Customer lifetime value (CLV) is a measure of the total income a business can expect to bring in from a typical customer for as long as that person or account remains a client.
When measuring CLV, it’s best to look at the total average revenue generated by a customer and the total average profit. Each provides important insights into how customers interact with your business and if your overall marketing plan is working as expected.
For a more in-depth look, you may want to break down your company’s CLV by quartile or some other segmentation of customers. This can give greater insight into what’s working well with high-value customers, so you can work to replicate that success across your entire customer base.
Note: There are multiple definitions of CLV: Basic calculations that only look at revenue and more complex equations that factor in gross margin and operational expenses like COGS, shipping, and fulfillment. Marketing expenses can be included but are sometimes left out if they are too variable. For the sake of simplicity, we’re using revenue throughout this article.
Why Is Customer Lifetime Value Important to Businesses? Why Does It Matter?
In the example above, we figured out the average lifetime value of a customer for a grocery store. But why do businesses care about CLV? Here are a few key reasons to track and use CLV:
- You Can’t Improve What You Don’t Measure:Once you start measuring customer lifetime value and breaking down the various components, you can employ specific strategies around pricing, sales, advertising and customer retention with a goal of continuously reducing costs and increasing profit.
- Make Better Decisions on Customer Acquisition Costs:When you know what you will earn from a typical customer, you can increase or decrease spending to ensure you maximize profitability and continue to attract the right types of customers.
- Improved Forecasting:CLV forecasts help you make forward-looking decisions around inventory, staffing, production capacity and other costs. Without a forecast, you could unknowingly overspend and waste money or underspend and put yourself in a bind where you struggle to keep up with demand.
4 Steps to Measure Customer Lifetime Value
This graphic shows how customer lifetime value can be calculated through average order value, number of transaction, and customer retention rates.
- Determine Your Average Order Value:Start by finding the value of the average sale. If you have not been tracking this data for long, consider looking at a one- or three-month period as a proxy for the full year.
- Calculate the Average Number of Transactions Per Period:Do customers come in several times a week, which might be common with a coffee shop, or only once every few years, which could be the case at a car dealership? The frequency of visits is a major driver of CLV.
- Measure Your Customer Retention:Finally, you’ll need to figure out how long the average customer sticks with your brand. Some brands, like technology and car brands, inspire lifelong loyalty. Others, like gas stations or retail chains, may have much less loyal customers.
- Calculate Customer Lifetime Value:Now you have the inputs. It’s time to multiply the three numbers together to calculate CLV per the formula below.
Customer Lifetime Value Formula
Here is the formula for customer lifetime value:
CLV = Average Transaction Size x Number of Transactions x Retention Period
Each of these inputs acts as a lever you can pull to grow your CLV. However, every move your business makes may have unintended consequences that impact CLV. For example, a price increase may improve your average transaction size, but it could push customers to shop less often or look for lower-cost alternatives.
Experienced marketers familiar with the four Ps of marketing — product, place, price and promotion — have a strong understanding of how marketing efforts directly influence customer lifetime value.
Customer Lifetime Value Examples
The best way to understand CLV is through examples. Here are examples from three very different industries to better demonstrate how customer lifetime value may impact your company:
A coffee shop is a perfect starting example for CLV, as it is easy to understand even if you don’t have an extensive business background. Let’s say a local coffee chain with three locations has an average sale of $4. The typical customer is a local worker who visits two times per week, 50 weeks per year, over an average of five years.
CLV = $4 (average sale) x 100 (annual visits) x 5 (years) = $2,000