Know your Customer's Worth by Calculating the Lifetime Value
1 year ago

The Lifetime value of a customer or Customer Lifetime Value (CLV) as commonly known refers to the prediction of the total profit or net value a business will derive from their entire relationship with a customer. The length of each relationship is not known.

The Lifetime Value of the Customer is a clear look at the benefit of acquiring and keeping any given customer. Customers are not created equal. In fact, the top 1% of ecommerce customers are worth up to 18 times more than average customers. As a business owner, there is a need to focus your efforts on acquiring the right customers; a valued customer can take your business from being a flash-in-the-pan success to a household name.

Importance of Customer Lifetime Value

Customer Lifetime Value is the most important tool for understanding your customers and also, one of the most important factors in determining your business’ present and future success. It gives you crucial insight into how much money you should be spending on acquiring your customers by telling you how much value they’ll bring to your business in the long run customer helps you make important business decisions about products, product development, sales, marketing and customer support:

Marketing: How much should be spent to acquire a customer?

Product: How can we tailor products and services for my best customers?

Customer Support: How much should be spent to service and retain a customer?

Sales: What types of customers should sales representatives spend the most time on trying to acquire?

Calculating Customer Lifetime Value

While the lifetime value of a customer is incredibly useful, there is a lot of difficulty in its calculation. Thankfully, there are much simpler ways to calculate your Customer Lifetime Value. Customer behaviors are very difficult to predict and can seem completely random at a glance which makes Customer Lifetime Value an inherently complex measure to track. Some of your customers might make small purchases every week, sometimes month; others might make big purchases once a year and there are all sorts of combinations in between. Although there are some more advanced methods for forecasting the lifetime value of a customer out there, the strategy that we’ll be covering in this post is a straightforward way for you to get the information you need to refine your approach to customer acquisition.

Customer Segmentation

Customer Segmentation deals with the division of a market or business into discrete customer groups that share similar characteristics. Customer Segmentation is a way of identifying and meeting customer needs. Businesses that identify underserved segments can then perform better by developing uniquely appealing products and services. Segmentation of customers is most effective when a company tailors offerings to segments that are the most profitable and serves them with distinct competitive advantages. This method of prioritization can help companies develop marketing campaigns and pricing strategies to extract maximum value from both high- and low profit customer.

Customer Segmentation requires business managers to:

-Divide the market into measurable and meaningful segments according to the needs of the customer, past behaviors or their demographic profiles.

-Determine potential profit of each segment by analyzing the revenue and cost impacts of serving each segment

-Segments should be targeted according to their profit potential and the company's ability to serve them

-Invest resources to create product, service, marketing and distribution programs to match the needs of each target segment

-The performance of each segment should be measured. Adjust the segmentation approach over time as market conditions change decision making throughout the organization.

Segmenting with RFM

There exist foundational elements of analyzing customer value such as: Recency, Frequency, and Monetary Value (RFM). RFM is a technique for organizing your customers according to their value; from least valuable to most valuable by taking into account the RFM factors:

Recency refers to the last time that a customer made a purchase. Customers who have made a purchase recently are more likely to make a repeat purchase than customers who haven’t made a purchase in a long time.

Customers who make purchases often are more likely to continue to come back than customers who rarely make purchases. Similarly, Customers who make larger purchases are more likely to return than customers who spend less.

By segmenting your customers with RFM, there will be ease in analyzing each group individually and determining which set of customers has the highest lifetime value. Using RFM to organize your customers, one needs to grab three pieces of data about every individual customer: The date of their most recent transaction, the number of transactions they’ve made within a consistent timeframe (a year will work best), and the total amount that they’ve spent during that same timeframe.

What is Needed to Calculate Your Customer Lifetime Value

After segmenting your customers with RFM, the value of each segment is to be determined; the results will reveal which customers perform best. To calculate the Customer Lifetime Value for each of your customer segments, three key pieces of data within your pre-established timeframe are needed: Average Order Value, Customer Value and Purchase Frequency

Average Order Value

Average Order Value represents the average amount of money spent by a customer at every order placed. To get this number, simply take your total revenue and divide it by your total number of orders. If you own a store, this information can be found by heading to the Reports section of your Administration and taking a look at your sales by week or month. You’ll just need to divide your Total Sales by your Order Count for the past year.

NB: To get a more accurate number, be sure to click Define under Total Sales and uncheck everything except for Subtotal.

Average Order Value (AOV) = Total Sales / Order Count

Customer Value

Customer Value represents the average monetary value that each customer brings to your business during a timeframe. In order to calculate your Customer Value, your Average Order Value will be multiplied by your Purchase Frequency.

Customer Value (CV) = Average Order Value x Purchase Frequency

Purchase Frequency

Purchase Frequency represents the average amount of orders placed by each customer. By using the same timeframe the Average Order Value calculations, one will need to divide the total number of orders by the total number of unique customers. The result will be the Purchase Frequency (PF). Store owners can also find this data in their Reports under Sales by Customer.

