Did you know that the term customer lifetime value was used among the first times in the book Database Marketing in 1988? Starting with the 1990s, the concept was used more and more by experts and businesses alike. Being such an important topic, today we are going to focus on finding out what is customer lifetime value and how can you calculate it.
Customer Lifetime Value Definition
Also called lifetime customer value (LCV) or lifetime value (LTV), customer lifetime value (CLV/ CLTV) refers to a prediction of the profit that should be gained from an entire future relationship with one customer. There are several types of prediction models that have varying degrees of accuracy and complexity.
It is an important concept that makes companies focus their attention on the long-term status of their relationship with the customers. As such, they shift their interest from the short-term profits to the long-term ones. At the same time, they find out what’s the upper limit of their spending for getting new customers. Marketing strategies rely a lot on this concept because it helps specialists calculate the payback of advertising they spend. Basically, you could say you are assessing the financial value of each of your customers.
How to Calculate Customer Lifetime Value – The Easy Way
As we mentioned above, there are various ways in which you can calculate the CLV. We will explain the steps you need to take and start with the variables you need.
1. Average Order Value (AOV)
The name of this variable is quite self-explanatory. Basically, you need to find out the average of the amount of money spent on your website with each order. The AOV metric is important because, in this way, you can decide whether you should increase the average order value or the order frequency. The formula you need is:
Average Order Value = Total Revenue (365 Days) divided by Number of Orders (365 Days)
2. Purchase Frequency (f)
The purchase frequency lets you know how many purchases a customer will make from your shop in a certain period. Since it’s easier, we will continue to use the annual perspective. This metric is very important because you can find out how often your customers buy from you and if they return. As we know, increasing the purchase frequency is an essential growth strategy used by many companies.
Purchase Frequency (f) = Number of Orders (365 days) divided by Unique Customers (365 Days)
3. Customer Value (CV)
Before calculating the customer lifetime value, you need to find out the customer value. This refers to the value of an average customer order, multiplied by the purchase frequency. Thus, you find out the value of a customer within a certain time frame. The time frame needs to be the same you used for the AOV and f.
Customer Value (CV) = Average Order Value (AOV) x Purchase Frequency (f)
4. Customer Average Lifespan (t)
The last variable we need to calculate the customer lifetime value is the customer average lifespan (t). This is the average period when a customer is active. Simply put, it’s the time between the first and last purchase.
There are two ways in which you can calculate this variable. The easiest way is to consider a range between 1 and 3 years as the average lifespan. The harder way supposes more calculation, but it can be more accurate. You need two other factors for this:
- The average time between purchases – take a customer spreadsheet and insert all the active customers and the purchases they made in the last year. Then, make a column that shows the time between purchases for each of the customers. Then, use the Average function to find out the number you need.
- The standard deviation of the data set – this will help you see how spread apart your information is, compared to the average time between purchases. In another cell, use the STDEV formula and select the columns with the previous metrics.
Once you have these two factors, it’s easy to calculate the store average lifespan. Add the standard deviation to the average time between purchases twice and you’ll see how long a customer is active.
Finally, after you found out all the variables above, it’s time to calculate the customer lifetime value. This is one of the easiest ways to find out this amount:
CLV = CV x (t)
As the formula shows, you need to multiply the customer annual value by how long your buyers remain active. You will obtain an accurate value that shows how important each of the customers is over their lifespan. Furthermore, you can see how much should you spend to get each of the new customers, as well as how much you should spend on keeping them as loyal followers.
Naturally, opting for a simple formula will leave out some important things, such as the customer variance and the store margin. Let’s have a look at these two.
1. CLV Including Margin
The value of the CLV metrics increases when you include the margin that appears in a shopper’s life. It’s useful to know the actual profit that comes from each new customer you gain, not just the revenue, so if you include the margin you will find out this number.
CLV with Margin = AOV x (f) x Margin (m)
2. CLV by Segment
Having an aggregate CLV is useful for making decisions regarding the store. However, if you look at the segmentation you will see the real value. We have no new calculation to show you here, you just need to apply the formula to a certain segment of the customers. And here, there are endless possibilities you can take, depending on your niche and/or interests: by channels, actions, location, gender, age, etc.
Here you have another two ways of calculating the customer lifetime value metrics by only using Excel:
To sum up, it’s not as hard as it seems to calculate your customer lifetime value metrics. The basic calculations provided above are enough to show you what you need to improve. The CLV, as unimportant as it may seem, helps you make smarter marketing decisions, which are essential for the long-term success of your website.
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