How Should SMBs Calculate Customer Lifetime Value?

A vital indicator of how well SMB is doing as a business is Customer Lifetime Value (CLV). CLV measures the total worth of a customer to a business over the entire relationship period. CLV goes beyond a transactional analysis to offer a long-term perspective of customer profitability.

Sussex Group will explain why calculating CLV based on profits rather than sales is crucial for small businesses aspiring for sustainable growth. We will define the concept of CLV, underscore its importance, and provide a detailed methodology for calculating CLV based on profits, with practical examples.

What is Customer Lifetime Value (CLV)?

At its core, CLV is a metric that estimates the total revenue a business can reasonably expect from a single customer account throughout the business relationship. The longer customers purchase from a business, the greater their lifetime value. Traditionally, CLV calculations might focus on sales or revenue generated from a customer. However, a more insightful approach is to consider the profit generated, as it accounts for the costs associated with acquiring and serving the customer, offering a clearer picture of their actual value to the business.

Why Focus on Profits Over Sales?

Focusing on sales provides a surface-level view of customer value, emphasizing revenue without accounting for the costs incurred to generate that revenue. This perspective can be misleading, as not all sales contribute equally to a business's profitability. By calculating CLV based on profits, businesses can:

Identify the Most Valuable Customers: Understand which customer segments are profitable beyond high revenue.
Optimize Marketing Spend: Allocate resources more efficiently by targeting efforts towards acquiring and retaining customers with higher profitability.
Enhance Business Strategies: Make informed decisions about product development, pricing, and customer service strategies that enhance profitability.
Improve Financial Forecasting: Gain a more accurate forecast of future cash flows by understanding the profit contribution of customer segments over time.

Calculating CLV Based on Profits: A Step-by-Step Guide

To calculate CLV based on profits, you need to follow a methodology that incorporates the net profit from each customer, considering both the revenue they generate and the costs associated with serving them. Here's a simplified approach:

Step 1: Determine Average Purchase Value

Calculate the average purchase value by dividing your total revenue over a specific period by the number of purchases.

Step 2: Calculate the Average Purchase Frequency Rate

Determine how often, on average, a customer purchases within a given period.

Step 3: Calculate Customer Value

Multiply the average purchase value by the average purchase frequency rate to determine the customer value.

Step 4: Determine the Average Customer Lifespan

Calculate the average number of years a customer continues purchasing from your business.

Step 5: Calculate CLV Based on Profits

Finally, multiply the customer value by the average customer lifespan to determine the CLV based on sales. To adjust this calculation for profits, subtract the average cost of serving the customer (including acquisition costs) from the revenue before multiplying by the customer lifespan.

Example:

Consider a hypothetical small business, "EcoFriendly Products," that sells sustainable household items.

Average Purchase Value: $100 (total revenue of $100,000 / 1,000 purchases)
Average Purchase Frequency Rate: 4 times a year
Customer Value: $400 (average purchase value $100 * average purchase frequency 4)
Average Customer Lifespan: 5 years
Average Gross Margin per Customer Purchase: 50%

To calculate the profit-based CLV:

Customer Value (Revenue): $400
Adjusted for Profit Margin: $400 * 50% = $200 (This represents the profit from an average customer in a year, considering the cost of goods sold.)
Profit-Based CLV: $200 * 5 years = $1,000

This calculation means that over the lifespan of their relationship with EcoFriendly Products, a typical customer is worth $1,000 in profit.

Conclusion

Calculating CLV based on profits rather than sales offers small businesses a more nuanced understanding of their customer base, enabling them to make strategic decisions that drive long-term profitability.

By focusing on the profitability of customer relationships, small businesses can prioritize their efforts towards the most valuable customers, optimize their marketing strategies, and ultimately secure a sustainable path to growth. Remember, the goal is not just to increase sales but to enhance profitable relationships that contribute to the enduring success of the business.