No business can be successful without customers around to purchase its goods or services. Not all of a company’s customers, however, are created equal.
Customer lifetime value (CLV), also known as user lifetime value (LTV), is a measure of the revenue a business can expect to generate from a given customer throughout the length of the relationship. By assessing CLV on a regular basis, companies can determine which of their customers are most valuable and adjust their acquisition strategies accordingly.
Importance of Lifetime Value
CLV helps businesses determine the amount of money that they should devote to customer acquisition and retention efforts. Many new business owners assume that all of their customers are equally valuable. But for most companies, a small number of clients generate a majority of the revenue.
In order to determine customer lifetime value, you need to pay attention to how often clients make a purchase, and calculate the average value of their purchases. Identifying your most loyal and lucrative customers helps you determine how to spend your valuable marketing dollars moving forward.
Additionally, CLV can be used to predict the end result of a new marketing campaign. Before investing their hard-earned marketing dollars in new endeavors, businesses should evaluate the ways in which their plans will affect retention and spending rates.
While a discount plan may seem like a good idea, some markdowns could result in your business losing valuable cash flow without seeing a significant influx in sales. If the cost of a marketing effort exceeds its benefits, you may want to rethink your strategy.
Of course, calculating customer lifetime value isn’t just about allocating your marketing and sales resources appropriately. CLV can also affect your business development plans in the coming years. To keep your best clients satisfied, you will need to tailor your products to meet their needs and wants.
For example, if the majority of the proceeds from a boutique clothing store come from women in their 30s, the owner may want to create more items targeted to this demographic. Additionally, businesses can instruct their sales representatives to spend the majority of their time promoting those products that yield the highest value.
Equations for Calculating Value
Businesses use various equations to determining customer lifetime value. Not only do the results of these equations affect overall marketing budgets, but they also help companies set limits on customer acquisition costs. After all, you don’t want to invest too much in acquiring customers who won’t help grow your business.
The simple LTV equation is one of the most basic methods of calculating customer value. To measure simple customer lifetime value, start by identifying the following values:
- Annual revenue per customer
- Average number of years that a customer relationship with your business lasts
- Initial cost of customer acquisition
Once you have these figures, simple LTV is calclated using this equation:
Annual revenue per customer x number of years – cost of customer acquisition
Once you determine simple LTV, you can better assess how much money to spend on customer retention. After all, customers with a low LTV may not be worth expending extensive resources on in the long term.
Custom LTV is a more sophisticated measure of lifetime value that breaks down customer spending at the per-visit level. Start by determining the following values:
- Customer expenditures per visit
- Number of visits per week
- Average number of years a customer relationship lasts
- Profit margin per customer
The equation for determining custom LTV is as follows:
Average number of years (52 x customer expenditures x number of visits per week x profit margin)
Finally, businesses may employ a traditional LTV equation to determine customer value, although it does have certain limitations. To assess traditional LTV, begin by finding the following values:
- Average gross margin per customer lifetime
- Retention, or percent of customers who repurchase your goods and services
- Rate of discount, or the interest rate for discounted cash flow analysis
Calculating rate of discount is crucial, as it enables businesses to determine the value of future dollars. After all, rising inflation rates may mean your money is worth less down the line. Traditional LTV is calculated as follows:
Gross margin x (retention/[1 + rate of discount – retention])
Targeting the Right Customers
It’s true that good customers often cost more to acquire. In the long run, however, these individuals will be the ones that generate a majority of your revenue and keep your company operational. By calculating CLV regularly, you can take steps to boost satisfaction among these most valuable players. Consider the alternative: 71% of clients have left a company because of bad customer service, and you don’t want your business to be in that statistic.
Customer lifetime value is one of the most crucial metrics for a business to track. Measure CLV regularly so you can make the best marketing and sales decisions moving forward. To learn about other important information to know for your small business, check out our article on the five critical metrics to watch in your business.