It’s fantastic to get new customers, but what happens once they make their first order? Do they come back, keep purchasing or recommend your business? These factors can have an impact on the lifetime value of each customer.
This is where Customer Lifetime Value (CLV) comes in handy. It enables you to make better estimates of the lifetime value or lifetime profit of a customer.
You can use the comparison of CLV and customer acquisition cost (CAC) to see if your customer acquisition programs on sales and marketing are being effective.
What Is Customer Lifetime Value?
Customer lifetime value represents the lifetime value to a business of any individual customer. It can be the revenue or gross profit based on the customer lifetime value formula used.
As mentioned, if a customer buys some product once for $50, then his lifetime value is different from someone buying the product at a price of $50 per month during 3 years.
CLV helps businesses understand:
- How much customers spend over time
- Whether customers return or cancel quickly
- Which customer groups are more valuable
- How much they can afford to invest to gain new customers.
You’ll find it particularly helpful for subscription service firms, ecommerce businesses, and merchants where repeat purchases are essential.
How to Calculate Customer Lifetime Value
The lifetime value formula that you use for calculating the customer lifetime value will vary depending on the business model. It’s not how a software company with a monthly subscription would compute it, it’s how a retailer with repeat purchases would compute it.
1. Basic CLV Formula for Ecommerce and Retail
For businesses that sell products, the basic formula is:
CLV = Average Order Value × Purchase Frequency × Customer Lifespan
Here is what each term means:
- Average order value: Average spending by customer on each order.
- Frequencies of purchase: Number of purchases that they make over a given time period, typically one year.
- Customer lifetime: Average time that they spent as a customer in years.
Example:
Suppose your average customer:
- Spends $60 per order
- Makes 4 purchases per year
- Remains a customer for 3 years
The calculation is:
CLV = $60 × 4 × 3 = $720
Your estimated customer lifetime revenue is $720.
This, however, is revenue and not profit. The average gross profit per purchase is a more accurate way of estimating the contribution to profit than the order value as it better represents the contribution of that package or contract.
2. CLV Formula for SaaS and Subscription Businesses
For SaaS companies, customer lifetime value can be calculated based on the average revenue, gross margin, and churn.
CLV = (Monthly ARPU × Gross Margin) ÷ Monthly Churn Rate
The acronym ARPU is used to represent Average Revenue Per User. Gross margin is the percentage of revenue (after excluding the direct costs involved in delivering the service. Churn rate is the percentage of subscribers lost in a period.
Example:
Suppose your SaaS business has:
- Monthly ARPU: $100
- Gross margin: 80%
- Monthly customer churn: 4%
The calculation is:
CLV = ($100 × 0.80) ÷ 0.04
CLV = $80 ÷ 0.04 = $2,000
Assuming that your customer revenues, gross margins, and churn do not change, your estimated contribution from each customer through gross profit is $2,000.
This is an approximate calculation. There can be variations in actual customer use, and check the customer numbers on a regular basis.
How to Calculate Customer Acquisition Cost (CAC)
Customer Acquistion Cost is the amount of money that you invest to acquire one new customer.
The formula is: CAC = Total Sales and Marketing Costs ÷ Number of New Customers Acquired
Add in relevant acquisition costs, including advertising, sales salaries, marketing items and agency costs.
Example:
During one month, your business invests $6,000 on sales and marketing efforts, and nets a profit of 30 customers.
CAC = $6,000 ÷ 30 = $200 per customer
The typical customer acquisition cost (CAC) is $200.Your average customer acquisition cost (CAC) was $200.
When comparing Customer Acquisition Cost to Customer Lifetime Value, be sure to look at the same timeframe and customer segment. If not, then the ratio will provide a skewed picture.
How to Calculate the CLV Ratio
After you obtain both figures, it is easy to calculate the ratio.
CLV Ratio = Customer Lifetime Value ÷ Customer Acquisition Cost
Using the SaaS example above:
- CLV: $2,000
- CAC: $200
CLV = $2,000 ÷ $200 = 10:1
This equates to a customer producing $10 worth of estimated gross profit for every $1 invested in acquiring him.
A high ratio is great, but doesn’t necessarily indicate that you business is profitable at the first glance. There are still other operating costs and the time to break even on the acquisition costs to be taken into account.
What Is a Good CLV Ratio?
Many SaaS businesses and a few other business models have an average CLV of 3:1. The best target, however, would rely on your margins, niche, retention and growth stage.
Here is a simple breakdown:
| CLV Ratio | What It Means |
| Below 1:1 | Acquisition costs exceed the estimated customer value. |
| 1:1 | All costs of customer acquisition are worthwhile, and acquisition cost is customer value. |
| 2:1 | Economics might work, margins and retaining needs to be addressed. |
| 3:1 | A widely cited criterion for sustainable development. |
| 4:1 to 5:1 | Economics potentially strong based upon retention and costs. |
| Above 5:1 | May suggest effective acquisition, or investment in growth may be increased. |
These are guidelines rather than a set of rules that apply to all. While a ratio of greater than 3:1 is not a positive sign of profitability, a lower ratio might be OK in a young company that is still experimenting with their business model.
How to Improve Your CLV Ratio
The ratio can be boosted with various means such as raising customer value and reducing acquisition costs or by a combination of both. Try these approaches:
- Make it easier to retain them: Offer good reasons for customers to keep buying or subscribing to your products.
- Follow up regularly: Answer people’s leads promptly so that they are not missed.
- Refined targeting: Increase your marketing efforts to people who are more receptive to becoming repeat clients!
- Promote further repeat sales: Make a recommendation of appropriate product, service or upgrade where appropriate.
- Monitor campaign performance: know what drives customers from different channels to stay and spend more.
- Analyze customer segments: Analyze by customer segments and not just averages of CLV and CAC.
If you have a number of prospects on your sales team, a CRM like LeadVix may enable you to gather leads, arrange follow-up calls and monitor campaign activity which will make it simpler to control sales leads acquisition.
Common Mistakes When Calculating CLV
The usefulness of a CLV estimate depends on the ‘sense’ of the numbers behind the CLV. Be sure to avoid these common pitfalls:
- Profit at the expense of revenue: Revenue-based CLV does not consider the immediate spendings for customer service.
- By letting churn go away, you lose customers who are worth even less than they’re estimated to be.
- Over-estimating customer lifetimes: CLV can be over-pronounced when unrealistic lifespans are used!
- A mismatch of time periods: Monthly churn and annual revenue need to be treated in the same way.
- Treat all customers equally: Cost of acquiring each customer group can vary drastically and so can their purchasing habits.
To Conclude
Customer Lifetime Value can help you gain insight into the value of customers beyond the initial sale. It gives you the picture of whether your sales and marketing activities are helping the business to grow sustainably or not when compared to CAC.
Use realistic numbers and expectations, choose the proper formula for your business, and a general CLV ratio is about 3:1. Above all, check the numbers regularly since customer behaviour and acquisition costs are changing.
Frequently Asked Questions (FAQs)
What is meant by customer lifetime value?
Customer lifetime value (CLV) refers to the lifetime value of a customer generated by a customer’s relationship with a business.
How do you calculate customer lifetime value?
Multiply average order value by purchase frequency and customer lifespan.
What’s a good CLV and CAC ratio?
The generally accepted rule of thumb is for CLV to be three times as long as the cost of acquiring a customer.
How do you model customer lifetime value (CLV)?
Predict what customers spend, their frequency of purchase and their life span or predict revenue per customer for subscriptions, gross margin per customer, and churn per customer.