What is Customer Lifetime Value?

Introduction to Customer Lifetime Value

Definition of Customer Lifetime Value (CLV)

Customer Lifetime Value (CLV) is a metric that estimates the total value (often revenue) a company can expect from a single customer throughout their entire relationship, ie “lifetime.” It considers purchase frequency, average order value, and retention rate, providing a full view of the value of the customer base and for every given customer.

Overview of Its Importance in E-commerce

In e-commerce, CLV is one of the crucial KPIs that must be understood to make informed and strategic decisions. When understood fully, measured correctly, and used in the right way, it can help businesses tailor their marketing efforts, optimize customer acquisition costs, and understand what customers are most crucial to invest in retaining. By identifying and nurturing high CLV segments, companies can enhance their growth, ensuring sustainable success in a competitive market.

Customer Lifetime Value Models

Historic LTV

Historic LTV focuses on past customer behavior to calculate the total value they have brought to the business. It’s based on actual transactions and offers a straightforward way to understand customer value but can miss future potential growth or changes in customer behavior.

Predictive LTV

Predictive LTV uses data modeling to estimate future customer value. It can incorporate various factors, including purchasing patterns, order data and engagement metrics, to forecast future behavior. This model helps businesses estimate the result of their tactics and strategies, offering a proactive approach to maximizing customer value.

The risk with Historical and Predictive LTV models

The general risk with looking only at historical or predictive LTV models is that you assume that historical buying patterns will tell you much about future buying behavior. And that is true; it often does, but it is generally just the best guess. If big changes accrue, such as with your brand, assortment, pricing strategy, competition, and more, then you must assume that they will affect the true LTV of your customer base.

The best way to mitigate the risk of betting too much on future LTV patterns being the same as they’ve been is to work with other customer data to validate/question your assumptions regularly. As long as you do that, you will understand how much your LTV models tell you about the future and how much is missed.

Customer Lifetime Value Formula

The Customer Lifetime Value (CLV) formula estimates the total revenue a business can expect from a customer over their relationship. It is calculated as follows:

CLV=(Average Purchase Value)×(Purchase Frequency)×(Customer Lifespan)

• Average Purchase Value: The average amount spent by a customer per transaction.
• Purchase Frequency: The average number of purchases a customer makes within a specific period.
• Customer Lifespan: The average duration a customer continues to purchase from the business.

By analyzing these components, companies can identify profitable customers, tailor marketing strategies, and optimize acquisition efforts, focusing on long-term profitability. This detailed understanding allows businesses to allocate resources more effectively and improve customer retention.

Customer Lifetime Value Metrics

To fully leverage CLV, it's essential to understand its relationship with other key metrics and the associated risks:

Customer Acquisition Cost (CAC)

This measures the average expense of acquiring a new customer. The relationship between CLV and CAC, the so-called CAC:LTV ratio, is crucial, as it indicates the balance between the customer's value and the cost to acquire them. However, as often done, assuming a steady CLV for all customers can lead to significant risks:

Acquire the wrong type of customers

With a set CAC:LTV ratio, marketers are incentivized to acquire lower CAC customers in the short term. However, without an efficient Future LTV Prediction Model, the risk of acquiring low LTV customers is significant for low CAC customers.

• Overpaying: When assuming all customers will have the same CLV, businesses might overspend on acquiring customers whose future CLV is not high enough to justify the cost.
• Underinvesting: Conversely, undervaluing potential high-CLV customers can result in missed opportunities for growth, as insufficient investment may fail to attract or retain them.

Churn Rate

This metric shows the percentage of customers who stop purchasing within a given period. A lower churn rate enhances CLV, indicating better customer retention. Therefore, it is important to work on anti-churn activities to constantly improve CLV.

Contribution Margin

This reflects the profit from sales after deducting the cost of goods sold, returns, and fulfillment costs. Understanding each customer's profitability, not just revenue, is vital, and it helps identify the true high-value customers who contribute significantly to the bottom line.

The connection between these metrics helps businesses make informed decisions about marketing spend, customer retention strategies, and overall profitability, ensuring a sustainable approach to growth. Recognizing and addressing the variability in CLV among different customer segments is crucial for maximizing returns on customer acquisition investments.

Customer Lifetime Value Example

To illustrate the Customer Lifetime Value (CLV) concept, let’s walk through a practical example.

