What is Customer Lifetime Value Analysis?
Customer Lifetime Value (CLV), or lifetime customer value, is the estimate of the total gross profit from all engagements you have with your customer over their lifetime. Note it is NOT the total revenues, a common mistake (due to the fact that this metric was innovated by SaaS companies, where revenue and gross profit are almost the same thing.)
Why is CLV or LTV important?
Lifetime value is a cost of growth metric used to evaluate the efficiency of your growth strategy. It is compared to to create an efficiency metric. If LTV/CAC < 1, you lose money for every customer you add. This is the most popular view on growth efficiency today, yet it is still largely unused outside of high-tech industries.
Modeling your CLV (with CAC) will also answer questions like:
- Should I invest more in sales or operations?
- Who is my most profitable customer segment?
- Are my loss-leaders really effective, or should I raise the price?
- How much do I need to invest in sales to get to $XXX profit?
How do you calculate Customer Lifetime Value?
CLV cannot be computed off financial statements, so you need to perform a customer lifetime value analysis for your business. The exact method you should use depends on your customer lifecycle. We’ll look at three simple examples here.
Calculate CLV for a one-time purchase
Let’s suppose you rent bicycles to tourists in the San Francisco warf. For the most part your customer will visit once, rent a bike, then never return. In this case, your CLV is the price for an average bike rental ($25) minus any damage or maintenance ($3)
CLV = Avg. price – Avg Cost = $25 – 3 = $22
Calculating CLV for repeat purchases
Most entrepreneurs have repeat customers, or regulars, that make up most of their revenue. For these customers, you need Customer Lifetime Value Analysis to understand the customer lifecycle.
MRR churn CLV
Software as a service is blessed by monthly or annual recurring revenue pricing structures. “Box-a-month” businesses like Dollar Shave Club and other monthly membership organizations have similar business models. For these businesses, CLV is defined by the churn rate. In particular, the inverse of the churn rate is an excellent predictor of customer lifetime.
Let’s suppose you own a cross-fit gym that charges $140/mo, with the average customer requiring $70/mo in group class costs. You churn through 5% of your members per month.
CLV = (Avg. Price – Avg. Cost) / churn rate = ($140 – 70) / 5% = $1400
Negative exponential CLV cycle
Many businesses experience a progressive customer decay as a cohort of new customers outgrow or leave the brand. That appears as a negative exponential CLV growth cycle depicted in the graphic. These businesses include most consumer-facing products, food & beverage, clothing/fashion, retail, etc. To map out your CLV cycle, you need to perform a cohort-based statistical regression analysis. This CLV analysis is very robust and excellent for forecasting.
Bell-curve CLV cycle
The most complex CLV analysis to perform is on a bell-curve customer lifetime. This occurs when customer engagements begin small and grow over time, as with services businesses, luxury brands, medical devices, pharmaceuticals and vertically-integrated offerings. To model a bell-curve CLV, the upsell cycle and repeat rate must be statistically analyzed and projected using a combination of factors (upsell rate, churn, product price-points, upsell costs, and product costs.)
Although this is the most difficult CLV to analyze, it is also potentially the most profitable business model.
What should my CLV be?
This depends on your customer acquisition cost (CAC.) An ideal ratio of CLV/CAC is 3:1, but anything over 1:1 is at least indicates you’re gaining more profit from customers than it costs you to add them.
When does CLV analysis fail?
CLV is a time-agnostic measure. So if your customer lifetime is, in fact, your customer’s entire lifetime (e.g. 80 years) your ROI will be too slow to keep up with inflation. This is where a complete cost of growth analysis is superior, as it plots both CAC and CLV across time to understand the growth cycle’s internal rate of return (IRR.) (See our page on Business Growth Analysis)
A rigorous customer lifetime value analysis will yield useful insights as you grow your business, and provide your team data to make smarter decisions. If you’re planning on growing your business, consider a CLV or complete cost of growth analysis to help you make better decisions.
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