There are two main approaches to calculating customer lifetime value.This article discusses the simple approach to calculating customer lifetime value – which is appropriate to use when customer profit contribution to each year are relatively flat. It is also a good idea to review the article on the full customer lifetime value formula, also available on this website.
The simple customer lifetime value formula
The simple customer lifetime value formula is:
Annual profit contribution per customer X
Average number of years that they remain a customer
Less the initial cost of customer acquisition
An example of the simple customer lifetime value formula
Let’s assume the following:
- Profit generated by the customer each year = $1,000
- Number of years that they are a customer of the brand = 5 years
- Cost to acquire the customer = $2,000
The customer lifetime value of this customer would be:
$1,000 (annual profit from the customer) X
5 (number of years that they are a customer) less
$2,000 (acquisition cost) = $3,000 = CLV.
That is, $1,000 X 5 – $2,000 = $3,000.
A more detailed example of the simple CLV formula
Let’s look at the same formula to calculate customer lifetime value, the building a little bit more complexity by changing the initial assumptions as follows:
- annual revenue per average customer is $2,000 per annum
- product costs associated with the average customer’s purchases is $500 per year
- the firm also spends $100 a year per customer to provide customer service
- annual retention rate (loyalty rate) is 80%
- average costs to acquire a new customer are $1,000
In this example, we have a similar challenge to the example above, but the information is not presented as neatly and we need to modify some of the above data to feed into the customer lifetime value formula.
Our first step here is to calculate the average annual profit per customer – which is determined by deducting the two sets of costs (product costs and service costs) from the annual revenue. In this case, it is $2000 – $500 – $100 = $1,400.
We have acquisition costs provided for us ($1,000), but unfortunately we do not have the average lifetime of the customer in years – we only have the annual retention rate. This will be a common situation in a workplace, as it is relatively easy from a customer database to calculate retention rates. So our challenge is now to convert a retention rate to the average number of years that the customer will deal with the firm.
There is another article (on another one of my websites) on converting retention (loyalty) rates to an average customer lifetime period. However, it is quite easy to calculate the customer lifetime in years from a retention rate, as follows:
100% divided by (100% minus the annual retention rate)
OR (1 / 1- annual retention rate)
So in this example of an 80% loyalty rate, the average customer lifetime would be:
100% / (100% -80%) =
100% / 20% = 5 years average customer lifetime period
Now we have all the inputs into the simple customer lifetime value formula, we can then calculate CLV as:
CLV = $1,400 (profit) X 5 (years) – $1,000 (acquisition) = $6,000