According to one report, 65% of business comes from existing customers. But, do you know how much value each customer adds to your small business over the course of your relationship? To estimate the total that customers will spend at your company, calculate customer lifetime value.
What is customer lifetime value?
Customer lifetime value (CLV, LTV) is a metric that businesses use to predict how much revenue a customer will drive over time. To find CLV, you can take an average of all your customers. Before calculating customer lifetime value, keep in mind that the number you calculate can be significantly higher or lower than the customer’s actual value.
Estimating a customer’s lifetime value can help you with decision making in your small business. You can determine whether you are spending too much on marketing to new customers by comparing the potential lifetime value of a customer to their customer acquisition cost.
You can also use customer lifetime value to create your business budget. However, do not put too much stock into your CLV estimate.
Customer lifetime value calculation
Your customers aren’t all going to spend the same amount at your business and shop at the same frequency. To find your customer lifetime value, you need to know the average purchase price, the average purchase frequency, and the average length of time customers shop at your business (known as lifespan).
First, choose a timeframe for your lifetime value calculation. Many businesses use one year as their timeframe.
You will need a few formulas to calculate your customer lifetime value. To get started, here is the main customer lifetime value formula:
CLV = (Average Purchase Value – Average Purchase Frequency) X Average Customer Lifespan
To find the average purchase value, divide your business’s total revenue during the time period by the number of purchases.
Average Purchase Value = Total Revenue / # of Purchases
To find your average purchase frequency, divide the total number of purchases in a period by the number of unique customers. If a customer bought from you more than once, only count them once.
Average Purchase Frequency = # of Purchases / Unique Customers
Lastly, find your average customer lifespan by determining how long customers stay with your business. Use past metrics to calculate average customer lifespan.
If this information seems a little overwhelming, take a look at the example below.
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Customer lifetime value calculation example
Let’s say your business’s revenue for one year was $100,000. During the period, you had 400 unique customers who made a total of 500 purchases. Your average customer lifespan is 10 years.
First, calculate your average purchase value by dividing your annual revenue by your total purchases:
Average Purchase Value = $100,000 / 500
Average Purchase Value = $200.00
Next, calculate your average purchase frequency by dividing 500 purchases by 400 unique customers.
Average Purchase Frequency = 500 / 400
Average Purchase Frequency = 1.25
Finally, plug in your numbers into the customer lifetime value formula:
CLV = (Average Purchase Value – Average Purchase Frequency) X Average Customer Lifespan
CLV = ($200.00 – 1.25) X 10
CLV = $1,987.50
Your average customer will spend $1,987.50 at your business over the course of their relationship with your company.
Customer lifetime value analysis complications
Calculating lifetime value doesn’t paint an entirely accurate picture of a customer’s actual value. Many factors positively or negatively influence your customer’s value. When analyzing your CLV calculation, consider the following.
According to one Harvard Business Review article, a customer’s value goes beyond how much they directly spend at your company.
Here are a few reasons a customer’s actual LTV might be higher than you anticipate:
- The customer’s positive reviews of your business helps you acquire more customers
- The customer develops a greater need for your products or services
- The customer begins buying more expensive products due to a financial change
- You see an increase in business after taking the customer’s feedback into consideration
On the other hand, one source found that a typical business in the United States loses 15% of its customers per year.
Here are a few reasons why your CLV calculation may be lower than you anticipate:
- The customer has a bad experience with an employee or product and stops frequenting your business
- The customer no longer needs or wants your products or services
- The economy takes a hit
- Your products or services last longer than you anticipate
Before calculating customer lifetime value, don’t forget to take unforeseen factors into consideration.
How to improve your business’s CLV
Some businesses naturally have a lower CLV than others, depending on what you offer, your prices, and how long the products or services last.
Before stressing that your customer lifetime value looks too low, consider your cost of goods sold and expenses, customer acquisition cost, and number of loyal customers.
If you still think that your estimated customer lifetime value is subpar, you can improve it without completely restructuring your business.
First, make sure you are marketing to the right customers. You may have done a market analysis when starting your business, but try taking another look at whether your products or services are aimed at the right consumers.
Your CLV may be low compared to how much you spent acquiring the customer. Try lowering your customer acquisition cost by using lower-cost marketing strategies, like social media, email marketing, and a business blog.
Another way you can improve your business’s CLV is by improving customer service. The way you and your employees deal with customers directly affects how long they will be a customer. Retain customers by providing personalized, polite, professional, and quick customer service.
Lastly, if your lifetime value is still too low, you can try raising prices. You can raise prices without losing customers by being open and honest about the price change and adding value to your offerings.
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This article has been updated from its original publication date of January 8, 2019.
This is not intended as legal advice; for more information, please click here.
