Knowing your customer lifetime value (CLV) can help your business increase revenue growth
Understanding your customer lifetime value (CLV or LTV) can transform your business growth.
It helps management understand the true impact on revenue and earnings every time you acquire a new customer (and to what extent you should go to keep each of them!).
This is why it’s essential to have an understanding of your current CLV, and then by using this figure as your baseline, you can develop strategies to increase its overall value in time.
As your CLV subsequently grows, revenue from sales and earnings from profit will increase in tandem – a win-win for your shareholders, employees and even your customers.
In this article, I’ll use my experience to teach you about:
- What Customer Lifetime Value means
- How to calculate your current CLV
- How to use your CLV to increase revenue growth and profit
So, what is customer lifetime value exactly?
It’s the average value of money (net profits) earned by your company over a customer’s lifetime with your brand.
Before reading further, take a few seconds to read that last sentence again, and try to visualize and comprehend its meaning in full.
It can be a little difficult to get your head around this concept, especially if this is the first time your learning about customer lifetime value.
Know that some people define and use CLV in different ways
In my career, I have seen some confusion regarding customer lifetime value, particularly around the term ‘value’ and how exactly it should be defined.
Commonly, I see people using 3 different definitions explained below:
- Top-line Revenue: Some define ‘value’ as the average top-line revenue (or sales revenue) generated by their customers.
- Gross-Profit: Others define ‘value’ as the average gross-profit (the earnings left over once you deduct your costs of sales).
- Net-Profit: And finally, some people define ‘value’ as the net-profit (the earnings left over once you deduct your cost of sales, as well as other fixed and variable expenses related to keeping your business operational).
If you have reached this far and are struggling with the financial terms used, don’t worry, many people have difficulty getting their heads around them.
I recommend a great book on this topic titled ‘Accounting for the Number Phobic by Dawn Fotopulos’ – it explains the core concepts of accounting for businesses very well and would help you understand the concepts of CLV even better.
So then, which definition of CLV is correct?
Of the three definitions of ‘value’ listed above, the third definition, net-profit, is technically the correct definition.
However, to calculate your customer lifetime value using any of the three definitions can reveal interesting insights to guide your business to further success.
The advantage of calculating your customer lifetime value based on net-profit is that it gives a more accurate picture of the money that builds in your company bank account.
In time will not only improve the value of your business, but also create a cushion to weather bad economic climates or fuel business growth.
Come back to read my separate article if you would like to learn how to teach your employees to increase profit.
For the purpose of this article, we will focus on calculating and using CLV based on your company’s net profit (and more specifically, you’ll need to be aware of your company’s average net-profit margin in order to do this).
So, where should you start to calculate customer lifetime value?
There is no single way to calculate CLV in my opinion, as you can ultimately make the method of calculation very simple or complex (depending on the level of accuracy you hope to achieve for your business).
Frankly, it depends if you want to use the calculation as a broad ‘true-north’ (to ensure your business is heading in the right direction), or you may want your CLV calculation to act as precise, laser guided coordinates; it’s entirely up-to-you!
However, to have some understanding of your CLV is certainly more advantageous than to have no understanding at all.
The purpose of this article is to give you an understanding of customer lifetime value, and how it can then be applied to your business.
With the basics in place, you can always delve into further research to enhance and improve the methodology of your work.
Now, let’s start to calculate Customer Lifetime Value
Customer Lifetime Value is broken into three main parts:
Part 1 = Average customer lifetime
The average amount of time a customer remains loyal to your brand (and by loyal, I mean that they keep coming back to make purchases, or refer new customers).
Part 2 = Average top-line revenue generated
The gross sum of money your customers pay your business in the form of closed sales.
Part 3 = Average net-profit margin
The net-profit your business receives over the course of your customer’s lifetime represented as a percentage of your top-line revenue.
Part 1: We’ll describe how to calculate the average lifetime of your customers.
- You’ll need to open your financial records (organizing your financial records using online software can help make this process significantly easier).
- Then bring up the accounts of each of your customers since your company’s inception (the larger the data sample, the more accurate the customer lifetime value calculation should be in theory).
- If you are aware of any customer accounts that act as ‘outliers’ in your records, feel free to remove them prior to starting this calculation.
- For example, if you have a customer that is a family member that will stick with you through thick or thin (no matter how good or bad your service is), you may want to remove them as your regular customers do not have such emotional loyalty to your brand.
- Within each customer account, make a note of the time between the first recorded purchase and the last sale.
- Tally up the period of time for each customer account – depending on the age of your business and the number of customer accounts, the total time could range from days, weeks, months or even years.
- Then divide the total time by how many customer accounts you have to get an average figure.
