Serve your customers well using customer lifetime value (CLV)

Customer Lifetime Value (CLV) is a very useful metric that helps you to understand your customers and serve them well. In short the customer lifetime value tells you how much money you make with each customer. If your customer acquisition cost (CAC) is lower, then your company is profitable in the long term.

Reasons for calculating your CLV

At the end it's all about the customer. The customer speaks, we listen. Understanding your customers better, and acting accordingly is the core and center of good a business.

Businesses go through different stages, and in each stage the use of CLV evolves. Although this one number won't answer all of these questions, it is a key figure in answering them.

No product, no customer

At the beginning there's no actual business. All there is are ideas and bold plans. Obviously without any sales there's also no means to calculate a CLV. Instead you can play with different assumptions and estimations to help answer questions like

  • How much should my product cost?
  • What effect has a superior customer service? (And therewith increased retention)
  • How much should I risk for initial marketing?

Product but no customers

Once you do have a product, you know your cost of sales. You can revisit your questions from above and adjust.

  • Is my intended pricing sustainable?
  • What if my customer retention plan doesn't work out?
  • How much can I spend on marketing?

Product and first customers

Now it's time for a first real calculation.

  • Do product price, cost of sales and marketing spendings yield profit yet?
  • When do I become profitable at the current rates?
  • Can I sustain investment long enough?

Growth

When a company grows, that's usually a good sign. Customers see a lot of value for the price. Focus shifts from customer acquisition to scaling delivery.

  • Which high-cost marketing activities can be scaled down?
  • Which customers are to be kept happy primarily?
  • Which customers require most maintenance?

Plateau

Earlier or later a plateau is reached. Sales and customer atrition balance out.

  • Has customer atrition increased? What are the reasons for leaving? Is there a pattern?
  • Which marketing activities can be scaled up cost-effectively?
  • Is increasing price a viable option?

Decline

A decline is often perceived a dangerous situation. Immediate action is required.

  • Are sales declining? What marketing channels perform worse than before?
  • Has the market changed? Are there new competitive offerings?
  • What customer segments are shrinking or growing?

Benefits of knowing your CLV

While the CLV gives clues on most of the above questions, I want to focus on the following:

What effect has a superior customer service?

Many underestimate the huge value of a loyal returning customer. The CLV-formula reveils what benefit a few percentage-points increase in customer retention provides.

How much can I spend on marketing?

Your marketing should not cost more than the aquired customers spend. As a rule of thumb you're in green if your customer acquisition cost (CAC) is lower than 1/3 of your CLV.

Is my pricing sustainable? When do I become profitable at the current rates?

Especially agressive growth strategies start with a big black hole in your bank account. The CLV gives you good advice on your chances to escape the hustle.

Which customers are to be kept happy primarily?

It's simple as that: 20% of your customers typically generate 80% of your income. It's those customers with an above average CLV that make the difference. Understand them in depth and serve them well.

Which customers require most maintenance?

High CLV and high efforts to maintain a good relationship is often good. Those who complain constantly but rarely spend a penny should not capture your focus.

How to calculate the CLV

Calculating the CLV is no rocket science. However there are some variations in use.

Simple example:

Paul buys first time from you and spends $89.00 . He places another order next year for $65.00 and buys an upgrade for $29.00. Afterwards Paul was never seen again.

Paul clicked on your ad on a popular search engine. On that advertising channel you spend on average $35.00 to make one sale.

Your products are being sold with an average profit margin of 50%

With this information, we can calculate Pauls individual CLV:

50% * ($89.00 + $65.00 + $29.00) - $35 = $56.50 - Paul has helped you succeed.

The general basic formula is:

CLV = ("Average profit margin%" * ("Average order value" * "Reorder rate") / (1 - "Retention rate")) - "CAC"

Factors

  • The CLV is usually calculated based on a timeframe, e.g. 1 Year.
  • "Average profit margin%" : Exclude sales and marketing, how much does it cost to provide your product? Sum up last years cost, sum up last years revenue then "Average profit margin%" = (revenue - cost) / revenue
  • "Average order value" : Divide last years revenue by the number of orders
  • "Reorder rate" : How often do customers order per year? Divide number of orders by number of unique customers
  • "Retention rate": How many of the customers that ordered last year also order this year? One way to calculate is ("Number of unique customers this year" - "Number of new customers this year") / "Number of unique customers last year"
  • Customer Acquisition Cost (CAC)

Example

  • Timeframe: 1 Year.
  • "Average profit margin%" : 50%
  • "Average order value" : $60.00
  • "Reorder rate" : 2.2
  • "Retention rate": (3,400 - 1,200) / 2,900 = 76%
    • "Number of unique customers this year" : 3,400
    • "Number of new customers this year" : 1,200
    • "Number of unique customers last year" : 2,900
  • CAC : $65.00

The CLV is (50% * ("$60.00 * 2.2) / (1 - 76%)) - $65.00 = $210.00

Extension: Discount Rate

A discount rate is especially relevant when customers keep coming back for years. Imagine I give you either a dollar now or a dollar in 3 years - which one would you prefer?

Right.. and if I give you 3 dollars in 3 years?

A discount rate reduces the value of future earnings. Let's assume we discount future earnings by 10% per year. This changes the formula to:

CLV = ("Average profit margin%" * ("Average order value" * "Reorder rate") / (1 - "Retention rate" + "Discount rate")) - "CAC"

The new CLV is (50% * ("$60.00 * 2.2) / (1 - 76% + 10%)) - $65.00 = $129.12

Using the CLV for good

Let's use our newly aquired knowledge to answer the questions above:

What effect has a superior customer service?

Let's assume we have an idea to improve customer service. We assume this would increase customer retention by 5%-points from 76% to 81% . Our current CLV is $129.12 . Insert 81% into the formula results in a new CLV of $162.59 ! That's a whopping 26% increase!

How much can I spend on marketing?

Our current CAC is $65.00, that's about 50% of our CLV - so we are profitable. If neccessary we could even spend a bit more. However lower CAC is always good.

Is my pricing sustainable? When do I become profitable at the current rates?

At our current average order value of $60.00 with a gross profit of 50% or $30.00 we need 2.17 orders from each customer to make a profit (earn more than the CAC of $65.00). This takes about a year from the first purchase. Rougly speaking we become profitable, when less than 1/3 of the orders are placed by new customers. Reducing CAC helps best if cashflow is running low.

Which customers are to be kept happy primarily?

The average customer orders $60.00*2.2 = $132.00 per year if retained. I'd say customers who spend more than $250.00 annually earn the "gold"-badge. Customers over $400.00 receive premium-treatment in the "platin"-program

Which customers require most maintenance?

The CLV doesn't tell us anything about who calls customer service every month. But those who didn't buy for more than 12 months need to be thought of as "lost" or "at risk".

Conclusion

The customer lifetime value is a relatively simple but powerful metric that everyone can calculate with a pencil and an envelope. You don't need much data, yet gain valuable insights, including

  • How to spend your marketing budget
  • Balancing growth with cashflow and profit
  • The value of good customer service and retention

But all those benefits are only the tip of the iceberg - CLV becomes an even more powerful tool when combined with customer segmentation. Which I will write about in a future post! =)