Are you trying to calculate Customer Lifetime Value importance ?
This guide will guide you.
Customer Lifetime Value (CLV) metric tells us how well we are resonating with our customers, how much our customers like our products or services, whether we are meeting their expectations, and how we can improve.
When customer lifetime value increases we can understand that we have happy customers, this helps to pertain our customers and use the same strategies for future ones.
In this context, we shall look into what customer lifetime value is and how we calculate it.
What makes Customer Lifetime Value Important?
Customer Lifetime Value (or life-time value (LTV)), is the average amount of money the customers will spend on our business over the entire life of their relationship with us.
Our customers are not just worth the amount of money they spend on our business today. They have future value if we are able to retain them as customers.
CLV impacts customer retention rates.
Further, CLV is important because, the higher the number, the greater the profits. We often have to spend more money to acquire new customers than to retain existing ones. Email marketing, SMS marketing, and social media marketing help us to retain our existing customers.
We can always improve customer lifetime value when we know how much it is.
Why should we calculate CLV?
Firstly, one of the key reasons to measure CLV is to retain customers. The probability of selling to a new prospective customer is lesser than the probability of selling to an existing customer.
It means that selling more to existing customers will bring significantly more profits. Hence it is important for promoting customer loyalty.
According to statistics, 80% of a company’s future revenue will come from just 20% of the existing customers.
By measuring CLV we can evaluate how much we should invest in retaining our current customers. Further, it helps our organization to plan further spending and divide the budget between retention and acquisition.
It also helps us to make specific marketing goals along with sales strategies to lower acquisition costs and keep retention high.
Moreover, it lets us devote more resources to encouraging our customers to spend more over their lifetime with our brand.
How to Calculate Customer Lifetime Value ?
So far we saw why Customer Lifetime Value is important. Now we will check the formula for customer lifetime value calculations.
There are a number of ways to do it, we can choose the suitable one depending upon the resources we have.
To measure CLV, we need to take into account things like:
1. Customer lifespan
2. Retention rate
3. Customer churn rate
4. Average profit margins (per customer)
Following are some of the common methods which we can use to calculate CLV:
1. Historic CLV
Basically, it is the sum of all the gross profit from a customer’s past purchases. To calculate it we need to add up all the gross profit values up to the last transaction (N) a customer made. If we measure CLV on the basis of net profit, we will get the true profit a given client generates.
This involves costs of service, return, marketing, acquisition, and so on. The drawback is that we might have to do some complicated math at the individual level to get the most up-to-date data.
Still, gross margin CLV gives us a thorough understanding of our customer's profitability to date:
Historic CLV = (transaction #1+transaction #2+...+transaction #N)/(Average Gross Margin)
Where: AGM = Average Gross Margin
In principle, this method is valid if customers share the same preferences and interact in the same way with our brand over roughly the same period of time.
2. Predictive CLV
First, its aim is to model the transactional behaviors of our customers to predict what actions they will take in the future. This method is a great indicator of customer lifetime value, better than historic CLV.
It works using algorithms that try to generate precise CLV while predicting a customer’s total value. Predictive CLV is fueled by a history of past transactions and the customer's actions to better forecast the value a particular customer can generate.
Also, there is no single perfect customer lifetime value formula and there are numerous ways to calculate it.
We will focus here on a simpler one.
First, the formula:
CLV = T * AOV * AGM * ALT
T = Average monthly transactions
AOV = Average order value
ALT = Average customer lifespan (in months)
AGM = Average gross margin
However, keep in mind that this approach does have a flaw: it is a prediction that won’t always be 100% accurate. To improve accuracy, we should adjust CLV calculations to the specific industry we operate in. Precision in the CLV gives us a tool for developing sound and effective marketing strategies.
3. Traditional CLV
In some circumstances, it is better to rely on the more traditional but in-depth CLV formula. This might be the case when our yearly sales are not flat. Then we can take into account the discount rate, as well as including average gross margin per customer lifespan and retention rate.
The final formula will look like this:
CLV = GML (R/(1+D-R))
GML = gross margin per customer lifespan
R = monthly retention rate
D = monthly discount rate
This particular computation looks at possible changes in customer revenue throughout a period of time. Next, each year is corrected by a discount rate to account for inflation.