Do you know how much your customer is worth to your small business?
Of course, every customer is important but if you’re running at capacity then every hour counts. You want to make sure that your time and effort is being rewarded fairly.
Calculating Customer Lifetime Value (CLV) is an important metric in business planning. It’s the total revenue you earn from a customer over the time of the entire client-customer relationship.
Through a simple calculation, CLV shows you the value your customers bring to your small business (and/or the headaches). This calculation is not a one-and-done method. If you’re doing it right, it should change as your business grows. However, the exercise will help you make more informed decisions that benefit your customers and are more profitable for your business.
What can Customer Lifetime Value tell me about my TrulySmall business?
Understanding how much your customer is actually worth, can tell you a lot about the current and future health of your small business.
As the owner, you are in direct control of each factor of the CLV formula: average purchase value, purchase frequency and lifespan.
By breaking down each factor, we can start to see opportunities that can help us plan for the future. Here are a few examples:
Find High-Value Sales Opportunities
Research from Bain & Company showed that increasing customer retention rates by 5% can increase profits by 25% to 95%.
But what does that have to do with CLV?
Your customer retention rate is directly correlated to your customers’ lifespan. If you can keep them as a customer for longer, you will make more money.
Using CLV as a guide, you can also discover the customers that contribute the most revenue to your business. This can help inform your customer acquisition strategy to find similar, high-value clients as well as let you know when it’s time to let some go. As a freelancer, your schedule is what keeps your business going. There’s no point filling it up with more stress for less value.
You can keep clients for long periods of time solely based on your pricing and payment terms, i.e. average purchase value and purchase frequency.
If you increase your prices too much or make your client pay too often, you can lose customers. However, if you don’t charge enough regularly, you won’t be able to take care of yourself. The price of your services should represent the value of the problem you solve for your client.
Calculating CLV can help you identify which existing customers you want to serve more. Combined with value-based pricing, you can create new packages for customers based on their patterns of purchase value and purchase frequency.
For example, clients paying an hourly rate may benefit from a retainer that includes a set number of working hours per week.
Calculating your CLV can help determine an appropriate marketing budget for your small business. In general, your customer acquisition costs, how much you pay to get a new customer, should be a fraction of your CLV. Understanding this can help you evaluate which marketing efforts are worth pursuing. In other words, don’t spend more to get a customer than their lifetime value.
Working backwards through the formula can help you set your own business goals. Based on your total budget and Customer Acquisition Cost, how many new customers can you expect to get?
# of expected new customers = Marketing Budget / Customer Acquisition Cost
To take it one step further, what could this look like in a specific timeframe, i.e. one month? One quarter? One year? Although this is a simple example, this can help give you a realistic start to developing your personal customer acquisition strategy.
Get Rid of Assumptions
Most importantly, calculating your Customer Lifetime Value will help get rid of any assumptions you have about your small business. This calculation is best used with real data from your business. By tracking your purchase value and frequency, the more accurate your CLV is which will help with your business planning.
Pro Tip: CLV is not the same as profit value for one customer. For that calculation you need to consider costs and expenses, so it’s better to start tracking everything!
How to calculate Customer Lifetime Value
The formula to calculate Customer Lifetime Value is quite simple, just multiply your customer’s average purchase value by their purchase frequency and their lifespan. The end-result is how much one customer is worth to you given the specified timeframe.
Average Purchase Value: The average amount a customer spends with you each time.
For those selling physical products you can also calculate Average Purchase Value by taking your total revenue and dividing it by the number of orders you have. Similarly for service businesses, take your total revenue and divide it by the number of customers you have.
Purchase Frequency: How often a customer purchases your product or service.
If you have payment terms with your client, this counts!
Lifespan: The entire duration of the client-customer relationship.
Pro tip: Make sure your Average Purchase Value, Purchase Frequency and Lifespan are measuring the same time frame!
Let’s say you’re a freelance writer, who charges a client $50 per article*. Let’s also say that the average client wants two articles per month and will stay with you for an entire year.
From this information, you can calculate that the Customer Lifetime Value is $1200. Let’s say that you want to start a paid advertising campaign to attract more clients and need to determine your marketing budget. Based on your CLV, you should not spend more than $1200 for each new client. Effectively, you could write an article for a potential client for free ($50 value) and it would fit well within your marketing budget. Just be sure to include it in your customer-acquisition costs.
*about mid-range for a 500 word SEO article on Fiverr.
Keep in mind
Understanding what Customer Lifetime Value is can give you a better understanding of the high-value areas of your small business. However, this formula is just one part of the puzzle. CLV only expresses its value in revenue, not profits. For that you need to track your costs and expenses.