How do you calculate the customer lifetime value?
Step 1: collect characteristic values
As long as a buyer is a customer of the company, the CLV represents the profit margin generated. For this reason, four values are required to calculate the customer lifetime value:
- t = the average customer lifetime → example: 2 years
- m = the average contribution margin generated by the customer → Example: € 9,464
- r = the repurchase rate of the customer → example: 35%
- i = calculate the discount factor for the costs → example: 10%
- p = profit margin per customer → example: 25%
The average customer lifetime is recorded statistically. The average contribution margin represents the amount from the revenue that contributes to covering the fixed costs.
The repurchase rate can only be deduced from the past for the future and is therefore a relatively uncertain plan figure.
Finally, the discount factor for the costs is determined based on the current interest rate. Changes in the real interest rate in the future can therefore also affect the forecast calculation.
In general, it can be said that the collected characteristic values are subject to greater potential for errors. Nevertheless, the CLV is an effective means of planning marketing budgets sensibly.
Step 2: Calculate the average of the variable values from the collected characteristic values
- s = the buyer spend per visit
- c = the number of visits per week
- a = the average customer lifetime value per week
Step 3: Calculating the CLV
Different methods are used to calculate the customer lifetime value. We’ll show you three of the most commonly used calculation methods. You can become them individually or in combination. For comparison, however, you should always use the same method.
The simple formula: 52 ( a ) * t
The standard formula: t (52 * s * c * p )
The classic formula: m * r / (1 + i – r )
After this calculation, it is clear that the simple CLV formula clearly overestimates the overall result. Regardless of which formula you choose – or the mean value – the higher the CLV, the higher the value of the customer or advertising channel .
Simplified example of customer lifetime value
The key figure “Customer Lifetime Value” (CLV) tries to help answer this question. Let’s say your business purpose is to sell travel. From these trips you generate a profit of 200 euros each without advertising. For example, your advertising campaign may not cost more than 100 euros per additional trip sold so that you still achieve a lucrative result. If you can see over time that your customer will buy three of these trips in the course of your business relationship, you could spend as much as 300 euros on marketing. So you stay in the profit zone.
The CLV model
In the calculation, you can fall back on simple or extended points of view. In addition to the mobile phone, which we have already tried in the above example, the car is a popular example of certain everyday objects.
A car dealership, just like a mobile phone seller, can use a relatively simple calculation for its planning:
- It is generally assumed that an average customer will buy a new car about every four years. Apart from this cycle, the retailer sets the average contribution margin for this purchase at around 15,000 euros, for example.
- After that, the annual service, possibly for tire changes and TÜV or small repairs, must also be calculated.
- Now all the dealer needs to do is determine how long the business relationship will last. Does the customer buy their first car when they are 18 and the last when they are 70? To be on the safe side, a duration of 20 years, i.e. 5 new cars, is usually estimated here.
Of course, these assumptions are only fictitious, because there are definitely people who only buy a new car at longer intervals and hang on to their car for a long time.
There are also products that are less easy to calculate. For this, the extended model of the customer lifetime value comes into question. Other aspects also come into play here. With this model, the focus is on the sum of the expected deposits and withdrawals . The entire business is divided into four sub-areas, which are weighted differently for the calculation.
The four business areas are – in order of their weighting:
- The base business (with a weighting of 50%)
- The expansion potential (with a weighting of 25%)
- The reference potential (with a weighting of 15%)
- The learning potential (with a weighting of 10%)
However, the percentages are not fixed, but are determined individually by the respective company. It is important that when calculating the advanced model, the expected profits are discounted to their present net present value. Then they are still to be assigned to the respective customer in one of the four areas.
However, the extended model is a more complicated prognosis because it is often not possible to foresee exactly whether a customer might buy a new car every year (basic business) or only once, but will use the service for 10 years before changing brands and buy elsewhere. The extended model is therefore very complicated and, if it is incorrectly assigned, has little or no meaning.
Evaluation of the customer lifetime value
It turns out that the calculation of the customer lifetime value as a future-oriented method and therefore based on assumptions has disadvantages. The results can quickly turn out to be incorrect if, for example, the needs of the customer or customer group change significantly, the financial situation shows significant shifts due to illness, unemployment, a changed economic environment, or a new, cheaper provider enters the market .
Nevertheless, due to the customer lifetime value, you can make more targeted decisions with regard to the use of various marketing instruments and with regard to setting priorities in customer relations management .
Criticism of the CLV concept
Exactly as shown in the example of the models, especially the extended model, the main criticism is the unreliable prediction. Because this is ultimately only based on estimates.
- How long a customer buys products, whether he buys new products (new cars) in a certain price segment. With the extended model, this forecast even has to be calculated across different business areas and the payment flows also have to be discounted correctly.
- Startups can only make limited use of this model, as they completely lack the historical experience of long-established companies. So if you are new to the market, you can only estimate your forecasts and that without your own basis. At most, based on experience from colleagues or competitive companies.
- The limits of this model are also data protection, which does not allow anonymous data to be correctly assigned, as well as the lack of logic that past sales can also be realized in the future.
This business management method has its justification as a reference point for customer and sales development . It is helpful for marketing measures, but unfortunately it is accompanied by many factors that can only be estimated. It is therefore not very meaningful overall .
It is actually unusable for start-ups due to the lack of historical figures. And even for established companies that can fall back on many years of experience, there is no guarantee that sales will remain just as stable or even increase in the future.
So that you can plan financial forecasts and marketing strategies at all, the method is definitely suitable where long-term forecasts are concerned, but should be viewed critically.