Learn how to calculate customer lifetime value. In this video, Noah Fleming discusses the value of knowing how frequently your customers buy from you and the true cost to your company.
- Wouldn't it be great to know exactly how much you can spend to get a customer, and more importantly, how much that customer is worth? Welcome to customer lifetime value, often known as CLV and for some, the holy grail of data analysis. It's a concept that's seductively simple and it makes great intuitive sense. And while I feel there's a number of challenges related to the use of customer lifetime value, it's one of the most important insights for you to know about your business because it allows you to know exactly how much you can spend to get a customer, how much you can spend to keep them, and what that customer is worth overtime.
Now before we talk about how to calculate CLV, I want to point out two major challenges with CLV. The biggest and most glaring issue with CLV is the use of the word lifetime. What exactly is a lifetime? It's not 80 years. Do we really need to wait until someone has died before we can calculate the customer lifetime value of our customers? Of course not, and that's why it's important for every business to determine what the specific lifetime is. For your business, a customer may buy from you in average of two years, so your lifetime would be two years.
If the customer buys from you on average for 15 years, that's your lifetime. After you specify how long your customer lifetime is you'll have a good estimate of when your customers should be buying, and more importantly, if they haven't. This information will better equip you to know the difference between a customer retained and a customer lost. The second challenge with CLV is there is no such thing as an average customer. It can be dangerous to lump your customers into this big amorphous blob in today's day and age.
In my opinion, we can use averages but it's important to understand that every customer is a person and every person deserves to be treated a little bit better than just an average. Okay, now let's talk about how to calculate CLV. There are many models out there but I'm going to show you the most efficient and the easiest. Very simply, you take the total profit of a client over the lifetime of buying from you and you subtract all the sales, marketing, and service delivery cost from that client. The number you have left is your customer lifetime value number.
Let's do the math together. Suppose a new customer brings you 100 dollars in profit on their first purchase. That same customer on average purchases two more times from you over the next two years. Each time they reorder, they spend approximately 250 dollars with an addition of 100 dollars in profit on each purchase. Therefore, if we do this really simple math, that customer is worth 500 dollars in profit per their lifetime. Now here's the recap, 100 dollars in profit on their first purchase, two more purchases in the first year with 100 dollars in profit on each purchase, and two more purchases in the second year with 100 dollars of profit on each of those purchases, therefore, every new client is worth 500 dollars in profit.
Now that you have an idea of what each new customer is worth, you need to decide what it costs to get that customer through your sales, marketing, and advertising efforts. This will give you the tools to decide what you're willing to spend to acquire a customer or if you need to spend less or if, you need to improve your customer retention. Let's suppose you run pay-per-click Google ads and it cost you approximately 75 dollars in clicks to generate that first sale. Now you might think because the customers spent 100 dollars and it costs you 75 dollars, you only generated 25 dollars in profit, but since you know the customer lifetime value of your customer's 500 dollars, you know that 75 dollars just generated an additional 425 dollars for your business.
Now that's not including any other cost you might have along the way in terms of marketing or servicing that customer but that's an investment I'd be willing to make every time. Some businesses for example, might be willing to spend the entire 500 dollars just to get that new client because they're confident they can increase the average order size, or increase the number of times a customer buys each year, or they're constantly improving their retention rates. As you start to calculate your customer lifetime value, let me warn you not to worry about getting overly complex.
Even just having a general idea of your customer lifetime value is better than knowing nothing at all.
- Key ingredients for world-class customer retention
- Calculating customer lifetime value
- Preventing customer loss
- Driving revenue growth through retention
- Identifying your most valuable customers
- Leveraging customer data
- Learning to observe behavioral changes
- Bringing back lost customers
- When and how to use automation