Customer lifetime value (CLV) measures the value of a customer over its lifespan, which represents the total profitability earned off an average customer based on the standard length of time you expect to maintain the relationship. Businesses calculate CLV to evaluate the return on marketing campaigns and to identify the most valuable customer segments.
One of the most important factors in calculating CLV is to know your numbers. QuickBooks gives you a picture of how your business is performing and helps you better understand metrics like customer lifetime value. Plans for small businesses start at $20 per month, and QuickBooks offers a 30-day free trial of all of their plans. Visit QuickBooks today to get started.
How Customer Lifetime Value Works
CLV works by using the following variables to calculate the overall value of an average customer relationship: the average revenue of your customers, your overall profit margin, and the length of your customer relationships. It provides you with a metric you can use to evaluate whether the return on your marketing efforts is worth it and to compare the relative value of your customers to determine which are over or underperforming.
By itself, CLV isn’t the most helpful business metric until you use it to compare things like customer acquisition and retention costs. This helps you look at the overall cost to your business to generate and keep customers and compare it to the value they provide to your business over the full customer lifespan, measured in profit. For example, you might use it to determine whether a specific marketing effort is likely to be worth the investment over time.
The equation for CLV is as follows:
[(Annual Revenue x Profit Margin) / (Number of Customers)] x Average Customer Lifespan
Components of Customer Lifetime Value Calculations
Before we look at a customer lifetime value formula that you can use for your business, we need to establish the components we’ll use and what they mean. Each of these should be data points your business already uses to make decisions, and can be found using your bookkeeping and accounting software.
Here are the components you’ll need to calculate CLV:
Current revenue is the most straightforward aspect of CLV to account for since it’s the one that every well-run business measures. Revenue is simply a measurement of all of your sales income for a specific time period. For our purposes, it will be helpful to determine your average annual revenue. The exception to this would be if your average relationship is better measured in months, in which case simply divide your annual revenue by 12.
Number of Customers
It’s important to be sure to include the total number of customers for the same period of time that you used to measure your revenue. If you are using your annual revenue, you should use the total number of customers you served during the year. If you use monthly revenue (for subscription services, for example), you should use your average number of monthly customers. This will allow you to calculate the average revenue per customer for a given period of time.
The profitability of your business is expressed as a profit margin, which is the difference between all of the costs and expenses associated with producing and selling a product or service, and the revenue generated. For example, if you sell widgets for $2.00 each, and they cost you $1.25 to produce and 45 cents to sell, your profit is 30 cents per unit. Profit margin is expressed as a percentage, making the margin in our example $0.30/$2.00, or 15%.
Income – Expenses = Profit ($2.00 – $1.70 = $0.30)
Profit / Income = Profit Margin ($0.30 / $2.00 = $0.15 (or 15%))
The reason using profit margin is important in calculating the lifetime value of your customers is it gives you a more accurate picture of the actual value of the customer relationship than revenue. Revenue can be deceiving as not all sales are equal. Sometimes it costs more to provide a product or service, and knowing how much you actually profit when you sell something is important to fully understand the value of the customer relationship.
Length of Customer Relationships
No customer relationship lasts forever, so you’ll need to take into consideration the normal lifespan for your particular customers. How you do this may vary depending on what you sell. If you sell recurring services or subscription products, you can measure the number of months a typical subscriber remains with you. If you’re a manufacturing supplier, you might measure the length of a customer relationship in years based on average contract and renewal terms.
Some customer lifetime value formulas represent this by using churn, or attrition rate. This is a representation of how many of your customers at the beginning of a month will remain a customer the following month, and how many will leave. While this works well for subscription-based businesses, it’s more complicated to calculate and doesn’t necessarily provide you with a more accurate reflection of lifetime value.
Alternative Metric for Length of Relationships: Churn Rate
If you aren’t sure how long your average customer lifespan is, you can calculate it using churn rate. Churn rate is the percentage of customers who leave your business each month. Using churn rate to calculate the average length of a customer relationship is a two-step process. First, you need to calculate your churn rate, which you can then convert to an average lifespan.
The simplest way to calculate churn is by dividing the number of customers who leave your business in a given month by the total number of customers that month. Once you have that number, you can calculate your average customer relationship length by using the following formula.
1 / Churn Rate = Average Length of Customer Relationship
For example, if you had 500 customers on September 1, and lost 15 customers, your churn rate was 0.03, or 3%. To convert that to the length of relationship, divide 1 / 3 = 33 months.
This version assumes a relatively constant rate of new customer sign-ups and customer churn each time period, and is less accurate for companies that are growing quickly, since the number of new customers probably far exceeds the number of churned customers.
How to Calculate Customer Lifetime Value
Once you’ve considered the information we discussed, you can plug them into a relatively straightforward customer lifetime value formula to give you a value you can use to make decisions. There are complex formulas available based on churn rate and other complicated metrics, but these simple versions will give you a good representation that you can use to make decisions about your sales, marketing, and customer service strategies.
