The complete guide to understanding customer lifetime value

Customer lifetime value (CLV) is a measurement of how valuable an average customer is over the course of their relationship with your brand. This can vary widely based on the products and services you offer. For example, a brand that sells a product that’s only intended to be purchased once may have a customer lifetime value equivalent to the sale price of that product, along with the cost of future maintenance. On the other hand, a brand that offers a recurring service may have a customer lifetime value equivalent to the amount a customer will spend on that service over their entire subscription period.

Along with Voice of Customer insight tools like surveys and CX Insights, customer lifetime value is one of the key components in tracking your customer experience and your brand’s profitability. It’s valuable for evaluating the health of your business, finding areas where you can improve profitability, and helping your brand grow to its full potential.

Determining your customer lifetime value will give you valuable insights into your business. Regularly evaluating your CLV can provide insight into fluctuations in your market and customer loyalty. Once you start understanding the factors that play into customer lifetime value, you can start taking a high-level view of your business and identify what areas you need to focus on to improve your ROI and help your business succeed.

So, why should you care about your brand’s CLV? Here are four good reasons.

Every aspect of the calculation to reach your customer lifetime value (see below for the full formula) is a key aspect of your business. The insight gained from calculating your CLV allows you to more accurately tend to the needs of your existing customer base. Once you start identifying ways to increase your retention time period, or even the number of translations of each customer, you will start to see a noticeable increase in your CLV as well as profits.

Retention and loyalty fall into the retention time and period, as well as the number of actions each customer takes. Expanding either of these aspects will consistently provide value. More loyal customers will provide more positive reviews, referrals and increase your overall sales, people want to trust the opinion of your peers, let your customers vouch for you.

As you know, acquiring customers is expensive. If your customers are only making one purchase, then the price of acquiring new customers will quickly add up. Learning the value of each customer coming through your doors and how to increase the length of their relationship with your business will ensure that the cost of acquiring your customers doesn't swamp your business.

Any information that you gain on your target demographic will give you insight into how best to speak to them. Knowing how much money your average customer will spend can help you formulate a better strategy to target these customers. Whether this is through specific deals or promotions that help get your target demographic into the door or a loyalty program for your most loyal customers feel welcome. Knowing which strategies to implement can help improve your business.

Customer lifetime value formula

Calculating CLV is a simple calculation, but you’ll need to know some statistics on your business.

The basic formula for CLV is:

Customer Lifetime Value= (Lifetime Value) x (Net Profit Margin)

Here are the formulas to get the Lifetime Value and Profit Margin values used in the calculation of CLV:

Lifetime Value= (Average Value of Sale) x (Number of Transactions) x (Retention Time Period)

Your average value of sale is calculated by dividing your company's total revenue in a regular cycle, most likely a year, by the number of purchases in that time frame.

AVP = Total Revenue in time period / Total number of orders in the same time period.

How can you increase your average value of sales? A few ways have proven effective:

1. Create order minimums for free shipping. There are few things people hate more than paying for shipping, so sometimes offering the incentive for free shipping can nudge your customers to purchase one or two more items they were debating. Just a small increase in every order will drastically increase your average value of sale.

2. Cross-selling complementary products. Whenever possible on your site, show recommendations of products that work well together or are often sold together. Mention similar products in descriptions or in your sidebars, whichever way you choose getting extra products sold in each order can do wonders for your average sales.

You can calculate your number of transactions by taking your number of purchases and dividing them by the number of customers.

T = number of purchases / number of customers.

This will give you your average number of transactions. What are some ways to increase the purchase rate of your customers?

1. Retargeting campaigns are a great way to increase the number of transactions. They will remind your website visitors of your product and services after they leave your site. Retargeting campaigns are great options to showcase your top-selling products or promote customer-specific products.

2. Take advantage of seasonal promotions. Small business Saturdays or local events are great ways to boost your transactions. People love deals and supporting their community, participating in these types of events can give you a dramatic boost to your business as well as raise brand awareness in your local community. Events tied to your industry are also a great option if small businesses Saturdays for example don't work well for your business model.

Retention time period is how long you keep your customers. So if your customers purchase ten products a year, and your average retention rate for a customer is ten years, that customer on average will purchase 100 items from you. The higher you can keep a retention rate, the more value you get out of your customers.

1. Offering loyalty programs to help keep long-term customers is a great option to increase RP.

2. If you have a product that requires regular maintenance or products like ink for a printer, subscriptions are a great option to go for the long-term retention period.

