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What Is Customer Lifetime Value and How to Calculate It?
In this article I want to talk about 2 different companies, company A and company B.
- Company A spends 45 euros to get a new client.
- Company B spends 800 euros to get a new client.
In your opinion, which of these two companies has a better model?
For a second your brain could think of the first one, but what if I told you that company A sells a 40 euro product and company B a 1500 euro product?
Your opinion changes and you'll think the first one is a wreck, right?
However, company A could be a supermarket, and the customer who has cost you 45 euros makes a purchase today for 40 euros but continues to make this purchase week after week for years.
On the other hand, company B could sell glass-ceramics, and once it sells one, its client will probably never buy from it again.
In that case, the first company would have again a better model, don't you think?
With this small exercise the only thing I want to show you is that, to manage a business in the best way, you need not only to watch the number of clients and how much it costs you to get them, but also, to ask yourself how much income you get from each of them.
And this very important metric is called customer lifetime value.
What is customer lifetime value (CLV) and why is it so important?
CLV or customer lifetime value is a sales and marketing metric.
This metric is a prediction of the profit attributed to the entire relationship you have with a client, from the moment you capture them until your relationship with them ends.
The first time this term appeared was in 1988 in the book "Database Marketing" and since then it has become one of the most important metrics in practically all companies.
The reason for its importance is twofold:
- This metric is one that defines whether or not a business model is viable.
- This metric is the one that defines whether your acquisition costs are correct or you are losing money.
How is customer lifetime value calculated?
To talk about the calculation method of this sales KPI you have to keep in mind one of the points I mentioned in the definition:
Customer lifetime value is only a prediction.
This means that for its calculation we can use from a simple equation based on our history to very elaborate techniques of predictive analysis.
If you want to determine which of these two approaches you should use in your business, you should ask yourself 3 big questions:
- Do you invest a lot of money (several thousand) in customer acquisition every month?
- Do you have staff trained to produce complex analyses or a good budget to outsource these tasks?
- Does your business operate with very tight sales margins?
If you answer 2 or 3 of these questions with a yes, you might start thinking about using more complex methods to determine your CLV.
Otherwise, a simple equation will suffice.
Bonus: Learn more about, How to Reduce Churn in Each Customer Type.
Which formula is used to calculate customer lifetime value?
Some professionals prefer to use a formula that takes into account acquisition costs so that their CLV represents the net income of each client.
In my opinion, using an equation that represents gross income is preferable when doing analysis. I recommend using this one in particular:
As you can see, the calculation is very simple, but keep in mind that if you want the CLV you calculate to be truly representative you need:
- That the data you have on income and customer lifetime are reliable.
- A sufficient history of this data for the calculation to predict the future.
If you do not meet these two requirements, your first job to calculate this metric should be to start collecting data today.
How can you collect this data?
The best way to keep track of this data in detail and without great effort is to use a CRM, and the best one for this task is efficy.
Why not try it out?
Advantages of using customer lifetime value in the management of your business.
If you work in the marketing area or have some notions of this discipline, simply by looking at the definition of this sales KPI you will have intuited the value it has for anyone in business, but in any case, let me list the 2 great advantages of using this metric:
- By defining the estimated income of each client, you will be able to define how much budget you can spend on capturing each client
Only if you know how much you earn with a client can you define limits for customer acquisition.
For example, in SaaS-type businesses such as efficy, a healthy customer acquisition employs ⅓ of what you earn with a customer in capturing it.
So if your SaaS has a €500 CLV, you could easily spend €166 on capturing each customer and keep the business running smoothly.
In addition, with customer lifetime value in mind you can try out new acquisition channels and compare them with each other.
- You encourage your team to focus on your customers, not just on acquisition
The metric that usually guides most businesses is monthly income and precisely because of this, many businesses focus only on recruitment.
However, according to many studies retaining a client is at least 4 times cheaper than getting a new one.
When you start using a metric like CLV to make decisions and encourage your team to focus on all your customers, not just getting new ones.
How do you improve your customer lifetime value?
To improve this metric as outlined in this article you only have 2 levers at hand:
- Increase revenue per client
- Increasing client recurrence
How to increase revenue per customer
One of the ways to increase your revenue per customer is through upsell and cross selling.
The former consists of offering extensions to your products to your existing customers.
This could be a superior model, an annual plan, or any other modality in which the average customer ticket increases.
The other major approach, cross selling, is to offer your existing customers products in addition to those they already consume.
Whether it's with personalised offers or any other method, you would also increase the average customer's ticket.
How to increase a customer's recurrence.
The other lever that you can activate to improve the company's customer lifetime value is the length of time that customers maintain their relationship with you, i.e. retention.
And the best way to improve retention in your business is to put the customer at the centre of your organisation and look after them.
And that task cannot be carried out without a CRM.
That's why I strongly recommend that, if after reading this article you want to start working with CLV, you start by implementing a CRM strategy in your business.
Most of the CRMs on the market will work for you, but efficy is simply the best.
Try it out today.
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