Example Scenario:

Imagine an online fashion retailer that wants to calculate the CLV of its average customer.

1. Average Purchase Value (APV): The retailer determines that the average customer spends $50 per transaction.
2. Purchase Frequency (PF): On average, a customer makes four yearly purchases.
3. Customer Lifespan (CL): The typical customer stays with the retailer for five years.

Using the CLV formula:

CLV=(APV)×(PF)×(CL)

CLV=$50×4×5

CLV=$1,000

So, the average CLV for a customer of this retailer is $1,000.

Additional Insights:

• Customer Acquisition Cost (CAC): If the retailer spends $200 to acquire a customer, the CLV-to-CAC ratio is:

CLV-to-CAC Ratio=CLV/CAC

CLV-to-CAC Ratio=1000/200
CLV-to-CAC Ratio=5

A 5:1 ratio indicates a healthy return on investment, as the customer's lifetime value is five times the acquisition cost.

Risks and Considerations:

• Segment Variability: Not all customers will have the same CLV. High-value customers may spend more frequently or have a longer lifespan, while others may have a lower CLV.
• Discount and Return Behavior: Customers who frequently use discount codes or return items can distort CLV calculations. These behaviors should be factored in to avoid overestimating customer value.

This example highlights the importance of accurately calculating and segmenting CLV to make informed decisions about marketing investments and customer retention strategies. By understanding the detailed nuances of CLV, businesses can better allocate resources and drive sustainable growth.

Customer Lifetime Value Importance

Why CLV is Crucial for Business Growth

Customer Lifetime Value (CLV) is a vital metric for businesses aiming for sustainable growth. It provides insights into the long-term value of customers, helping companies:

• Optimize Marketing Spend: By understanding the potential value of different customer segments, businesses can allocate their marketing budgets more effectively, focusing on acquiring and retaining high-value customers.
• Enhance Customer Retention: CLV highlights the importance of retaining existing customers. Strategies focused on improving customer experience and loyalty can lead to higher retention rates and increased profitability.
• Improve Product and Service Offerings: By analyzing CLV, businesses can identify which products or services generate the most value, allowing for better inventory management and product development.
• Increase Profitability: Focusing on customers with higher CLV ensures that resources are invested in the most profitable segments, boosting overall business profitability.

Misconceptions About Uniform CLV Application Across Customers

A common misconception is applying the same CLV across all customers, which can lead to significant issues:

• Overpaying for Low-Value Customers: Assuming a uniform CLV can result in overspending on customer acquisition for segments that do not justify the cost. This misallocation of resources can harm profitability.
• Underinvesting in High-Value Customers: Conversely, not recognizing the higher potential value of certain segments can lead to underinvestment in acquiring and retaining these customers. This missed opportunity can stunt business growth.

Ignoring Customer Behavior Variations: Uniform CLV application overlooks variations in customer behavior, such as purchase frequency, average order value, and lifespan. This can skew strategic decisions and lead to ineffective marketing and retention strategies.

The Risk with Not Using Profit as the “Value” in Customer Lifetime Value

Relying solely on revenue to calculate CLV without considering profitability can mislead businesses into valuing customers who frequently use discounts or return products, ultimately draining resources. Here’s a comparison example to illustrate this point:

Example Scenario:

Consider three different customers with the following revenue-based CLV profiles:

Based on revenue alone, Customer C appears to be the most valuable. However, let's consider profitability by factoring in discount usage, return rates, and gross margins:

Explanation:

Customer A: Despite having the lowest revenue-based CLV, Customer A has low discount usage and return rates, resulting in a high gross margin. This makes them the most profitable customer with a profit-based CLV of $945.

Customer B: Although Customer B has a relatively high revenue-based CLV, their high discount usage and medium return rate reduce their profitability significantly, resulting in a profit-based CLV of only $420.

Customer C: While Customer C has the highest revenue-based CLV, their medium discount usage and high return rate lower their gross margin, making their profit-based CLV $672, less than Customer A.

This example highlights the importance of considering profitability when calculating CLV. Focusing solely on revenue can lead businesses to overvalue customers who are less profitable due to high discount usage and return rates. By incorporating profitability into the CLV calculation, businesses can better identify and invest in truly valuable customers.

Understanding CLV's nuances and applying them accurately across different customer segments is crucial for maximizing the return on investment and driving sustainable business growth.