Hopefully, now you have an understanding of average customer lifetime.
Next, I’ll show you how to calculate Part 2, the average top-line revenue generated by your customers.
Part 2: How to calculate the average top-line revenue generated by your customers
- Again, bring up your financial records and now tally up the total top-line revenue from sales earned across all of your customer accounts since your company’s inception.
- Then divide the total top-line revenue figure by the total number of customer accounts to get an average figure.
In summary, you should now know the average lifetime (part 1) and average top-line revenue (part 2) for every customer acquired by your business.
Part 3: Finally, let’s look at how to calculate the true ‘value’ of your average customer
- Using your financial records, determine the average net-profit margin for your company (read this if you would like better understand what net-profit margin is and how it is calculated).
- Then, take your average top-line revenue from part 2 and multiply it by your average net-profit margin.
Congratulations, the figure in front of you should represent the true customer lifetime value (in net-profits) that you can safely assume to earn every time you acquire a new customer.
Just so we’re on the same page, I’m going to recap the calculations above for an imaginary business called ‘Company X’:
Imagine Company X is a business just like yours.
They followed the instructions listed in Parts 1-3 above, and determined the following for their business:
- Their average customer lifetime came to ‘5 years’
- Their average top-line revenue generated was ‘USD 600,000’
- Their average net-profit margin was ‘12.5%’
- Finally, they multiplied their average top-line revenue (USD 600,000) by their average net-profit margin 12.5% (0.125), and this revealed that the true value of their customers is USD 75,000 in net-profit.
Therefore, Company X’s customer lifetime value is USD 75,000 over 5 years.
As most businesses operate from financial year to financial year, it can be beneficial to calculate the ‘Annual CLV’ of your business .
To do this, divide your CLV figure by the average lifetime – so in the case of Company X, they would divide USD 75,000 by 5 years which gives annual CLV of USD 15,000.
Or written in another way, for every new customer acquired, they can safely assume they will earn USD 15,000 in net-profit per annum.
Congratulations, if you have followed the steps above, you have now determined the true monetary value of a customer for your business. It’s possible that you’ll never look at a customer in the same way again.
Your CLV gives greater meaning to the phrase that ‘the customer is always right’.
Why is this so you may you ask? Well with your customer lifetime value calculation in hand, you can see the monetary cost of lost profit every-time a dissatisfied customer chooses to do business elsewhere!
So, how should you actually use this information to improve revenue growth for your business?
After running through this process, you can make a number of well-informed conclusions that will shape your future decision making:
- How many leads and customers will you need to acquire in order to make your sales targets?
- How much can you actually spend to acquire another customer whilst remaining profitable? Also known as your target cost per acquisition (target CPA).
- How much can you actually spend to acquire a lead whilst remaining profitable? Also known as your target cost per lead (target CPL).
- And finally, how much money should you budget toward your marketing and sales budget whilst remaining profitable?
Let’s tackle each question above one by one below.
How many customers will you need in order to hit your annual sales targets?
If you set quarterly and annual goals for sales, you can reverse engineer these goals using the figures generated in Part 1-3 of the customer lifetime value calculations above:
- Let’s say Company X would like to add an additional USD 1,000,000 on-top of their last year’s sales figures – how many customers would they need to acquire in order to reach this figure?
- As Company X have calculated that their average top-line revenue for newly acquired customers is USD 120,000 per annum (USD 600,000 divided by 5 years), they would simply need to divide USD 1,000,000 (the goal) by USD 120,000 (the expected annual top-line revenue for each new customer) – this means that Company X needs to acquire 8 new customers in the coming year.
- Most businesses lose customers (it’s unfortunate but a natural reality), this is called ‘churn’ or ‘attrition’.
- If you want to account for this, determine on average how many customers you lose per year (let’s say Company X loses 10% of newly acquired customers within their first year).
- You can then compensate for this fact by taking the number 8 and multiplying it by 1.1 (110%) to help make up for the inevitable 10% of customers lost.
- This means that Company X should actually target 9 new customers if they wish to hit their additional USD 1,000,000 by the end of the year.
How many leads will you need to hit your annual sales targets?
Now that you can determine how many customers your business needs to acquire in order to achieve your annual sales target, you can further reverse engineer this figure to determine how many leads you’ll need to source over the same annual period.
If we look at Company X as an example, if they know they need to close 9 new customers this coming financial year, they can look at their existing sales ‘closing ratio’ to determine how many leads their marketing and sales teams need to generate.
Closing ratio means how many leads their sales teams need to meet in order for one customer to close into top-line revenue (a confirmed sale!).
Company X knows that their sales teams’ historically have a closing ratio of 5:1. Therefore, for every 5 leads their sales teams interact with, at least 1 of these leads will turn into a new customer for their business.
