The importance of Customer Lifetime Value

Written by Keith Errington | March 2022

In the ever-changing marketing landscape, many businesses are increasing their emphasis on Customer Lifetime Value (CLV) as a key measurement to plan their marketing strategy.

In the recruitment industry, retaining long term clients is particularly crucial to success, as gaining repeat business, as well as decreasing churn, is often the key factor determining success and growth. Or, looking it at the other way – a successful recruitment company will always be one that works with its clients, meets their unique needs and keeps them satisfied.

So what is CLV and why is it important?

Customer Acquisition Cost

A metric that has been used for many years when planning a marketing strategy and budget is Customer Acquisition Cost (CAC) – how much it will typically cost you to gain a new customer.

To calculate this figure, add up all the costs associated with gaining new business – advertising, marketing material, salaries of salespeople and other staff related to marketing and sales, office overheads and so on, and then divide that figure by the number of new customers you gain. Look at both figures over a set period – usually a year. This then gives a figure which tells you how much you are spending, on average, to gain a customer.

If your CAC is too high compared with the money you are making on your products and services in the same period, then you will need to find a way to reduce your costs and consider cheaper ways of gaining new customers. The lower your CAC, the better. A low CAC means that your marketing is very effective and ultimately adds more to the business’s bottom line.

This CAC figure can be used in budget setting if you work the figures the other way around. Decide how much profit you can spare from each new customer for marketing. Multiply that by the number of new customers you anticipate gaining in a year. This will give you a budget for your marketing. If this doesn’t at least cover your basic marketing overheads, you’ll be in trouble.

Of course, you may find that it’s not enough – in which case you will need to look for cost savings elsewhere to free up more money for marketing. If this isn’t possible, then you may have to face the fact that you don’t have a viable business. (There is no shortage of examples of product launches that have failed due to a lack of a decent marketing budget).

Typically, B2B companies might spend between 10% and 20% of their revenue on marketing, but it will vary by sector. Recruitment companies spend around 5% of revenue on marketing for example. This figure varies not only by industry but also by type of sales – whether that be products or services – with service companies spending more. (Current figures have been skewed by the effects of the pandemic, with some companies spending more on marketing and other companies cutting costs.)

Whilst CAC is a useful metric, it does not tell the complete story, and limits you in a number of ways.

Most B2B businesses have repeat customers, and many will have customers that stay loyal and buy again and again. The cost of acquiring that customer happens at the beginning – so repeat sales cost less and usually a lot less. According to the Harvard Business Review: Acquiring a new customer is anywhere from five to 25 times more expensive than retaining an existing one.

It is also far easier to sell to an existing customer – according to the book Marketing Metrics, businesses have a 60 to 70% chance of selling to an existing customer while the probability of selling to a new prospect is only 5% to 20%.

Because CAC only examines revenue from new customers, you are not factoring in the total sales over time, as it ignores the repeat revenue you might gain from your loyal, long-term customers in the future. So based on CAC, you could be spending too little to win those important, long-term, high revenue customers.

Customer Lifetime Value

If you are just using CAC to plan your marketing budget, you may not be spending enough to acquire customers that could be worth a great deal to your business in the long run. If you were to spend more, you might acquire those high-value customers, and any extra costs would be outweighed by the profits from those loyal customers over time. The initial extra spending therefore becomes a sound investment to gain future revenue.

This is where Customer Lifetime Value is useful – it takes into account all the likely sales an average customer will make over their lifetime. Amongst other benefits, this will allow you to make a better judgement as to how much you can afford to spend initially in order to gain that customer’s lifetime business.

Calculating CLV

Because CLV is effectively predicting the future, there are a number of different methods used to calculate it, with no accepted standard definition. And you may also find it referred to as Lifetime Customer Value (LCV). Whatever it is called, the two core components in the formula are always purchase frequency and average order value.

Clearly, it helps if you are an established business with many years of trading, as you can then look back at your historical data for some real figures to base your calculations on.

In a simple form, the formula would be:

Purchase Frequency x Average Order Value x Average Customer Lifespan

For more on how to calculate CLV, check out this useful article by HubSpot.

However, this is purely based on revenue and does not factor in the acquisition costs or the costs of retention. So you might choose to use:

Purchase Frequency x Average Order Value x Average Customer Lifespan – (Acquisition Cost + Retention Cost)

Take a read of this article from ClickZ for more on this version of the calculation.

There are additional elements you could consider, like the margin on each sale. The version you decide to use depends on what you are using CLV for and how you view it.

If you compare CLV to CAC, it will give you an idea of how long it takes to recoup the costs of the initial acquisition.

