Customer lifetime value (CLV) is increasingly becoming an important metric for rationalizing ad spend. With the price of online ads increasing everyday, adding a big burden on any online retailer’s P&L, there is a big need to measure the real return on these ads. This is where customer lifetime Value started to gain popularity among marketeers.
What is Customer Lifetime Value?
Customer lifetime value, as the name suggests, measures the value each customer delivers to the business over the lifetime of his relationship with the company. This lifetime could be 3 years, 5 years, 7 years, or any amount of time depending on the type of product or service the company is selling.
How to Calculate Customer Lifetime Value in Retail?
There are many ways and formulas to calculate customer lifetime value, some even take discount rate into consideration, but here we are going to take the simplest way that would be easy and practical for a small retailer or ecommerce owner to use
CLV = ATV x No. Transactions per Customer x No. of years x gross margin (%)
ATV: Average Transaction Value or AOV = Total Sales ÷ No. of Transactions
No. of Transactions per Customers = Total no. of Transactions ÷ Number of Customers
No. of years: Typical time a customer stays with the company
You sell apparel for 10-14 yr olds and your total annual revenue is 234,000$ at 55% gross margin
Your number of transactions in one year is 2093
Total number of customers who buy in a year is 1645
ATV = 234,000$ ÷ 2093 = 111.8 $
No. of Transactions per customer = 2093 ÷ 1645 = 1.272
No. of years a typical customer stays with the business: 3 years
CLV = 111.8 $ x 1.272 x 3 x 55% = 234.6 $
The result simply means that each customer contributes 234.6 $ on average to your business over the lifetime of the relationship (3 years on average)
Not All Customers Are Equal
You must have noticed that this formula has used your total sales and total number of customers. However; it is more beneficial to dig deeper into your analytics and segment your customers into levels based on average order value (AOV) to segment the highest spenders vs. average spenders vs. bargain hunters.
Then you can calculate the CLV for each customer segment on its own. This will show you the real value of this metric, because the main reason to calculate CLV is to optimize our ad spend and customer acquisition efforts.
After you have determined the CLV for each customer segment, you will be able to set a ceiling for your customer acquisition cost (CAC), above which it becomes unprofitable for you to spend that money on ads.
For example: If you have determined that the CLV of your average customer is 234.6$ over 3 years and you run an ad campaign and the cost of customer acquisition from this campaign was higher, it means you will never recoup your investment on acquiring those customers.
How Can It Benefit Me As a Retailer?
Brick & Mortar and online retailers can benefit a lot from knowing their customer lifetime value, especially for ecommerce businesses, where customer acquisition costs are higher.
Attracting The Right Customers
When you calculate the CLV by customer segment, you will be able to understand what type of customer is the most profitable for your business.
You will find that 80% of your profits are coming from 20% of your customers. Those are ones that deliver the most value for you over the years, and so these are the ones you need to cater for the most.
A lot of retailers find it tempting to create a discount after discount to attract customers. However; the ones who run their analytics and act on them have realized that this strategy only attracts people who solely come for the offer. They might not even come back to you again, unless you have another offer.
That’s why I don’t use discounts as a method to acquire customers, but only as a method to clear stocks or generate cash.
In this article by Google a case study is mentioned where an agency worked with Open Table on an ad campaign to get more diners to use the service.
Instead of targeting just anyone who is interested to go for a meal, they focused on high frequency diners. By doing this, they will be spending the same amount to acquire one customer, but since this customer is a high frequency diner, their CLV will be higher and the ROI over time will also be higher.
This also takes us to the next point..
Rationalizing Ad Spend
After you have performed the calculation of CLV you will also calculate the cost of customer acquisition (CAC) for your ad campaigns and tweak your advertising strategy so that your CAC doesn’t exceed CLV.
In many cases, such as one-product stores, you might find that the CAC is just too high for your operation, because you are only going to sell each customer one product and chances are, they will never return back.
On the other hand, for subscription business models, you will find that companies don’t mind spending high upfront, because they know that this will pay off over the years from recurring subscriptions.
Understanding the long term return you will be getting on your initial ad spend will serve as a better guidance for your budgeting.
Read More: Retail Budgeting Process
Better Marketing ROI Measure
A lot marketers are now using CLV, rather than old ROI measures to track advertising efficiency. That’s because in some cases or segments looking at the immediate ROI from a campaign can prove to be really short sighted. You are going to get more out of each new customer over time, so it makes sense to take this as a measure instead
Better Buying Decisions
Yes, I’m just about to connect buying to marketing.
