Customer Relationships: A Simple Guide to Customer Lifetime Value
Metrics have never been so useful.
By Allan Diaz — Finance Director & Senior Copywriter at Masterpiece Web
If you’ve been around long enough, you’ve heard the age old saying, “The customer is always right.” Many service based companies ensure their daily operations follow this mantra — for good reason, too. The customer must keep coming back. If he or she decides to continue business with you, that’s more money in your pocket. So, what if I told you there’s a way to quickly analyze how much revenue your business makes from any given customer? Let’s take a look at this.
What is Customer Lifetime Value?
You might see customer lifetime value written as CLV, LTV, lifetime value, CLTV, or total customer value. Maybe you haven’t heard of its more formal names at all. You’ve definitely given customer lifetime value some thought though. It plays a big role when making decisions for your business.
Customer Lifetime Value is essentially the amount of repeat business you can get out of a particular customer. You can also think of it as the total revenue a customer will generate in their lifetime with your business.
I’m sure some gears started turning in your head, huh? Like I said, you’ve given this concept some thought in the past. CLV isn’t just a qualitative measure though, we can actually quantify the number. Different formulas for calculating CLV exist. Some of them are more accurate than others, but we’ll go through a few of them.
Calculating Customer Lifetime Value (CLV)
It might be surprising to learn that CLV is one of the most important metrics to analyze. Sadly, different methods to find it can give us different values. Let’s begin with the easiest and most simple one.
Method 1 (Easiest)
52 × (Avg. Customer Expenditure per Transaction × Avg. Number of Transactions per Week) × (Average Customer Lifespan)
Let’s dissect this formula a bit. Since it’s dealing in weeks, we use the number 52 to represent the number of weeks in a year. If you’d like to use a different time measure, make sure to change it accordingly. We take those 52 weeks and multiply it by the average customer value per week (what you see in the first parentheses). We get that number by multiplying the average amount a customer spends in a single visit to your store by the average number of times a customer purchases from your store per week. We then multiply that by the average amount of time a customer continues to buy from your store (the length between the first time they buy something to the last time they buy something). This might be the most difficult variable to find. Generally, you might want to use 1–3 years for that. That’s the typical store’s lifespan. Of course, a company like McDonalds might have an average customer lifespan of about 20–40 years. We probably won’t be that lucky, though. Once you calculate the equation, you’ll get a rough customer lifetime value for your business.
Let’s come up an example. You own a taco shop called Tito’s Tacos. The average customer at Tito’s Tacos spends about $8.21 per visit. The average customer also visits about 2.1 times per week (Taco Tuesday isn’t enough — have to get in those Taco Thursdays too). The typical customer also continues to buy from Tito’s Tacos for about 5 years. Using method one for calculating CLV, we’d do the following:
52 × (8.21 × 2.1) × 5=$4,482.66
$4,482.66 is the revenue we’d get out of the average customer at Tito’s Tacos. After we get through a few more CLV equations, we’ll discuss how to use this number.
Method 2 (Kissmetrics)
The following formula to calculate CLV comes from a Kissmetrics infographic. It looks like this:
Average Customer Lifespan × (52 × Avg. Customer Expenditure per Transaction × Avg. Number of Transactions per Week × Avg. Profit Margin)
This equation looks like the previous one, but with the introduction of the profit margin per customer. You should already be tracking your profit margin, but in case you don’t know: (Gross Profit÷Sales Revenue×100). You can usually use this as your profit margin per customer.
Let’s use the Tito’s Tacos example again. This time using their imaginary 19.8% profit margin:
5 × (52 × 8.21 × 2.1 × 0.198) = $887.57
Uh, oh. This looks significantly less than our previous customer lifetime value. That’s okay! We’ll deal with this at the end. Keep reading to learn about the last method and what to do with the different values.
Method 3 (Most Difficult)
This is the traditional way of computing customer lifetime value, but also the most complex:
(CLV using Method 1) × ((Customer Retention Rate) ÷ (1+Rate of Discount-Customer Retention Rate))
Wow, that’s a doozy. Though you may not use this one, let’s dig in a little deeper. First, we have to get the CLV computed by method 1 (the easy one). The second part of the expression uses what’s known as the customer retention rate. Find the CRR using this formula: (# of non-new customers) ÷ (#total customers last period). To simplify this more, divide the number of customer who purchased from you in the last 12–24 months and also purchased in the last 6 months, by the total number of customers that have purchased from you within 12–24 months.
It doesn’t end here though. We also have to use the rate of discount. I won’t get into it, but if your mind is set, check out more about the rate of discount here. It’s the discount rate used in discounted cash flows — intricate stuff.
Let’s once again take a look at the marvelous Tito’s Tacos. Using method 1, Tito’s Tacos had a CLV of $4,482.66. Let’s say their customer retention rate is floating around 66%. Their rate of discount is at 13% (it’s usually between 8% and 15%). This is what that looks like:
(4,482.66) × (.66 ÷ (1 + 0.13–0.66)) = $6,294.80
Okay, that was the final method we’ll be learning today. But what do we do with all these different customer lifetime values? Easy.
Find the Average
Let’s take the average of these three numbers to find the official Tito’s Tacos CLV. Our customer lifetime value would be about $3,888.34 if we get the mean. This number isn’t perfect, but it gets the job done. The average Tito’s Tacos customer provides $3,888.34 of revenue for the company in their lifetime with the store. The question is, what do we use that number for?
How Do We Use Customer Lifetime Value?
Customer lifetime value seems like a cool metric and all, but you’re probably wondering what it’s useful for. That’s simple. CLV has uses in your marketing, customer service, sales force, and product development. Each of these things plays a large role in your company. You might as well optimize them using customer lifetime value.