Accordingly, company X needs to multiply 9 customers by 5 which is 45 leads. They can now split these leads across their marketing and sales departments as part of their KPIs for the upcoming year.
How can you calculate your closing ratio?
A simple way to calculate this important metric is to:
- Define a set time period, for example, you can look at the last financial year for the most recent representation of your sales performance.
- Count how many quotes and proposals were created and sent to your leads during this time period.
- Within this time period, count how many of these quotes / proposals actually converted into new customers.
- Place your figures into a ratio format as shown below:
- Number of Quotes / Proposals Sent : Number of New Customers Closed
- If you have two large figures on either side of the ratio, find the common denominator between the two numbers to get the smallest ratio figure possible
How much can you actually spend to acquire another customer whilst remaining profitable? Also known as your target cost per acquisition (target CPA)
Using your company’s customer lifetime value figure, you can ask a very simple, but profound internal question:
From our CLV, what percentage should we reinvest in order to acquire another ideal customer?
To help you visualize this scenario, using Company X’s annual CLV figure as a reference, we know that on average, for each customer they acquire, they generate USD 15,000 in net-profit.
So we can rephrase the question above to:
Of the USD 15,000 earned (the CLV), what percentage should we reinvest in order to acquire another ideal customer?
There is no single right or wrong answer to this question, as long as your answer is in-line with the goals of your business and allows enough money to fund other operations within your organization (for example, buffering for emergencies, budgeting for continued research and development, training programs, new assets etc).
Typically, companies focused on rapid growth may invest 50 percent or more of their customer lifetime value back into their marketing and sales efforts. Companies focused on more gradual growth may allocate 5-15% instead.
So let’s say Company X decides to reinvest 25% of their CLV (and therefore of their net-profit per customer) to acquire an additional customer.
Therefore, to determine their target cost-per-customer-acquisition (CPA), they should not spend more than USD 3,750
The formula to calculate target CPA is:
Your CLV x Chosen Percentage of Profits to be Reinvested = Target CPA
How much can you actually spend to acquire a lead whilst remaining profitable? Also known as your target cost per lead (target CPL)
To determine your target cost-per-lead, divide your target CPA by your sales closing ratio, the formula is shown below:
Target CPA / Closing Ratio = Target CPL
So, earlier we noted that for Company X, they had a sales closing ratio of 5:1 (meaning 5 leads were needed in order to close 1 customer).
Therefore, they would need to take their target CPA from above (USD 3,750) and divide it by 5 leads, resulting in a target CPL of USD 750.
Essentially, Company X should inform their marketing team to never spend more than USD 750 on generating a single lead if they wish to keep their business profitable over the long term.
Finally, how much money should we invest in marketing and sales to acquire new customers (effectively, what should be your marketing budget for the coming year)?
To calculate your marketing and sales budget, take your target CPA and multiply by your desired customer acquisition goal:
Target CPA x No. of New Customers to be Acquired = Marketing & Sales Budget
So for Company X, the formula above looked like this:
USD 3,750 x 9 = USD 33,750
With all this information at hand, how do you increase revenue and profit growth?
Let’s quickly summarize what we’ve learnt so far:
- Customer lifetime value: you know how much profit every new customer generates for your business over their lifetime with your business.
- Annual customer profit: you know how much profit every new customer generates for your business in a given year.
- Target cost-per-customer-acquisition: the maximum amount of money you should spend to acquire a new customer whilst maintaining your net profit margin.
- Target cost-per-lead: the maximum amount of money you should spend to acquire a new lead whilst maintaining your net profit margin.
- Marketing & sales budget: the maximum amount of money you should spend across marketing and sales whilst maintaining your net profit margin.
You’ll want now want to compare how much money you have been historically budgeting and spending as part of your marketing and sales efforts to A) generate leads B) to close new customers and C) to retain your customers to increase the customer lifetime value of your business.
Consider the following key questions:
- Have you been budgeting / spending too little or too much to acquire leads for your business?
- Have you been budgeting / spending too little or too much to acquire new customers for your business?
- Do you invest enough money to improve your customer’s experience with your product and or service?
Accordingly, the answers to these questions will ultimately help you develop new strategies to take corrective action, or to build upon your existing successes.
Also, try having a read of how I recommend to increase sales using the sales revenue formula. Alternatively, see my recommended reading page for books that elaborate on this subject further
Now the ball is in your court!
This article was extensive, but I hope it has shed new light on how you see your customers and how can leverage customer lifetime value to enhance revenue and profit generation for your business.
If you have any questions regarding customer lifetime value and how to best apply it to your business, please do not hesitate to get in touch.
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