1. What is it?
CLTV (or CLV) is how much your average customer is worth, in dollars, over the lifetime of his or her relationship with your company.
A more sophisticated way of saying it, for you accountants out there, is: “The dollar value of a customer relationship, based on the present value of the projected future cash flows from the customer relationship.” – Thanks for that one, Marketing Strategy From the Masters text book!
2. Why should I care?
CLTV is important to know because it shifts your focus from immediate revenue to the long-term health of your customer relationships. It also serves as a maximum investment you should be willing to make for customer acquisition, and a reference point to measure the return on investment generated by marketing campaigns.
3. How do I calculate it?
There are many ways to calculate your CLTV. The important thing is to stick with a method you are comfortable with, and to be aware of the strengths and weaknesses of each formula.
In simple form, the concept is this:
- Average order value (example: $50)
- Profit margin (example: 50%)
- Average number of orders per period (example: 1 order per year)
- Average lifespan of a customer (example: 3 years)
Average Order Value x Profit Margin x Average Number of Orders Per Period x Average Lifespan of a Customer
$50 x .50 x 1 x 3 = $75
If you said this in sentences, it would sound like this: “The average customer spends $50 per order, at a profit margin of 50%, which equals $25 of profit per order. She usually places one order per year, and is an active customer for three years. Three orders at a profit of $25 per order is $75. So, the average Customer Lifetime Value is $75.
For some other variations of how to calculate CLTV, check out this great article by KISSmetrics.
4. What does it mean?
If you are spending less than $75 in acquisition costs to get a new customer, over the lifetime of the customer you are probably going to make a profit. Conversely, if you are spending more than $75, you are likely going to lose money. This can be used as a measuring stick to determine the ROI of marketing activities, filtered through a long-term lens.
With any model or formula, there are issues and limitations. You may have noticed that this formula doesn’t take into consideration the Time Value of Money. Since you will not be receiving this revenue today, and we know that the value of the dollar will likely decrease by the time the money is received, it is important to discount the CLTV to reflect the Net Present Value (NPV).
Using an NPV calculator and a discount rate of 10% (3% to account for inflation and 7% to account for the opportunity cost of not being invested elsewhere; like the stock market) reduces the CLTV to approximately $62. This is your break-even point. Spending more to acquire a new customer is likely to cut into your profit margin.
- CLTV is useful as a measuring stick for marketing activities
- CLTV shifts your focus from short-term to long-term thinking
- CLTV views marketing expenses as a measurable investment, not a cost
- CLTV formulas are not perfect, so be aware of the limitations