Customer lifetime value (CLV)--or customer profitability, customer profitability analysis, or simply “figuring out who makes you the most money”--is an essential metric that can help optimize your business so that it makes you the most possible money while wasting the least possible time and resources. CLV simply calculates the net profit attributed to your relationships with customers and is a common consideration within large corporations that is often underutilized, or given no consideration, in small businesses and startups.
Why should I care?
A straightforward example of the relevance of customer lifetime value is to examine customer acquisition in an e-commerce company. When acquiring customers through digital channels like Google Adwords, Facebook Ads or Youtube Ads, the most basic, common sense approach to optimizing your spending would be to invest more where it is cheaper to acquire new customers. A scenario for example:
Based on simple analysis, it appears obvious that it would be wisest to spend money on Google Adwords because that is where new customers can be acquired the most cheaply.
But, if we also consider customer lifetime value in context, the equation changes:
With additional data, it’s clear that the initially “obvious” answer (considering only customer acquisition cost) would not have lead to the most ideal decision. For the same $100, you would ultimately make $500 more by initially spending more money on the expensive Youtube ads when customer lifetime value is factored in.
This example is a simplification of the concept but is representative of real-world scenarios. For any business that sells a product or service to customers, understanding the short and long-term costs and benefits in acquiring and maintaining client relationships is significantly important.
Customer acquisition costs and customer lifetime values are not just pieces of information that are only relevant in retrospect; there are steps that can be taken to make better prospective decisions and help determine who your best customers are and will be.
Calculate Customer Lifetime Value
Many customer lifetime value formulas are based on getting the average customer lifetime value for all of your customers. This can be helpful, but it does nothing to tell you about the types of customers that you should be targeting and acquiring, and most formulas require 5+ years of data and knowledge about the customer lifecycle to predict what the CLV is going to be with the highest degree of accuracy. However, there are methods that startups and small businesses can use to achieve the same goal. You need to determine the following for each of your current customers:
- How much money has each customer paid you?
- Over what timeframe did each customer pay you?
- Margin / How much did it cost you to make the product that the customer bought?
- How much did it cost you to acquire the customer?
- (optional) How much will the customer spend?
- (optional) How much of your fixed cost should this customer cover?
Once you have determined those variables, a general formula to calculate customer lifetime value (CLV) is:
Imagine you own an e-commerce company that launched ~3 years ago, you’ve had a number of sales but you’re not sure how the underlying metrics look, so you want to determine your customer lifetime value. Here’s how to go about doing so in a spreadsheet:
- Transactions: Put all of your sales transactions into a table that lists sales amounts, and identify the sources of your customers.
- Customers: On separate tab, determine how many clients fit into different categories by source and sum up how much they have spent, over what time frame, and what they spent it on, on a per-client basis.
- By Source of Customer: Determine how much each source costs to put together: customer acquisition costs, costs of goods sold (COGS), and profit.
Then you’ll have the data needed to determine customer lifetime value to date and see what areas are working best for your company.
The categorized information should provide the following example data:
The goal is to be able to segment your customers and identify which are the most valuable:
The chart above demonstrates that not all types of customers are equal. Frequently, it is not the customers that account for the majority of revenue that generate most of the profit because of high costs incurred. At the other extreme of the spectrum are the small, infrequent customers that never purchase enough to cover the cost of acquisition and administering accounts. This graph is generated when net margins are plotted against customers according to their revenue size. While many customers may not be generating a positive net margin, most make some contribution to overhead. It is critically important to understand the overall profitability of tranches of customers and consider how they interact with your business, which relationships are the most beneficial, as well as how relationships can be more successfully (profitably) managed as a result.
In our example company (), on a set marketing budget, we can see that certain customers aren’t worth the expense (e.g. those gained through events) and effort, and therefore should not be actively pursued because on average they don’t spend as much, while we should attempt to find more customers online. This information allows us to direct our limited/fixed marketing budget wisely.
It may seem controversial, but all customers are not equal. And all potential customers are not equally worth your time or investment. Considering customer lifetime value will allow you to identify the customers that should be eradicated and which types you should seek.
You can do this by identifying customer lifetime value for each of the following segments:
- By the source of the customer.
- By the customer’s location.
- (B2B) By the size of customer.
- (B2C) By the customer’s wealth (approximated by zipcode).
- Etc… (The variables you could use to determine metrics are virtually unlimited).
Of course, how to actually get the data and specifics for customer lifetime value can vary from business to business depending on what you sell and how, how long customers are likely to remain, and how long you’ve been in business.
To take that into account, without being overly complex here, we’ll be addressing the challenges of the following types of companies in future articles:
- For companies that sell software products.
- For companies that offer software as a service.
- For companies that sell physical products.
- For companies that sell digital content.
- For service companies that charge by the hour.
- For service companies that charge by project.
The process of calculating customer lifetime value can be challenging for startups and young businesses that lack a full scope of historical data (less than 5 years) but understanding your customers and how they interact with your business is essential and can lead to making better forward-thinking decisions. With many variables and the potential for great complexity, it’s most useful to start with the basics and begin with simple calculations around CLV and adjusting your decision making as your knowledge of your business and customers grows.
To get a free excel template for doing the analysis shown above,.