What is Customer Lifetime Value?

What is Customer Lifetime Value - Basic Concepts of CLV

It is important to recognize that customer value optimization (CVO) and customer lifetime value (CLV), sometimes also referred to as LTV (Lifetime Value), go hand in hand. By focusing on CVO, we not only enhance the immediate value of customer transactions but also contribute to the overall lifetime value of customers for a business. This article explains what CLV is.
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Customer Lifetime Value: What Is It and How Do You Calculate It?

CLV refers to the total value a customer is expected to contribute to your business over the entire duration of the relationship. It is a predictive metric that is essential for understanding the long-term value of customers and helps guide decisions regarding marketing spend, customer service, and product development. CLV highlights the importance of customer retention and maximizing the value of existing customer relationships.
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‍Key Aspects of CLV

• Focuses on long-term customer value
• Helps allocate resources to high-value customer segments
• Drives customer retention and loyalty strategies
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The Importance of CLV in E-Commerce

CLV plays a central role in strategic planning for e-commerce businesses because it provides insight into long-term profitability and helps optimize marketing spend, product development, and customer service.

A higher CLV indicates healthy, sustainable business growth, while a lower CLV may signal underlying issues with customer retention or profitability.

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How to Calculate Customer Lifetime Value (CLV)?

Let's go through some simple examples of how to calculate Customer Lifetime Value (CLV) using different methods. These examples will help clarify the concepts and provide a foundation for applying these calculations in practice.

Each method has its own advantages and limitations, and the choice depends on available data, business goals, and the level of complexity a company can manage.
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Simple CLV Formula

CLV = Average Purchase Value × Number of Purchases per Year × Average Customer Lifespan in Years

Example Calculation

Data:

• Average purchase value per customer: €50
• Average number of purchases per year: 4
• Average customer lifespan in years: 5

Calculation:
CLV = €50 × 4 × 5 = €1,000
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CLV with Profit Margins

CLV = (Average Purchase Value × Number of Purchases per Year × Average Customer Lifespan in Years) × Net Profit Margin

This approach takes into account the net profit margin or at least the gross margin of each transaction, providing a clearer picture of the actual profit generated by a customer. We believe this is the best and only way to use CLV effectively.

Example Calculation

Data:

• Average purchase value per customer: €100
• Average number of purchases per year: 2
• Average customer lifespan in years: 10
• Net profit margin per purchase: 30%

Calculation:
CLV = (€100 × 2 × 10) × 0.30
CLV = €6,000 × 0.30
CLV = €1,800
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Cohort-Based CLV

By grouping customers into cohorts based on their purchase date or behavior, businesses can calculate and compare CLV for specific segments. This approach helps in identifying the most valuable customer segments and understanding their purchasing patterns over time.

Example Calculation

Data:

• Month 1 spending per customer: €30
• Month 2 spending per customer: €20
• Month 3 spending per customer: €50

Calculation:
CLV for 3 months = Sum of spending over 3 months

CLV_3 months = €30 + €20 + €50
CLV_3 months = €100
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Benefits of Monitoring CLV

Tracking customer lifetime value provides several advantages for business growth.

1. Identify high-value customers
CLV helps pinpoint the most loyal and profitable customers, as well as those who are easier to attract and retain.

2. Determine acquisition investment (CAC)
While customer acquisition cost (CAC) tells you how much it costs to acquire a new customer, CLV reveals how much a customer is worth. These two metrics answer the key question: "What is the true value of a customer to my business?" Together, they represent return on investment (ROI) and help determine if acquisition investments are sustainable in the long run.
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Build brand loyalty

By measuring customer lifetime value (CLV), businesses gain insights into who their most loyal and valuable customers are. These customers tend to stay longer and become brand advocates, enhancing your brand reputation. Improving CLV through loyalty programs is an essential strategy for strengthening customer relationships and increasing brand loyalty.

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CLV as a Driver for Strategic Decisions

Having a clear understanding of CLV allows businesses to make strategic decisions about how much they can invest in customer acquisition (CAC) without compromising profitability. Balancing the cost of acquiring a new customer with the expected revenue from that customer is essential for achieving a positive return on investment.
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Strategies to Increase CLV

Improve customer experience: A superior customer experience can enhance loyalty and extend customer lifetime.

Implement loyalty programs: Reward customers for repeat purchases to increase retention and customer value.

Optimize cross-selling and upselling: Offer relevant products or services that increase the value of each customer transaction.

Focus on customer retention: Invest in customer service and satisfaction to reduce churn and extend customer lifetime.
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Relationship Between CLV and CAC (Customer Acquisition Cost)

To illustrate the relationship between CLV and CAC, consider an online store that sells luxury beauty bundles. These boxes contain premium beauty products and are available in three price categories:

• Standard Beauty Bundle: €50 per box
• Advanced Beauty Bundle: €75 per box
• Exclusive Beauty Bundle: €100 per box

An average customer purchases 10 of these boxes per year over a period of three years.

Total revenue per customer is calculated as follows:
(50+75+100) / 3 * 10 boxes * 3 years * 0.3 = €2250

To generate €2250 per customer, the store invests around €9000 per month in customer acquisition, resulting in a CAC of €90 per customer (€9000/100 customers). The additional yearly costs per customer amount to €40.

The CLV of a customer for the store is calculated as:
€2250 (total revenue) - €270 (total CAC: 3 years * €90 per year) - €120 (additional costs over 3 years) = €1860

This means that, over three years, the average customer generates €1860 in profit for the store. Since the CAC of €90 is significantly lower than the CLV of €1860, it can be concluded that the store is effectively allocating its marketing budget and making a substantial profit per customer compared to the acquisition costs.

Balancing Acquisition and Retention

While attracting new customers is essential for growth, CLV demonstrates that retaining existing customers is often more cost-effective. A strategy that balances acquisition and retention can lead to the highest long-term profitability.

Customer lifetime value is a fundamental concept for any e-commerce business aiming for sustainable growth. By focusing on increasing CLV, businesses can not only improve profitability but also build deeper and more meaningful relationships with their customers. Understanding and optimizing CLV is key.
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The Golden CLV to CAC Rule

The key to sustainable growth lies in the ratio between customer lifetime value (CLV) and customer acquisition cost (CAC). An ideal ratio is 3:1, meaning that every euro invested in acquiring a customer should ultimately generate three euros in return. This ensures a healthy balance between growth and profitability.
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Optimal Ratios

Target a 3:1 Ratio
A 3:1 ratio is often considered ideal, especially for SaaS and subscription-based models. This provides a stable foundation for profitable growth while maintaining the balance between acquisition and retention.

Other Ratios
1:1 or lower: Indicates potential losses or challenges in customer acquisition.
If this is the case, prioritizing acquisition cost management while improving CLV is necessary.

1:5 or higher: Suggests significant potential for growth investments due to high returns.
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Ratios in Growth Investments

Depending on the stage of the business, deviations from the ideal ratio may be justified:

Lower ratios (e.g., 1:2): Suitable for early-stage businesses that are aggressively investing in customer acquisition.
Higher ratios (e.g., 1:4 or 1:5): Ideal for established businesses focused on maximizing profitability.
Dynamic approach: Adjust goals as the business grows, starting with lower ratios and gradually scaling up.

Each business is unique, so strategies should be tailored to the specific situation.

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Do you have any questions about profitable e-commerce growth after reading this article? Contact Polaris Growth for more advice.