Customer lifetime value – Short Conceptual Explanation

The customer lifetime value (CLV) enables a business to calculate how much money a customer will spend on products or services during their lifetime. It is an important metric to follow because it highlights the profits associated with specific customer relationships. It can then be compared to the cost of customer acquisition (CAC), which can then drive the creation of marketing strategies and spending.

Why the customer lifetime value matters

A new customer may spend the same amount as a repeat customer when purchasing products or services during a single shopping trip, but repeat customers are more valuable. They are easier to sell to because they are already familiar with the brand, reducing the amount of money spent on marketing, and they are more likely to promote the business to friends and family.

However, not all repeat customers are created equal. Some may return just a few times and spend a few dollars each time while another may spend high amounts of money many times throughout the years. Figuring out how much money customers will spend throughout their lifetime enables a business to better understand their target audience, which ultimately results in higher revenue and a higher return on investment on marketing campaigns and new product designs.

CLV

Important values to calculate

There are multiple values to consider when calculating customer lifetime value. A few values to calculate include:

  • Average purchase value: Divide total revenue during a certain time period by the number of total purchases during that time period to calculate how much the average customer spends.
  • Average purchase frequency rate: Divide the number of purchases by the number of customers to see how many items are purchased.
  • Average customer lifespan: Average the number of years a customer purchases from the company to determine brand loyalty.

All of these numbers can be calculated individually to share important information about customer spending habits. For example, the average purchase value may be higher during the holiday season than it is during the summer months, while the average customer lifespan can uncover troublesome data that demonstrates an unwillingness to purchase items or services repeatedly.

Diving into CLV and its corresponding values can answer questions like:

  • How much can be spent to acquire a similar customer and still have a profitable relationship?
  • What kinds of products do high CLV customers want?
  • Which products make the most money?
  • Who are the most profitable types of clients?

Easiest way to calculate customer lifetime value

The calculations listed above can provide very specific data points, but it’s important to combine this information to calculate the customer lifetime value.

This amount is calculated as follows:

Average purchase value X average purchase frequency rate X average customer lifespan, in years

For example, new moms may shop at a children’s store and be worth:
$100 spent on clothes each shopping trip X 5 shopping trips each year X for 5 years=$2,500

In contrast, someone shopping for gifts for the children of friends and family members might be worth:
$50 spent on clothes each shopping trip X 10 shopping trips each year X for 10 years=$5,000

This value can then be compared to the CAC), highlighting how long it will take the company to profit from the investment that’s needed to gain a new customer.

How to use customer lifetime value to drive marketing strategies

The above example illustrates an interesting situation. Intuitively, it would seem like a kid’s clothing store may want to spend the majority of their advertising budget on moms, but the above findings suggest customers shopping for friends and family will end up spending twice as much as the parents themselves.

These findings are important because they can greatly influence marketing strategies and spending. The children’s clothing store may want to promote free gift wrapping services and create gift baskets that appeal to gift givers over sending out coupons to new moms.

Knowing the CLV can help a company narrow in on the phase of the customer lifetime cycle that needs the most attention. For example, if customers don’t return for repeat business, the marketing department may want to focus on the activation phase, which is where one-time customers return to become repeat customers. That might mean making it easy for customers to purchase items they have already purchased online or creating a rewards program that is targeted at customers with the highest customer lifetime value.

If the CAC is high compared to the CLV, the marketing department may want to focus on the conversion stage of the process with a free trial version of a product or a one-time coupon for new customers.