How to calculate lifetime value in order to make sure you understand exactly how much cash each customer represents.
Every business needs customers in order to survive. On one hand, the method for succeeding in business may seem rather simplistic: Get customers, make sales, succeed. Of course, in business, nothing is that simple. You have to spend money to get new customers, and then you have to spend money to support your business. Customers should add revenue to your business, but the cost of getting that customer — and then the total revenue they generate — are extremely important metrics to consider. Ultimately, this number can be determined by the lifetime value (LTV) that a customer brings to your business. Increasing the customer lifetime value is vitally important for helping your business grow and succeed.
What Does Lifetime Value Mean?
Customer lifetime value (CLV or CLTV) is a vitally important metric for your business. It is the term used to describe the total monetary value that the average customer brings to your business. Value here is meant to be defined as cold, hard cash. The more money a customer spends at your business, the more a customer’s lifetime value increases. However, a customer’s lifetime value cannot simply be calculated as pure, gross revenue. It’s more complicated than that. Customer lifetime value also includes factors related to:
- Customer retention: refers to how much a business has to spend in order to keep a customer.
- Customer acquisition cost (CAC): refers to how much it costs you to acquire a customer in the first place. Many factors can be included in this calculation, including money spent on a marketing budget or marketing efforts, the cost of the time a staffer spends, administrative costs related to customer onboarding, and more.
- Ongoing operating costs: includes the cost of actually producing your product or service.
Why Is Lifetime Value Important?
Lifetime value is important because it factors in costs that are often hidden by mere examinations of your gross revenue or average revenue per user (ARPU). It gets at the costs associated with customer acquisition, ordering new goods and services, administration, and more. It can also be extremely useful for helping you determine the best way to spend your limited marketing and advertising dollars: If you know you can increase the average lifetime value of a customer by spending more money in a couple of areas, you can save money and target it in a more surgical manner. This will lead to greater profits for your business.
How Do You Calculate Lifetime Value?
There are many customer lifetime value formulas that can be used to calculate the lifetime value of a customer:
- By using the average lifetime value of a customer, which is determined by dividing the total revenue by the number of orders a customer makes;
- By using the customer value, which is the average purchase frequency rate multiplied by the average purchase value; or
- By using the customer lifetime value, which is the customer value times the average customer lifespan.
As you can see, calculating customer lifetime value requires that you have access to good and up-to-date data. This may mean that you need appropriate IT upgrades and dashboards to make the appropriate calculations. You may also need to look into appropriate SAAS in order to ensure that you are constantly getting access to this data.
How Does Lifetime Value Impact Your Revenue?
Analyzing and attempting to increase the lifetime value of your customers can and does make a positive impact on your revenue because it forces you to pay attention to the interworkings of your business.
Using the various calculations above allows you as the business owner to be able to “pop the hood” and see what is working and what isn’t. Maybe there are paid marketing campaigns that are losing their efficiency. Maybe your content marketing efforts are starting to pay off. Because lifetime value involves various metrics, this helps you understand what really makes your business tick. It tells you why existing customers decided to shell out for your good or service.
Remember, finding new customers is expensive too. Increasing the amount that you sell to existing customers is easier and cheaper than acquiring new customers.
What Should be Considered When Calculating Lifetime Value?
As noted above, a variety of revenue and expenses are considered when calculating the lifetime value of a customer. However, many other factors also play a role when making this overall calculation. This is more than just the individual factors that go into supporting and serving each individual customer, as you also have to examine broader features of your business. This includes:
- A slew of different revenue factors: including total revenue, number of customers, your profit margin, average purchase frequency, and more.
- Customer satisfaction with your business: which can impact customer loyalty. A happy customer is more likely to stay with your business, resulting in a higher customer retention rate and an increased likelihood to be receptive to a potential upsell. This can be increased by ensuring that you are fulfilling all of your customer’s needs and providing appropriate levels of customer support. Building good customer relations is a “soft” factor, but a vitally important one, as loyal customers are also valuable customers.
