In a world where the customer is always right, it's important for businesses to focus on building customer lifetime value. This means that you need to think about how to improve customer retention - in other words, keeping your customers happy and coming back long after they've made their first purchase.
In this blog post, we'll discuss customer lifetime value, why it's important, how to calculate it and some tips on how to increase customer retention rates.
What is customer lifetime value?
Customer lifetime value (CLV or CLTV), sometimes referred to as lifetime value of a customer (LTV), is the cumulative value that individual customers spend on your products or services over their 'lifetime', so from their first acquisition to their last.
While some customers will only transact once with your business, others will come back for repeat business. It is often the case, that customers making a series of small repeat purchases for several years are more valuable customers than those making a large one-time purchase.
Supposing that one of your customers makes their first and final purchase from your business over the space of exactly three years, their lifetime will be 36 months and the lifetime value will equate to the total value of all their purchases in that 36 months period.
Therefore, the three variables behind the lifetime value of a customer are the average spent on each purchase, the frequency of purchases (the number of purchases made) and the period of time for which a customer is buying. The higher the value of each purchase, the longer the customer stays with the company and the more frequent its purchases, the higher the lifetime value of that customer will be.
Why is customer lifetime value important?
Customer lifetime value can help you understand your audience - their tastes and appreciation for your product, their preferences, their purchase patterns, what to improve customer loyalty and where to concentrate your marketing efforts.
Customer value is closely connected to total revenue
There is a direct correlation between how much revenue your company is making and the lifetime value of your customers. As we mentioned above, CLV is positively correlated to how long a customer keeps buying from your company, how frequently and the value of his purchases. Therefore, the higher the CLV will be, the more revenue your company will be making.
Identify high-value customers
By analysing lifetime value, you can also identify customers who are contributing more revenue to your business, and adapt your offering to better serve that customer segment.
In fact, customer lifetime value can either be calculated on an aggregate basis (therefore working out the average value for all your customers), it can be calculated by customer segments (i.e. by batching clients into groups, based on showing similar characteristics), or it can be calculated more granularly for each individual client.
In theory, you could measure each customer's lifetime value and rank them in order to identify which customers have a high lifetime value and are the best customers. In reality, calculating customer lifetime on a client-by-client basis is too granular for most companies.
A useful type of approach is trying to understand the average lifetime value of defined customer segments. You can do this by grouping customers into cohorts, depending on which month or year they made their first purchase. If you are doing all the right things, your customer lifetime value would hopefully be higher in more recent cohorts.
Regulate your customer acquisition costs (CAC) and marketing spend
Another reason to measure customer lifetime is it can help you define your customer acquisition strategy.
A solid understanding of your customer lifetime value can help you monitor how much customers are worth to your business, compared to how much you spent on acquiring them. In other words, customer lifetime value should always be higher than how much you spend to acquire customers: if you are spending more to acquire a customer, than the worth of that customer over his lifetime, economically this can be problematic. We have included an example further down this article.
This relationship is summed up in the LTV/CAC ratio, a key focus of investors. CAC represents the marketing cost to acquire a new customer. It is juxtaposed to LTV as the pair sum up how effectively your business is extracting value from customers, compared to what it cost you to acquire them - the higher your LTV/CAC, the more profitable your business. You can also think of this metric as a metric of ROI on your customer.
It can help improve your company's customer retention rate
Customer lifetime value is a function of loyal customers and repeat business. If you find that your customer lifetime value is consistently low, it might indicate an issue with the rate at which you re-engage customers.
This is particularly important because the cost of selling your solution to an existing customer is far lower than the cost of selling it to a new customer (in other words, it is cheaper to market to an existing customer than it is to a new customer). Therefore, it is more profitable to keep selling to existing customers, rather than having to acquire new ones.
How to calculate customer lifetime value
There are several ways to calculate customer lifetime value, some of them more complex than others, but each with its own advantages and drawbacks. The main methodologies are the historical method and the predictive approach.
When using any of these methods, use gross margin, rather than revenue, to calculate your customer lifetime value.
