Selling to current customers is almost always cheaper and easier. In fact, improving customer retention by just 5% can help increase profits by at least 25%.
But that’s only true if you know which customers to focus on.
Knowing what types of buyers tend to become the best outcomes for your business can help make better decisions about:
- brand voice,
- customer experience,
- product selection,
- and every other aspect of your business.
But figuring out how to make those choices isn’t always easy.
Luckily, there are methods for accurately measuring customer value that can have far-reaching benefits for your business.
To help you get started, let’s take a look at what customer lifetime value is, why measuring it is essential, and the different calculation approaches you can use.
What is Customer Lifetime Value (CLV)?
Customer lifetime value, also known as CLV (or LTV), is a method for measuring the amount each customer spends throughout their relationship with a business. It measures the time and the amount spent from the very first sale to the last time a customer buys.
Knowing how much a customer spends can be very valuable in situations where you need to figure out how much you can pay to acquire a customer, how much you can gain from adding various types of customers, and where to focus your efforts.
Even though there are a few variations on how the metric is calculated, the basic principle remains more or less the same.
Instead of looking at each purchase separately, you can use CLV calculations to see the bigger picture of how your customers operate, which is a more informed way to look at how your business generates revenue and find the best ways to optimize the process.
And for eCommerce companies, the ability to better forecast demand and understand audience behaviors is absolutely crucial.
Why is Measuring Lifetime Value Important?
There’s a reason why customer lifetime value has become such an integral part of running a successful eCommerce business. In fact, there are numerous reasons why measuring lifetime value is essential.
Let’s look at a few of these reasons below.
First off, CLV helps to plan marketing campaigns with more confidence. Without it, online stores would be largely in the dark about how much revenue they might expect from an acquired customer, which would make it impossible to control whether the campaigns are profitable or not.
With rising competition, customer acquisition costs on most paid channels have increased significantly, which has resulted in a situation where a single purchase might not always be enough to produce a satisfactory ROAS (Return on Ad Spend).
And that means that only companies that can accurately measure their customer value will be able to run successful campaigns and increase customer retention.
For instance, if you know that your customer will spend $500 over their lifetime with your company, you can allow yourself to spend much more to attract them, even spending more than they might spend on the initial purchase.
Using this approach also makes scaling your business much easier to manage.
When you know who you need to attract and what you can spend on getting them to your store, you can bid on paid advertising spots more aggressively, become more visible, and start accumulating a larger audience much faster.
However, for any of this to matter, you must be able to measure customer lifetime value correctly. And that isn’t always easy.
If you get the measurements wrong, you can end up spending way too much on your marketing, which can make it hard to recuperate the losses over time.
So, the accuracy of your calculations and the reliability of the numbers are absolutely vital, and you should continually monitor your sales and adjust the equation accordingly.
The good news is that there are multiple ways to look at customer lifetime value, which means you can get a complete picture of how much your audience will spend and gain more confidence when using that data in your decision-making process.
And eCommerce businesses that understand how to accurately calculate their customer value can reap massive benefits.
For instance, an online hair piece store called Super Hair Pieces have used the data about their customers to take a more personalized and value-based approach to increasing customer lifetime value.
By offering premium products at competitive prices, showcasing success stories, and using a rewards program to incentivize referrals and repeat business they have allowed the company to be more aggressive in its marketing and reach a broader audience while still remaining profitable.
But it all starts with having a way to accurately measure your customer value in the first place.
How to Measure Customer Value
When measuring customer value, there isn’t really a one-size-fits-all formula that can be applied to every situation. Instead, there are multiple ways to calculate how valuable a customer is over a given time period, each serving its purpose and allowing you to see a more comprehensive view of what you can expect.
With that in mind, let’s look at some of the most important calculations you should use and how to apply them in your business.
Calculate Customer Value
First and foremost, you’ll need to get a basic calculation of how much revenue an average customer brings for your company. Unlike customer lifetime value, customer value is used to determine how much revenue a customer generates over a given period.
This type of calculation can be useful when determining what kind of revenue you can expect in the upcoming six months or a year instead of the entire customer lifetime, which can sometimes be multiple years.
