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The Pragmatic Entrepreneur: The Importance of Calculating CLV

Before you implement a marketing promotion, do you take the time to calculate and consider Customer Lifetime Value?

If this term is foreign to you, or you just haven’t had time to deal with, it this article will give you a quick and dirty method to tackle it.

What is Customer Lifetime Value?
Customer Lifetime Value (CLV) is a formula that helps you arrive at the dollar value associated with the long term relationship of a given customer. You can actually determine how much a customer relationship is worth over a specific period of time.

It is a powerful tool, and can aid you in determining how much you should spend on user acquisition and advertising.
There are a number of articles and resources that discuss the method in depth, but we will walk you through the basics.

First, you need to know (or estimate) your customer’s average spending, order frequency and retention. At the most basic level, Customer Lifetime Value is calculated as follows:

CLV = (Customer Average Order) x (Number of Orders per Year) x (Customer Retention)

For example:

  • Customer Average Order = $50
  • Number of Orders per Year = 4
  • Customer Retention = 3 years
  • So, in this example, CLV = $50 x 4 x 3 or $600

While this is good to know, it will be even more useful if you use a bit more data such as:

  • Customer Acquisition Cost
  • Customer Retention Cost
  • Cost of Goods Sold

Suppose you spend $400 for a successful postcard marketing campaign that brings in 10 new customers. Using these numbers, the acquisition cost for those new customers is $40 each ($400 / 10).

Add the acquisition cost to the retention cost multiplied by the retention period. Over the course of the same three year period, your customer acquisition and retention cost will be:

Acquisition & Retention Cost = $40 (Acquisition) + $20 (Retention) x 3 (Years)

Therefore, the acquisition and retention cost for the life of that customer is $100: $40 + ($20 x 3). When this is deducted from the first calculation the Customer Lifetime Value becomes $500 ($600 – $100).

Finally, subtract the actual cost (to you) of the goods sold to calculate your profit.

Calculating CLV can get very fancy, taking into consideration things like churn rate (the value of future income) and changes in buying habits over the years. But if you start with the basic formula outlined in this article, and adjust your spending based on the numbers, you should see an improvement in your bottom line. You can add more complexities as you become more comfortable.

Resources
http://blog.kissmetrics.com/how-netflix-measures-you/
www.dbmarketing.com
http://www.zeromillion.com

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