What is Customer Lifetime Value?
Customer Lifetime Value (acronyms CLV or LTV) underpins scalable economics; it’s a metric that enables you to evaluate whether you’re able to scale your startup. It helps you estimate future revenue and measure long-term business success by determining how much profit you can reasonably expect from an average customer over the course of their lifetime with your company as an active consumer. The longer a customer continues to purchase from the business, the greater their lifetime value is.
By calculating the CLV, you can answer the following questions:
- How much can you afford to spend on sales and marketing?
- What revenue can you predict in the future?
- How can you optimise acquisition cost for the maximum value?
- How much money should you invest in the retention of customers?
- What customer segments are the most valuable to the company?
There are several different formulas to calculate CLV. One of the key downsides of CLV calculations for startups is that there needs to be a decent sample size (number of customers) to be meaningful. The lower number of total customers or revenue, the larger the impact of each individual customer on the CLV calculation – so losing one or two customers in a month could cause your CLV to spike for that month. Also, the calculation can become mathematically impossible if you have 100% retention in a given month, as you can’t divide by zero.
There are a number of notable methods to guide you, based on historical, predictive, and traditional approaches. So the choice of methods to measure customer lifetime value is dependant on your resources and business. We have some variables (e.g. customer expenditure value or purchase cycle) and constants (e.g. retention rate or profit margin, which are less likely to change significantly).
Let’s start with the variables.
- Customer value per week (A) – how much does a customer spend weekly?
- Customer expenditures per visit (S) – how much are customers willing to pay each time they visit your shop?
- The purchase cycle (C) – how often do customers visit each week?
Note: These variables are defined in this example as weekly variables, but you can adjust those to monthly values if it fits your business model better. You will obtain the values A, S and C by estimating median values for all your existing customers.
Example:
- Average customer expenditures per visit (S) = £5.90
- The purchase cycle (C) = 4.2
- Average customer value / week (A) = £24.30
When you have estimated your variables you will have to take into account some constants. These are:
1. Average customer lifespan (T) – How long, based on your experience, do customers remain your customers?
Calculate Churn Rate %:
CB – Customers at the beginning of a period
CE – Customers at the end of a period
If you had 100 customers at the start of the period, and 95 customers at the end of the period, your churn rate would be:
Churn rate (%) = (100-95)/100 = 5/100
= 5%
T = 1 / 5%
= 1 / 0.05 = 20
2. Discount rate (I) – No, this is not your customer’s discount. You are projecting a value, into the future, but you’ll have to adapt this value to present tense. Simply put – the value of a certain good in the future is lower than that of one you are holding in your hands today. This is the interest rate used in discounted cash flow analysis to determine the present value of future cash flows. Confused? Go with a standard 10% rate.
3. Customer retention rate (R) – How many of your customers come back to your store and purchase from you, compared to the previous, equal amount of time?
- CE = customers at the end of a period of time
- CN = customers acquired during a period of time
- CB = customers at the beginning of a period of time
Say you had:
CE = 95
CN = 20
CB = 100
R = ((95-20) / 100) × 100
= (75 / 100) × 100
= 0.75 × 100
= 75%
4. Profit Margin (P)
Total revenue: £500
Cost of sales: £393.45
P = ((500-393.45) / 500) x 100 = 21.3%
5. Average Gross Margin per Customer Lifespan (M) – the gross profit per customer expected in the given average lifespan.
M = 21.3%( 52(24.30) x 20)
=£5,382.94
NOTE: the number 52 comes from the number of weeks in a year.
So now we have the variables and the constants, let’s start with the LTV equations, from simple to complex.
1. Simple Customer Lifetime Value Formula
We will be using one year as a reference timeframe and we will approximate how much will we be making in a year on any given customer. There are two variables required – the average customer value/week (A) and the average customer lifespan (T), expressed in years.
Note: this is a pretty rudimentary estimate so it will only act as a base for further calculation. This is because it does not include the retention rate and attrition (loss of customers), the discount rate, nor the profit margin. It simply calculates how much would we presume our customers to spend with us, during their customer lifetime.
Simple Customer Lifetime Value Formula:
NOTE: the number 52 comes from the number of weeks in a year.
= 52(24.30) x 20
= £25,272
2. Extended Customer Lifetime Value Formula
So we understand approximately how much will our customers will be spending with us. However, that’s the revenue number, not our actual profit. So let’s step a little further and take into account our profit margin and go over the figures, by including the Customers expenditures per visit (S) and the Purchase cycle (C) values.
Extended Customer Lifetime Value Formula:
= 20(52 x 5.9 x 4.2 x 0.213)
= £5,491.49
However, we will still have to think of a future projection of our customer lifetime value.
3. Projected Customer Lifetime Value Formula
This formula considers Gross Margin per Customer Lifespan (M), discount rate (I) and retention rate (R). It is also one of the oldest and simplest ways to estimate customer value (well, as simple as it can be).
Projected Customer Lifetime Value Formula:
= 5382.94(0.75/(1 + 0.1 – 0.75))
= £11,535
This formula is directly proportional to two of the values – gross margin per customer lifespan and retention rate. So the value increases as you extend your customers lifespan and the retention rate.
So now we have three formulas. Each outputs a different value. Which is the right one?
The answer is all of them. And none of them. Don’t forget – this is an estimate. The best you can do with these three is to find an average or evaluate them with common sense and choose the value that makes the most sense. Once you have a number you now know how much should you be spending on your customers.
So, from this working example, we can average our three values (£25,272, £5,491.49, £11,539.54) to reach an Average Customer Lifetime Value of £14,101.01, so as long as its spending less than that to turn someone into a customer and keep them one – you’re profitable. However, we’ll delve into that in more detail below.
Why is Customer Lifetime Value so Important?
When coupled with another metric, Customer Acquisition Cost (CAC), CLV becomes particularly valuable by measuring the efficiency of a critical part of your business: the sales and marketing funnel.
CAC is the cost to acquire a new customer. You can break this down into two costs: sales and marketing costs. CAC is simply your total sales cost + total marketing cost, divided by your total new customers over a given period of time.
So the CLV: CAC ratio measures the relationship between the lifetime value of a customer and the cost of acquiring that customer. It is a KPI traditionally used by investors and venture capitalists as an evaluation of business growth and viability.
To break it down, you can have three different situations:
Business failure where CAC > CLV
In this situation, you are paying more money to acquire consumers than they are providing you with over their lifetime relationship with your company. So, the more consumers you gain, the more the money depletes. The quicker you acquire customers, the quicker you run out of cash.
Business stagnation where CAC = CLV
In this situation, you are paying the same amount of money to attain a customer as they are paying you back over their lifetime with your company. At this point, you’re essentially flatlining; from a cashflow point of view, you’ll be negative for the entirety of the consumer’s lifetime with you as it will take them their entire lifetime to repay the initial spend.
Business success where CAC < CLV
This situation is ideal – you payback your CAC over the course of your consumer’s lifetime with your company, and you’re also producing further revenue. Your company will grow, and you should strive for further customer acquisition to grow your business faster. However, to ensure the cost of acquiring customers isn’t higher than anticipated, you need to model CLV.
CLV and CAC metrics are rarely static, and they are very sensitive to assumptions. Consequently, early-stage investors can be sceptical of these ratios. To combat this, research the CAC, churn and CLV of similar companies to yours at scale, and work to those benchmarks. If not, you need a convincing response to why you’re more efficient or have a stickier product. Secondly, prepare a detailed plan for increasing and evolving your LTV over time.