What is customer lifetime value and why should you care? Customer lifetime value is one of the most important numbers in all of business. Here's why:
Calculating customer lifetime value tells you how much money a customer can generate for your business. To effectively advertise and grow your revenue over time, you'll want to know your customer lifetime value and then improve it over time.
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If you don’t know how much a customer is worth to you, you CANNOT know if you are spending the right amount of time or money to acquire new customers. Even if you hire professional marketers to help you, if they are good at their jobs, they’ll ask you for these numbers.
Warning! I have good news and I have bad news about this post. The bad news is that this article has a decent amount of math. Boo. I know. Math isn’t sexy for most people. You know what is sexy?
- Making money
- gaining new customers
- protecting you business.
The good news is spending 5–10 minutes on your math will help your business, AND this isn’t calculus. It’s just good old-fashioned addition, subtraction, multiplication, and division. You could get your fourth grader to help you. If you don’t have a fourth grader, I will help you!
How Do You Calculate Customer Lifetime Value (CLV)?
Many people have their own formulas. Rather than giving you complex numbers, let's make it as simple as possible.
How much do you make off the first sale?
On average, how often do your customers buy from you again?
What percent of your customers provide referrals that turn into closed business?
Now, not everyone likes including referrals in lifetime value, but here is why I believe it is important.
You're going to use the customer lifetime value to figure out how much you can spend on advertising and acquiring a customer. So, let's say you figure out a customer will spend $1,000 with your business. But, half of those customers will refer another customer to you that will also spend $1,000 with you. So, each customer will bring you $1,000+$500 worth of referrals. Increasing your number of referrals should be a key part of maximizing the lifetime value of a customer. You'll likely make different decisions related to acquiring a new customer if you see their value as $1,000 vs $1,500.
How Do You Maximize the Lifetime Value of Each Customer?
While entire books have been written about maximizing customer lifetime value, here are the main activities that you can do to maximize customer lifetime value.
•Get customers to pay more or purchase more items
•Get customers to buy from you more often/stay with you longer if they pay monthly
•Get a higher percentage of your customers to buy from you again
•Get more referrals from your customers.
Customer Lifetime Value (CLV) Equation:
Customer Lifetime Value CLV:
First purchase $ (F)+Repeat Purchase $ (R) =Individual Value (I)
Individual Value(I)+(Individual Value x Referral Percent(L))
L is a decimal and is the percentage of referrals that turn into closed business.
So, let's say the first purchase is $1,000. On average, people spend an additional $3,500. And, on average 25% send referrals that turn into closed business.
I know it seems confusing when there are the number there. But, in a nutshell we're simply taking the money that we're getting from a customer's first and repeat purchases. Then, we get that same amount from a certain percentage of referrals. So, if 25% of customers provide referrals, we take .25x$4,500=$1,125. Then we need to add that number to the individual customer value of $4,500.
Is Customer Lifetime Value Important?
It is vitally important.
"The business that can spend the most to acquire a customer wins".
If you don't know what value your average customer is worth to your business, how can you know how much money you're able to safely spend on advertising? Doing these calculations will not only tell you what the customer is worth to your business today, it will also get you thinking about a number of ways that you can improve their lifetime value. How can you get more referrals, more repeat customers, higher first sales. What gets measured gets improved.
Customer Lifetime Value (CLV) for Software as a Service (SaaS) Companies
Let’s say a software company has a subscription service. One plan is $25 a month, and the other is $50 a month. Half of their users sign up for the $25 a month plan, and the other half sign up for the $50 a month plan.
To determine S1, (the money they gain from a customer’s first purchase), we’ll take the amount of money the two types of sales generate and then divide by two to get the average first sale.
$25 + $50 = $75
$75 / 2 = $37.50
The average first sale (S1) is $37.50.
Now, how much does this business receive from customers on average? Some people may stay on their plans for several months. Others may only stay for a month or ask for their money back.
The longer you have been in business, the more accurate this number will be. If you have only been around for 3 months, you may not know how long the average person will stick with you. If you don’t have enough data, you can look up the average for your industry.
Let’s say this software company’s $50/month clients stick with them for 3 months on average, and their $25/month clients stick with them for 4 months.
Again, we’ll calculate the average money gained from a customer (S2) by taking the amount of money between the two plans and then dividing by two:
$50 x 3 months = $150
$25 x 4 months = $100
$150 + $100 = $250
$250 / 2 = $125 (because there are the two plans, each comprising 50% of sales)
This company gains $125 in repeat business per customer on average (S2).
Each customer’s average first purchase is $37.50, and then they do $125 of repeat business. That’s the first part of the lifetime customer value equation.