To start, figure out how much revenue each order generates. You can do that by multiplying your average order value and the purchase frequency in a time period. Which would look like this:
Average Order Value x Purchase Frequency = Customer Value
For instance, if you know that the average order value is $70 and the purchase frequency over a period is 2.5, your customer value for that period would be $175.
The big advantage of using customer value over customer lifetime value is its ability to provide you with deeper insights about different parts of the year. That can be useful when you need to forecast demand or make adjustments to your marketing strategy based on the type of revenue you can expect over that time.
Calculate Customer Lifetime Value
If customer value is a calculation used for periods of time, customer lifetime value measures the revenue that a customer generates over the entire relationship with your company.
It can be a bit more tricky to calculate, but the extra effort is well worth it when you consider how useful knowing this number can be when making crucial decisions regarding your business.
The biggest challenge when calculating the CLV is deciding at what point the customer becomes inactive. Each customer is unique, and even someone who’s been inactive for a while may still choose to purchase in the future.
Companies that have been in business for a long time can usually identify when the cutoff point won’t impact the accuracy of the results. For those who haven’t been around for very long, using a benchmark of about three years usually serves as a good starting point.
Once you decide what “lifetime” means for your business, the calculation becomes relatively straightforward. If you already know the customer value in a month, you can quickly turn that into a CLV calculation with just one additional step.
Take the number you got in the previous section, and multiply it by the average customer lifespan. That would look like this:
Customer Value x Customer Lifespan = Customer Lifetime Value
So, if your customer value per month was $175, and they stayed with you for three years, your customer lifetime value would be $525.
Since this is a complicated calculation with many variables, it will take time to come up with an accurate number. But once you do, it will help you make better decisions and maximize the available growth opportunities because you’ll know exactly how much you can expect to gain with every new customer.
Subtract Your Costs to Get Net Value
The biggest issue with the aforementioned customer value calculations is that they don’t always show the complete picture. More specifically, they don’t account for the expenses that each sale might come with, which can provide a skewed view of how much each sale actually generates.
That’s where a net value calculation can be so useful.
Using it, you can deduct the expenses associated with each sale, determining an accurate number of the pure profits you’re left with.
There are a few ways you could use this, but in the simplest form, you should multiply the lifetime value and the profit margin, coming up with the net profit after expenses have been deducted. It would look like this:
Customer Lifetime Value x Profit Margin = Net Customer Lifetime Value
With the help of this additional step, you can make better decisions about how much various aspects of your business can cost and what you are actually left with once you account for all the expenses.
Look at Your Audience Segments
The calculations we looked at above are essential, but they usually won’t provide you with the full picture of how valuable each customer group is for your business.
That’s why it makes sense to group your audience into segments and calculate the lifetime value based on that as well. By looking at different groups of buyers individually, you can adjust your strategies according to the group you’re targeting and ensure that your marketing model remains sustainable.
One of the easiest ways to group customers is by the amount they spend.
By setting up a tier-based system, you can start looking at each group’s lifetime value, determining how much they spend and which customer groups are the most worthwhile to pursue.
Sometimes, you may find that even though one group makes smaller individual purchases, they tend to buy more frequently and for a longer period, which could mean they are more valuable over the entire lifespan.
You should also look at which groups are the biggest, as you may find that even though one group is significantly more profitable than the others, it’s simply too small of a segment to become a central part of your marketing efforts.
Finally, using this type of segmentation when calculating customer value will provide you with insights into how to position your business.
Having a clear brand voice and messaging is essential if you want to stand out in a crowded marketplace, and catering to a specific segment or a price point are important parts of making that happen.
Measuring lifetime value is an essential tool when running an eCommerce business. But the number of calculations can be confusing for someone who hasn’t done it before.
Luckily, the four ways to measure customer value listed above should be more than enough to get a better picture of how much you can expect to earn from your customers.
- Customer Value = Average Order Value x Purchase Frequency
- Customer Lifetime Value = Customer Value x Customer Lifespan
- Net Customer Lifetime Value = Customer Lifetime Value x Profit Margin
- Value by Segments = Customer Value based on custom variables.
Using these four calculations, you can get a much more complete picture of how your typical buyers interact with your brand, which will help you make more informed and confident decisions regarding all aspects of your business.