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What Is Customer Lifetime Value (CLV) And How To Calculate It

Customer acquisition is one of the primary objectives of a marketing campaign. SaaS and Ecommerce businesses spend their most of their budgets to stay ahead of their competitors in the race for acquiring new customers. But what is the return generated by every unit invested in a marketing program? This dilemma is one reason why not all businesses actively support in-house marketing teams; it is difficult to evaluate returns on investment.

Customer Lifetime Value (CLV) shows you how to optimize the acquisition cost of expanding your market base with a focus on maximizing returns instead of minimizing expenses.

What is Customer Lifetime Value?

Customer Lifetime Value (CLV) is a way of predicting the value a customer adds or contributes to your business during the entire lifetime of his or her relationship with your company.

what is customer lifetime value

A good way to understand CLV is through the Pareto Principle.

According to the Pareto Principle, 80% of the effects come from 20% of the causes. Thus when applied to e-commerce, it means 80% of the revenue you generate comes from 20% of your customers. The implication is that some customers are definitely worth more than others. They assure you of repeat business through continued patronage, larger purchases or new customers through word- of- mouth.

Understanding CLV will create a shift in your priorities when it comes to market or customer acquisition. Marketing becomes less of a numbers game; it is no longer about the size of the market or finding ways to streamline the budget for the sake of cutting costs. CLV will help you maximize the value of your customer acquisition cost.

The Importance Of Customer Lifetime Value

If you’re in the SaaS or E-Commerce business, CLV is perhaps the most important metric you can use to assess the performance of your business and to develop a solid marketing strategy. By knowing what is your Customer Lifetime Value, you can know how much you can spend on acquiring a new customer, and still turn profitable.

In order to ensure the success of your business, you have to focus on 2 areas of potential revenue growth: new market acquisition and existing market retention. The process of acquiring new customers can be very costly especially when compared to retaining the existing customer base by reducing the churn rate. (Here’s what is Churn Rate and how to calculate it)

Customer Lifetime Value can help improve your current business model for acquiring and maintaining end users in the following ways:

1. Maximize ROI on Customer Acquisition

The Customer Lifetime Value metric helps you identify the marketing channels that generate the most profitable customers. These are the end users that present a higher lifetime value to your brand and not just on the gross profit on the initial purchase.

It’s often the case that a marketing channel will help you acquire a lot of customers at the beginning, but the churn rate will be at a very high level. Each marketing acquisition channel has different marketing metrics, thus it can have a different churn rate and customer lifetime value.

For example, in your quest to acquire more customers to your SaaS, you can use three of the most popular marketing channels: AdWords, Facebook and Twitter. Your strategy had the following results:

Marketing Channel Amount Spent Total number of customers acquired Customer Acquisition Cost (CAC)
Twitter $150 150 $1
Facebook $200 100 $2
Adwords $250 50 $5

Based on this table, it may seem that Twitter was the best marketing channel because it resulted in the least cost per acquired customer. However, once we apply the Customer Lifetime Value metric, the results will lead to a different conclusion:

Marketing Channel CAC CLV Revenue Profit
Twitter $1 $20 $3000 $2850
Facebook $2 $40 $4000 $3800
Adwords $5 $120 $6000 $5750

Once CLV is added to the equation, it shows that despite acquiring only 50 customers, Adword’s net hauled in the most profitable end users for your business.

With CLV, the cost of acquisition holds less meaning compared to the maximum value you can extract from each customer. It makes more business- sense to allocate more resources on a channel that ensures you of regular patronage than another that is “one and done”.

2. Improve Your Customer Retention Strategies

Once you’ve uncovered your VIP customers; the ones with the highest CLV, you will have the necessary information and insights to fine tune your customer retention strategies.

You would be able to identify characteristics and spending behaviors of key demographics. This data will help you conceptualize customized messaging that will directly resonate with your high CLV customers.

