Customer lifetime value: The only metric you'll ever need
In ecommerce, there are all kinds of numbers and formulas you can use to gauge the health of your store. You can check your visitor count, calculate your average order value, scrutinize your conversion rate, and you’ll probably gain some valuable insights from each of them.
But there’s another metric out there—one that may not get the attention it deserves, but whose importance we think outweighs all the rest.
It’s called Customer Lifetime Value (CLV), and in this post we’re going to explain why it’s the single most important metric for understanding your business. We’ll also show you how you can calculate CLV and use it to make wise investments, build loyalty programs, and drive increased revenue and growth for your store. Ready? Let’s get started.
What is CLV?
Defined roughly, CLV is the projected total economic value a customer brings to your business over their “lifetime” (ie. the duration of time they will spend with your company, from first interaction to final purchase).
At the heart of understanding CLV lies the recognition that there is more value in a long-term relationship with a customer than there is in a single transaction. (If that sounds familiar, it’s because it’s the same concept we covered in our post on retention marketing.)
Venture capitalist David Skok conceptualizes CLV (which he calls LTV) as the counterpoint to CAC, or the Cost to Acquire a Customer. He argues that many web businesses fail because they over-invest in the initial transaction and neglect the relationship that comes afterward.
“It doesn’t take a genius to understand that business model failure comes when CAC (the cost to acquire customers) exceeds [Customer Lifetime Value (CLV)],” Skok writes. “A well-balanced business model requires that CAC is significantly less than [CLV].”
To put that in dollar terms: if it costs you $60 to acquire a customer, and over their lifetime they spend just $40, you’ve got a problem. But if it costs you $60 to acquire a customer, and they spend $140, you’re golden—or at least in the black.
Why is CLV so important?
To say that CLV is the only metric you’ll ever need may be a bold statement, but we’re standing by it. Why? Because if you don’t know how much your customers are worth, you’ll never know how much to spend to acquire or retain them.
It also makes way more sense to evaluate your store’s success based on long-term results of marketing activities than the short-term high of a single sale. CLV allows you to step back from the peaks and valleys of sales patterns and look at the overall health of your store—or, as author and “digital marketing evangelist” Avinash Kaushik puts it, to base your outlook for a relationship on something besides a one-night stand.
“I reserve the best hugs, kisses, smiles, love, respect and admiration for marketers who use lifetime value computations,” Kaushik writes. “That is focusing on real success, not simply the conversion (or one-night stand). That is focusing on finding the customers that create value for the company, long-term. That is truly doing the kind of Analysis Ninja work that solves tomorrow’s problems today!”
You can’t tell us that kind of enthusiasm isn’t infectious. Now, put on your ninja suit and let's start calculating CLV for your business.
How to calculate CLV (without a bunch of crazy formulas)
A quick Google search reveals that there are a lot of ways to calculate CLV. Some of them look like they came from a graduate-level statistics textbook. Look at this freakin' thing!
Others may seem approachable, but they're just as useless if you haven't already run a bunch of numbers and determined your yearly discount rate (pro tip: it has nothing to do with price reductions).
These formulas will give you an accurate CLV figure if you know how to use them, but for most stores they're overkill. Thankfully there's a way of calculating CLV that won’t make your head spin, and it starts with two numbers you’re probably familiar with: your store’s total annual revenue, and your total number of orders.
Let’s say that last year you filled 700 orders to the tune of $40,000 (nice work!). You can take these two figures and very simply calculate your Average Order Value (AOV) using this equation:
Total Revenue ÷ Total Number of Orders = AOV
Using the example above, that’s: $40,000 ÷ 700 = $57.14 High five! You have your first variable, and you didn’t have to solve for sigma. The next thing to determine is Purchase Frequency (PF), or how many times on average a customer buys from you each year. This is about as easy as calculating AOV, although it’s important to note that your result will vary dramatically based on what you sell. People buy toothpaste a lot more often than they buy mattresses, for example. Here's the PF formula:
Total Number of Orders ÷ Unique Customers = PF
If you had 400 unique customers last year, the equation would be:
700 ÷ 400 = 1.75
Once AOV and PF have been figured out, you can calculate your Customer Value (CV). Note that this is different from Customer Lifetime Value (CLV) because until now all of our calculations have been based on a defined timeframe (one year). This figure (CV) gives you the customer value for just the year you are calculating. It looks like this:
AOV x PF = CV
$57.14 x 1.75 = $100
How satisfyingly tidy is that? On average, your customers contributed $100 each last year! At this point, you can check your math by doubling back to make sure your customer value multiplied by your total number of customers adds up to your total revenues.