Using gross margin when calculating lifetime value
Customer lifetime value is ultimately based on a profit contribution number, normally gross margin. In fact, in order to quantify a customer's contribution to the profits of the business, you need to analyse this after variable costs of serving the customer have been stripped away - depending on your industry these could be costs ranging from customer success costs, to shipping costs, to sales commissions, to materials, etc.
Historical customer lifetime value calculation
The historical approach is a straightforward calculation method, relying on data from existing customers. This can be computed either by determining average revenue per user (ARPU) or by using cohort analysis.
Average revenue per user (arpu) method
The average revenue per user method is based on the gross profit sum made from customer purchases in the past. The formula to calculate ARPU:
ARPU = Gross profit in a chosen period/# of customers in a chosen period
So if 50 customers contributed £2,500 in gross profit over a three-month period, then:
ARPU (three-month) = £2,500/50 = £50
The historical customer lifetime value is equal to ARPU for one year. Therefore:
ARPU (twelve-month) = ARPU (three-month) * 4 = £50 * 4 = £200 per year
Therefore, in this case, your historical CLV would be equal to £200.
The advantage of the ARPU calculation is that it provides a straightforward, if approximate, customer lifetime value that can be calculated from limited data.
The drawback of this method is that the data is not segmented. As such, it only provides an aggregate overview of customer lifetime value and it does not consider evolution in customer behaviour.
Unlike the ARPU method, cohort analysis takes into account the evolution in customer behaviour and lifetime value. As hinted above, cohorts are groups of customers who made their initial purchase with your business in the same period.
So, if you are looking at monthly cohorts, you might have a cohort for January, one for February, one for March and so on and so forth. If you are looking at quarterly cohorts, you might have a cohort for Q1 (meaning anyone who made their first purchase between January and March), one for Q2, etc.
By looking at cohorts you can calculate the ARPU for each cohort and, in addition, you can review the evolution of ARPU for each individual cohort on a monthly basis.
The upside of this is that it facilitates the analysis of changes in behaviour between one cohort and the other. You can track the evolution of ARPU from older cohorts of customers to new ones. Moreover, assuming there were changes in business, strategy, marketing or product, you can track the impact by comparing ARPU in cohorts before and after these changes.
The drawback is that it is limited to historical data and does not allow to predict future customer lifetime value.
Predictive customer lifetime value formula
As mentioned above, the three key items to calculate predictive CLV are:
- Average purchase value
- Average purchase frequency rate
- Average gross margin
- Average customer lifespan
The formula can be summed up as:
CLV = Average purchase value * Average purchase frequency * Average Gross Margin * Average lifespan of a customer
So let's see how each of these factors is calculated.
Average purchase value
This can be calculated, either on a single customer basis or on aggregate, by dividing the total revenue by the total number of purchases:
Average purchase value = Total revenue/Total # of purchases
Average frequency of purchase
On an aggregate basis, the average purchase frequency is calculated by dividing the total number of purchases by the number of unique customers.
Note the emphasis on unique customers - to get the correct value of frequency: you should count each customer only once (meaning if it made multiple purchases, it should still only be counted once):
Average purchase frequency = Number of purchases/Number of unique customers
Average gross margin
The average gross margin is your business' profit after calculating the costs related to serving the customer.
Gross margin = (Sales - COGS)/Sales *100
In order to find the average gross margin, you can average the monthly gross margins for a time period of six or twelve months.
Average customer lifetime
If you have far-reaching historical data, you could calculate the average lifetime of a customer by dividing the sum of all customers' lifespans by the number of customers:
Average lifespan = Sum of customer lifespans/Number of customers
However, oftentimes this data is not available. In these instances, you can calculate customer lifespan by using your customer churn rate:
Average customer lifespan = 1/Churn rate %
What is your churn rate?
