Understanding Customer Lifetime Value & Why It Is Important
How can you tell if your company is succeeding? Usually by looking at operating metrics like sales, revenues, and profit margin and then comparing these figures to your annual projections, historical numbers, or competitors in the same industry. But what metrics can you use to determine your company’s success in the long term? One of the most useful calculations is the company’s customer lifetime value or CLV. As the term implies, the customer lifetime value represents the total amount of money that a particular customer is likely to spend over his or her lifetime. It’s easy to see how CLV can be used to help predict future revenues for a company.
How To Compute Customer Lifetime Value
There is a myriad of ways to calculate customer lifetime value, but the simplest one involves just three components: the average order value, the purchase frequency, and the customer lifetime length.
The average order value represents how much money the typical customer spends when he or she is placing an order. The quickest way to determine this figure is to take the total revenues for a given time period (i.e., per week, per month, per quarter, per year) and divide it by the number of orders in that time period.
The purchase frequency represents how often a typical customer makes a purchase with your company. This can be computed by taking the total number of orders in a given time period and dividing it by the total number of customers in that time period.
The customer lifetime length represents the length of the time period during which the typical customer makes purchases from your company. Unless a company possesses several years’ worth of sales data, this value can be difficult to calculate. For new businesses, the assumed customer lifetime length is usually about three years.
When you multiply these three metrics together, you get the customer lifetime value.
Here’s an example: Let’s say that you own a candy store and you want to determine the CLV of your business. When you scour your purchase records, you discover that the average order value is $12.50 and that each customer places 2.5 orders on average each month. You would multiply $12.50 and 2.5 to get $31.25, which is the average customer value per month. If you assume a customer lifetime length of three years, you would then multiply $31.25 by 36 (the number of months in three years) to get a customer lifetime value of $1,125.