Customer lifetime value: how to calculate it and why it’s important

What is customer lifetime value?

Why is customer lifetime value important?

CLV yields important insights into the long-term value of customer relationships, which are useful when prioritising marketing strategies.

It’s well-accepted that it costs significantly more to acquire new customers than it does to keep existing ones (though specifics depend on industry, market, and business model). Loyal customers with a high CLV are, therefore, often very cost-effective targets for marketing outreach, while customers with little to no CLV offer less return on investment (ROI).

CLV also helps companies gauge how service improvements, communications programs, and advertising initiatives impact customer relationships. Analysing CLV fluctuations after deploying these initiatives sheds light on how they impact long-term customer relationships. Paying attention to CLV also helps companies convert the most-revenue-generating customers into advocates by inspiring them to give referrals, which can have an enormous impact on the bottom line.

Understanding high-value customers also helps your company devise marketing strategies that attract customers with similar characteristics.

The customer lifetime value formula

In its most basic form, the lifetime value of a customer is a relatively simple calculation:

CLV = Number of annual purchases × average sales amount × the number of years they remain a customer

So, if a customer averages $500 in purchases three times a year for five consecutive years, their customer lifetime value is:

Three purchases per year × $500 average per sale × five years = $7,500

How to adjust CLV based on customer referrals

Direct transactions are only one element of the customer value equation. To get a deeper sense of CLV, it’s important to consider the impact the customer has on other customer transactions, specifically via referrals.

To calculate the lifetime sales value of a customer’s referrals, it helps to first build a program that makes it easy to track referrals. Many companies offer customers gifts, discounts, and free products and services in return for referring customers via email or an online form, for example.

Once you know who referred whom, you can track how much each referral spends. This spending can be attributed to the customer lifetime value of the original referrer.

To incorporate referral value into a customer’s CLV, calculate the CLV of each customer they refer. Don’t forget to subtract the cost of any referral rewards program you implement. For example, if you award a $100 gift certificate for every successful referral, and a customer brings in two new clients, you’d deduct $200 from the referrer’s adjusted CLV.

How to calculate the total customer lifetime profit value

The CLV concept, especially when adjusted for referrals, highlights the fact that customer relationships can be much more valuable than they seem. A nuanced metric that plumbs this understanding is customer lifetime profit value (CLPV). CLPV is used to get a more comprehensive view of how profitable it would be to acquire and retain specific customers. The calculation for CLPV, however, is more intricate than the strictly revenue-centric CLV.

To calculate CLPV:

• Start with the CLV. If not already included, add the lifetime value of referrals attributed to that customer.
• Multiply this value by your company’s gross profit margin.
• Subtract the total costs of acquiring and serving the customer over their projected relationship lifespan.

For example, if the gross profit margin for your company is 50% and the CLV, including referrals, amounts to $75,000, you’d calculate:

CLPV = ($75,000 x 50%) – Total acquisition and service costs for that customer

Bear in mind, CLPV might not fully capture long-term customer value because one customer’s referrals may lead to additional referrals, amplifying the CLPV over time.

Other methods of calculating customer lifetime value

There are other methods of determining customer lifetime value, but they’re often much more complex because they require numerous assumptions, including discount rates, churn rates, the potential future value of money, or other variables.

Some approaches may deduct corporate expenses, such as sales, marketing, and overhead costs, to determine the net income lifetime value for a customer. However, this may dilute the decision-making value of the calculation by incorporating expenses that may not be directly related to the customer relationship.

Why you may not want to keep some customers

Every business has had at least one customer that, given the choice, they might prefer to direct toward a competitor. The CLV approach helps you identify which customers don’t meaningfully contribute to your bottom line, so you can make more informed decisions about whether to engage with them.

For example, infrequent purchasers who generate little or no profit, and provide no referrals, detract attention from more valuable customers. As a result, companies would be wise to limit involvement with them.

The bottom line

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