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The Formula for Calculating Customer Lifetime Value

Customer lifetime value (CLTV) is one of the most important metrics for subscription ecommerce businesses. Using these formulas can help improve customer acquisition and revenue generation.

methods to help ecommerce merchants to calculate cltv

Customer lifetime value (CLTV) is the projected revenue that a customer will generate during their lifetime. As the ecommerce industry pushes toward subscription business models, CLTV becomes an essential metric. With this insight, merchants can better understand how to enhance customer experience in order to lower acquisition costs and improve churn rates. Making these data-driven decisions can help transform all levels of thinking in your organization. We’re answering the question that frequently comes up — “How do you calculate customer lifetime value?”

Calculating customer lifetime value can help online businesses succeed with subscription commerce. CLTV is a performance indicator that should be on your shortlist of key metrics and a core focus to help improve overall recurring revenue growth. There are several ways to learn how to calculate CLTV and we are providing a few examples below. For additional insight in increasing customer retention, be sure to check out our post on the science of customer emotions, where we outline 10 ways to build stronger emotional bonds with customers.

Importance of Customer Lifetime Value

The power of calculating customer lifetime 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 efforts 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 the questions surrounding CLTV calculations are so common. For one, the cost and effort involved in acquiring customers are high. Recent changes in privacy laws ultimately limit how much information merchants can collect about a customer’s journey from acquisition through retention. As a result, ecommerce businesses are faced with the challenge of reducing acquisition costs and limiting churn rates. Keep in mind:

  • It costs five times more to attract new customers than to keep existing customers
  • Increasing customer retention rates by 5% increases 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.

CLTV is arguably the most important metric for subscription business, 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 touch points during the customer journey. That activity is healthy for any business.

Find various methods of calculating customer lifetime value (CLTV)

6 Popular Methods to Calculate CLTV

In these six methods for calculating customer lifetime value, you’ll notice that all but one (method 4) take some form of expenses into consideration. Some people argue that a CLTV formula should account for customer acquisition costs, sales/marketing expenses, operating expenses and COGS (Cost of Goods Sold). In looking at a CLTV number, it may be beneficial to know the value customers bring to the bottom line.

However, there are 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. 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.

Importance for calculating CLTV for subscription ecommerce businesses

CLTV Formulas

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 are: “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 the suggestion is 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 customers clients and the one we use within our platform today.

This method may or may not be beneficial for you, but it’s a simplified process. The caveat is that this CLTV formula only considers expenses related to 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’s a less than favored 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. Some MBA programs use this method and method six frequently to calculate CLTV. It remains the preferred CLTV calculation among many professionals and instructors. 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. We’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.

the customer lifetime value model helps ecommerce businesses identify winning strategy to boost recurring revenue

The Takeaway for Calculating CLTV

Building a stronger subscription commerce business requires leveraging data to help scale efforts more efficiently. Businesses should focus on measuring performance by calculating CLTV at least on a quarterly basis. And as new tech emerges to help merchants succeed with subscription models, the demand for robust systems that easily capture this data is in high demand.  

Using personalized reporting dashboards can help ecommerce subscription businesses define unique strategies and capitalize on customer journeys that work. sticky.io is a subscription commerce platform that can help elevate the way ecommerce business owners harness data and improve processes for enhancing customer experience at every level. By focusing on building long-lasting customer relationships, you can ultimately boost CLTV for long-term revenue growth.  

See how sticky.io helps extend customer lifetime value and increase customer loyalty. Request a demo to learn more.