Customer Lifetime Value (CLV) is the expected dollar amount a customer is estimated to spend over the lifetime of their patronage. The thought behind it is very intuitive: if your customer base has a low CLV, it is likely better to focus on acquiring new customers over retaining them. For this purpose, we are generalizing all customers into one category.
Let’s start by finding the inputs. We will use the following denotations:
- D = Average customer expenditure per visit: in USD
- V = Average number of visits per week
- T = Average customer lifespan: in years
- R = Customer retention rate: in decimals
- P = Average profit margin: in decimals
- I = Discount rate: your cost of capital (in decimals).
Let’s assume we currently have four customers. They have the following characteristics and combine to have the average listed in the bottom line.
|Customer||Avg. Expense/Visit||Avg. Visits/Week||Repeat Customer?||Years of Purchase||Profit Margin|
There are two main ways to calculate CLV: the simplified method and the traditional method. The simplified version has the benefit of giving you a good understanding of what a customer is worth to your business in a straight forward manner. The simplified version is calculated as follows:
CLV = (T x 52 x V) x (D x P)
Effectively we are calculating how many times we expect the customer to walk on your shop over the period of their patronage and then multiplying it by the profit made per visit. Let’s continue with the example. With the average number of years for your customers (T) being 1.4 years, average visits per week (V) being 2.75, average expense per visit (D) being $6.44, and profit margin (P) being .16 the CLV is calculated as follows:
CLV = (1.4 x 52 x 2.75) x ($6.44 x .16) = $206.29
So, what does this $206.29 mean exactly? It means that over the lifetime of an average customer, you would expect to earn $206.29 in profit. Now let’s expand this model for the traditional model. The main difference is the addition of what we will refer to as the multiplier, which will be referred to as M. Effectively, the multiplier gives the CLV a weight that incorporates your shops retention rate and cost of capital. The multiplier is calculated as follows:
M = R / (1 + I – R)
With the multiplier, we can recalculate CLV as follows:
CLV = (T x 52 x V) x (D x P) x M = (T x 52 x V) x (D x P) x [R / (1 + I – R)]
Let’s continue plugging in the variables from the example. For this example, we will assume the interest rate or cost of capital (I), on your small business loan is 8%, or .08, and your retention rate (R) is .75 as calculated above. We previously calculated CLV to equal $206.29 and we can calculate the new CLV to be:
CLV = $206.29 x [.75 / (1 + .08 – /75)] = $468.83
As you’ll notice this number is significantly higher than the initial estimate. The difference is that this model both accommodated cost of capital and it removes the low value of non-retained customers from the average. Where the initial $206.29 can be interpreted as the average customer, the $468.83 can be interpreted as the average retained customer. You may be asking “why does this difference matter?” Simply put, if your retention rate is high enough they will be worth more than a non-retained customer.
Now that you’ve calculated your CLV let’s look at some applications. The most practical example is looking at the cost of acquisition and retention. In theory, your cost of acquisition for a single customer should be less than the first CLV we calculated. If you spend $200.00 in advertising to acquire a customer your profit for that customer will go down to around $6.00 over the lifetime of that customer. With the second CLV taking into account the retention of a customer the cost of acquisition and the cost of retention together should be less then it. So, what does it mean if the cost of retention is $300.00 and the profit is now negative? You have two options: find a way to lower your cost or focus less on retention.
Now you know how to calculate and apply CLV. Best of luck on your new venture!