S1 + S2 = avg. customer spend
$37.50 + $125 = $162
So, each customer, on average, spends $162.
Let’s say this company also asks for referrals from every customer. Of their customers, 25% send referrals, and 50% of those referrals end up signing up for the service.
If possible, these should be actual numbers from your business, not simply a guess.
Knowing these numbers, we can calculate the percentage of customers provide a referral that turns into repeat business:
R1 x R2 = Percentage of referrals that turn into repeat business
0.25 x 0.5 = 0.125 (12.5%, or 1 out of 8 people)
So, each customer on average makes this company $162, and 1 out of 8 provide a referral that leads to a new client.
We’ve already calculated that the average client nets this business $162, so multiply that by the percentage of referrals that become repeat business (12.5%).
(R1 x R2) (S1 + S2) = avg. revenue from referrals, per customer
$162 x 0.125 = $20.25
This means, on average, the software company can expect $20.25 worth of referrals per customer.
So, this means the lifetime value of a customer is
$37.5 (first purchase) + $125 (repeat business) + $20.25 (referral business) = $182.5
Or, S1 + S2 + (R1 x R2)(S1 + S2)
Once you know that number, you know how much money you can spend to acquire a new customer while making a profit.
You can also see that improving some of these numbers will make a huge impact on your bottom line.
For example, if you increase your level of service, resources, and customers, so that people on both the $25 and $50 plan stay for an average of 6 months (instead of 4 and 3 months, respectively), your lifetime value will increase by $100 per customer.
$25 x 6 months = $150
$50 x 6 months = $300
$150 + $300 = $450
$450 / 2 = $225 repeat business per customer (because there are the two plans)
$37.5 (first purchase) + $225 (repeat business) + $20.25 (referral business) = $282.75 customer lifetime value.
See how quickly it went from $182 lifetime value to $282? If two companies with similar products and price points are competing, but one makes $182 per customer, and the other makes $282, which company will win in the long term?
Customer Lifetime Value (CLV) for Real Estate Agents
Here's the formula that you'll use to calculate the lifetime value.
First, you'll need to find 3 values, profit, repeat business, and referral income.
Profit*times someone does repeat business=Repeat Business $
Profit+Repeat Business*Percentage of customers that provide referrals that turn into a sale=Referral income
Profit+Repeat Business Money+Referral income=Customer Lifetime Value (CLV)
Really, we are doing 3 short equations. Then we add those 3 together to receive the customer lifetime value. First we find profit, then repeat business money, then referral income, then we add them together.
A quick example followed by an in-depth explanation.
Average selling price, $419,285.
75% of the time 3% commission: $14,558
25% of the time 6% commission: $7279
You spend a total of $600 on selling the house when you are preparing for open houses, using gas, etc. A detailed list of what to include is in our longer example.
So, you make $18,197-600=$17,597
Your profit is $17,597
People use you as their realtor again 2.1 times on average.
So, the repeat income will be your profit on one sale*2.1.
So, on average each customer will give us $17,597 on the first sale and $36,953 in repeat business.
To calculate income from referrals we want to add first sale profit and repeat business and then multiply by the percentage of customers that provide referrals that turn into paying customers. So, maybe 25% of your customers provide referrals, but only 15% provide referrals that turn into closed business. 15% is the number we care about
So, to find referral income, we take profit ($17,597)+Repeat business ($36,953)*Percentage of customers that provide referrals that turn into business (.15)
Now we have the numbers to do the final equation.
Customer Lifetime Value is Profit($17,597)+(Repeat Business Money ($36,953)+Referral income ($8,197)=$62,747
Or, our full equation looks like this.
Profit($17,597)*Times Someone Does Repeat Business(2.1)=Repeat Business Money ($39,953)
Profit($17,597)+Repeat Business($39,953*Percentage of Customers that Provide Referrals that Turn into a Sale(.15)=Referral income ($8,197)
Profit($17,597)+Repeat Business Money($39,953)+Referral income($8,197)=Customer Lifetime Value ($62,747)
Let's start with the selling price. Find the average. You may have sold a $1 million home and a $200,000 home, but the average is $600,000. Note: We're looking for the average(mean), not the median. Add up the total price for all the homes you've sold recently. The more homes you can include, the better it will be. For example
$2,935,000/7=$419,285 average home selling price.
Now, how much do we receive in commissions?
Now, put in the percentage of the commission that you receive. For many realtors, you can leave this at the default of 3%. If your commission is different, change the number.
So, with an average selling price of $485,285 and a 3% commission, you would earn $14,558 on each home sold.
However, some percentage of people you work with may ask you to help them buy AND sell. So, with those people, you'd receive a 6% commission instead of a 3% commission.
