Customer Lifetime Value

by Admin
Updated: July 25, 2020

The Customer Lifetime Value (CLV) is an estimate of the total net profit per customer

Customer Lifetime Value (CLV) is an estimate of how much net profit a customer contributes, which can be used to determine how much can be spent on the customer relationship.

Knowing your CLV is necessary to avoid overspending on customer acquisition and underestimating the requirements for growth. It will likely differ for different types of customer and calculations can become as detailed as is useful.

Direct and indirect value

There are two sources of customer lifetime value:

  1. Direct value: The profit derived from the customer’s direct purchases calculated from known values of sales & costs.
  2. Indirect value: The saving of acquisition costs gained when new customers are introduced by the customer (either by direct referral such as recommending to friends, or by indirect referral such as writing favorable reviews).

Indirect value is generally quite difficult to quantify and is often ignored for the purposes of calculation.

This, of course, does not mean it has no value and experience suggests it is essential for the long-term health of a business.

CLV is total net profit

The biggest mistake when estimating CLV is to base it on sales alone. This is obviously wrong, e.g. if a $100 product uses $20 of materials then the maximum contribution is $80.

Gross margin is also incorrect because it doesn’t take account of all the direct costs of fulfillment (admin, shipping etc.).

Example: If the net margin per sale is 75% and a customer purchases $400 worth of products over 3 years then the CLV is $400 × 75% = $300, i.e. $300 is the maximum we can afford to spend acquiring that customer.

Notes:

  1. CLVs are Lifetime amounts, not periodic (annual) amounts.
  2. CLVs should be adjusted by retention probabilities.
  3. CLVs should be discounted present values.

Acquisition costs

Two types of activity are necessary to ensure the CLV:

  1. Acquisition: The cost of converting a prospect into a paying customer and getting that initial sale.
  2. Retention: The cost of servicing the customer relationship and getting repeat orders in line with the CLV calculation.

The acquisition cost per customer is the total spend divided by the number of initial sales.

Retention costs can be ignored if they are already included in overheads (the cost of operating the business regardless of the number of customers). Otherwise, they must be added to the acquisition costs to arrive at a total acquisition cost.

Strategies

For any sales strategy to be viable the CLV multiplied by the number of new customers must be greater than the total acquisition cost.

Example: If an advertising campaign is going to cost $4,000 and the average CLV is $200, it will be necessary to convert at least 20 leads.

An intelligent sales strategy will seek to optimize conversions of customers with the highest CLV.

More info

Lifetime Value
Infographic by Neil Patel

“How To Calculate Lifetime Value” with Infographic by Neil Patel illustrates some details involved in calculating (estimating) CLV with a focus on Starbucks as a case study. The article includes a video an comments.

“How to Calculate Customer Lifetime Value (CLV) in Ecommerce” at blog.ometria.com distinguishes Historic CLV from Predictive CLV and includes some equations.

Internal links

Customer service DCF analysis made simple The improbable salesperson Go to Articles
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