A customer’s lifetime value is more important for an organization than the profits on the first, or perhaps even the first several sales.

Many companies offer discounts — sometimes steep ones — to obtain the customer’s initial business. Some may even make the first sale at a loss, with the idea of making it up on subsequent sales. But to determine if a discount will pay off in the future, a company needs to know how to accurately calculate customer lifetime value (CLTV). It’s not as easy as it might first seem.

Attracting and retaining the highest value customers is key for every business. Knowing your customer’s lifetime value can help you make sound marketing decisions.

A Basic CLTV Formula

The most basic CLTV formula is average annual gross revenue per customer times average customer relationship time, e.g., $250/year x 3 years = $750 CLTV, said Stephen Farr-Jones, president of ADM Marketing, a subsidiary of the OvareGroup. After the initial calculation, calculate your marketing cost per acquisition (CPA), e.g., $20,000 in acquisition media drove 200 new customers = $100 CPA.

“Simply put, you spend $100 to acquire each new customer, who will then spend $750 with your business, for a gross profit per customer in their lifetime with your business of $650. In order to be profitable, CLTV must be greater than CPA,” Farr-Jones explained.

Some companies with lower margins will benefit by using net instead of gross revenue in CLTV calculation, deducting the cost of goods or services sold, Farr-Jones added. “Looking at net revenue is also valuable if you are calculating CLTV by customer segment. You would do this in order to identify and profile the highest value segments in order to find ‘look alike’ customers for acquisition marketing efforts. You can also change the time period to months or a single year, to manage for a shorter cash flow cycle.”

Farr-Jones emphasized allocating and analyzing marketing dollars spent on retaining the customers you already have, because acquiring a new customer on average costs five to 10 times more than retaining an existing customer.

Related Article: Don't Forget Your Customer After They Become Your Customer

Different Metrics Offer Different Values

While many firms report on their customer lifetime value, the metrics used vary wildly in terms of accuracy and informative value, according to Neil Burge, CEO at Cognopia. “For accuracy, we should refer to expected CLTV, which forecasts what will happen in the future, not what has happened in the past. ECLV describes the present value of the expected sum of discounted cash flows of an individual customer.

The task of reporting ECLV is more straightforward for a subscription business, like a telco, where the customer is “locked in” to a service contract and the future cash flows are largely known in advance (or can be predicted with reasonable confidence), Burge said. A company can predict when a customer might “churn” based on their contractual end-date and metrics to understand their customer satisfaction levels.

For a discretionary customer, e.g. a customer of Walmart or Amazon, the challenge is harder. You won’t know whether a customer simply doesn't need what they sell, and therefore will reappear in the future, or whether they’ve churned, never to be seen again, according to Burge. You also need to predict the basket-size of any future purchases. More forecasting is required, as well as predictions on whether the customer is active or inactive.

Learning Opportunities

“Mistakes that are commonly made are over-simplification of the calculation; e.g. Peloton’s pre-IPO in August 2019 showed their CLTV formula failed to apply any discounting, resulting in at least a 50% overstatement of the value of their subscribers,” Burge said.

Related Article: Keys to Building Customer Lifetime Value

Look at Profit Instead of Revenues

Many people default to calculating customer lifetime value with gross revenues, not profit, said Pushpraj Kumar, business analyst for iFour Technolab. This seems like a trivial difference when considering the calculation of customer lifetime value is a projection and not based in fact. Customer lifetime value is important because, the higher the number, the greater the profits.

In order to calculate CLTV, a business owner must estimate the value of the average sale, average number of transactions, and the duration of the business relationship with a given customer, Kumar added. Established businesses with historical customer data can more accurately calculate their customer lifetime value.

Related Article: Focus on the Experience First and the Metrics Will Follow

Monitor CLTV Estimates for Accuracy

The most common failing when calculating the lifetime value of a customer is the assumption that interests don’t change over time, cautioned Morgan Taylor, CMO for LetMeBank. “I often hear people talking about their customer list, and how it will build over time, as if the people on it weren’t actual humans, with interests that change and hobbies that come and go."

So as a rule of thumb, Taylor assumes that whatever a customer is going to be worth in the first six months, they’ll be worth under half in the next six months, and probably 10% following that. However, it does depend heavily on the type of business.

“If it’s hobby based, assume the type of attrition I mentioned,” Taylor said. “If it is need based then you will have more luck. Ultimately though, no matter what you assume, you will be wrong. Only by actually monitoring the lifetime value, and separating by demographic and acquisition source, will you be able to see some solid figures.”