CLV calculation can be daunting thought. Expensive software can calculate CLV for you. Fortunately, you do not have to be a data scientist. Or mathematician to calculate a basic estimate. For most organisations, a rudimentary calculation will suffice. Just as well given the price of some software packages.
The secret is data. The more data you gather about your customers buying patterns. The more accurate your estimation will be.
Basic three-part CLV estimation process.
A typical customer revenue estimate can be calculated using this method.
First decide if you need to break customers into specific segment. Assuming you do then average the revenues of several customers within each segment.
If you do not need to segment. Choose several customers from your entire market.
Let us assume you own a sandwich shop. A customer purchases around £8 (sandwich, drink and piece of fruit).
The Revenue per purchase chart below. Illustrates fictional purchases from six customers plus the average.
The bigger the customer sample the more accurate your results will be. Use historical or current sales data to acquire accurate averages.
Estimate the frequency of the customer’s purchases.
Purchase cycles (time frame) vary according to industry. For example, on average people replace their car every three to five years. Depending on the customer segment. Let us assume our sandwich shop is located in the business district. Office workers tend work Monday to Friday. During the week customers visit three times as illuminated in the chart below.
Calculate the revenue per customer over a certain time period.
Multiply the revenue per purchase by purchase frequency:
Revenue per purchase multiplied by Frequency of purchase equals Revenue over a certain time period
Apply the above formula to the sandwich shop example above.
£8 (purchase) multiplied by three times (a week) equals £24 per week (customer spend).
The chart below shows the average for six customers.
Calculate the CLV
The easiest way to gauge the customer lifetime value. Is to determine how long the average customer does business with you. Then calculate how much revenue is generated for that cycle.
Applied to the sandwich shop example.
£8 (purchases) multiplied by three times a week multiplied by fifty-two weeks (year) multiplied by twenty years equals £24,960 customer lifetime revenue (CLR).
£24,960 does not factor costs. For example employees to make and sell the sandwich, rent, utilities (light, heat, gas).
To obtain a more realistic customer lifetime value figure. We need to factor in profit margin. The percentage of revenue left after costs are deducted.
Revenue per purchase multiplied by Frequency of purchase multiplied by Customer lifetime multiplied by Profit margin equals CLV.
Applied to the sandwich shop. Let us assume the profit margin is twenty one percent. The CLV becomes £5,242.
Key Learning Point
The more realistic your profit margin reckoning is. The more accurate your customer lifetime value calculation.
Two additional values can strengthen your CLV estimate.
Customer retention rate (the percentage of the customers who repurchase over a period).
For example, if 700 out of 1,000 office workers remain customers for a year the retention rate is 70%. If you have data for several years, then your calculation will be more accurate.
Discount rate is used to calculate the present value of future revenues. Think of it this way. Sandwich shop revenues 2020 are likely to be far less than 2019 because of COVID 19.
If you were the sandwich shop owner would you rather have 2019 revenue now or in ten years.
The profits can be thought of in the same way. Future profits are discounted to account for their current value.
If the lifetime of a customer is short (weeks, months, or a year). Then the discount rate will not have as much of an effect as if the lifetime lasts years or decades.
If retention rate and discount rate are accounted for. Your CLV calculation is likely to be more accurate.
Revenue per purchase multiplied by Frequency of purchase multiplied by Customer lifetime multiplied by Profit margin multiplied by (retention rate) divided by (1 + discount rate minus retention rate) equals CLV.
Applied to the previous example above. A retention rate of seventy-five percent and a discount rate of ten percent the CLV is £11,233.
Retention rate is always lower than one hundred percent this reduces the CLV figure. Considering the value of future money using the rate of discount. The result is higher but CLV figure is more realistic.
Key Learning Point
The accuracy of your CLV figure depends upon the quality of your data. Plus the number of variables to be evaluated. However, even if your results are less than perfect. You can still gauge the value of different customer segments.
Identifying profitable customers
Calculating the value of different customer segments. Empowers you to find your most lucrative customers.
Be warned differences in lifetime value between segments can vary considerably. However, acquiring customers’ loyalty. Might prove expensive but in the long run, they will generate more revenue.
Applying the sandwich shop example. Frequent customers may generate about £3,000 more. Than the infrequent customers over their lifetime.
A £500 marketing investment to acquire more frequent customers would pay off. But you could only know that if you did the calculations above.