Customer lifetime value is one of the most widely used metrics for determining a customer’s worth. It’s also one of the most misunderstood. Here’s a look at what lifetime value means, how it’s calculated, and how it can be useful to you as a business owner or marketer.
Why is customer lifetime value important?
Knowing the lifetime value of your customers is important because it helps you better understand how much revenue you can expect from a customer over time, which in turn determines the actual value of each new sale.
For example, Bob will spend $20 on your products this month and return every month after that for a year. If he only spends $20 per month, then his CLV would be $240 ($20 multiplied by 12 months). If his CLV is greater than what he paid upfront (for example, if he paid $100), then it makes sense to sell him the product even though there are no immediate gains in monthly revenue.
Getting from MRR to CLV
The formula for CLV is as follows:
CLV = Average Revenue per Customer x Average Customer Lifetime x Retention Rate
To get to this equation, you’ll need to do the following:
- Calculate the average revenue per customer in a given month.
- Calculate the average revenue per customer over 12 months (or 24 months if you’re using monthly metrics).
- Multiply these two numbers together.
Before you can begin to calculate CLV, you first must define what it is. In short, customer lifetime value (CLV) is the amount of money a customer is worth to a business over their lifetime. Calculating CLV requires some basic information about your customers—such as how long they stay with your company and how much they spend while they’re there—and then uses those metrics to calculate the total amount of profit generated by each customer during their relationship with your brand.
To calculate CLV, first determine how many customers are needed for each one’s average revenue over time (AROT) equals $1; this is called the break-even point or BEP. To determine this number, take all costs involved with servicing a single customer (for example salaries for salespeople who sell products/services) and divide that figure by AROT.
Then set aside any marketing costs incurred during this period so that only direct costs associated with servicing customers are factored into breaking even ($0). Next, add up all projected revenues from customers over their lifetime (this includes both current revenue streams plus future potential profits) and multiply them by their respective AROTs; add this result together with any additional projections made on behalf of non-customer sources such as referrals or word-of-mouth advertising initiatives.
Understand CLV and you’ll understand how to be profitable
CLV is the total value of all future transactions from a customer. It’s a much more accurate valuation metric than MRR—which is only a measure of the current revenue your business generates.
While MRR can be helpful, it doesn’t tell you how much money you’ll make over time because it doesn’t consider churn rates, which are crucial for calculating CLV. For example, let’s say you have two customers who both have monthly recurring revenue (MRR) of $1,000 per month and an average lifetime value (CLV) of $3,000 per month. In one month they churn out and leave while in another they stay but don’t buy anything else from you because they aren’t happy with their experience with your product or service (or any other reason).
In both scenarios—churning out or not buying anything else during that period—their CVs are the same ($3k), but their MRRs differ by $2k since one customer churned out while the other didn’t buy anything new during that time frame ($1k vs $3k).
Understanding customer lifetime value is a key factor in increasing your profits. By understanding what makes up the customer lifetime value, you can better calculate how much you are spending to acquire customers and then make adjustments as needed.