Calculating the Lifetime Value of a Customer: 5 steps

When it comes to making investments in marketing, customer lifetime value, or CLTV, is one of the most important metrics to measure. For those who have never heard the term before, CLTV is essentially the estimated amount of profit earnable from a customer over time. This is essential to know because it informs a marketing budget and helps to better evaluate the customer acquisition cost (CAC).

This article will explain the concept of the lifetime value of a customer in more detail and elucidate how to calculate CLTV, and then use that figure to inform marketing strategies moving forward.

Understanding Customer Lifetime Value

What does the lifetime value of a customer really mean? It might be thought that it’s simply the amount of money a customer will pay overtime, but it’s a little more complicated than that. In addition to purchasing goods or services, customers can also refer new businesses to the company; this is especially true nowadays in the age of social media.

That said, for the sake of simplicity, CLTV can be thought as the measure of how much money a company can reasonably expect to earn, directly or indirectly, over the lifetime of the business relationship between the company and that customer.

Why is Customer Lifetime Value Important?

There are a number of reasons for why CLTV is important in business. The first and most important reason is that it directly affects revenue. By knowing the lifetime value of a customer’s profile, businesses can identify the customers who are likely to spend the most money with them over time, and as such, they can tailor offers and customer loyalty programs for those customers, which can directly and dramatically increase revenue both in the short term and in the long run.

The second reason why CLTV is important is that it enables companies to significantly boost customer retention and loyalty rates, which are again directly tied to revenue. The more loyal a customer is, the more likely they are to spend money with a company, and as such, being able to identify customers with a high CLTV and then actively attempt to boost their loyalty level can have long-term benefits for any company.

Finally, by understanding CLTV, you can lower your customer acquisition cost (CAC). This is an important concept to grasp, so it is explained in detail below.

The Relationship Between CLTV and CAC

It can be very costly to acquire new customers, especially those with a high CLTV. There is a direct correlation between the amount of money companies spend on marketing and the number of new customers they attract to their business.

By knowing the CAC for a target customer and comparing that number against the CLTV for that same customer, businesses can determine the exact amount of profit they can reasonably expect to earn from a customer after recuperating the costs associated with obtaining that customer in the first place.

As a general rule of thumb, a business would never want to spend more on CAC than they can reasonably expect to be returned from the lifetime value of a customer; this is basic economics, and businesses that fail to grasp this concept are doomed to fail sooner rather than later.

How To Calculate Customer Lifetime Value

To calculate the lifetime value of a customer, companies need to first calculate a number of other equations, including the average purchase value of a customer, the average purchase frequency of a typical customer, the average customer value, and the expected lifetime of an average customer. Only once all of those equations have been solved can a business calculate CLTV with any degree of accuracy.

Calculating the Average Purchase Value of a Customer

This figure can be determined by dividing the company’s total revenue over a certain time period by the total number of purchases over that same period of time.

Calculating the Average Purchase Frequency of a Customer

This is determined by dividing the number of purchases in a given time period by the number of new customers acquired during that timeframe.

Calculating the Average Customer Value

This can be calculated by multiplying the average purchase value of a customer by the average purchase frequency of a customer.

Calculating the Average Lifespan of a Customer

This is calculated by averaging the total number of years that customers shop with your company.

Calculating Customer Lifetime Value

Finally, to calculate the CLTV, you multiply the average customer value by the average lifespan of a customer. The figure you end up with will be the amount of money the company can realistically expect to make from the average customer over the course of their mutual business relationship.

Summary

Customer lifetime value is a key metric that every company should calculate yearly, if not quarterly. By knowing the CLTV, companies can ensure that their customer acquisition budget is in line with their forecasted profits over any given period of time.

Companies looking to glean more insight into CLTV, CAC, or any of the other critical metrics that inform profitable marketing strategies are encouraged to contact Vervology.