Customer Lifetime Value : Why It’s Important to Your Small Business

November 7, 2016

Business Accumen Customer lifetime value (abbreviated CLV or LTV) is an important metric for any business. This number helps determine how much a business can afford to “buy” customers. CLV, put simply, is the total dollar value of a customer. It’s the combined present value and future cash flows from any given customer relationship.

Lifetime value helps determine the upper limit your business should spend on advertising. Businesses with higher CLV can spend more on their marketing up front because initial spending will be recuperated in the future.

 

A Simple Way to Calculate Customer Lifetime Value

 

The simplest way to calculate a customer’s lifetime value is to add all of a customer’s purchases. However, for predictive value many businesses will rely on averages.

To figure the average customer’s lifetime value, you can multiply the average sale by the average number of transactions per customer in a year. Multiply this total by the average retention rate of customers (in years).

Here’s what the equation looks like:

 

(Average Sale in $) * (Average transactions in a year)*(Average period of retention in years)=Customer Lifetime Value

 

Let’s use Cindy’s Candy Shoppe as an example. Cindy calculated that the average person buys $10 worth of candy each time they visit her store. The same person, she figured, visits the store twice each month and keeps coming back for three years.

Cindy’s equation would look something like this:

 

($10)*(24)*(3)=$720

 

She would know that each customer would have a lifetime value of $720 in this example, or that each customer is worth $240 every year.

Now that Cindy has this information, she can determine how much she should spend to acquire new customers.

This is a simplified example, and there are many more complex equations businesses can use to get a more accurate CLV. Check out the Kissmetrics Infographic below for a more detailed explanation of how companies average their CLV.

 

Calculating customer lifetime value

 

 

How CLV Impacts Marketing Budget Decisions

 

Once businesses know a customer’s lifetime worth, they’ll want to know how much to spend acquiring each new customer.

Customer acquisition costs (CAC) are found by determining total acquisition costs—what was spent to acquire new customers—and dividing that by the total number of new customers in a given time period.

 

CAC= (Total spent acquiring customers)/(Total number of new customers)

 

If Cindy spends $2,000 a year to acquire new customers, and last year she acquired 4,000 new customers, her customer acquisition costs are $0.50 per customer. This would be great, as it would mean that for the $0.50 spend, Cindy would gain a customer worth $240.

Essentially, Cindy is buying $240 of revenue for $0.50. Way to go Cindy!

There are two types of acquisition costs that businesses can utilize effectively, which businesses will want to consider when making budget decisions.

 

Allowable acquisition cost:

This is a short-term strategy where businesses will calculate and spend only the amount per customer that does not result in an initial loss. Acquisition costs are a bit more complicated because they also account for the expenses incurred during each customer transaction and maintaining a set profit margin.

Click here for more information on calculating allowable acquisition costs.

 

Investment acquisition cost:

An investment acquisition is an amount businesses spend on marketing that results in initial and subsequent losses. However, customers with high lifetime values will eventually cover this loss, bringing gains to a business.

 

Of course, this strategy only works when businesses have enough cash flow to cover the initial investment—but it’s just that, an investment that involves some amount of risk. However, with careful planning, businesses can reduce their risk and reap even greater financial rewards.

 

CLV and Knowing When to Discount

 

Customer lifetime value calculations are also help businesses determine appropriate discounts without severely affecting cash flow, which would result in difficult losses.

Businesses should not discount their product or services more than their current cash flow and expenses can support, but knowing a customer’s lifetime value means they can discount products or services initially, if customers will bring future profits.

Using Cindy’s example, we know for sure she would not want to spend or discount more than $240 in a year to acquire a new candy customer. But of course, in reality we know she should spend a lot less than this. As a general rule, the ratio of CLV to CAC should be 3:1. Cindy would not want to spend more than $80 a year acquiring any customer.

If your business frequently calculates the customer lifetime value, you can know which marketing methods are working. With a constant goal of improving lifetime value, businesses can ensure their growth.

 

Adcart is One Way to Improve Value

 

Knowing a customer’s lifetime value and the cost of acquisition can help any business devise a reasonable and effective marketing budget. Even basic estimates and simple equations can serve as great guidelines for your spending.

Of course, the more detailed the numbers and the better the averages, the stronger your predictions when determining how much you can spend to “buy” customers.

Adcart offers a cost-effective marketing solution that has helped many businesses increase the lifetime value of their customers. If you are interested in a customized register tape advertising program, please contact us here for a free consultation.