on real customers and can’t be done only with web metrics.

Is my CLV normal? There’s nothing like “normal” for CLV. 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.

 

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CLV is done. What’s next?

Compare your CLV results with acquisition costs to see if your marketing efforts are profitable:

  • If CLV is higher than the cost of acquisition, you might be in a good situation due to repeat purchases or high retention. However, the interpretation also depends on your industry and gross margin.
  • If you see that your costs constitute a small part of the gross margin (i.e. are lower than 10%), you might not be spending enough on marketing. Thus, you can invest more to grow.

It’s another matter if your CLV is equal to or close to your acquisition costs. This says that your business is spending almost as much on a customer as it gains. This might be a strategy when you want to attract new clients. However, it’s always a warning sign, telling you that your marketing efforts aren’t effective. So think about improving your lifetime value. One way to do that is through customer segments using OWOX BI Pipeline.

Customer lifetime value can be interpreted in many ways. This metric 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.

Just to give you an idea of possible benefits of CLV monitoring, take a look at these statistics by Criteo:

 

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Final word

For the original article, click here.

 

Want to learn more about Customer Lifetime Value and how you can use it in your business? We can help you! Click the button below to get in touch.

 

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