Each new customer your business earns is a win — but just how big of a win is it? Will they contribute enough revenue to help your company grow, or will they barely earn out their acquisition cost before churning?
The answer to these questions can be found by calculating one metric: customer lifetime value (CLTV). CLTV is the projected amount of revenue a business can expect to earn from a customer over the entire duration of their relationship.
There are several ways to calculate CLTV, and each way has its own benefits and drawbacks. Read on to learn how you can use these formulas to make informed business decisions and understand if your business model has longevity.
Customer lifetime value (also known as LTV, CLV or CLTV) is the expected amount a customer will spend with your company throughout your relationship. It considers not just the initial purchase but also all subsequent purchases and interactions that generate revenue. The calculation will always return an average.
CLTV is crucial for businesses because it helps them understand the long-term value of their customer relationships and informs decisions regarding marketing, customer service and product development.
Deployed at scale, CLTV helps merchants understand whether their business model has longevity. A company with a low CLTV might end up operating at a loss if the cost of retaining customers is high.
Merchants should use CLTV to drive important business decisions, track consumer trends and spot potential problems with your business model before they cause harm. Knowing how much a customer is worth will help you:
Your CLTV is also essential for understanding other ecommerce metrics that track acquisition and retention.
For instance, customer acquisition cost (CAC) measures the cost and effort involved in acquiring a new customer. Changes in privacy laws and data collection have limited how much information merchants can collect about a customer’s journey from acquisition through retention. As a result, ecommerce businesses are left with fewer ways to understand CAC and must look to numbers like the CLTV:CAC ratio to understand whether their business model is sustainable.
It’s also easy to understand the importance of reducing churn rates when you consider them through the metric of CLTV. Keep in mind:
CLTV is arguably the most important metric for ecommerce businesses, mostly for the way it supports the shift to a relationship-focused business. To fully understand the drivers of CLTV, organizations are forced to dig deep into their customers’ experiences and measure feedback at all key touchpoints during the customer journey. That activity is healthy for any business.
There are multiple formulas merchants can use to calculate CLTV, depending on what they want to learn from the metric. The simpler methods may ignore metrics like CAC, gross margin or growth ratio. However, these calculations can provide enough data to help you make informed business decisions.
Metrics used to find CLTV:
Difficulty: Low.
Use this method if: You have high acquisition or servicing costs or your subscribers only stick around for a few months.
In this method, you subtract the cost of acquiring and servicing customers from the gross revenue generated from customers over an average lifetime.
Because this formula puts more emphasis on costs than some others, you’re likely to get a lower CLTV from this calculation. However, it’s typically better to underestimate your CLTV than to overestimate it, especially if you spend a lot acquiring customers or keeping them around.
You can use this formula even if you don’t have enough data to provide a good ballpark of your average customer lifespan. It only requires you to know how much a customer spends with you before they churn. This formula is also useful for companies in acquisition mode because it does factor in those costs.
One weakness of this formula is that it subtracts the customer servicing cost but not the cost of goods sold; therefore, it’s a stronger candidate for SaaS companies than those that deliver physical products.
You may be wondering, how often do you update the averages for this calculation? You should re-figure these numbers at least as often as your customer base turns over. If you don’t know your average customer lifetime, sample a few accounts to get an idea of how long your customers stay. Then, make sure you’re updating each of the metrics used at this frequency for a more accurate calculation.
Difficulty: Low.
Use this method if: Your customers stick around for at least a year and stay at the same price point rather than frequently upgrading or purchasing add-ons.
This method multiplies the average revenue customers generate per year by the average duration a customer remains with your organization and then subtracts the average cost of servicing customers.
Unlike the previous method, you’ll need historical data on your customers’ annual spending and average lifetime with your company. Merchants that don’t have at least a year’s worth of data won’t be able to use this formula.
This calculation is suitable in situations where the figures are likely to remain relatively flat year-over-year. Because it uses the customer servicing cost rather than cost of goods sold (COGS), this is another useful formula for SaaS companies.
You’ll notice CAC is not a part of this formula, which means it’s a better choice for companies that aren’t spending heavily on acquiring new customers.
Merchants that are heavily focused on retention might use this formula, however, as it accounts for the costs you’ll face from serving those customers who stick around.
Difficulty: Low.
Use this method if: Your main customer-related expense is physical goods.
Method 3 first calculates gross profit (gross revenue minus cost of goods sold, or COGS) and then divides that figure by the number of unique customers.
