Customer lifetime value (CLV) is the foundation of recurring revenue business models: you recoup the costs and profit from a customer over their lifetime using your product, not from a single transaction. CLV is important because you need to make sure that the costs you spend to acquire and maintain your customers are worth it! If you calculate CLV correctly, you can use it strategically to evaluate the ROI of different acquisition and retention tactics. But if you calculate CLV wrong those decisions will be off the mark!
In this post I will explain the concept behind CLV and dispel some common misconceptions. I’ll also show you the right way to calculate CLV, but it requires you know your customer churn probability. So this post assumes you have calculated your average churn rate as I described in my old post on churn rate calculation. Or, better yet, you have calculated individual customer churn probabilities with a regression as I explained in my last post.
But what does churn have to do with customer lifetime value? I’ll show you the details in a moment. But in a nutshell, the lower the churn rate the longer customers stay with you. And the longer customers stay with you, more lifetime value. So the lower your product churn rate the higher your customer lifetime value.
What Goes Into Customer Lifetime Value?
The picture below illustrates the components of CLV :
- Customer Acquisition Cost : CAC. The total cost you pay to acquire each customer, Including both sales and marketing expenses.
- Recurring Revenue : RR. The amount the customer pays you each month.
- Cost of goods sold: COGS. The amount it cost you to maintain the customer each month. COGS includes things like the cost of your cloud computing or data center, and customer support. (But Not the R&D cost of creating your product.)
As you can see in the picture, CLV Is the combination of all the costs and revenue over the customers journey From sign up to churn. If you like equations, here’s how that all goes together:
Misconceptions about Customer Lifetime Value
The biggest misconception about CLV is that it is based on the total of the payments your customer made you in the past.
- CLV also includes the payments you expect your customer to make in the future!
But how can you know how much your customer will pay you in the future? You don’t have a crystal ball to see the future. That’s where the churn rate comes into play.
How Customer Lifetime Value depends on Churn
The relationship between churn and customer lifetime value is actually very simple. That’s because customers expected lifetime As your customer is just the reciprocal of the churn rate. Meaning, one divided by the churn rate. If you like equations, heres what that looks like:
Importantly, If you measure your churn with a monthly rate this gives you the customers lifetime in months. But if you measure your churn with an annual rate then this gives you the customer lifetime in years. Here are some examples:
- If the churn probability is 5% per month, the expected customer lifetime is 1.0 / 0.05 = 20 months
- If the churn probability is 30% per year, the expected customer lifetime is 1.0 / 0.30 =3.33 years
If you have calculated individual customer churn probabilities, then you can estimate lifetime individually for every customer. If you don’t have individual customer churn forecasts, then you can just use your churn rate. In that case, you are estimating the average lifetime for all your customers.
CLV From Churn
Now that you know you can predict customer lifetime from the churn rate, you should see where this is going. You can multiply the periodic recurring revenue and cost by the lifetime! Then just subtract your acquisition costs and the result is customer lifetime value. Here’s how that all comes together in an equation:
If you are familiar with the concept of the margin, then you can write CLV in a simpler equation:
where m is the margin, defined as the proportion of recurring revenue that you keep after costs of goods sold, or: m= (RR – COGS)/RR.
Advanced CLV: Cashflow Discounting
Calculating CLV isn’t that hard, but there is one more misconception for pitfall. The truth is, the simple method I showed you above only works when your customers expected lifetimes are going to be shorter than a couple of years. If your customer lifetimes are longer than a couple of years, then you should also use a technique known as cash flow discounting to reduce the value of payments far in the future. So that means you only have to worry about this if your return rate is around 20% per year or less.
How do you do the discounting? That’s an advance subject I’m not going to tackle in a blog post. I recommend that you read this article called Customers as Assets by a Columbia professors Sunil Gupta and Donald Lehman. They can do a better job explaining the concepts than I could. I just want to make sure you’re aware, and do the right thing if you’re at one of those lucky companies with a low churn rate.