Operating costs are associated with the maintenance and administration of a business on a day-to-day basis. Operating costs include direct costs of goods sold (COGS) and other operating expenses—often called selling, general, and administrative (SG&A)—which include rent, payroll, and other overhead costs, as well as raw materials and maintenance expenses. Operating costs exclude non-operating expenses related to financings, such as interest, investments, or foreign currency translation.

There are two ways to look at your CLV: a historical model and a predictive model. Both have their uses, but deciding which is best for your business is important.

The historical model uses past data to predict the value of a customer without considering whether the existing customer will continue with the company or not. A historical model will use the average order value to determine the value of your customers. Historical models tend to be more useful for customers who interact with your business for a certain period of time. This model is not the best at predicting when patterns of your customers change, so if you have an active customer that suddenly stops or an inactive customer who starts buying your products again; either can throw this model off. This model will not help you predict any future behavior changes of your customers, it just extends their behaviors into the future.

• Aggregate model: Use past transactions to create an average CLV. This gives a single value for CLV.

• Cohort model: Group customers into different cohorts based on transactional data, and calculate average revenue per cohort.CLV for each cohort. This can help you focus on effective areas of the business.

The predictive model focuses on past data to predict and forecast buying habits. This model can better help you identify your most valuable customers or products and can help you map out a more successful business plan. These models are more complex than your historical models, and often use probabilistic models or machine learning models.

• Machine learning model: Use regression statistics to predict future CLV

• Probabilistic model: Probability distribution for future cohort sales

In all of these models, you can either reduce the cost of acquisition, increase the number of sales, or extend your retention period to increase your CLV. The best of these options is to increase retention because doing so can turn customers into loyal brand advocates who will recommend your brand to others, resulting in more sales without higher marketing costs.

In fact, research shows that it costs five times more to attract a new customer than to retain an existing one. Furthermore, the same data suggests increasing retention by just 5% can increase profits by anywhere from 25-95%. Thus, you should emphasize keeping your existing customers happy. To do so, here are a couple of things your brand can do.

Customer experience starts the moment a customer first interacts with your brand, but often customers need care after their purchase as well. Improving the onboarding of new customers can help ensure that it is an easy process to become a customer of your brand. One way to do this is having an online community that can work as a self-service station and even a guide to your product. If your customers already have a support system in place to help them learn about your product and see a support system already in place, your product can sell itself with the help of your community. Check out our other posts on building a community to help build your brand!

Customer experience is all about listening to what your customers want and need. Your customers are your greatest asset in improving your business. They will be brutally honest about what’s working and what isn't. Having a good customer experience will help increase your retention rate and give you those lifelong customers to really boost your CLV. Read our case study on how SAP Concur pivoted quickly based off customer input.

Loyalty programs can help increase retention rates and target your top customers with deals targeted towards them specifically. Not only do loyalty programs longer customer lifetimes, but also they allow you to gain important insight into your customer’s habits and preferences, allowing you to make better decisions based on what your customers want. Learn what your top customers value, and acquire more of those high-value target customers. View our post on how a community can help reduce the churn rate of your customers.

Gamification is the process of adding game mechanics into non-gaming environments like websites, online communities, or the shopping experience. The goal of gamification is to increase engagement with customers and allow for collaboration between your brand and your customers. Bringing in gamification techniques can reduce the churn rate of your customers and allow you to retain high-value customers for a longer period of time. Communities often work hand in hand with gamification, having a strong community to build it gamification can lead to super engagement from your most loyal customers, where customers are providing large portions of the content in those communities. Our post on gamification goes into more detail.

Depending on your industry, often your top customers are accounting for large portions of your profits, providing some return value to those customers to show your appreciation can go a long way to retaining them as well as acquiring more customers of the same caliber. Rewarding these customers can be done in a plethora of ways. For example, Sky rewarded users who participated in their community with perks and private community areas. A loyalty program is a great start, but going past a loyalty program, offering free products or discounts to those who spend above a certain limit can really show these customers you appreciate them and their business. Showing your top customers you appreciate them will improve customer retention and brand loyalty increasing your CLV. 

Overall, calculating your customer lifetime value will provide valuable insight into your business. When calculating the components of the formula, you can gain insight into where your brand is doing well, and what areas could use help.

CLV and customer acquisition cost don’t exactly have an inverse relationship, but they do have correlations. The more you improve your CLV, the more value you get out of each customer, helping to absorb the cost of acquiring future customers.

Whether your focus is to improve CLV or reduce CAC, Khoros is there to help. Your goal should be to have a higher CLV than your CAC, whether you achieve that through adding loyalty programs, building a community, or gamification, our experts are there to help guide you and your business into a more sustainable and profitable business model.