Purchase Frequency (PF) = Total Orders / Total Customers

Estimate Customer Lifetime Value

Another way to calculate Customer Lifetime Value is to take the revenue you earn from each customer and subtract out the money spent on acquiring and serving them. Performing in-depth customer lifetime value analysis is time consuming. For example

Let's say that the value of an average order at your business is $60.  Any time someone makes an order, whether it's their first, second or their third, they have a 10% chance of coming back and making a repeat purchase.  Finally, assume that it costs you $15 to acquire each new customer. 

The total revenue you can expect to get from each customer is your average order value divided by one minus the repeat purchase rate, or

$60 / ( 1 - 0.1) = $66.67.

Subtract your customer acquisition cost from the above result and the result will be a customer lifetime value of $51.67.

Looking at Pareto Principle which states that, for many events, roughly 80% of the effects come from 20% of the causes. When this principle is applied to e-commerce, this means that 80% of your revenue can be attributed to 20% of your customers. Though the exact percentages may not be 80/20, some customers are still worth a whole lot more than others, and identifying your valued customers can be extremely valuable to your business.

Taking Customer Lifetime Value into account can shift how you think about customer acquisition. Rather than thinking on how you can acquire a lot of customers and how cheaply you can do so, Customer Lifetime Value helps you think about how to optimize your acquisition by spending for maximum value rather than minimum cost.

Predicting Customer Lifetime Value

Customer Lifetime Value can be calculated historically, that is over specific periods; it can also be predictive. Each of these calculations serves different purposes. Predictive Customer Lifetime Value projects what new customers will spend over their entire lifetime. The Predictive Customer Lifetime Value is the most powerful way to not only understand what a customer is worth to you at the time, but also how their value will change overtime for better or worse.

On day one, customers with the highest lifetime values have already distinguished themselves. This means marketers don’t need to take a long time to make important “invest or not invest” decisions for their marketing campaigns. Customer Lifetime Value is the best metric to predict future customer behaviors.

Disadvantages in Customer lifetime Value

The standard Customer Lifetime Value approach calculates the net present value (NPV) of all anticipated cash flows coming in (revenues) and going out (marketing dollars spent) over some period (months, years, or even decades) for a given customer. It is expected that you keep customers who show a positive NPV for the marketing investment, and drop the ones who show a negative NPV. Those are rational choices at the time of the calculation but only then do they make sense. The conventional calculation is flawed; this is so because you are not able to factor in a business’ flexibility to cut a given customer loose at any time. The concept of Flexibility means having options, and options have value.

Businesses have been using real options for a long time to optimize their investment portfolios. It’s about time they apply them in the valuation and management of their investment in customers (Customer Value Management), too. Here’s a five-step process for bringing real-option analysis into the Net Present Value calculation:

1. The future purchasing behavior for a set of customers is estimated, using the common RFM approach. This determines expected revenues.

2. Calculate costs generated per customer per period.

3. Use those two inputs to estimate the profit contribution for each customer over the time horizon under consideration.

4. For each period, determine whether the expected future profit contribution for that customer might be negative.

5. Finally, calculate the CLV that includes the value of abandoning that customer. Is there profit in dropping that customer at any given period?

 To give a highly simplified example of this fifth step, take into consideration a customer that cost $50 to acquire and $50 to retain for each subsequent period, thus costing $250 to keep for five periods. Based on data from previous customers with similar characteristics, if that customer might be expected to purchase $70 of goods in the first period, $50 in the next, $30 the next, and $0 in the final periods, a normal CLV calculation would show that the customer would be unprofitable (he generates just $150 of revenue at a marketing cost of $250). But, add in the value of the option of dropping him after the second period ($50 × 3 = $150) and the same customer suddenly looks profitable: Over the five periods, the marketing cost is $100 ($250 minus the $150 option to drop) and revenues are $120 ($70 for period 1 and $50 for period 2). In an actual business scenario, such calculation can be mathematically demanding and generally can’t be carried out easily using simple spreadsheet. More advanced option-pricing approaches will be needed.

Improve your Customer Lifetime Value

Improving your Customer Lifetime Value can have a dramatic impact throughout your business. Your Customer Lifetime value calculations may have given you some results to get excited about; there is always room for improvement. There exist some quick tips for getting the most out of every customer relationship by creating new opportunities to increase their value:

Encourage Your Customers to Spend More. A key part of increasing your customers’ lifetime value is encouraging them to spend more on each purchase; this boosts your overall average order value.Pricing plays a huge psychological role in how much customers spend and what customers choose to order. Below are some ideas that might improve your pricing model:

English speakers read from left to right. If one is selling expensive items, they should focus on making the left digit as low as possible to trick the mind into perceiving the price as smaller than it actually is. As an example, $200 seems a lot less expensive than $201.

