Customer Lifetime Value Explained

What lifetime value means

Customer lifetime value, often shortened to CLV or LTV, is an estimate of how much a customer is worth to your business over the whole time they buy from you. It shifts attention away from a single sale and toward the relationship. A customer who spends a modest amount once is worth less than one who spends the same amount several times, even though the first order looks identical.

The word “estimate” matters. Lifetime value looks backwards at past behaviour and projects it forward, so it is only as reliable as the data and assumptions behind it.

A simple illustrative calculation

The numbers below are made up for illustration. Replace them with your own figures.

Suppose a small online shop finds that, on average:

• a customer places an order worth 40;
• they order 3 times a year;
• they stay a customer for 2 years.

Step 1: revenue per customer. 40 x 3 = 120 per year. Over 2 years, 120 x 2 = 240.

Step 2: allow for costs. Revenue is not profit. If roughly half of each sale is left after the cost of the goods, the figure becomes a margin-based one: 240 x 0.5 = 120. Using margin rather than revenue is usually more honest, because it reflects what the customer contributes to covering your other costs.

Step 3: compare with the cost of winning the customer. If it costs about 30 in advertising and time to acquire one customer, then 120 - 30 = 90 is what remains. This is the same idea as cost per acquisition applied to the long term.

So in this illustration, the customer is worth about 120 in margin over two years, or 90 after acquisition costs. A useful ratio is lifetime value divided by acquisition cost: 120 / 30 = 4. You will sometimes see rules of thumb about a “good” ratio, but they vary by industry and business model, so treat them with caution and judge by your own cash position.

The ingredients to gather

To build a figure of your own, you need three pieces of information, plus margin:

• Average order value: total revenue divided by number of orders over a period.
• Purchase frequency: how often a typical customer buys in a period.
• Customer lifespan: how long they keep buying before they stop. This is the hardest to know, because customers who have not yet left are still “in progress”.
• Gross margin: the share of revenue left after direct costs.

Records of purchases and dates are the raw material, which is one reason clean, consistent customer records matter. A CRM or a well-kept spreadsheet can supply most of it.

Where the estimate can mislead

• Averages hide differences. A few big spenders can pull the average up, making a typical customer look more valuable than they are. Looking at groups separately, as in customer segmentation, is often more informative.
• The lifespan is a guess. If your business is new, you may have too little history to know how long customers stay. A short, conservative estimate is safer than an optimistic one.
• Costs are easy to leave out. Support time, returns, discounts and payment fees can reduce the real value.
• The past may not repeat. Prices, competition and your product change.
• Subscription and one-off businesses differ. If customers pay monthly, a simple approach is monthly revenue multiplied by the expected number of months, again using margin. Check this calculation against what you actually observe.

What you can use it for

Used carefully, lifetime value can inform several decisions.

• How much to spend on acquisition. If a customer is worth about 120 in margin, spending 30 to win one may be reasonable, while spending 150 would not. This links into setting a marketing budget, although outcomes are uncertain.
• Where to focus retention. Small increases in repeat purchases often change the value more than small changes in first-order price. The ideas behind this are in the article on post-purchase journey.
• Which channels bring better customers. Comparing the value of customers by source, rather than just the cost of acquiring them, can change which channel looks best.
• Which customers to look after. Identifying your most valuable group helps you decide where to spend service effort.

Keeping it simple

You do not need a complicated model. A sensible approach for a small business:

1. Choose a fixed period, such as the last 12 or 24 months.
2. Calculate average order value, orders per customer and margin from your records.
3. Use a cautious estimate of lifespan.
4. Write down the assumptions next to the result.
5. Recalculate once or twice a year and compare.

Treat the answer as a rough range rather than a precise number. A figure that is roughly right and understood is more useful than a precise one nobody trusts. Results vary between businesses, and past behaviour never guarantees future sales.