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Calculating Customer Lifetime Value

Posted by Origins Ecommerce - April 25, 2014 in ,

One of the biggest challenges that many software companies face when moving to a subscription model is calculating customer lifetime value (CLV). It’s one of the most important metrics for estimating revenue projects so it’s worth taking the time to calculate. If you calculate it correctly, customer lifetime value will give you insight into revenue cycles and allow you to adjust your business plan accordingly.

Importance of Customer Lifetime Value      

When customer lifetime value is calculated correctly, it will give you insight into how much your customers are spending now and how much they will spend over a given time frame. Using customer lifetime value to counter evaluate against your marketing spending will allow you to make more informed decisions. It’s more feasible to retain current customers over the long run than it is obtain new ones. Instead of focusing on your AOVs or yearly revenue metrics, customer lifetime value will translate a one-time $40 sale into the opportunity of incurring thousands of dollars over the customer’s lifetime, which helps put customer’s value into perspective.

Measuring Customer Lifetime Value

There are several ways to measure your customer lifetime value that pull in added layers of complexity.

Quick Formula:

1. Start by using a simple formula to get a snapshot figure that’s great for gathering a preliminary understanding of your customer lifetime value.

2. To get a sense of what your customers’ average lifetime with your business is, use your churn rate:

The drawback to both sets of these formulas is that they do not take time valuation into account and they assume that AOV, the number of transactions, retention, and churn rates are constant over the customer’s lifetime.

3. To assess yearly churn rate’s impact on customer lifetime value use this formula:

Once you’ve accounted for your customer lifetime value, try plugging in different churn rates to see how this impacts the outcome. Estimating the impact of different churn rates while keeping recurring revenue constant can help indicate where future churn rate objectives should range.

More Realistic Calculations:

In order to get a more accurate estimation of future cash flows, calculate them by incorporating a discount (interest) rate, which is accomplished by using your company’s WACC rate (weighted average cost of capital). You can get an even more accurate estimation if you segment your WACC rates by product type (i.e. traditional download, subscription or SaaS).

The most accurate customer lifetime value calculation for subscriptions involves discounting future cash flows using churn and WACC rates and subtracting your cost of service rate (i.e. overhead costs, hosting, maintenance, hardware, licensing etc.).

Whether the churn rate you calculate appears to be good or in need of improvement, there are always measures that can be taken to reduce the rate at which your customers decide to leave. Examples include introducing incentives for referrals, simplifying your signup process and engaging with customers on social media. If you'd like to learn more strategies like these for reducing churn rate and increasing your recurring revenue, check out our white paper.

Segment Your Customer Base To Understand Their Acquisition Costs

Once you’ve gathered an understanding around your company’s customer lifetime value rates, try and segment your customers to break them down by their corresponding acquisition costs. This will show you how valuable it is to acquire a customer and retain their business over a longer period of time.

Comparing a long-term customer to a short-term customer will help justify whether to build out customer acquisition strategies or procure more resources. Segment your customers by traditional downloadable, order + upsell/cross sell, subscription, and SaaS. This analysis can be applied to different acquisition channels (i.e. customer arrived to your website through an ad, organic search, backlink etc.) to get an idea of how valuable each of these dimensions are.

Here’s an example similar to Avanish Kaushik’s blog (a leading industry expert):

Subscription - Top end Customer Subscription - Mid range Customer
Estimated Life Expectancy 5 2
Orders per year 4 2
AOV $60 $80
Revenue Year 1 $240 $160
Revenue Year 2 $240 $160
Revenue Year 3 $240 -
Revenue Year 4 $240 -
Revenue Year 5 $240 -
Lifetime Revenue $1,200 $320
Gross Profit Margin 10% 10%
Gross Profit $120 $32
Acquisition Cost $10 $3
Net Profit $110 $29

This example highlights the importance of investing in your top end customers and shows the value in building out your customer acquisition strategy to attract premium customers that will generate recurring revenue throughout their life expectancy. This breakdown also emphasizes how lucrative it can be to provide exceptional service and technical support in order to maximize your customer retention rate and increase your customer’s life expectancy.

Try calculating your customer lifetime value with a few of the formulas to get an idea of how variables affect the outcome. Keep in mind that the more variables involved in the formula, the more accurate your calculated customer lifetime value will be. Calculating your customer lifetime value will provide a holistic overview of the expected future revenues based on current sales. It will also help differentiate premium customers from average customers, which will help you capitalize on their lifetime value as customers continue to demand software services to maintain their computers.

About the Author

Origins Ecommerce

We love sharing our expertise in online payments and helping our customers succeed. From the technical team to our customer service team, everyone at Origins Ecommerce is ready to support your success. Our goal is to reduce your expenses and risks while optimizing your revenue, by managing your online payments for you. The Origins Ecommerce payment solution is there to keep your payments in motion, so you don’t have to.
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