June 16, 2020

The Formula for Calculating Customer Lifetime Value

Author: Chad Buckendahl

In the last 15 years, I’ve had one question come up more frequently than any other — “How do you calculate customer lifetime value?” 

Customer lifetime value (CLTV) is the projected revenue that a customer will generate during their lifetime. In this article, I am going to provide evidence that CLTV is a metric that should be on your shortlist of key metrics, and explain several ways to calculate CLTV. I am not going to provide you with ideas on how to retain customers, but I do suggest that you read one of my recent posts about The Science of Customer Emotions, where I outline 10 ways to build stronger emotional bonds with customers.

Evidence

The power of calculating customer value is alluring for many reasons. If we know how much customers are worth, we can:

  1. Determine how much we can afford to spend on acquiring them
  2. Focus our media budget on sources that generate the most profitable customers
  3. Know how much budget to allocate toward reducing customer churn
  4. Accurately identify top customers

It’s no wonder that this is a common question. The cost and effort involved in acquiring customers are high. 

  • It costs five times more to attract new customers than to keep existing customers. 
  • Increasing customer retention rates by 5% increase profits by 25% to 95%, according to research done by Frederick Reichheld of Bain & Company.

The CLTV metric brings both quantitative rigor and long-term perspective to the activities of customer acquisition and building strong customer relationships. It can help us differentiate who is most likely to be profitable over the long term. 

It should be no surprise that I am a big fan of the CLTV metric for many reasons, but mostly for the way it helps to transform the thinking at all levels of organizations. In order 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.

6 Popular Methods to Calculate CLTV

In the six methods, you’ll notice that all but one (method 4) take some form of expenses into consideration. Some people argue that CLTV should account for customer acquisition costs, sales/marketing expenses, operating expenses and COGS (Cost of Goods Sold). I personally fall into this camp, because when I look at a CLTV number, I want to know the value customers bring to the bottom line. 

However, over the years, I’ve heard very compelling arguments about why expenses should not be considered. The main argument against expenses playing a part in the ratio is that doing so decreases the calculation’s accuracy since expenses fluctuate over time. And, by adding expenses into the equation, it forces us to make unnecessary assumptions. The purpose of this article is not to debate whether we should or shouldn’t include expenses into the equation but to arm you with the formulas behind six popular methods so you can confidently calculate CLTV.

Method 1

This is the first of four simple methods where we subtract the average cost of acquiring customers and the average cost of servicing customers from the gross revenue generated from customers over an average lifetime. Two common questions that I get is “How do you calculate the averages?” and “How often do you update the averages for this calculation?” If you are calculating this outside of business intelligence (BI) software (i.e. Looker), then I suggest that you update the averages as frequently as you can, since the accuracy of expenses has a big impact on this calculation.

Method 2

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.

This calculation is suitable for situations where the figures are likely to remain relatively flat year-over-year. The challenge with this calculation is when you need to factor in changes that happen across the customer lifetime — that is where a more complex method is needed, such as methods five and six.

Method 3

Method three first calculates Gross Profit which is Gross Revenue minus COGS (Cost of Goods Sold), and divides Gross Profit by the number of unique customers. This is the preferred method by sticky.io’s clients and the one we use within our platform today.

Although this is not my personal method of choice, I do like the simplicity of it. There's something to say for simplicity when calculating CLTV, but my biggest issue is that the only consideration for expenses is COGS. The argument in favor of this method using only COGS is that COGS is the only expense that can be very accurately estimated at any given point without involving accounting. Typically, customer acquisition costs, sales/marketing expenses and operating expenses have to be estimated on a frequent basis by accounting, and then used as assumptions until the next time those expenses are calculated.

Method 4

The fourth method divides the Recurring Average Order by churn ratio. This method is so simple that it leaves a lot of room for error. While it is my least favorite method, it is widely used. Another noteworthy point is that method four does not consider expenses, so they will need to be understood outside of the calculation and taken into account when using CLTV to make decisions.

Method 5

As you can see by the formula, this calculation gets a little more advanced. As I went through Colorado State’s MBA program, we used this and method six frequently to calculate CLTV, but this was the preferred formula. It remains my preferred CLTV calculation to this date. The formula leverages margin, retention rate, discount rate and acquisition cost. All of these ratios, except for discount rate, are commonly used in most businesses. If the discount rate metric is new to you, it’s actually a rather simple concept — it’s the rate of return used to discount future cash flows back to their present value.

Method 6

The most complex formula for calculating CLTV is method six. As with method five, this formula leverages discount rate, margin, and churn (the opposite of retention in method five), but leverages growth ratio. The growth ratio is the amount of increase over time as a percentage of its previous value. For example, a 5% growth rate means that the value is 105% of the value of the previous year. Again, for more information on discount ratio, please refer to method five.

As you can see, there are many ways to calculate CLTV. I’ve unmasked the formulas for each of these six popular methods, and it’s up to you to decide which formula you prefer. The critical takeaway is that if you are not calculating CLTV in your business, you should. Acquiring new customers is likely one of your business’s largest expenses. This makes it imperative that you realize your CLTV, identify customers that fall above and below that figure, and learn as a business what you need to do to retain those customers. This will not only increase your CLTV, but total revenue to your company’s bottom line.

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