Tips to Increase Customer LTV

Tip 1: Get Control of Your Profit LTV

Prioritizing profitable customers over high-revenue ones is crucial for driving true incremental growth over time. Using profit-based CLV helps identify customers who contribute positively to the bottom line, rather than those who generate high revenue but with high costs. Implementing this approach ensures that marketing and retention efforts are directed towards segments that maximize long-term profitability.

Everyone knows that loyal, high return-rate, coupon hunters is not valuable, but yet they might be the customers with CLV, if you base the model on order intake, ie gross sales. But even if you base it on net sales, you still might have the coupon hunters shopping many small orders, that all have a negative contribution margin.

So, with that in mind, use a profit-based CLV model.

Tip 2: Understand What Distinguishes High CLV Customers and Double Down There

To improve the acquisition and lifetime value of new customers, it’s essential to understand the characteristics and behaviors that distinguish high CLV customers. By analyzing these traits, businesses can refine their marketing strategies to attract similar high-value customers.

Common similarities among high value CLV customers are most often found in the first order’s data, than traffic source etc. Look for AOV, Gross Margin (full price vs discount), categories, what country they come from, when in the season they buy etc.

With those insights, it’s easy as a digital marketer to start tailoring marketing messages, offers, and channels to better resonate with this segment, thereby increasing the overall CLV of newly acquired customers.

Most often, the buying and product desginers get a lot of ideas for future prioritzation of the inventory when getting introduced to good CLV data. And when they act on it, you eventually get a flying wheel of more high value customers steering assortment to cater to even more high value customers.

Tip 3: Retention Strategies

It’s easy to get blind when working on improving the CLV by optimizing the customer acquisition when in fact, increasing the value of your current customer base might be more effective depending on your level.

Some retention strategies that are the absolute basics to just make sure that you’ve done when trying to improve your LTV are:

• Segmenting Customers: If you are not experimenting with segmenting, get started now! Start easy; based on buying behavior, CLV, and other relevant factors to tailor retention efforts.
• Personalized Communication: Use personalized marketing to engage customers and foster loyalty. It has been possible for long, AI makes it even easier. And remember; everything doesn’t need to be automated in the beginning while testing.
• Customer Support: Invest in customer support to address issues promptly and improve satisfaction. It’s so obvious, but yet so often overlooked, good customer support is increasing loyalty and AOV

Tip 4: Don’t Trust One CLV Metric

Relying on a single CLV metric or a model based solely on historical data can be misleading, especially when significant parts of your business or market are changing. It’s important to:

• Consider Profitability: Even on the first purchase, focus on customers who are profitable.
• Adapt to Changes: Ensure that CLV models are flexible and can adapt to changes in customer behavior, market conditions, and business strategies.
• Use Multiple Metrics: Combine various metrics and data points to get a comprehensive view of customer value.

By diversifying the metrics and models used to calculate CLV, businesses can make more informed decisions and better navigate changing market dynamics.

Summary and Key Takeaways about Customer Lifetime Value

1. Definition and Importance of CLV: Customer Lifetime Value (CLV) estimates the total revenue a business can expect from a customer over their entire relationship, considering purchase frequency, average order value, and customer lifespan. Whether you measure it or not, it is one of the defining numbers of every business.
2. Profit-Based CLV Over Revenue-Based CLV: Relying solely on revenue to calculate CLV is misleading. A profit-based approach gives you valuable insights to guide you towards genuinely profitable customers, avoid the pitfalls of high discount usage and return rates, and drive true incremental growth over time.
3. CLV-Related KPIs to Know: Key performance indicators such as Customer Acquisition Cost (CAC), churn rate, and gross margin are essential for refining growth and retention strategies. Just as CLV should not be seen as flat across all customers, these KPIs must be adapted to reflect the true value of different customer segments. A high CLV can justify a higher CAC and vice versa, ensuring a balanced and profitable approach.
4. Basics and Experimentation: Ensure that the fundamental strategies for improving CLV are in place, such as customer segmentation, personalized communication, and loyalty programs. From this solid foundation, continuously experiment and iterate to find new ways to enhance customer retention and value.
5. Critical and Analytical Mindset: Apply a critical and analytical mindset, as always. Never rely on a single KPI. Instead, understand the cause-and-effect relationships between various metrics. Analyzing multiple data points and adapting to changes will lead to more informed decisions and accurate customer value assessments.