Customer Lifetime Value (CLV) is the total amount that a customer is anticipated to spend during their relationship with a business. CLV is a prediction of future customer behavior based on available data.
How is Customer Lifetime Value calculated?
To calculate CLV, you need three pieces of data:
- T = average length of a customer relationship lifecycle
- V = value of the average customer purchase
- F = average value of a customer purchase
The customer lifetime value is then calculated with this formula:
CLV = T x V x F
For example, a college bookshop catering to undergraduates might see a typical customer relationship lifecycle of four years. During this time, the average student makes 4 purchases per year, each with an average value of $400.
Applying the CLV formula, we get:
4 years x $400 per purchase x 4 purchases per year = $6,400
When a freshman arrives in the shop to purchase their first book, the store owner knows that the student is likely to spend around $6,400 over the next few years.
In practice, the store owner will find that different types of students have different CLVs. For example, those on two-year courses will spend half as much as those on four-year courses, while some students of certain subjects will require more expensive books than others.
At this point, the business owner will start segmenting the data by identifying customer subgroups. Once they have accurate data for each segment, they can apply the same CLV formula.
What are the Applications of Customer Lifetime Value?
Measuring CLV helps business to perform vital functions such as:
Defining long-term strategy: CLV is earned over several years, which means that the business must have a corresponding long-term plan. CLV helps to guide this strategy, and can also be used to justify investment in people, processes, or technology required to realize each customer’s value.
Evaluating Customer Acquisition Cost: Customer Acquisition Cost (CAC) is the amount spent on bringing in customers through marketing, sales, digital platforms, and other channels. If CAC is more than CLV, then the business won’t see any revenue growth.
Focusing resources on the greatest source of value: Without CLV analysis, companies can tend to focus on customers that make a small number of big-ticket purchases. Often, these customers don’t offer as much value as customers who make consistent purchases over a long period. CLV analysis can help identify those high-value customers, and the business can devote resources to retaining them.
Identifying missed opportunities: CLV is predictive of future customer behavior. If the prediction is wrong, then it means that some of the underlying assumptions are also wrong. Customers who don’t meet their expected CLV may have encountered a problem that drove them to a competitor. On the other hand, if customers exceed CLV, it may indicate an opportunity for the business to expand.