$100 x 400 = $40,000
And it does! Way to go, Pythagoras.
The final component to determine is Customer’s Average Lifespan (CAL). It may sound morbid, but remember you’re not forecasting anyone’s mortal demise here, just figuring out how long a customer is going to stay a customer.
The most precise way of doing this is rather painstaking. It involves going through your sales records and determining your store’s average time between purchases. According to Sweet Tooth Rewards, “Once this time period has been established, and the customer goes more than two standard deviations past that time period, it can be safe to assume they are no longer a customer. Therefore, the average time a customer goes before reaching that point is your store’s average lifespan.”
Did that make your head hurt? Yeah, sorry about that. The truth is, you can get a pretty accurate result by simply picking a number between 1 and 5. It sounds weird, right? But just think about how many of your own relationships with companies fall outside that spectrum. Probably a few, but not many. Our friend Avinash suggest three years for a typical consumer ecommerce player, so if you have no reason to deviate, go with that.
Now that you’ve done the legwork, calculating Customer Lifetime Value (CLV) is a snap. Here’s what to do:
CV x CAL = CLV
$100 x 3 = $300
That’s it! You just determined that your customers have an average lifetime value of (approximately) $300. (And don't forget that this was all dummy info—your own stats will produce a different result.)
One more time, here are all those acronyms in one place:
- AOV - Average Order Value
- PF - Purchase Frequency
- CV - Customer Value
- CAL - Customer’s Average Lifespan
- CLV - Customer Lifetime Value
This is all extremely valuable stuff, but before you start using it to inform any Big Decisions, there are three more things you should consider.
When calculating CLV, many retailers focus strictly on the revenue the customer brings in over their lifetime, forgetting the “marginal profit,” which accounts for costs associated with producing and delivering the product. No matter what your product's markup is, the $57 or whatever your customer pays isn’t going straight into the company coffers, and using revenue as a component of your CLV calculation can only exaggerate the value of the customer.
To mitigate this effect, you have two options. Either start with marginal profit at the beginning of your calculations (dividing it by your total number of orders to find your average order profit), or subtract your costs off your CLV at the end (this is easy if you know exactly how much it costs to produce a certain product—which you should!).
Calculating your store’s aggregate CLV is a great place to start, but diving headlong into number-crunching without first segmenting your customers is going to limit the accuracy and usability of your calculations. If you really want an accurate picture of what’s going on with your customers, you have to segment.
So, what is segmenting? According to BusinessDictionary.com, it’s “the process of defining and subdividing a large homogenous market into clearly identifiable segments having similar needs, wants, or demand characteristics.” Basically, it means looking at your customer base as a whole pie, and cutting it into slices based on differentiated products, channels or purchasing behaviours.
By segmenting and then discovering the CLV of individual segments of your customer base, you’ll develop a much clearer idea of the value each one brings to your store. And once you know that, you can begin to make informed decisions about how much to invest in each segment or customer type, and ideally maximize your returns.
We suggest trying to identify at least three segments: "VIP", average, and low-performing customers. Of course you could take it further (it’s common to work to five or six segments), but three is a good start and will inform your retention and acquisition program strategies.
Remember those uber-complex CLV calculations we showed you? Remember the "discount rate" that actually has nothing to do with price reductions? Well, now we’re going to tell you what it means.
Essentially, discount rate converts future revenues/profits into today’s dollars, similar to the way inflation calculations work. It’s based on the time value of money (TMV) principle, or the idea that a dollar today is worth more than a dollar tomorrow. In 2016, $10 buys you lunch. In 2036, the same amount might buy you a bottle of water or a cookie. According to Investopedia: “Provided money can earn interest, any amount of money is worth more the sooner it is received.”
