What Is Customer Lifetime Value? How To Calculate It?

Introduction

As a business grows and expands, it becomes highly critical to have the clearest picture of its customers. That does not only mean focusing on customer preferences and expectations but also understanding their worth to the business. 

No matter what the size of your business is, it is crucial to have an idea about aspects like customers or segments which are worthy of more investments, how much worth a customer is to your business in terms of revenues, and more. And that is where Customer Lifetime Value comes into the picture.

What is Customer Lifetime Value?

Put in the simplest words, customer lifetime value (CLV) is used to determine how valuable a customer is to your business over the entire course of their relationship with you. This is not just applicable for the initial few purchases but over an unlimited period of time while they are associated with your brand or business. So, customer lifetime value is essentially a metric that indicates the overall worth of your customers and also offers a practical understanding of your business expenses per acquisition.

This is a vital metric for your business since you get an effective idea about how to retain your existing customers by optimizing expenses. The fact that CLV can measure a tangible impact on your business revenues is what makes it valuable and vital. Based on it, you can build customer experience strategies that are ultimately profitable for your business and also develop models to predict customer loyalty. 

Calculating the CLV is especially important for large enterprises with a vast customer base of old and existing customers – a slight dip in their CLV can imply customer attrition and must be taken seriously at the earliest.

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How to calculate customer lifetime value?

Before you start calculating the CLV for your business, you need to know that CLV can be calculated at three different levels:

1. At your company level, which is essentially the average value across all your customer segments
2. At each customer segment level, which is the CLV for specific groups of your customers
3. At an individual level, which is the CLV of individual customers

Now, there are specific data points that you will need to calculate the customer lifetime value, namely:

Average value of purchase

This is the total value of all purchases, usually in a specific timeframe, like one year, divided by the count of purchases in the same time period.

Customer value

The multiplication of the average frequency of purchase and the average value of purchase.

Average frequency of purchase 

The count of purchases in a specific timeframe divided by the count of individual customers who transacted during the same time period.

Average lifespan of customer 

The average period of time a customer keeps purchasing from your business.

When these values are ready, you can use the customer lifetime value formula to obtain the final value.

Calculating CLV at the company level

Calculating CLV at your company level uses a simple customer lifetime value formula:

CLV = Customer Value*average lifespan of customer

This metric is highly useful in driving plans and policies for every functional aspect of your company, starting from your investment decisions for enhancing customer experience to optimizing the strategies for customer acquisition and more.

Calculating CLV at a customer segment level

Not all your customers are the same; while some tend to spend more on each purchase, others share a longer relationship with your business. So when you start calculating CLV based on each segment of customers, you can expect to find differing values for different segments. It is possible that one category of customers comes with a significantly higher CLV than another one. 

• Before you calculate the CLV of a particular segment, you will obviously need to divide your entire customer base into distinct segments or categories. 
• Once customer segmentation is complete, you can use the same ltv calculation formula mentioned earlier, i.e.

CLV = Customer Value*average lifespan of customer

• But this time, you will need data based on specific segments only, not company-wide values. So make sure to calculate the average value of purchase, average frequency of purchase and average lifespan of a customer focusing on a particular segment. 

Finding out the CLV based on segments is crucial. It helps to understand which customer segments are actually boosting your CLV and identify opportunities to convert the lesser valuable customers into more valuable ones.

Calculating CLV by individual customers 

This time, you simply multiply how much a particular customer spends every year and how many years you can expect them to continue their relationship with your business. This is more suited for cases where the numbers are expected to remain the same, more or less, year-on-year basis.

For this ltv calculation, you need to use the formula: 

CLV = Customer revenue in one year * Duration of the customer relationship with your business – Overall costs of acquiring and serving the customer 

Knowing the customer lifetime value per individual customer helps decide how you can prevent customer churns and retain more customers. For instance, you might consider investing more for customers with a value of CLV beyond a specific threshold.

How to calculate traditional customer lifetime value?

When year-on-year customer revenues keep fluctuating, you need to consider the changes that appear across the entire customer relationship period. In such cases, you need to use the traditional ltv calculation formula, which is:

CLV = GML * Retention rate / (1 + Discount rate – Retention rate), where

GML – Gross margin per customer lifespan, i.e. the revenues you expect over the average lifespan of a customer minus your expenses

Retention rate – Percentage of customers who have stayed with you in a specific time period

Discount rate – The inflation percentage, which is generally considered to be 10%

How to calculate predictive customer lifetime value?

With the help of advanced technologies like data analytics, you can now develop more effective predictive models for your CLV. Such advanced models can deliver near-accurate forecasts of your CLV by working at a greater granularity. For instance, they can provide more accurate values of future CLV by taking into account details like the tendency of churning of individual customers. 

The customer lifetime value formula used here is:

CLV = Customer revenue in a year * Customer relationship duration in years – Total expenses in customer acquisition and service

Calculating predictive CLV is essential for formulating business strategies that minimize customer churn and boost loyalty. If you have the correct details in your customer database, then predictive CLV can be extremely useful and insightful going forward.

For instance, an average Netflix customer stays on the platform for 25 months and pays $291.25 during the time. This becomes an important figure for several business and marketing decisions. Even if the user pays only $107.64 in the first year, it makes total sense to spend even $150 to acquire the customer. The company loses money in the short run but manages to stay profitable towards the end of the life cycle. An efficient way Netflix uses to increase CLV is by sending them relevant notifications when they are inactive for long. This increases their chances of starting a new TV series and thus reduces their chances of canceling their subscription.

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Conclusion

Customer lifetime value (CLV), like Customer Satisfaction (CSAT), helps leaders and strategists drive crucial business decisions. However, while CSAT is more of an indicator of an intangible value like the future of customer loyalty, CLV measures a more direct, concrete effect on your business revenues. In many ways, customer satisfaction drives customer loyalty, which in turn increases the CLV for the business. The customer satisfaction rate of Starbucks is close to 89% and it is no surprise that its CLV is as high as 14099 USD.

To learn more and sharpen your leadership and strategy skills, you can enrol for the Master of Business Administration (MBA) from  Liverpool Business School in association with upGrad. You can choose to specialize in any of the principal functional domains like Finance, Marketing, HR, Operations, Analytics, and Strategy & Leadership. 

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