The components you will use are represented as follows:
- AR = Annual revenue
- MR = Monthly revenue
- PM = Profit margin (as a %)
- N = Number of customers
- LY/LM = Average length of a customer relationship in years or months
The simple formulas you can use to calculate CLV include:
Overall Customer Lifetime Value Formula
This formula gives you the overall customer lifetime value for your business based on your average annual revenue and number of customers. It tells you what the average customer relationship is worth to your business in terms of the expected profit you’ll earn over the course of its lifespan. You can use this number to determine whether specific marketing costs are worth it in terms of the profit they will generate for each customer acquired.
((AR x PM) / N) x LY = CLV
Individual Customer Lifetime Value Formula
In order to determine the relative value of a customer compared to your average lifetime value, you can substitute your overall annual or monthly revenue for the specific revenue from that customer and use the same formula. This will tell you whether or not that particular customer is performing better or worse than average.
((AR x PM) / N) x LY = CLV
Subscription Customer Lifetime Value Formula
This formula is essentially the same as the overall CLV formula, except you use monthly values for both revenue and total relationship length. This formula is useful for measuring CLV for subscription-based businesses like software as a service (SaaS) providers, service firms like maintenance and landscape contractors, and retainer-based businesses like marketing agencies.
((MR x PM) / N) x LM = CLV
Benefits of Measuring Customer Lifetime Value
One of the most important benefits of measuring customer lifetime value is that it requires you to think about a customer in regard to the overall profitability of the relationship instead of just the overall revenue they generate. Not all customer relationships are the same since some customers are more profitable than others, and CLV can help you compare and make informed decisions about how you acquire new customers and maintain existing ones.
A few of the most significant benefits of measuring CLV include:
- Understanding your customer lifecycle: CLV helps you get a better picture of how long your customers stick around and helps you identify areas you can improve to increase the length of customer relationships.
- Predicting revenue: Gives you a metric you can use to forecast the amount of revenue and profit that can be expected from a particular customer over its total lifespan.
- Comparative value: Measuring CLV gives you a baseline to use in evaluating which customers are the most profitable for your business over time, and which ones might be costing you more than they are worth.
Who Should Measure Customer Lifetime Value
Customer lifetime value is a measurement frequently used by businesses that primarily sell to other businesses (B2B). However, companies who sell to consumers can also benefit, especially those that sell products and services on a subscription basis. Within a business, one of the important aspects of measuring CLV is that it can help you make decisions about activities meant to acquire new customers and activities designed to retain existing customers.
In both cases, the cost of marketing and retention activities can be measured against the expected long-term value of a customer relationship. For example, if a company determines that its CLV is $5,000 over 10 years, it might decide it is worth it to acquire new customers at a cost of $300. It also may decide that a loyalty program aimed at retaining customers at a cost of $400 per year would not be worth it, as it would be less expensive to simply find new customers.
- Business owners: Business owners should have a good grasp of CLV for their customer base since it informs many of the strategic decisions that they make regarding new products and services, as well as marketing campaigns to attract new business.
- Sales teams: Sales team members and managers can use CLV to determine which customers are most valuable and should be cultivated for new business, and which ones are not worth investing time and energy to pursue.
- Customer service managers: Managers who handle customer retention can use CLV to determine which efforts make sense in terms of trying to save customer relationships, especially when you are trying to sort out how to keep your most valuable customers.
One of the primary reasons CLV is so important for small businesses is that it gives you an anchor point from which to make intelligent business decisions about how to allocate your financial and people resources. It also provides a baseline to measure against when considering new marketing and sales initiatives. The bottom line is that all small businesses should take the time to evaluate the lifetime value of their customers.
Tools to Help Calculate Customer Lifetime Value
Calculating CLV involves data from a variety of sources. As such, there is no one software tool that will do it. Instead, you’ll need to pull information from your accounting software as well as your customer sales management tools like a CRM. Once you’ve done that, you can use the formulas we’ve included to run your calculations.
Here are a few of the software applications you can use as you calculate CLV:
1. QuickBooks Online
Who it’s for: Small businesses that want online access to manage their bookkeeping and keep track of financial reports
What it costs: $20 to $150 per month
QuickBooks Online is used by millions of small businesses to keep track of their finances. It gives you the ability to record income and expenses, track customer sales, generate reporting, and evaluate the financial health of your business. QuickBooks Online is especially helpful in calculating CLV since it provides you with a look at your revenue, profit margin, and length of customer relationships.
2. Salesforce Essentials
Who it’s for: Fully-featured CRM for small businesses and enterprises with advanced automation, reporting, and lead assignment rules, as well as customer service features built in
What it costs: $25 per user, per month (up to 10 users); $75 per user, per month
Salesforce Essentials is a CRM with powerful contact and deal management tools, along with robust reporting tools that help small businesses manage their sales process, for $25 user, per month. In addition, Salesforce integrates with hundreds of third-party applications, including QuickBooks, making it a great option for connecting your sales and accounting tools.
Who it’s for: Small businesses that sell both products and services and are looking for pipeline-driven sales process and a clean, simple user interface
What it costs: $12.50 to $49 per user, per month
Pipedrive is a CRM with a highly visual sales pipeline tool that makes it easy for small businesses to keep track of sales opportunities and move them through the sales process. Pipedrive plans begin at $12.50 per user, per month, and include features like two-way email sync, product catalogs, and invoicing, making it an affordable option for businesses that sell both products and services like landscape designers, HVAC installers, and IT consultants.