Let's say 25% of people we work with have us both buy and sell.
So, with 75% of the people we get a 3% commission, and 25% we get a 6% commission. A 3% commission in the example is $14,558 and a 6% commission is $29,116.
So, for the 75% of people where we do one side of the sale $14,558*.75=10,918
And for the 25% where we do both sides:
So, the average commission we receive will be $18,197.
Here's another way to do that calculation. We get 3% commission ($14,558 )from all our customers. We also get an ADDITIONAL the commission from 25% of our customers. So, our additional 3% for a quarter of our customers makes us an additional $3,639.
We'll end up at the same number: $14,558+$3,639=$18,197.
Now, you need to remove your expenses.
Your commission isn't going to be all profits. You'll see how much you actually take home.
Do: Include gas, supplies for open house, advertising and mail for selling homes.
Do not include: Your own business cards, your own advertising. Here's why.
We're trying to figure out how much money you make on average when you buy or sell a home. Once you discover how much money you take home for each customer, THEN you can create a plan for the year and plan out our own advertising. That's why you need to only include expenses that are directly associated with helping your clients buy and sell their home.
How many times are people a "repeat customer?"
You can do some calculations to figure out how much repeat business you’re likely to get from that person.
People on average sell their home and buy a new one every nine years. If you’ve been in the business long enough, see if you can find your exact average. You’ll have some customers who stay in one home all of their lives and some who move every year or two. All you care about is the average.
A study found that on average 11% of home buyers used their same realtor again. 88% say that they'd be interested in using the same realtor again.
The percentage that use you again should be significantly higher than 11%. Really, you should be aiming to have half of your customers work with you again.
So, how do we calculate how often we get repeat business from customers?
Let's plan on people purchasing homes again every 9 years. It's likely that for each person we sell a home to, they'll purchase another 2 homes. The average age of a homebuyer is 34. That means, that our average person we help buy and sell will purchase another 4-5 homes.
That means the average buyer could purchase at least 3 more homes with you. How many years until you retire? If it's 27 or more years from now, you can plan on 3 potential additional sales. If it's 18-27 more years, plan on 2 additional sales. or if it's 5-17 years plan on one more potential sale.
For this example, we'll say half of people will use you again and you have 3 more potential sales. 50% will choose you as their realtor for the 2nd sale, 25% for the 3rd sale, and 12.5% for the 4th sale.
Customer Lifetime Value (CLV) for Consumer Goods or Ecommerce Companies
If you're selling physical products, you'll likely have significantly higher costs that you need to figure in.
The product costs $95. However, the parts, labor, storage, and shipping costs amount to $55 per product.
So, the net profit for each product is $40. That means Your average first sale is $40.
The average customer purchases an additional 2.8 products from you.
$40 x 2.8 =$112 in repeat sales
$40 + $112 = $152 average customer revenue
OK, let’s track referrals. Sure, you may get some from word of mouth or people recommending your product to their friends, but you want something you can keep track of.
Let’s say you give people a referral code. It will give the referrer $5 off their next order, and the person who is referred also gets $5 off their order.
This means that instead of a $40 profit, since you’re incentivizing with $10 off in total, the profit will be $30 on the first sale. However, it will be the full $40 on all repeat purchases.
So, each referral will net you $30 in profit on the first purchase and $112 in repeat purchases.
Or $142 in total.
Let’s say 1 out of 10 customers gives a referral or recommendation that turns into a sale.
$142 x 0.1 = $14.20 in referral sales per customer
Alright, let’s look at our total.
So $40 initial sale
$112 in repeat business
$14.20 in referral sales, per customer
So, your customer lifetime value is $157.20.
OK, now that you understand the lifetime value of a customer, let’s figure out how much you can spend on advertising.
You'll find the cost of the initial purchase and include average future purchases.
The only time you’d want to do multiple calculations would be if there are products or services without an overlap in services.
I’ll give a real life example:
There is one school I work with that is focused on enrollment as well as donations. We did lifetime value calculations for both enrollment and for donations.
If the average enrollment brings the school $15,000, but the average donation is $45, the approach to marketing to the two should be very different.
Donors and students are two different audiences need different ad campaigns, so it’s worth knowing the lifetime value of a student compared to to the lifetime value of a donor.
Conclusion: Customer lifetime value will give you a compass for all future spending and growth.
Customer lifetime value is vitally important. Do the calculations before you start running paid ads. Keep track of your customer lifetime value and continue to improve that number.
If you stuck with this post and did the full calculations you'll have a significant competitive advantage over anyone that doesn't know their customer lifetime value.
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