In marketing terms, we’d pay attention to how much you should spend to get a new customer. How much of our expenses should go towards things like advertising and public relations? The CLV tells us the total amount of revenue a customer will give us, so we’re going to want to stay below that amount for our marketing to be worth it. With that said, we have two ways to approach the acquisition of customers.
The first method is short-term, makes more sense when you’re first starting out, and cash flow is a concern. Divide the CLV by the average customer lifespan to get the customer value per year (works with other time measures as well). In the case of Tito’s Tacos, the value they get out of the average customer per year is $777.67. Using this method, you’d be able spend less than $777.67 in the first year to get a new customer. Maybe you want to give new customers a one month of free tacos card. If it costs less than $777.67, you’re doing fine. This method is best if you need some quick cash.
The second method is long-term, makes more sense when the value of your customers is higher, and you have enough resources to take a hit with your initial investment. Your initial marketing costs would outweigh the revenues for the first and maybe second year. If Tito’s Tacos was a high class eating establishment, this might be the right choice for you. Customer value per year might be around $1,500. Tito’s Tacos would be able to give away a $2,000 golden burrito to new customers. They’d be taking a loss in the first year, but then making it back later for a CLV of $10,000. Amazing.
CLV also has uses in customer service. How much should I be spending to maintain a customer? Tito’s Tacos better be ready to pick up that phone at any time to respond to customer complaints about their house sauce (pretty rough on the bowels). If the total cost of keeping a customer coming back beats the CLV, it might not be worth it. Providing great service might increase the average customer lifetime, though. Be be careful with this one.
The sales team can also enjoy customer lifetime value. What kinds of customers should the sales force spend their time trying to get? Time is money, so spending wages on a sales team going after the wrong leads can be quite the waste. The sales team’s main goal should be to target customers that will make larger purchases, buy more often, and buy for longer periods of time. The sales team can help the CLV more than the CLV can help them, but the metric intertwines into the department.
Finally, we have product development. What kinds of product and services can I offer to my best clients? Obviously, they must tailor to the wants of these glorious people. If providing them with exactly what they want increases their CLV variables, then it should shoot up like a rocket. Don’t neglect these gems.
You’re thinking, “Damn, customer lifetime value really is an amazing metric. Do you have any tips for increasing it?” Well pal, you’ve come to the right place.
How Do I Increase Customer Lifetime Value?
As the title of this article suggests, customer lifetime value is all about customer relationships. Building these customer relationships is key. The top 1% of eCommerce customers spend up to 18 times more than the average customer. Finding the right types of customers is essential. Positive client relationships increase customer lifetime value, but how do we build and expand on these relationships? We either increase average spending per order, or we increase shopping frequency and shopping length.
Encourage Customers to Spend More on Orders
Basic business tactics can help more with CLV than you think. Here are a few you might be able to use in your own venture.
Use the age old .99 trick. Readers of the English language read from left to right. This is the reasoning behind the greatest marketing ploy in history. When we see $3.99, we look at the 3 first and subconsciously view this as significantly cheaper than $4.00. You rarely see anything in a retail store ending in .00. They get you and you don’t even realize it.
Allow your customers to compare prices. Let them see prices and descriptions of other models or services you sell side-by-side. They’ll feel like they have more power in their hands and will lock in that buy — possibly even a more expensive buy.
Make things urgent and exclusive. Act now! While supplies last! Hurry before they’re all out! Let the customer know your product is unique and might sell out soon. As humans, we love exclusivity and we need things at the moment. Give discount sales a set end date and enjoy the difference in profit.
Set a free shipping threshold. Boy, do I love free shipping (gets me every time). Let’s say you offer free shipping if a customer orders $100 or more. Customers close to that threshold might add a few more products to get free shipping. Heck, If I’m at $50, I’ll order $50 more just for that shipping.
Upsell and cross-sell. Why get the model 1 when you can get the model 3.5? Why just get the shirt when you can get the matching pants too? You want to sell as much as possible. Make sure the client leaves with the store!
Keep Customers Coming Back
We’ll focus on frequency and lifetime here, essential parts of any CLV formula.
Make unboxing an unforgettable experience. I don’t know if you’ve ever seen an unboxing video on Youtube, but people truly enjoy watching other people open things. It’s weird, but it’s a thing. Regardless, opening your package should be a grand event for the customer. Things like bonus gifts, personalized notes, and fun packaging can do that. Being the nerd I am, I shed a tear when I order something from Fangamer to see they’ve included a pin and a personalized comic strip (don’t tell anyone).
Keep customers updated with newsletters. Email marketing is all the rage nowadays and can work wonders. Your clients should be hearing about your new products, discount sales, and maybe even company news from time to time. You’ll both be glad they did.
Connect on social media. Facebook, Twitter, LinkedIn, and Instagram aren’t just for your own personal shenanigans. These are serious marketing tools that have made it easier than ever to connect with your clientele. Post content that’s relevant to them and always respond to their comments.
Install loyalty programs. You don’t even need stamps and physical cards anymore (though physical cards are great). Have an app developed or use an existing platform like Belly to start a loyalty program for your business. A free taco after the 10th taco sounds like an amazing idea.
Provide outstanding customer service. As mentioned earlier, great customer service creates happy customers. Respond instantly through phone, email, social media, instant message, and text message. Make every client feel like they’re your only client. Provide quality work before deadlines. These are rules to live by.
Without your clients, your business is nothing. Make sure to focus on those client relationships. Oh, and forget the bottom line, customer lifetime value is what gets you places (okay, maybe they’re both important). See ya’ next time.
Liked this? Follow Masterpiece Web for more content.