The Importance of Customer Lifetime Value In eCommerce
What’s the Customer Lifetime Value (CLV) of your eCommerce business?
Or let me rephrase, do you know what your customers are worth to your business?
I’m sure that many eCommerce marketers can’t answer this question. Not only because CLV is a neglected or often overlooked metric, but also because it can be very difficult to calculate – perhaps this is why there are too many CLV formulas out there.
Regardless of how complicated CLV is as a metric or concept, if only you knew how vital it is to sales, marketing, and ultimately your business growth, you will always keep an eye on how it moves.
In this article, we will take a look at what CLV is, different formulas you can use to calculate it, how you should break it down across your entire eCommerce business, and its importance in eCommerce businesses.
What exactly is Customer Lifetime Value?
All customers are important. But some customers are more valuable than others.
For your eCommerce store to be successful, you need to focus on customers that are more valuable than others.
This is where CLV comes in.
CLV is a vital metric that helps you measure how much each customer is worth to your brand. Alternatively, it helps you know how much money a customer will bring your brand throughout their entire time as a paying customer.
This metric uses a combination of average order value (AOV) and purchase frequency to estimate the average customer’s total value to the brand over the entire time they remain a customer.
Kevin Donnelly, Shopify’s Marketing Lead, Growth, and Acquisition says:
“CLV is one of the most important factors in determining your business’ present and future success. It’s an often-overlooked metric that can accurately predict how much your customers are really worth. By measuring the net profit that you’ll take in over the course of your entire relationship with a customer, you’ll be able to narrow down exactly how valuable they are to your business.”
So, if CLV tells you how valuable a customer is to your business, it’s safe to conclude that it determines how successful your business will be in the future.
Calculating Customer Lifetime Value
Now that you know what CLV is all about let’s talk about how you can calculate it. If you do a quick Google search, you will be presented with dozens of measuring CLV methods. You just need to use a formula that works well for your business.
But since you are already reading this, I will save you the hassle of searching and show you the most uncomplicated – simple and traditional – formulas you can use on your eCommerce website. Depending on the data you are using, CLV can also be historical or predictive.
Historic customer lifetime value is the sum of the gross profit from a customer’s previous or past purchases. It takes into account the customer’s existing data from the moment they started purchasing from you. But considering how constant data changes, it can be challenging to calculate the historical CLV of individual customers.
Predictive customer lifetime value is an efficient and complete way of determining your CLV. This method allows you to project how much revenue an individual customer will generate for your business during their relationship with your brand.
Unlike the historical method, the predictive CLV uses transactional history, predictive analysis, and behavioral patterns. Using these three elements determines the customer’s current value and forecasts how customer value will evolve over time. The more data you include in this calculation, the more accurate the value it predicts.
It’s also important to note that predictive CLV is dynamic, not static and it always going to be lower than the historical one because it’s in real-time. And it’s highly impacted by the purchase frequency, AOV, and retention rate.
According to Juliana Jackson, the Chief Evangelist at Omniconvert, you should always keep an eye on the predictive CLV:
“Predictive CLV is the one you should always monitor because it tells you the truth of how you are doing, and where you should look to start improving. When you see your predictive CLV going down, you have to check how many valuable customers you lost and how much your retention rate went down. You have to watch how it is moving over time.”
With that said, now let’s take a look at how you can calculate CLV:
The Simple CLV Formula
This is the most basic way of calculating CLV. All you have to do is to multiply the customer’s annual revenue by the average customer lifespan and then subtract the initial cost you paid on acquiring them.
CLV = (Annual revenue per customer * Customer relationship in years) – Customer acquisition cost
To help you understand, here’s a quick example using this formula:
Let’s say your customer generates $3,000 each year for your eCommerce business, and their average lifetime is 5 years, and you spent $1,000 acquiring them.
You can calculate your CLV this way:
$3,000 * 5 – $1,000 = $14,000
This doesn’t look bad at all. If your CLV looks like this, then you have a healthy relationship with your customers. And your business will be making profits.
But the problem with this method is that it assumes that the revenue generated by the customer remains the same during the time they are in a relationship with your business. But it’s not always like that unless your business is based on a subscription model with two or three tiers.
The Traditional CLV Formula
This method takes an in-depth look at CLV than the simple formula.
The traditional CLV formula doesn’t assume that your annual sales per customer are relatively flat. It also takes the discount rate into account and provides a detailed understanding of how customer CLV can change over time.