- The number of years a customer stays with you: The longer a customer stays with you, the more they spend at your business, and the more a customer lifetime value calculation will increase.
- Average purchase value that a customer brings to your business: Increasing the amount of money that a customer spends with you can increase your gross margin and lead to better profits for your business.
You should also keep in mind that a customer lifetime value can refer to either a single customer or the average customer lifetime value of all customers for your business.
What Is Churn Rate?
Churn rate is the term used to describe the percentage of customers who stop using your service or no longer purchase your goods. It can be viewed as a proxy for overall customer satisfaction with your service.
If you have a high churn rate, that means that your customers have real doubts about the value your business provides to them. Reducing churn rate is another way of increasing customer lifetime value. As such, your business needs to determine why customers are leaving your business, what they are not satisfied with, and what changes you can make to address the churn rate in your line of work.
It is important to remember that every business will have a different churn rate, with some businesses having historically high ones. It is important to benchmark your business against an industry-appropriate churn rate. Doing so can help determine how you are performing in your sector.
The opposite of churn rate is retention rate. This is the term used to describe the number of users who stay with your company or who continue using your service over a set period of time. For example, if you have 100 customers, and 90 customers stay with your business after a year, your one-year retention rate is 90%.
What Is Brand Loyalty?
Brand loyalty is a factor that determines how likely a customer is to use your brand when purchasing a relevant product or service. Some people will shop at multiple locations when making purchases and only seek to get the best deal. Others stick with brands because they value their name, reputation, or quality.
If you can generate high brand loyalty in your business, you are more likely to increase the amount of revenue that you can generate from a customer. This can reduce your customer churn rate, increase your retention rate, and make it more likely that you can cross-sell a customer.
You are also more likely to sell them add-ons that relate to your products, thus resulting in an increase in customer lifetime value. Brand loyalty is not something that is generated instantly. A start-up will not immediately generate a ton of brand loyalty. Instead, brand loyalty develops over time and as a result of a positive customer experience, excellent customer service, and reasonable prices.
However, there are ways to develop brand loyalty. This includes marketing efforts specifically designed at enhancing the purchases of already existing customers, making sure that every customer has a positive experience when they are shopping with you, and appropriate deployment of loyalty programs that are designed to enhance the overall customer experience.
What Are Ways to Increase Lifetime Value?
Since the lifetime value of a customer is so broad, there are many ways to increase the lifetime value of a customer. This includes:
- Increasing the customer retention rate of your business, even if you are just increasing it for certain customer segments. This means that your business will have to examine ways to keep customers from leaving your company. In many cases, working on customer retention is less expensive than acquiring new ones.
- Instead of concentrating on recruiting new customers, work on increasing the average order value of a customer.
- Increase the number of purchases that each customer makes, rather than concentrating on increasing the amount they spend. You can do this by increasing the discount rate that you give to your customers if they order more from you. As long as this results in greater profits to your business, you wind up making more money on each transaction. This, in turn, results in an increase in customer value.
- Creating a more positive customer experience for your customer base. This won’t work for every business, as some customers simply want to order as quickly as possible, regardless of how good they feel. Customer experience can be more important for retailers. However, everyone wants a positive experience, and if you can create a customer experience where they enjoy coming to your store, a customer will be more likely to return to it and place another order. This, in turn, has alternative benefits. It may increase the average purchase value of a customer, and it may make them more likely to post about your business on social media, thus turning your customers into your promoters.
- Find easier and more convenient ways to sell to your customers that also keep expenses down, like eCommerce. In many cases, eCommerce can be a less resource-intensive way of making a sale, as you may need less staff to sell a product. As such, an expansion into this area can prove to be more profitable.
All too often, businesses fall into the trap of thinking that the only way to increase their profitability is to sell more products. Understanding the lifetime value of a customer is crucial, as it can show you alternative ways to increase your net profit and enhance the overall success of your business. It can help you make better, more data-driven decisions, thus leading to a better and more successful business.