As a business owner, there are dozens of important metrics you need to both track and understand. From your net profit margin to sales revenue and retention, these critical metrics help you stay on track as you grow and scale your business. Not tracking the right metrics is a dangerous road to walk, as it can lead you to some unsuspected surprises throughout your business journey.
One of the most important metrics you’ll want to pay particular attention to relates to your customer lifetime value. This metric tells you what you can expect from an average customer over the course of your business relationship.
In this guide, we'll walk you through exactly what customer lifetime value is and why it’s important, as well as show you how to calculate customer lifetime value (CLV.)
What is customer lifetime value (CLV)?
Customer lifetime value is the total amount of money a customer is expected to spend with your business, or on your products, during the lifetime of an average business relationship. This is an important figure to know because it helps you make decisions about how much money to invest in acquiring new customers and retaining existing ones.
Customer lifetime value helps you understand and gauge current customer loyalty. If customers continue to purchase from you time and time again, that’s usually a good sign that you’re doing the right things in your business. Furthermore, the larger a customer lifetime value, the less you need to spend on your customer acquisition costs.
Let’s look at an example.
The CLV of a Honda owner might be as much as $100,000 if they are happy with their car or minivan choice and end up buying several through the years. Or the CLV of a regular coffee drinker might be even higher than that, depending on how many cups of coffee they drink a day and where they buy it. Conversely, someone who buys a home twice in their life might be worth only, say, $15,000 to a real estate agent, because while the value of the purchase is huge, the percentage paid to an agent is only a fraction of the total.
In the big picture, customer lifetime value is a gauge of the profit associated with a particular customer relationship, which should guide how much you are willing to invest to maintain that relationship. That is, if you estimate one customer’s CLV to be $500, you wouldn’t spend more than that to try and keep the relationship. It just wouldn’t be profitable for you.
If you understand your CLV well, that can help shape your business strategy to keep loyal customers, rather than investing the resources in acquiring new ones. Of course, new and current customers play an important role in business building in general.
How to calculate customer lifetime value (CLV)
Fortunately, calculating customer lifetime value is relatively straightforward.
The simplest way to calculate CLV is:
CLV = average value of a purchase x number of times the customer will buy each year x average length of the customer relationship (in years)
So a marathon runner who regularly buys shoes from your shoe store might be worth:
$100 (per pair of shoes) x 4 (pairs per year) x 8 (years) = $3,200
And the mom of a toddler might be worth:
$20 (per pair) x 5 (pairs per year) x 3 (years) = $300
So who should you be paying more attention to? Using CLV, the marathon runner should be your focus!
Understanding how to calculate customer lifetime value is essential for everyone in leadership, and especially for a CEO. Knowing how much you can expect from an existing customer can give you a clear and updated picture of the health of your business.
If you find your customer lifetime value is declining over two consecutive quarters, for example, you might invest more into retention and customer service. While not the only factor that affects customer lifetime value, customer satisfaction does play a key role. If there's a difference in quality of service between when a customer first buys and their third purchase, CLV will likely decline.
CLV should be one of the most important metrics you track.
The value of knowing your CLV
Calculating the CLV for different customers helps in a number of ways, mainly regarding business decision-making. Knowing your CLV you can determine, among other things:
- How much you can spend to acquire a similar customer and still have a profitable relationship
- The exact amount you can expect an average customer to purchase over time
- What kinds of products customers with the highest CLV want
- Which products have the highest profitability
- Which customer relationships are driving the bulk of your sales
- Who your most profitable types of clients are
- Using your CLV as a base, you can work to better understand your most loyal customers. What do they like? Why do they continue to purchase from you?
Together, these types of decisions can significantly boost your business’ profitability.
As with any metric you track in business, knowing the number is not enough. You have to use your CLV to shape your overall business strategy. If your customer lifetime value is on the rise, that could mean you should continue to invest in product development or your customer success teams. If your CLV is declining, that might tell you your latest marketing strategy could use a reboot. One of the main benefits of understanding CLV is that it can help you significantly reduce your customer acquisition costs over time.
Boosting customer lifetime value
Since the odds of selling to a current customer are 60% to 70%, according to eConsultancy, and the odds of selling to a new customer are 5% to 20%, investing your resources in selling more to your existing customer base is the key. In most cases, it’s far easier to sell to existing customers than it is to invest in acquiring new customers.
So what tactics will increase the likelihood of a customer buying more from you? How can you increase your average order value?
Here are some proven techniques:
- Make it easy for customers to return items they’ve purchased from you. Making it hard or expensive will significantly reduce the odds of them making another purchase.
- Make strategic exceptions for your most loyal customers. For example, if someone is planning on canceling a subscription service you offer, give them an option of remaining a user with a small discount.
- Interview and connect with your best customers to understand why they continue to choose your brand.
- Set expectations regarding delivery dates, aiming to underpromise and overdeliver. It’s much better to promise delivery by August 1 and have it in their hands by July 20 than the reverse.
- Create a rewards program to encourage repeat purchases, with rewards that are both attainable and desirable.
- Offer freebies for doing business with you to build brand loyalty.
- Run exclusive deals only for existing customers.
- Use upsells to increase the average value of a customer transaction, which is the equivalent of McDonald’s asking, “Would you like fries with that?”
- Stay in touch. Long-time customers want to know you haven’t forgotten them. Make it easy for them to reach out to you as well.
By using CLV to shape your business strategy you’ll ultimately build a more profitable, successful business by focusing on attracting and retaining long-term customers who will become advocates for you, as well as repeat buyers.
Customer lifetime value FAQ
What are the three parts of customer lifetime value?
To calculate customer lifetime value, you need to know:
- The average purchase a customer makes
- The average rate in which a customer makes a purchase
- How long a customer typically remains loyal to your brand
Why is customer lifetime value so important?
Understanding CLV allows you to make informed decisions based on how long a customer typically buys from you and what they spend over the lifetime of that relationship. This metric can help inform your strategy on customer acquisition, retention, customer service, and even the quality of your products and services.
What is the customer lifetime value (CLV) formula?
While the formula can be a little more complex if needed, the most basic way to calculate CLV is as follows: The average value of a purchase x number of times the customer will buy each year x average length of the customer relationship (in years)