Unlike the simple CLV formula, the traditional method involves a few additional concepts. To calculate it, here’s what you need to know:
- Average gross margin per customer lifespan
- Customer retention rate
- Rate of discount (A percentage to account for inflation. It’s usually set at 10%)
And here’s how the formula looks like:
Gross margin per customer lifespan * (Retention rate / [1 Rate of discount – Retention rate]
As you can see, the traditional formula is very flexible as it allows fluctuations in customer revenue over time, and you can adjust each year by a rate of discount to account for inflation.
How you should look at Customer Lifetime Value on e-Commerce Stores
Let me be blunt here; no matter which formula you use to measure CLV, it will always be an average. And guess what? CLV is too important to look at as an average. This is one huge mistake that most e-Commerce marketers still make.
When you look at CLV as an average across your website, you are more likely to miss valuable insights. Juliana says:
“In the wrong hands, customer lifetime value can really mess up a business. If you don’t understand how to use it, if you don’t take into consideration all the aspects of it, and you use it as an average, then it might work against you.”
Remember, customers, are different. They use various sources to get to your site. They access your site from different places. They have different preferences when it comes to your products.
So if you don’t break down your CLV and look at it from different angles, chances are you will miss valuable insights that you can use to make your sales and marketing efforts more effective.
With that said, let’s take a look at how you can break down CLV on an e-Commerce site:
There are different kinds of channels that customers use to reach your site. The most popular channels are email, social media, influencers, SEO, etc. Every channel has its own value that it brings to your business.
Customers who reach your site via ads might have more CLV than those who come through emails. The idea here is to identify the most profitable channels.
In other words, you want to focus more on a channel that has the lowest acquisition cost and the highest CLV rate.
If a channel has a CLV to Customer Acquisition Cost (CAC) ratio of 1:1, it’s not worth it. That means you are not making any profits on that channel – customers are offering the value that is equivalent to what you paid to acquire them.
On the other hand, if a channel has a CLV to CAC ratio less than 1:1, abandon the channel. Because you’re paying more to acquire customers than the value they are bringing.
The same way you look at CLV from one channel to another is the same way you look at the location. You want to take a deeper look at your customers’ different locations and see which geographical area is bringing prosperity to your business.
For instance, if you are selling your products across Europe, you might have a better CLV from customers in the UK than those in Portugal. Likewise, if you are selling your products within one country, you might need to check which cities have the highest CLV and double down on those.
But as you do this, you should also keep in mind the ratio between CLV and CAC.
This is very important, especially when you are selling different products on your sites. You probably know how the story goes by now…every product category on your site has a different CLV.
A furniture eCommerce store that sells outdoor, bedroom, living room, dining room, and office furniture should look at the CLV of each and every category. If you just focus on the site’s CLV as one unit or as an average, you might miss too many opportunities on doubling down on the best categories that generate more revenue.
If you’re selling multiple brands on your site, there’s a high chance that one brand has a better CLV than other brands.
For instance, let’s say you are selling Nike, Adidas, and Reebok on your site. You may find that Adidas generates more revenue than the other brands.
The main idea is to focus on the brand that has a high CLV, and if possible, try to revamp brands that have a low CLV.
The monthly cohort is an interesting one. And, the funny thing is, not many marketers think about it.
When you run campaigns every month, you will, later on, realize that campaigns perform differently according to the month or season.
BigCommerce states that October, November, and December generate 40% of online sales. And there’s no doubt that February also generates more sales because of Valentine’s day.
This goes on to show that customer behavior changes according to seasonality. And this pattern is not always universal across all eCommerce stores.
So, if you launch campaigns every month and you acquire new customers, you need to look at the CLV of every month to determine which one has the lowest and which one has the highest customer value. But, with monthly cohorts, you don’t just have to only focus on CLV, according to Juliana:
“In order to determine the monthly cohort customer lifetime value, you also have to look at the stickness rate. Stickness rate is the percentage of new customers that buy again in the next month. Let’s say you acquire 1000 customers in April, and in May just 100 of those customers purchase from you again, then that means you have a 10% stickness rate.
She also adds that “Understanding customer lifetime value by monthly cohort helps you know which campaigns and promotions work better and make people repeat purchase after the first order.”
As you can probably tell, the RFM model segments customers based on the value they brought to your store, judging by their previous behavior on your site. It seeks to answer three questions:
- How recently did they buy?
- How frequently do they buy?
- What value did they bring?
Knowing this kind of information allows you to create effective campaigns targeting ideal customers based on their previous behavior.