It’s a simple way to find your CLTV even if you don’t have reams of historical data or know your average customer lifetime value.
Because this formula subtracts COGS instead of customer acquisition or servicing costs, it’s best for companies that spend a lot on physical goods. While SaaS companies may not have to worry about the price of procuring a product to pass on to their customers, product-based subscriptions must account for this substantial expense. In fact, estimating your CLTV without subtracting COGS might give you an incorrect view of your business model’s viability.
The caveat is that this CLTV formula only considers expenses related to COGS. Arguably, COGS is the only expense that can be accurately estimated at any given point without involving accounting — customer acquisition costs, sales/marketing expenses and operating expenses are typically estimated by accounting teams. Those numbers must be used as if they were true until accounting can make the estimation again, which may leave you working with outdated data.
One downside of this method is that it’s less likely to give you customer lifetime value as opposed to the average amount you earn per customer over a set period. Calculating your gross profits requires you to use a time period so you can determine your COGS and gross revenue. You’ll have to count your number of unique customers within this time period for an accurate calculation. However, bounding CLTV calculations by time period will lead to fewer exact numbers because some of your customers’ lifetimes will extend beyond it in either direction.
Difficulty: Low.
Use this method if: You don’t have a lot of customer data or customer-related expenses.
This formula is one of the simplest ways to calculate CLTV — you divide average order value by churn rate.
While super simple, this method is also less accurate because it does not consider expenses. Your COGS, CAC and customer servicing costs need to be taken into account when using CLTV to make decisions, and you’ll have to do that separately if you use this calculation.
Still, this formula is especially useful when you need to make quick calculations. If you’re using CLTV to track customer trends, you’ll be able to get a quick view of your customer base. You can also use this formula as a part of the calculations that have other ways of addressing expenses, such as your CLTV:CAC ratio.
One potential hurdle: This formula only works if your billing periods are standard. It estimates customer lifetime using churn rate or the likelihood a customer will leave during a given billing period. For instance, a 10% churn rate on a subscription with a one-month billing period looks very different from the same churn rate on a subscription with a three-month billing period.
If you offer flexible payment plans so some customers pay twice a month and some only pay twice a year, this formula won’t return meaningful data.
Difficulty: Medium.
Use this method if: You want your CLTV calculations to account for future differences in value (and you have plenty of time to do the math).
This calculation, while complex, remains the preferred CLTV calculation among many professionals and instructors. It’s often taught in MBA programs or other advanced business courses. The formula leverages margin, retention rate, discount rate and acquisition cost to give merchants a more thorough understanding of their CLTV.
Before you can use this formula, you’ll need to pull some different figures. Gross profit per sale and retention rate should be easy to find. Discount rate is a bit more complicated — it represents the difference in the value of a dollar today and the value of that same dollar in the future. This formula uses it because it’s seeing what your retention and churn rates will mean for your business. If you don’t know the appropriate discount rate, you can look up the current Federal Reserve interest rate for short-term loans and use that number.
So, what’s going on in the rest of the formula?
When you multiply your gross profit per sale by the adjusted retention rate, you’re finding the average value of each customer each month (including those customers who churn). Subtracting your retention rate from 1 plus the discount rate returns your adjusted churn rate. And since dividing 1 by your churn rate gives you the average customer lifetime, dividing your average value per customer per month by your churn rate returns your average lifetime value. Finally, you subtract CAC from that number so you’re not overstating your CLTV.
Figuring out this calculation does take more time, but it will also give you the most accurate figure for your CLTV. The formula figures in costs (COGS in gross profit per sale, CAC at the end) and calculates customer lifetime value rather than using another calculation as a stand-in. It’s, therefore, more accurate than the previous four formulas.
The way you calculate CLTV will affect what decisions you can safely make.
A formula that doesn’t include expenses or only includes some expenses will make your business seem more profitable than it really is.
On the flip side, formulas that include every expense may make it seem like streamlining operations is key to increasing CLTV when improving your retention rate will have a greater impact.
Ultimately, it’s up to you to decide which formula you prefer. Make sure you understand the strengths and weaknesses of your formula of choice. Just know that any CLTV calculation is better than no CLTV calculation.
CLTV is more than just a number; it’s one of the most crucial metrics for any growing company. By measuring CLTV in relation to CAC, businesses can determine how long it takes to recoup the investment required to gain a new customer, including sales and marketing expenses.
Here are some quick tips for increasing CLTV:
By focusing on these strategies, you can significantly enhance your CLTV, driving sustainable growth and long-term success for your business.
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