Because Customer Lifetime Value is making predictions about how long your relationships with valued customers might last, it is important that you retain those customers. If you start losing customers for any reason, then not only do you lose their potential sales, but your CLV calculations for other future customers will be skewed in a way that means you will be spending too much to acquire them.

So it’s important that you maintain consistent levels of customer support or even improve your customer support in order to retain customers for as long as possible.

It is also important to keep an eye on what your competitors are doing – their prices and comparable products or services. No amount of high-quality customer service will stop a customer from jumping ship if there is a great disparity between your price and a competitors, or if they are offering something you cannot match.

This brings us to another closely related factor, the Churn Rate – the percentage of customers who end their relationship with a company in a given period. Reducing your churn rate will increase your CLV. You can find a version of the CLV calculation that incorporates Churn Rate in this article from ChartMogul. As that calculation formula is quite complex, it may be easier to stick with a simpler CLV calculation and try to improve, or at the very least, maintain, your churn rate.

Customer Lifetime Value and Segmentation

You can also look at CLV for different types of customers. You may find some groups of customers buy from you many times over the course of their business relationship with your company and provide a high CLV, whereas others buy just the one time, or rarely after that – giving you a low CLV.

Analysing why this second group doesn’t repeat buy may allow you to develop support and sales techniques that result in more repeat sales, a higher CLV, and greater revenue for the business. But you might also decide to target those groups that generate higher CLV and focus less on those that don’t.

If you do have distinctly different groups of customers in terms of their pattern of buying, then you should segment them for the purposes of calculating CLV. Likewise, if some customers receive higher discounts or cheaper prices for any reason, you would want to create a separate segment for them for CLV calculation purposes.

You may want to segment overseas customers as the cost of delivery may be much higher. It may be more profitable for you to sell locally.

Knowing your CLV for each segment helps put things in perspective – you may realise you are spending too much of your marketing budget trying to gain large numbers of new customers whose value is widely variable and not enough on retaining those high value, long-term customers.

When CLV doesn’t help

Whilst CLV is a great way to value your customers, there are a number of situations in which it might not be a useful metric.

If you have a small number of varied customers with wildly different buying patterns, an average CLV is unlikely to be very useful. You may prefer to consider each potential customer, along with any existing long-term customers and take a view of their value to you.
A newly established business will have no long-term customers, so CLV would have to be a best guess and therefore not reliable enough to base key decisions on. As a start-up, you are likely to be spending a disproportionate amount of your business budget on marketing anyway.
If the majority of your customers make one-off purchases, it will be simpler for you to use CAC instead. (Although you might want to think about developing your product or service offerings to create a reason for customers to return to you and buy again).

A business-wide approach

If you are using CAC as a key performance indicator it may encourage a culture around the quick win – which could result in unhappy customers because they didn’t get exactly what they wanted or were oversold something. Those customers will not repeat buy and their business lost forever.

Using CLV, on the other hand, implies an approach that places an emphasis on four stages:

Acquiring customers
Building customer value
Retaining customers
Building advocacy

With its emphasis on the long-term relationship, CLV is a metric that encourages a different culture – a different approach. Instead of going for quantity – lots of short-term sales – it encourages a longer-term, potentially more stable and successful approach.

Advocacy – the unseen benefit of a long-term approach

There are additional benefits to a long-term relationship with a customer over and above the repeat sales. Today, buyers get their advice and recommendation from peers and other buyers through social media, business forums, blogs and other channels. So new prospects will be asking your customers what they think, how they rate the product and the service. If you don’t have satisfied customers, you will be losing those potential sales.

If you can go further and turn a loyal customer into an advocate, then you will see some real added value. A customer advocating your business is far more effective than a salesperson – as a customer’s advice is considered independent, impartial, and so carries more weight, more authority, with other buyers. A customer will have real experience of using your product or service and therefore can give more relevant and useful advice and recommendations to a potential buyer doing their research.

This potential benefit of a small army of loyal, long-term customers singing your company’s praises is hard to measure – so it’s not traditionally an explicit part of calculating CLV, but it is a factor and will add more value. Advocate customers certainly add weight to the validity of using CLV as a key metric and taking an approach with your customers that values their long-term business.

CAC vs CLV – who’s the winner?

CAC and CLV seem to infer two different approaches – do you pursue new customers, or do you support existing customers? In reality, a balanced approach is always going to work best. Getting that balance between the budget allocated to new customers and that allocated to supporting existing customers is always going to be tricky and probably subject to trial and error but optimising the mix of the two approaches will give you the greatest success and the highest revenue.

LogicMelon

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