The battle for market share is fierce and today’s consumers have more choices than ever. It’s critical that you understand your customer, and how they interact with your company and its products. Your customers aren’t just worth the amount of money they spend on your business today. They have future value if you’re able to retain them. Knowing your customer’s value “Customer Lifetime Value (CLTV) is key.
What is Customer Lifetime Value (CLTV)?
According to Wikipedia, the definition of Customer Lifetime Value is the “prediction of the net profit attributed to the entire future relationship with a customer.” Customer lifetime value can also be defined as “the monetary value of a customer relationship, based on the present value of the projected future cash flows from the customer relationship.”
Here at Shoptelligence, we view Customer Lifetime Value (CLTV) as the total revenue you can expect one customer to generate over the course of their relationship with your company. The longer a customer continues to purchase from you, the greater their lifetime value becomes.
Why Customer Lifetime Value (CLTV) is important
Customer acquisition is expensive but increasingly important. The Harvard Business Review supports this by stating that acquiring a new customer can cost anywhere from 5 to 25 times more than retaining an existing one. In addition, a study conducted by Bain & Company found that a 5% increase in customer retention can lead to an increase in profit between 25% to 95%. It’s critical that you identify and nurture your most valuable customers, those that interact with your products and company. By doing so, you gain more total revenue.
Ponder this: According to the Gartner Group, 80% of your future profits will come from just 20% of your existing customers. That means the revenue sources you’ve been trying to find are most likely inside the company versus outside, waiting to be nurtured and cultivated.
In addition, CLTV can help you make better business decisions that affect your entire organization. Sales, marketing, product development, customer support and more can all be influenced by the level of investment placed on current customer retention. But, how do you calculate this investment? How can a business know that the resources used to foster a consistent loyal customer is beneficial to the bottom line?
Measuring Customer Lifetime Value (CLTV)
The simplest customer lifetime value formula is the historic model. The CLTV is equal to the total value of each transaction multiplied by your average gross margin.
According to Statista in 2018 the average US consumer spends $518.43 on home furnishings annually while more affluent consumers spend on average $1098.00. For the purposes of the example let’s say they spend $1000.00.
The Home Furnishing Business retail metric report, states the home furnishing industries’ average gross margin is 24.4% after deducting how much money is spent on getting the customer to purchase.
So, $1000.00 x 24.4% is $244.00 in gross margin. You’ll then multiply $1000 (average spend) by $244.00 (your average gross margin after selling expenses) to get $244,000.00.
The end result, $244,000.00, represents the total potential Customer Lifetime Value of a customer.
An alternative to the historical model is the predictive model. The predictive model is more complex and in order to calculate the CLTV, you’ll require several data points.
• Total annual revenue
• The average number of transactions/purchases
• The average amount spent per transaction
• The average number of customers
• Average purchase frequency per customer (purchase return rate)
• Average gross margin
Crunching these numbers together will give you the predictive CLTV. We’ll use the same base assumptions as of the example above and a few additional ones. Here’s how the math works.
- Calculate average purchase value: Calculate this number by dividing your company’s total revenue in a time period (usually one year) by the number of purchases over the course of that same time period. Total revenue $20,000,000.00/20,000 purchases = $1,000.00
- Calculate the average purchase frequency rate: Calculate this number by dividing the number of purchases by the number of unique customers who made purchases during that time period. 20,000 purchases/4,000 (assuming 20% of customers make more than one purchase) = 5
- Calculate customer value: Calculate this number by multiplying the average purchase value by the average purchase frequency rate. $1,000.00 (average purchase value) x 5 (purchase frequency rate) = $5,000.00
- Calculate average customer lifespan: Calculate this number by averaging the number of years a customer continues purchasing from your company. 25 years old through 65 years old = 40 years (assumption)
- Calculate CLTV: Multiply customer value by the average customer lifespan. This will give you the revenue you can reasonably expect an average customer to generate for your company over the course of their relationship with you. $5,000.00 (annual customer value) x 40 years (customer lifespan) = $200,000.00 CLTV
Using the Predictive Model calculations, let’s take a quick look at improving your Customer Lifetime Value (CLTV) (more come on this). One of the keys strategies for improving this metric is increasing your average order value. What would happen if you increased your average-order-value by 30%?
Increasing Customer Lifetime Value
- $22,600.00/20,000 purchases = $1,300.00 Average order value
- 20,000 purchases/4,000 = 5 (same as above)
- $1,300.00 (average purchase value) x 5 (purchase frequency rate) = $6,500.00
- 25 years old through 65 years old = 40 years (same as above)
- $6,500.00 (annual customer value) x 40 years (customer lifespan) = $260,000.00 CLTV
The result: $60,000.00 Customer Lifetime Value increase
Powerful, right? Can you imagine what would happen if you simultaneously increased the likelihood of repeat purchases?
Join Shoptelligence’s CEO, Laura Khoury at the Las Vegas Market for an in-depth look at Customer Lifetime Value (CLTV) and the best strategies to increase your CLTV to positively impact your bottom line.
Tuesday, January 28, 2020 | 9: 00 – 10:00 am
Home Furnishing Association Resource Center – Las Vegas Furniture Market