The question of how much a customer is worth is nothing new. Neither is the KPI (Key Performance Indicator) of Customer Lifetime Value (CLV). Nevertheless, it is often not used effectively enough - even though it should be gaining in importance. This is because you can use it to focus on your important customers or, for example, to compare your marketing budget with your profit in a meaningful way. Read on to find out what you need to know about CLV and why you should use CRM software.
Table of contents
- Definition: What is Customer Lifetime Value?
- Why is Customer Lifetime Value important? What does it have to do with CRM?
- How do I calculate customer lifetime value?
- How high should a good Customer Lifetime Value be?
- CLV and CAC
- How do I improve Customer Lifetime Value?
- Advantages and disadvantages of customer lifetime value
- Conclusion
Definition: What is customer lifetime value?
Customer lifetime value (CLV) is a key figure from business management. It describes the average value of the profit that a customer has and will potentially have over the period of their existing customer relationship with your company.
Depending on how the value is calculated, you can use it in different ways. For example, it can be used as a key figure for monitoring customer value development, e.g. to check the success of your CRM strategy and therefore the CRM system. Marketing and sales also use the CLV for budget planning for acquisition and marketing measures. It makes a difference whether an individual customer or an entire segment is considered.
Why is Customer Lifetime Value important?
What does it have to do with CRM?
Customer lifetime value is so important because it helps companies to evaluate their customers more holistically than purely transaction-oriented approaches - i.e. those geared towards quick sales - allow. The focus here is on the customer relationship level and customer potential, not on sales generated in the short term.
This key figure therefore provides a valuable basis for estimating the profitability of investments in a customer relationship. This is one of the reasons for the close link between CLV and customer relationship management. The CLV makes it tangible that a long-term customer relationship can be significantly more valuable than a short relationship with a one-off high turnover. It is no coincidence that the rule of thumb is that acquiring a new customer is around five times more expensive than retaining a single existing customer.
How do I calculate the customer lifetime value?
There are many ways to calculate customer lifetime value. Depending on which company wants to use the key figure and how, different influencing factors can be used or more or less complex calculations can be made.
The simplest form of calculation is based on the net present value method.
The first step is to consider which time period is to be considered and how long the business relationship is expected to last. The expected turnover and the expected investment are used to calculate the cover amount that your customer will achieve for such a period. The calculation interest rate is used to compare payments that are due at different times.
The following variables are used for this purpose:
- T: expected duration of the business relationship
- t: time period of the consideration (years, months, days)
- et: expected turnover of the business relationship for period t
- at: expected investment in the business relationship for period t (e.g. marketing, consulting, etc.)
- i: interest rate based on the duration of the customer relationship
An example of the calculation of the CLV
A simple example illustrates the procedure for calculating the customer lifetime value. Let's assume a mechanical engineering company wants to plan its marketing budget for the coming year using the CLV as a basis.
The average customer relationship of the mechanical engineering company lasts around 10 years, which results in a calculation interest rate of 10%. The company replaces a machine for its customers every 5 years on average, generating revenue of €10,000. Maintenance worth €1,000 is due every year. This results in an expected turnover of €40,000 over the 10-year period. That is an average of €4,000 per year - our observation period. The costs for customer service and management amount to an average of €800 per year. This gives us the following values for the calculation:
- T = 10 years
- t = 1 year
- et= 4.000€
- at= 800€
- i = 0,1
The Customer Lifetime Value for the coming year would be €3,200. The CLV for the next 10 years would be around €22,863. The marketing team can now use these figures for the coming year's budget planning to estimate how much should be invested in the customer.
The calculation can be adapted for the many individual cases of different business models and applications. Most companies develop their own formulas that are tailored to their specific business model and the associated customer behavior. This usually means that other factors are included.
Into the future with CRM
Of course, you can't look into the future now. So how are you supposed to know how long a business relationship will last or how much turnover your customer will generate?
In order to be able to make estimates for these values, it is worth looking into the past - if possible - and drawing on experience or average values. This is where a CRM system with a comprehensive 360° history of your customers pays off.
A dashboard for management that prepares these figures saves you from having to search for, prepare and present the figures you are looking for. Software for dashboards and reports is therefore an integral part of a CRM system.
How high should a good Customer Lifetime Value be?
There is no specific figure for a good customer lifetime value. However, it can be said that a positive CLV indicates that money should be invested in maintaining the customer relationship. A negative CLV is more likely to indicate that it might be better to cut the budget.
However, it can just as well serve as a signal for the type of measures: Customers identified as profitable are nurtured and, if possible, retained by the company. Less profitable customers are instead approached with up-selling offers in order to make them profitable.
CLV and CAC
When interpreting the CLV, it is worth including another key figure in the analysis: the Customer Acquisition Cost (CAC).
What is the Customer Acquisition Cost (CAC)?
The CAC describes the costs incurred by a company in acquiring new customers in relation to individual customers and, alongside the CLV, is a valuable indicator for assessing acquisition and customer retention measures.
How is the Customer Acquisition Cost calculated?
The CAC is calculated relatively simply: the total costs of acquisition measures in marketing and sales are divided by the number of customers actually acquired in a defined period.
What does the CLV and CAC ratio tell you?
Put simply: CLV and CAC tell you how much you spend on a customer and how much they give back to you. And what should a good CLV/CAC ratio look like?
It stands to reason that it looks rather bad for you if your CAC is higher than your CLV. This means that you spend more on acquiring a customer than you later earn from them. If the ratio is balanced (1:1), at least you are not making any losses. But not more than that. In these cases, you should urgently work on your marketing and sales strategies.
Ironically, there is also a need for action if your CLV is much higher than your CAC. This is an indicator that you are not showing your valuable customers enough that you appreciate them. This could lead to difficulties.
How do I improve Customer Lifetime Value?
There are many possibilities. A good approach would be to take a critical look at the company's customer centricity and then work on optimizing customer relationships. Try to obtain answers to the following questions, e.g. through surveys:
- How satisfied are your customers?
- What do they expect in terms of your products or services?
- What about your company?
- Have you selected the right contact points for your customers and do you offer the right content there (customer journey)?
- What is your customers' experience like at individual contact points, e.g. customer service on the phone (customer experience)?
- etc. ...
While customer centricity should be deeply embedded in your company culture, tools such as CRM systems can help you to make processes and interactions aspleasant and courteous as possible for customers. As mentioned above, CRM software provides a comprehensive database for calculating your CLV overtime.
Advantages and disadvantages of customer lifetime value
With all the advantages of CLV mentioned above, there are of course some disadvantages to be weighed against the advantages.
Advantages of customer lifetime value
- The focus is on achieving long-term profitable customer relationships by considering their entire lifetime.
- An objective key figure for customer value also makes it possible to objectively estimate the ROI of investments in the customer relationship.
- The CLV provides a basis for controlling and optimizing budget and resource planning.
Disadvantages of the CLV
- Despite its holistic nature, CLV is a key figure based on forecasts. These are always associated with a certain degree of uncertainty and risk. However, the longer the customer's purchase history is included, the lower the risk of an incorrect estimate.
- Data protection guidelines make it difficult to collect and process the required customer data for the benefit of customer privacy. This must be done anonymously, which poses challenges for some companies.
- Especially when calculating an average CLV, it should be borne in mind that the behavior and therefore the value of individual customers can deviate significantly from the average. In this case, the justification of measures based on the CLV should be done with caution.
Conclusion
Customer Lifetime Value is a great metric for a holistic view of your customers. Nevertheless, you should understand it comprehensively in order to be able to use it sensibly.The better your database is maintained, the more meaningful your calculations will be.
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