Another approach would be to organize data into categories whereby you can identify triggers that influence buying behavior from your best customers. The objective of your marketing campaign shifts from generating sales from new customers to making them repeat purchasers and maintain an extended relationship with your business.

3. Maximize the Power of Customer Support Services

Customer service is a powerful tool in retaining patronage or encouraging brand loyalty.

With CLV, you will be able to plan out your customer support services. You can direct them to avenues best preferred by the high CLV customers and come up with more effective ways to fast track resolution to concerns or enhance the overall customer experience.

For example, if high value CLV customers prefer using inbound calling channels, make sure they receive an e-mail confirmation or transcript of the conversation, a copy of the trouble ticket and an assurance the concern would be resolved within 24 to 48 hours.

Take a proactive approach and have customer service reach out and update the end user of the status of the concern.

How To Calculate Customer Lifetime Value

There are 2 main methods of calculating CLV for SaaS and E-Commerce businesses:

1. Historic CLV – The sum of the gross profit from all historic purchases from an individual customer. Assuming that “X” is the last transaction a customer made with your SaaS business or e-commerce store, simply add all the gross profit values up to “X”.

CLV (Historic) = (Transaction1+Transaction2+…..+TransactionN) x Average Gross Margin (AGM)

An Excel spreadsheet will suffice in preparing the Historic CLV as long as your transactional data is complete.

If you calculate CLV based on net profit, you can derive the actual profit contributed by a customer to your business. Net profit calculation takes into consideration cost of returns, acquisition costs, marketing and customer service costs.

The problem with net profit based calculation of CLV is that it can be difficult to run on an individual basis especially if you want data to be regularly updated. For this reason, gross margin CLV will give you a better perspective on the true profitability of your customers to date.

Historic CLV is considered a good indication of Customer Lifetime Value.

2. Simple And Predictive CLV – This method uses a more predictive analysis of the previous transaction history and different behavioral indicators that forecasts the lifetime value of the individual customer. The calculation of the value will remain precise with every purchase made as long as the equation is accurate.

CLV = (Average Gross Margin) X (Number Of Repeated Transactions) X (Average Retention Time – In Months Or Years)

Let’s take a real life example. A SaaS that has an average gross margin (profit) per user of $35.90 per month, and an average retention rate of 18 months would have the customer lifetime value calculated as follow:

$35.90 X 1 (month) X 18 (AVG retention time) = $646.2

As long as the SaaS spends less than $646.2 for acquiring new customers, it will continue to be profitable. The less you spend on acquiring new customers, the more profit the business will make.

Ways to Use Customer Lifetime Value

As discussed earlier, CLV can be used to determine if you are over-spending or under-spending in your efforts to acquire a customer. Online marketing offers many tools at your disposal: CPC, Facebook, Twitter, Content Marketing Process, Cross Promotion campaigns for SaaS and AdWords to name a few.

But a more effective approach would be to use CLV to determine if you should spend more or less on a specific marketing channel. The cost of acquiring a customer should matter less if the marketing channel generates higher profit per individual customer. CLV helps you establish greater efficiency in your marketing budget.

As an example, your marketer may be utilizing cheaper keywords to acquire customers. However, CLV may show that using expensive keywords may bring in more VIP customers. Thus, you could initiate a shift in strategy by instructing your marketer to use the more expensive keywords in the content marketing process.

CLV can also be utilized to determine how to capitalize on the different tools your marketing has within reach. The objective is to find out how to optimize on these tools so you can influence the desired consumer behavior from every individual customer.

For example, do not immediately disregard customers who buy low margin items from your e-commerce business. They could merely be trying out your products and services and want to keep their risk at a minimum. If they have a good experience with your business, they would most likely return and opt for your better- margined products.

If CLV confirms this to be the case, you may have to re-think or re-strategize how you organize products on the home page of your e-commerce website.

The key takeaway from knowing your Customer Lifetime Value is that it is an essential metric for understanding the true value of your customers. It gives your marketing campaign direction and a reliable reference from where to build strategy on.

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