Now, if the customer average lifespan (CAL) you’re using in your calculations is relatively short—let's say three years—TMV isn’t a huge deal, since prices (thankfully) don’t change that rapidly. But if you’re working with a longer time horizon—20 years, for example—TMV is an important consideration.
For our broad-stroke ecommerce purposes, we’re going to assume that your lifespan values are relatively low, and so it's safe to disregard discount rates. Just understand that the longer your customer lifespans are, the more important it is to account for TMV, and the more unreliable your calculations become when you decide to exclude it.
Here’s a bit more info on choosing a discount rate for CLV.
Putting it into practice
Now let's loop back to where we started and help you apply what you’ve learned. Remember David Skok’s seesawing business models? Well, since you now know your CLV (in our example it's $300), you can weigh it against your CAC (Customer Acquisition Costs). (Don’t worry if you can’t always keep these acronyms straight—neither can we.)
If you’ve been in business a while, it’s easy to determine your CAC. Simply take all the costs spent on acquiring new customers and divide that figure by the number of customers acquired in the period the money was spent. If you spent $1,500 on acquisition marketing in the first quarter of this year and acquired 25 customers in that time, your CAC would be $60. And since a $300 lifetime value is greater than a $60 acquisition cost, in this simplest of snapshots, the health of your business would be a-okay.
But let’s say you’re just starting out and don’t have a whole lot of data to draw on. Even though you know a customer could net you $300 (or more) over three years, in the short-term $60 to acquire a single customer might sound like a lot. Maybe you don’t have that kind of capital. Maybe you’d like to see some returns on your investment a little sooner than six or 12 months out. Maybe you’re just not comfortable ponying up the cash for something that isn’t a sure thing.
In this case, where cash flow is a concern and you’re less sure about how many customers you’ll acquire and/or how long they’ll stay with you, you might lean towards an allowable acquisition cost strategy. In this strategy, the amount you spend to acquire a customer must be less than the profit you would make on your first sale. It's a short-term conservative strategy many businesses use until they’ve built up a customer base and become comfortable investing capital they might not see returns on for months or even years.
On the other hand, if you’re an established business, or if you have high customer lifetimes or average order values, you might consider an investment acquisition cost strategy. That means taking a loss on an initial or even subsequent purchase, knowing you’ll make up the losses in the long term.
The strategy you choose comes down to where you’re at in your business development, and how much risk you’re comfortable taking on.
Increase CLV without thinking about CLV
Now that you know how to calculate CLV and apply it to your store, the next logical step is using it to bump up profits. As KISSmetrics points out, “by focusing on returning customers—their lifetime value—you are focusing on a strategy that gives your business higher profit margins.” Increase CLV, increase revenue, plain and simple.
There are already tons of articles out there with strategies and suggestions for how to increase CLV in ecommerce, and frankly, they’ve done a great job. If you’re looking to get inspired, click one of those links and see what others have to say about post-purchase emails and multichannel returns and featuring your fans in your content. It’s good stuff.
The one piece of advice we’d add is to not to think about CLV when you’re trying to increase it. That might sound a bit cryptic or counterintuitive—especially after you’ve just spent so much time decoding it—but believe us, it’s much easier to focus on improving the components of CLV than it is to try to improve it all at once.
Consider ways to increase your average order value, such as bundling, product recommendations, and free delivery thresholds. Think about how to speed up your purchase frequency with techniques like regular emailing and time-sensitive offers (stoke that FOMO!). And perhaps most importantly, try to come up with strategies that increase loyalty, “stickiness,” and customer lifetime—things like rewards programs, subscription programs, and a more personalized shopping experience.
Focus on just one of these strategies for a quarter, and see what it does to your CLV. Then try something else, and something else after that. If you throw enough spaghetti at the wall, some of it is bound to stick.
Questions? Comments? A life-changing recipe for spaghetti sauce? Hit us up in the comments. We always love to hear from you.