Every for-profit business understands the vital role customers play in their growth, but the truth is that some customers ultimately contribute more to a company’s success than others. A one-time customer, for example, won’t have the same impact on a company’s bottom line as one who makes a purchase five times a year for the next 20 years. As a result, today’s most successful companies focus on building “customer lifetime value (CLV),” a metric used to identify and encourage consistent, repeat purchasers over time.
CLV is more than a valuable tool for measuring the contribution a customer makes to the bottom line; it also fuels marketing strategies designed to build customer loyalty and revenue. This article explores how to calculate CLV and how it can help you focus your company’s efforts on customers who offer the most long-term potential.
What Is Customer Lifetime Value?
CLV represents the total amount a customer is expected to spend with your business over the entirety of their relationship with you. Understanding CLV helps companies move beyond transactional thinking to develop longer-term strategies that focus their efforts on customers with the highest potential to spend over time.
For example, calculating CLV helps companies understand how much to invest in acquiring new customers versus retaining existing ones. CLV can also help companies make smarter decisions about budgets, marketing strategies, and customer service initiatives.
Why Is Customer Lifetime Value Important?
In general, CLV yields important insights into the long-term value of customer relationships. These insights can be useful when prioritizing marketing strategies. For example, it’s a well-accepted notion that it costs significantly more to acquire new customers than it does to keep existing ones (though specifics depend on industry, market, and business model). Loyal customers with a high CLV are, therefore, often very cost-effective targets for marketing outreach, while customers with little to no CLV offer less return on investment (ROI).
In addition to prioritizing marketing efforts, CLV can help companies gauge how service improvements, communications programs, and advertising initiatives impact customer relationships. More specifically, analyzing post-initiative fluctuations in CLV provides insights into which strategies produced the greatest positive impact on long-term customer relationships. Paying attention to CLV can also help companies convert the most-revenue-generating customers into advocates by inspiring them to give referrals, which can have an enormous impact on the bottom line.
The more you know about existing customers, the better you can communicate with them to nurture and enhance the sales potential of the relationship. In addition, understanding high-value customers can help your company devise marketing strategies that attract new customers with similar characteristics. CLV is a key piece of that puzzle.
The Customer Lifetime Value Formula
In its most basic form, the lifetime value of a customer is a relatively simple calculation:
CLV = Number of annual purchases x Average sales amount x Number of years they remain a customer
So, if a customer averages $500 in purchases three times a year for five consecutive years, their customer lifetime value is:
Three purchases per year x $500 average per sale x five years = $7,500
How to Adjust CLV Based on Customer Referrals
To get a deeper sense of CLV, it’s important to consider not only a customer’s transactions with your company, but the impact that customer has on other customer transactions, specifically via referrals. To calculate the lifetime sales value of a customer’s referrals, it can help to first build a program that makes it easy to track referrals. Many companies offer customers gifts, discounts, and free products and services in return for referring customers via email or an online form, for example.
Once you know who referred whom, you can track how much each referral spends. This spending can be attributed to the customer lifetime value of the original referrer.
To incorporate the value of referrals into a customer’s CLV, calculate the CLV of each customer they refer. Don’t forget to subtract the cost of any referral rewards program you implement. For example, if you award a $100 gift certificate for every successful referral, and a customer brings in two new clients, you’d deduct $200 from the referrer’s adjusted CLV.
How to Calculate the Total Customer Lifetime Profit Value
The CLV concept, especially when adjusted for referrals, highlights the fact that customer relationships can be much more valuable than they’re perceived to be. A nuanced metric that plumbs this understanding is customer lifetime profit value (CLPV). Companies can use CLPV to get a more comprehensive view of how profitable it would be to acquire and retain specific customers. The calculation for CLPV, however, is more intricate than the strictly revenue-centric CLV.
To calculate CLPV:
- Start with the CLV. If not already included, add the lifetime value of referrals attributed to that customer.
- Multiply this value by your company’s gross profit margin.
- Subtract the total costs of acquiring and serving the customer over their projected relationship lifespan.
For example, if the gross profit margin for your company is 50% and the CLV, including referrals, amounts to $75,000, you’d calculate:
CLPV = ($75,000 x 50%) – Total acquisition and service costs for that customer
Bear in mind, this CLPV might not fully capture the comprehensive long-term value of the customer relationship. This is because one customer’s referrals can lead to additional referrals, amplifying the CLPV over time.
Other Methods of Calculating Customer Lifetime Value
There are other methods of determining customer lifetime value, but they’re often much more complex because they require numerous assumptions, including discount rates, churn rates, the potential future value of money, or other variables.
For example, some approaches may deduct corporate expenses, such as sales, marketing, and overhead costs, to determine the net income lifetime value for a customer. While this aims for a more comprehensive view of customer profitability, it can also dilute the decision-making value of the calculation by introducing allocations of corporate and other expenses that may not be directly related to the customer relationship.
Why You May Not Want to Keep Some Customers
Every business has had at least one customer that, given the choice, they might prefer to direct toward a competitor. The CLV approach can help you identify which customers don’t meaningfully contribute to your bottom line, so you can make more informed decisions about whether to engage with them.
For example, infrequent purchasers who generate little or no profit, and provide no referrals, only serve to detract attention from more valuable customers. As a result, companies would be wise to limit involvement with them. A small professional services firm, for example, might politely say they’re too busy to take on an assignment from a low CLV customer.
The Bottom Line
The lifetime value of a customer is a useful way to develop insights into the true long-term benefit of customer relationships. Using CLV to establish marketing priorities for targeted communication and sales promotional programs, for example, can help you achieve growth and profitability objectives for long-term success.
A version of this article was originally published on October 21, 2021.
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