Customer lifetime value

What customer lifetime value says

Customer lifetime value, short CLV, is the profit a customer brings over the whole duration of the relationship. It shifts the view from the single order to the customer. An order with a thin margin can be valuable if it is the start of a long relationship. A large order with a good margin is worth little if the customer never returns.

How it is calculated

The simplified formula is average contribution margin per order times number of orders per year times number of years. A customer with 30 euros of contribution margin, two orders a year and four years of tenure brings 240 euros. That figure is the amount available for acquiring and looking after this customer.

The three factors differ in how hard they are to estimate. The contribution margin can be taken from the accounts and is solid. The order frequency is calculable for existing regular customers and an assumption for new ones. The tenure is the most uncertain value of all, because it comes from customers who have been around a long time and need not apply to new ones.

Why it steers advertising

CLV determines how much a new customer may cost. Anyone who knows a customer brings 240 euros of contribution margin on average can spend 60 euros on acquisition and still have room. Anyone looking only at the first order sees perhaps 30 euros and spends nothing. The difference between these two calculations decides whether a shop can grow.

At the same time CLV guards against a mistake many shops make: serving only the most profitable channels. A channel with small first orders can be valuable when its customers stay for a long time.

Which assumptions invalidate the calculation

• Too short a data basis: a shop that is two years old cannot know a five year tenure.
• One average over everything: the average of customers with one purchase and those with twenty describes nobody. Groups by first purchase month are more sensible.
• Returns forgotten: without returns the contribution margin is too high and CLV too optimistic.
• Future cost ignored: discounts, customer service and win back campaigns cost money and belong in the calculation.

Frequent questions

• Is CLV the same as customer value? Largely yes, both terms are used side by side.
• Do customers of a firm with high CLV see less advertising? They should, because acquisition cost has to stay within limits.
• What is the biggest benefit? Knowing what a customer may cost instead of guessing it.