What is Customer Lifetime Value?

Customer Lifetime Value represents the amount of money a customer is expected to spend on your products or services throughout their entire relationship with your business. It is an essential measure because it helps you understand how much you can afford to spend on acquiring new customers, retaining existing ones, and developing effective marketing campaigns.

Why is CLV Important?

1. Marketing Efficiency: Knowing your CLV allows you to budget your marketing and customer acquisition expenses wisely.
2. Resource Allocation: You can allocate resources effectively to customer segments that deliver the highest lifetime value.
3. Profitability Forecasting: Understanding CLV helps predict long-term profitability and sustainability.

How to Calculate CLV (revenue-based)

Calculating CLV doesn't need to be complicated. Here's a simple way to estimate it:

• Average Purchase Value: How much a customer typically spends per transaction.
• Purchase Frequency per Year: How often a customer buys your product/service within a year.
• Customer Lifespan: The average duration (in years, or months if you prefer) a customer stays with your business.

Practical Example:

Suppose you run a coffee shop:

• Average Purchase Value: 5 € per transaction
• Purchase Frequency per Year: 50 visits per customer per year
• Customer Lifespan: 3 years

Applying these values:

This means each customer, on average, is worth 750€ to your coffee shop over their lifetime. Use this for quick strategic thinking or back-of-the-envelope estimates. But it doesn’t account for your real costs.

However, for practical, business-focused calculations, especially when using CLV to make strategic decisions about customer acquisition spending or profitability forecasting, it is essential to factor in Cost of Goods Sold (COGS). Including this provides a clearer measure of the net profit generated per customer, rather than merely the revenue. Although to get to the closest estimation of net profit, you should also take into account the cost of acquiring the customer, for simplicity and clarity, I’ll leave that for another article. 

COGS = Cost of Goods Sold

It simply means: How much does it cost you to make or deliver the product or service you’re selling?

It includes only the direct costs—what you absolutely need to produce what the customer buys.

Continuing our example:

• A barista making the drinks in a coffee shop (5 mins of production work): 17 € / 12 = 1,42 €
• Cost of packaging the drink 0,28 €
• Coffee grind 0,3 €

The Average Cost of Goods Sold per purchase is thus 2 €.

Here's the refined formula, taking into account COGS:

CLV = (Average Purchase Value − Average Cost of Goods Sold per Purchase) × Purchase Frequency per Year × Customer Lifespan

Revised Example (with COGS):

Using the previous coffee shop scenario with COGS included:

• Average Purchase Value: 5 €
  Average Cost of Goods Sold per Purchase: 2 €
• Purchase Frequency per Year: 50 visits
• Customer Lifespan: 3 years
  
  

The calculation would then become:

CLV = ( 5€ − 2 €) × 50 × 3 = 450 €

This revised figure (450 €) represents the profit generated per customer over their lifetime, providing a much more accurate and actionable measure.

Why Include COGS?

• Profitability: Ensures CLV reflects true profitability rather than revenue alone.
• Budgeting Accuracy: Helps businesses accurately determine sustainable acquisition costs.
• Decision-making: Guides strategic choices, including pricing, promotions, and loyalty programs.

Recommendation:
When applying CLV practically for strategic decisions, always include COGS to ensure the metric truly reflects customer profitability and informs your investment decisions accurately.

Using CLV to Drive Business Decisions:

• Marketing Spend: If your CLV is 450€, investing 30 to 50€ to acquire a new customer makes strategic sense.
• Retention Strategies: Knowing a customer is worth 450€ encourages investment in loyalty programs or customer service improvements.
• Segmentation: Identify and target customer segments with higher CLVs to optimise profitability.
• Additional remarks: Notice that some customer segments might be worth investing more into acquiring them initially and at first serving them with a loss or very low profit margins to retain more value from the relationship long term. Additionally, some segments might never be profitable on their own, but if they are opinion leaders or trend setters, attracting more customers with them, then the total value they bring might be worth the investment in you retaining the relationship in total estimation.

Key Takeaways for Entrepreneurs:

• Calculate and revisit your CLV regularly to reflect changing consumer habits and business conditions.
• Use CLV as a benchmark to measure the effectiveness of your customer acquisition and retention strategies.
• Prioritise investment in activities and customers that maximise long-term value rather than short-term gains.

Understanding Customer Lifetime Value enables you to make informed, strategic decisions, ultimately driving sustainable business growth and profitability.

One of the most useful use cases for Customer Lifetime Value is to compare it to your Customer Acquisition Cost to figure out the difference and ratio, but more on that in my article on Customer Acquisition Cost (CAC).

‍

Disclaimer: This article has been written in cooperation with AI to improve clarity and concise structure. And to limit the tendency of the author to keep on expanding his texts ad infinitum. The author has taken close care that the informational content of the article has been retained or improved in the process.