Comparison in pricing helps make decisions for customers. Are there multiple models of the same product? If so, line them up and contrast the strengths of each model to justify the price point and help your customers pull the trigger quicker.

Social proof is a powerful thing. To do this, try incorporating an Instagram feed into your product pages with apps like Like2HaveIt and Shoppable Instagram to show off how other customers are using your products. This way, not only will your customers feel inspired, but they will be more inclined to hit the “Add to Cart” icon.

Scarcity means exclusivity. The more exclusive something seems; the more valuable it is in the minds of your audience. Do encourage your customers to act immediately and place larger orders by setting up sales with fixed deadlines.       

Free shipping discounts create larger carts. Do offer free shipping, and consider setting your discount threshold higher. This threshold discount can be $60, $100, or even higher depending on your business and the average price of your products. If your customers typically come close to hitting the threshold, then they’ll easily be able to justify tossing an extra item in their cart to get free shipping.

Keep Your Customers Coming Back for More. For better Customer Lifetime Value, it’s important to not just keep your customers wanting for more, but to keep them coming back frequently and for longer amounts of time.

There are some easy ways to improve your customer frequency and lifespan by giving your customers some incentives to pay you a visit more often. The key to keeping your customers surprised, delighted, ecstatic and coming back for more is a memorable unwrapping experience. This can be done by putting some extra love and care into how products are shipped with free gifts, personalized notes, and fun packaging. Newsletters are your secret weapon. eMarketing is a fantastic tool for any business. You need to keep customers in the loop on product restocks, any upcoming sales, and exclusive deals with a beautifully designed newsletter. Engage with your fans on social media. Stay at the top of your customers’ minds with an engaging and fun social media presence.

Loyalty programs keep customers around. Offer customers gifts and rewards for repeated purchases. Consider using the concept of subscribing to get customers hooked. Do you offer a product that customers need to buy regularly like coffee, beans, soap or socks? Think about setting up a subscription program to lock in repeat business. This is easier for you and your customers.

Put Your Customer Lifetime Value to Work. With your Customer Lifetime Value known, it is now possible to start building more efficient and smarter campaigns; this is done by optimizing your spending and fine-tuning your targeting.One of the primary uses for CLV is to help you keep your Cost Per Acquisition as low as possible.

If the cost of acquiring new customers is not known, then you need to divide your total marketing or sales budget for a specific timeframe by the amount of new customers you gained in that same timeframe. The resulting number will be the average amount that you spend every time your business acquires a new customer.

The difference between your Customer Lifetime Value and your Cost Per Acquisition is your Return On Investment (ROI). This is the amount of money you get out of a customer relationship after deducting the money used to start up the relationship. To stay profitable, you will need to maximize your Return On Investment. Additionally, if your CLV is known, you’ll also be able to figure out how much you can afford to spend on paid ad campaigns on Google and Facebook.

To determine the amount needed for necessary campaigns, you’ll first need to know your conversion rate. For instance, if your Customer Lifetime Value is $100 and the conversion rate for one of your marketing campaigns is 10%, then your maximum bid for that campaign should be 10% of $100. So, in this scenario, you’d be able to bid a maximum of $10 per click without blowing your budget.

Get the Right Customers. Success isn’t about finding customers; it’s about finding the right customers. Knowing how to calculate the lifetime value of your current customer base, a business will be able to start crafting campaigns that target and win over those customers that really make the difference for your bottom line.

Customer Value Management (CVM)

Customer value management measures the performance of one business relative to the competition, it will help a business to accurately determine what drives value for customers, align efforts, focus scarce resources and create your sustainable competitive advantage. If taken into consideration, Customer Value Management is a good way to improve customer lifetime value.

The Customer value management concept is really simple:

Ask for Customers’ opinion. Ask customers in your target market what they're looking for when they do business with vendors.

Determine customer’s rating system. Determine how customers in your target market rate the value you provide relative to the value provided by your competitors.

Make positive changes. Decide what changes on your part will have the greatest positive impact on customers' perception of the relative value of your offering.

Have a common focus. Align people and processes in a common focus to deliver value.

Create availability of information. Provide a consistent flow of data and information to keep them aligned.

Win with everyone. Win with your customers; also win with shareholders and employees.

Businesses in today's business environment are stressing on customer focus. However, what's lacking in most businesses are useful and practical ways to capture customer needs, to measure how well their needs are satisfied, and build actionable plans to improve your business's bottom line, that is what customer value management will do for your company.

Six important lessons that businesses can employ for successful Customer Value Management (CVM), that integrate available research knowledge and best practices include:

(1) Using Customer value management to improve business performance;

(2) Ensuring that Customer value management is more customer driven than IT driven;

(3) Adopting customer lifetime value as a core metric;

(4) Investing in strong analytical capabilities;

(5) Understanding the three drive keys which are the concept of customer acquisition, the concept of customer retention and the concept of customer expansion; and

(6) Managing channels to create customer value.