Your churn rate indicates the rate at which customers are not returning as repeat customers, and therefore how often they are churning. A churned customer ceases to be a customer of your business, meaning the customer lifespan ends and he will make no further purchases from your company. The churn formula:
Churn rate % = (Number of customers at the beginning of a period - Number of customers at the end of a period)/Customers at the beginning of a period
As an example, if you had 20 customers at the beginning of January and you have 18 customers at the end of January, your monthly churn rate will be:
(20-18)/20 = 10%.
Using the churn rate, you can imply your average customer lifespan, per the above formula:
Average customer lifespan = 1/10% =10 months
Bringing it together to CAC (customer acquisition cost)
The point of comparing CLV to CAC is understanding if your marketing efforts are profitable (and by how much!).
To understand the relationship between CLV and CAC let's take the example of a D2C online soap company. Suppose they sell their products under a single tier, with unlimited access to the full content library for £15 a month.
A subscriber churns after 5 years on average, so the revenue from that customer is approximately £900 (£15 * 12 months * 5 years).
The company is also paying £6 per month in royalties to the content producers, hence making a gross margin of 60% and this is the only cost of serving customers. The customer LTV/CLV is therefore £540.
Now assume that the business is spending £1,000 to acquire 10 customers. Their cost to acquire customers (CAC) is £100 per customer. Given that the LTV is higher than the CAC by a factor of 5.4x, the business is investing its marketing budget wisely, because every customer is 5.4x more profitable than the cost to acquire them.
If your customer acquisition costs are significantly lower than your gross margin (lower than 10%), that might indicate you might want to spend more on marketing CAC. Conversely, if your LTV/CAC is close to 1x, it means that your cost to acquire new customers is the same as what you are gaining from them, which might suggest you want to refocus your strategy.
Understanding LTV and how it relates to your marketing costs is crucial to help you refine your marketing strategy.
How to improve customer lifetime value
Now you know how to calculate customer lifetime and how it can help your business, you might be wondering what are the steps to improve it. Remember that CLV is calculated as:
CLV = Average purchase value * Average purchase frequency * Average customer lifespan
Therefore increasing any of these three levers, will lead to an increase in CLV. So what can you do to persuade your customers to spend more, spend more frequently or stay with your business for longer?
Increase average order value
The first way to increase customer lifetime is to increase purchase value or average order value. For a transactional business, this often means cross-selling complementary products or upselling higher-value items. For a subscription business, this could entail moving active customers to a higher subscription tier or migrating them from a monthly to an annual subscription plan.
Build customer loyalty
Another way to increase customer lifetime value is by improving customers' purchasing frequency and lifespans. Building customer loyalty will achieve both of these aims, as clients will purchase exclusively from your business, rather than opting for alternative solutions on the market, and will stick around for longer.
You could consider introducing a loyalty program. Typically, these consist of unlocking free or discounted products after a certain threshold spend has been reached. This is a great way to personalise the customer experience, while encouraging repeat purchases. There are a number of companies that will design and roll out a loyalty program for your business.
Increasing customer loyalty will also have other effects, such as lowering your cost of acquiring new customers, as you build brand advocates that introduce your solution to new customers, and also improving your feedback through their willingness to engage with you.
Developing great customer relationships and improving customer retention
A key contributing factor towards improving lifetime value is how long you are able to retain customers before these customers stop shopping for your products or services.
If you want to improve your retention rate and average customer lifespan, being obsessed with customer experience is pivotal. Everything from your website, to your storefront, to customer service and call centres, to generous refund policies, omnichannel touchpoints and support are part of the customer experience. A low-stress shopping experience is a given and experiences of substandard customer service are too often a common reason for customer churn.
In addition, collecting, reflecting on and, where appropriate, acting on your existing customers' advice is critical. Ultimately they are the beneficiaries of your products or services and modifying this according to their needs will ensure a happier customer base. If your customer satisfaction is high, your retention rate will also increase, improving customer value.
Customer lifetime value is a crucial metric for any business that wants to succeed in the long run. By understanding what it is, how to calculate it and using some best practices, you can make sure that your customers are happy and keep coming back for more. Do you focus on customer lifetime value in your business? What are some other retention strategies that you use?