In the ever-changing marketing landscape, many businesses – particularly B2B businesses – are increasing their emphasis on Customer Lifetime Value (CLV) as a key measurement to plan their marketing strategy.
So what is CLV and why is it important?
Customer Acquisition Cost
Well, first let’s look at a metric that has been used for many years when planning a marketing strategy and budget – Customer Acquisition Cost (CAC). This is simply the cost of acquiring a new customer.
Add up all the costs associated with gaining new business – advertising, marketing material, salaries of salespeople and other staff, overheads and so on, and then divide that figure by the number of new customers you gain. Look at both figures over a set period – usually a year. This then gives a figure which tells you how much you have to spend to gain a typical customer.
This CAC figure can be used in budget setting – if your CAC is too high compared with the money you are making on your products and services, you may need to trim your marketing budget. If your CAC is low, you may be able to increase your marketing budget and gain more revenue overall.
Whilst CAC is a useful metric, it does not tell the whole story, and limits you in a number of ways.
Most B2B businesses have repeat customers, and many will have customers that stay loyal and buy from you again and again. The cost of acquiring that customer happens at the beginning – so repeat sales cost less. According to the Harvard Business Review; Acquiring a new customer is anywhere from five to 25 times more expensive than retaining an existing one. It is also far easier to sell to an existing customer – according to the book Marketing Metrics, businesses have a 60 to 70% chance of selling to an existing customer while the probability of selling to a new prospect is only 5% to 20%. If you just use CAC you are not factoring in the total sales over time, as it ignores the repeat revenue you might gain from customers in the future.
Customer Lifetime Value
One issue with just using CAC alone is that you may not spend enough to acquire a customer that could be worth a great deal in the long run. If you were to spend more, you may acquire that customer, and the extra costs would be outweighed by the profits from that loyal customer over time. The initial extra spending would be an investment in future revenue.
This is where Customer Lifetime Value is useful – it takes into account all the likely sales an average customer will make over their lifetime. Amongst other benefits, this will allow you to make a better judgement as to how much you can afford to spend initially in order to gain that customer’s lifetime business.
Another benefit: if you compare CLV to CAC it will give you an idea of how long it takes to recoup the costs of the initial acquisition.
You can also look at CLV for different types/segments of customers. You may find some groups of customers buy from you many times over the course of their business relationship with your company and provide a high CLV, whereas others buy just the one time, or rarely after that – giving you a low CLV.
Analysing why this second group doesn’t repeat buy may allow you to develop support and sales techniques that result in more repeat sales, a higher CLV and greater revenue for the business. But you might also decide to target those groups that generate higher CLV and focus less on those that don’t.
Because CLV is effectively predicting the future, there are a number of different methods used to calculate it, with no accepted, standard definition. However, the two core factors are purchase frequency and average order value. It helps if you are an established business with many years of trading, as you can look at historical data to provide some real figures.
In a simple form the formula would be:
Purchase Frequency x Average Order Value x Average Customer Lifespan
For example, check out this useful article by HubSpot.
However, this is purely based on revenue and does not factor in the acquisition costs or the costs of retention. So you might choose to use:
Purchase Frequency x Average Order Value x Average Customer Lifespan – (Acquisition Cost + Retention Cost)
Take a look at this article from ClickZ for more on this version of the calculation.
There are additional elements you could include, like the margin on each sale, the version you decide to use depends on what you are using CLV for and how you view it.
Another closely related factor is the Churn Rate – the percentage of customers who end their relationship with a company in a given period. Reducing your churn rate will increase the CLV. This is particularly relevant to SaaS businesses. You can find a version of the CLV calculation that uses Churn Rate in this article from ChartMogul. And if you think that version might be useful to you, then they offer a free, no sign-up required Ultimate Guide to SaaS Customer Lifetime Value.
When CLV doesn’t help
Whilst CLV is a great way to value your customers, there are a number of situations in which it might not be a useful metric.
- If you have a small number of varied customers, an average CLV is unlikely to be very useful. You may prefer to look at each customer and take a view of their value to you.
- A newly established business will have no long-term customers, so CLV would have to be a best guess and therefore not reliable enough to base key decisions on.
- If the majority of your customers make one-off purchases, it will be simpler for you to uses CAC instead.
A business-wide approach
With its emphasis on the long-term relationship, CLV is a metric that encourages a different culture – a different approach. Instead of going for quantity – lots of short-term sales – it encourages a longer-term, potentially more stable approach.
CAC may encourage a culture of the quick win – which may result in an unhappy customer because they didn’t get exactly what they wanted or were oversold something. That customer will not repeat buy and their business may be lost forever.
CLV implies an approach that places an emphasis on four stages:
- Acquire customer
- Build customer value
- Retain Customer
- Build Advocacy
The unseen benefits of a long-term approach
There are additional benefits to a long-term relationship with a customer over and above the repeat sales. Today, buyers get their advice and recommendation from peers and other buyers through social media, business forums, blogs and other channels. So new prospects will be asking your customers what they think, how they rate the product and the service. If you don’t have satisfied customers, you will be losing sales.
If you can go further and turn a loyal customer into an advocate, then you will see some real added value. A customer advocating your business is far more effective than a salesperson – their advice is considered independent, impartial, and so carries more weight, more authority, with other buyers. They have real experience of using the product or service and therefore can give more useful advice and recommendations.
These last two benefits of loyal, long-term customers are hard to measure – so they are not traditionally part of calculating CLV, but they are a factor and will add more value, and they certainly add weight to the validity of CLV and a long-term relationship approach to your customers.