Cost of Measuring Customer Lifetime Value
Most of the costs associated with calculating CLV are already incurred by a business that uses bookkeeping and sales management software. Otherwise, the only other direct cost is the time required to gather the data and run the calculation. In fact, there’s a far greater potential cost associated with not calculating the lifetime value of your customers, since you won’t have the information you need to evaluate whether your marketing efforts are worth the cost.
- Software: Bookkeeping and accounting software like QuickBooks starts at $20 per month. Customer relationship management software with advanced reporting ranges from $20 to $50 per user, per month.
- Time: It probably won’t take you more than an hour at most to calculate CLV for your business if you’re already measuring the components needed.
When you consider the benefits of measuring customer lifetime value, the costs seem almost insignificant. In fact, the direct and indirect costs to your business in terms of not having the best information to make business decisions are substantial if you aren’t evaluating the value of your customer relationships.
Alternatives to Measuring Customer Lifetime Value
There are several business metrics that are closely related to customer lifetime value (CLV). In fact, sometimes these alternatives are just as important, if not more important, to your business than CLV. For example, understanding customer lifetime value is most helpful in comparison to the cost of acquiring new customers. Likewise, it’s important to quantify the cost of selling your products and services so that you can accurately reflect your profit.
Here are a few alternative metrics you should consider:
Customer Acquisition Cost (CAC)
The cost of acquiring new customers through marketing and sales activities is an important consideration for every business. This metric is often evaluated in comparison to CLV in determining whether or not a particular marketing activity is worth the return on the investment. It is measured by taking the total cost of a marketing activity and dividing it by the number of customers acquired from that activity.
Total cost of marketing activity / Number of customers generated = Customer acquisition cost (CAC)
For example, if you run a series of digital search ads that cost you $1,000 and you generate 25 new customers, your customer acquisition cost is $40 ($1,000 / 25 = $40). Or, if you spent $10,000 on marketing efforts last year and generated 150 new customers that can be attributed to those efforts, your CAC is $67.
Cost of Sales (CoS)
This metric includes everything that goes into the sale of a product. It is one of the two types of expenses a business incurs, the other being fixed expenses, which are costs to the business whether you sell anything or not (e.g., insurance, rent). Cost of sales (CoS) includes the materials that go into a product, labor to produce that product, and the cost associated with sales activities. CoS is used to determine the profit margin of specific product or service lines.
Return on Investment (ROI)
Measuring the return on investment (ROI) is similar to the comparison between the customer acquisition cost and CLV. It attempts to quantify the overall gain to a business from a particular investment, whether it is a capital outlay, labor cost, or other monetary expense. For example, if a business spends $5,000 on a piece of equipment, it will want to know how much overall profit can be attributed to that purchase to determine the return on the investment.
ROI is expressed either in absolute terms (the overall difference above the outlay) or as a factor. In the previous example, if the total income generated from that equipment is $15,000, you could express the return on the investment as $10,000. Likewise, you could express it by saying that it generated three times the investment.
Income – Outlay = Return on investment OR Income / Outlay = Return on investment
Frequently Asked Questions (FAQs)
Can customer lifetime value change?
The short answer is yes. This is especially true of younger businesses and companies that are experiencing rapid growth. As you streamline processes and become more profitable, the value of each customer relationship increases. In addition, as you implement processes to reduce customer attrition, you’ll see your CLV increase. At the same time, if your business begins to neglect customer relationships, you’ll likely lose customers faster and see a lower CLV.
How do I increase my average CLV?
There are essentially two ways to increase your business’ average CLV. You can increase the profit you earn from each customer, or you can find ways to retain existing customers for longer periods of time. Most businesses focus on some combination of both, especially since it is considered easier and less expensive to keep an existing customer than to find a new one.
What if I don’t have very many customers yet?
Since calculating CLV relies on historical data like past and current revenue, as well as the average lifetime of your customer relationships, it can be hard to measure if you’re just getting started. You may have limited data on which to rely, or you may not yet know how long to expect your customers to stick around, which can make it hard to accurately evaluate CLV.
That said, now is the best time to put in place the systems and processes that will help you grow into a profitable and sustainable business. In fact, if you only have a few customers, knowing whether or not they are likely to have long-term value is even more important since every customer relationship has a far larger impact on your business and your bottom line.
Measuring the average customer lifetime value for your business is an important aspect of making good strategic decisions about your marketing, sales, and customer retention efforts. In addition, it helps you evaluate the strength and health of your individual customer relationships and prioritize those that add the most value to your company. Since we’ve made it easy to understand and calculate CLV, there’s no reason not to start using it in your business.
If you’re looking for a sales management application that can help, Salesforce Essentials is a robust CRM with powerful contact and deal management features, as well as useful reports and third-party integrations including QuickBooks. Salesforce Essentials is $25 per user, per month for up to 10 users. Visit Salesforce today to start your 14-day free trial.