Nowadays, thanks to technological advancement, you don’t have to do this CLV segmentation manually. Platforms such as Reveal can help you do the heavy lifting for you. For each segment, you can rely on this platform to display the number of customers and the revenue they have generated for your business.
The Importance of Customer Lifetime Value in e-Commerce
Unless you are still a newcomer in this space, you can’t talk about vital eCommerce metrics and not include customer lifetime value in your list.
CLV isn’t just a metric. It’s a forward-looking concept that can show you what the future holds for your business.
Considering how vital a metric CLV is, it’s pretty ironic that not all eCommerce marketers don’t know how much it is on their website.
Studies show that businesses tend to invest a big chunk of their budget into customer acquisition – and other metrics such as NPS, CLV, and retention are given less attention.
But that’s an awful blunder. Why?
Because acquisition-based growth needs you to keep on spending more, and your business growth depends on how much you spend. On the other hand, an increase to CLV means:
Positive Cash Flow
Most people wrongly believe that an increase in traffic translates to increased sales, profits, and loyalty.
But, regardless of how much you spend on acquisition, you will have a healthy cash flow in your business if you focus on maximizing your CLV.
Sounds unbelievable, right?
But studies have concluded that 65% of sales come from existing customers, and existing customers spend more than first-time customers.
Increasing customer loyalty
At its core, maximizing or optimizing customer lifetime value is about improving each step of the entire customer journey.
Take a wild guess what happens when you improve the customer journey?
Yes, you’re right…customers enjoy their experience on your site, and they continue to buy from you, now and in the future.
And when they continue buying from you, it simply means they are loyal to you, isn’t it?
Remember CLV is all about understanding your customers based on the value they bring to your business. So this means you can use CLV as a segmentation strategy.
And when you can segment your customers, you can identify the least and most profitable customers, personalize the customer experience and maximize the use of your resources.
Segmentation is fundamental in marketing, and incorporating customer profitability can improve the effectiveness of marketing efforts.
There is a shift in customer expectations resulting in firms needing to understand the customer’s new demands. CLV segmentation divides customers into groups based on factors driving purchase decisions (Vishwanath and Krawiec, 2011).
Determines customer acquisition spend
The goal of every business, whether it’s e-commerce or not, is to make more money.
This means having an income that is higher than the expenditure. If it happens the other way round, your business will obviously fail eventually.
Customer lifetime value gives you valuable insight into how much money you should be spending on acquiring your customers by telling you how much value they’ll bring to your eCommerce business in the long run.
Rather than using a haphazard approach, CLV gives you a clear understanding of which customers you should be focusing on and, more importantly, why you should be focusing on them.
Measures the Financial Impacts of Marketing Campaigns
Using CLV to evaluate the performance of your marketing campaigns is not difficult.
All you have to do is to look at the CAC to CLV ratio. The lower the ratio, the lower the ROI you’re getting on your marketing campaigns.
Successful businesses know how to evaluate their campaign ROI just by comparing their CAC to their CLV. In an ideal world, the CAC to CLV ratio should always be 3:1. This means that the value of your customers is 3 times higher than the cost of acquiring them.
Evaluates Your Retention Strategy
In more ways than one, customer retention is a part and parcel of CLV. Your CLV is higher when you are able to retain a customer for a long time.
If your CLV is low, you either need to come up with a retention strategy or significantly improve your existing one.
You will constantly have to acquire new customers to keep your business afloat if your retention strategy isn’t effective. And, tell you what, that’s a dangerous way of running a business.
Sanity checks for sales forecasts
At its core, CLV is not just a metric, but it’s a forward-looking concept.
If it helps you understand what customers are worth to you over time, then it becomes easier for you to do sanity checks for sales forecasts. And if you can do sanity checks for sales forecasts, then you know whether your business is scalable or not.
If you notice that your business is not scalable, then you can begin to craft campaigns that target and win over those customers that will bring prosperity to your business.
Conclusion: Optimize CX for better CLV
Now that you know the importance of customer lifetime value, you should always try to maximize it. And one way of doing that is to make sure that your site provides a great customer experience – this means you’d need to optimize the whole customer journey. This is very important. You can also increase your CLV by offering loyalty perks, creating package deals, having great customer service, and maintaining a minimum threshold for free shipping just like Amazon.
Simba Dube is the Growth Marketing Manager at Invesp. He is passionate about marketing strategy, digital marketing, content marketing, and customer experience optimization.View All Posts By Simba Dube
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