This is actually how a good retailer should work; looking at his business from a holistic perspective and connecting all the metrics together to improve profitability.
When you calculate the customer lifetime value for your retail or ecommerce customers, you will soon understand who your most profitable customer segments are and what exactly they are buying. Besides attracting those customers through targeted ads, you also need to cater for them and source the products that they want to see in your store.
For example if you have a store that sells maternity clothing and also toddler clothing, you might find that your pregnant customers have a low CLV because they only shop with you for few months and also because of the nature of items they buy, which are used only temporarily.
On the other hand, mothers with toddlers stay with you for 2 years (and probably shopping with future kids in mind as well) and hence their CLV is higher. Rather than making buying decisions solely based on the gross margin of the item or GMROI, you will now start to think more long term. You will find a way to cater for mothers of toddlers more, by sourcing more relevant products that they might like, so that you can maximize their purchases from you over the course of 2 years.
So the results of your efforts might not reflect immediately in this year’s P&L, but will show up over the next few years in the form of business growth.
Amazon Customer Lifetime Value Example
One of the most clever examples for the use of customer lifetime value and thinking long term as a retailer is the Amazon Prime program.
Statistics have shown that Amazon Prime member spend more than double the amount spent by non-members year after year, and so their CLV is higher.
By creating the Amazon Prime program, not only did Amazon automatically increase the CLV with the subscription fee itself, but it also gave a reason for members to prioritize purchases from its platform over the competition, since they are already members and will get free shipping.
Now Amazon can focus on, and justify, spending on acquiring more Prime members, even if it meant giving them free perks left and right.
How to Improve Customer Lifetime Value in Retail & Ecommerce ?
As a retail or ecommerce business, you have many opportunities to maximize your customer lifetime value. Here we will show a few examples:
1. Target The Right Customers
To start off: you want to focus on acquiring the right customers. By the right customer I mean the most profitable ones, who will stick with your business for the long term and buy your products on full price.
Doing this starts with drafting the persona of your high value customers and then targeting them with your marketing and advertising efforts. Since you now already know their CLV, you will be more willing to spend more on acquiring them, and it will pay off in the form of higher CLV for your store in the future.
2. Start a Loyalty Program
Already most big retailers have a loyalty program for the same reason. Small retailers and ecommerce businesses need to also test this concept.
The good thing about the loyalty program is not only that it increases CLV of your customers by making them buy more from you, but also it allows you to track their purchases and see what they are buying, especially if you are a brick & mortar and have no other way to link purchases to customer profiles.
With this tracking in place, you will be able to serve them better and, again, increase their CLV even more.
3. Maintain a Feedback Loop
This is something that is often ignored by big retail, and so easy to maintain by small retailers.
Developing a mechanism to capture customer feedback and use it to source better products or to even make your customers feel more valued will definitely improve your customer lifetime value.
By feedback I don’t just mean putting a number or e-mail for customer complaints. You don’t want to hear about their complaints only. You want to also know why they left without buying? What were they looking for and couldn’t find? What are the products they are buying from the competition that you could provide for them?
What I do is to make each store maintain a feedback booklet, where they write down missed sales opportunities and the reason for that. We actually launched a lot of new products and got ideas only from this feedback.
Another thing I do while doing store visits is that I always stand at the cash register. I had this habit since I was a store manager. The reason I do this is that customers always talk about their experience and what they found and didn’t find while they are being billed by the cashier. I start asking them questions, like “how did you know about us?”, “What were you looking for?”…etc.
Online retailers can easily do this through feedback forms or emails with specific questions. The trick is to take this feedback seriously and actually act on it.
4. Test Different Business Models
As we have shown with the Amazon Prime example, testing with new business models can pay off decently. You too can do the same for your customers.
Think about a system or a service that you can implement that will make your customers stick with you longer and come back for more purchases. This will diversify your sources of revenue and automatically increase CLV of your customers.
Customer lifetime value is an important metric for retail and ecommerce businesses to understand the real profitability of the customers they are acquiring. It helps them optimize their ad spending, as well as their buying decisions.
Read our article on How to Actually Make Money in Ecommerce?
Retailer & Founder of Retail Dogma, Inc.
Rasha has 12 years of retail & ecommerce experience. She has started an ecommerce business in 2008, and later worked at H&M, Bath & Body Works, Victoria’s Secret and Landmark Group. She has lived in 4 different countries, speaks 3 different languages and holds a master’s degree in Strategic Management & Marketing.