— October 31, 2018
In marketing, there are widely regarded experts who advocate for the same methods, ad infinitum. Why question what’s widely known? Famous Silicon Valley investor and entrepreneur, Peter Thiel, begs a very significant question, “What important truth do very few people agree with you on?”
It’s difficult to swim up the intellectual stream, hypothetically speaking, and challenge the status quo. We found a question up for debate when calculating customer lifetime value, the estimate of how long a single customer will remain a loyal patron.
Many people default to calculating customer lifetime value with gross revenues, not profit. This may seem like a trivial difference when considering the calculation of customer lifetime value is a projection and not based in fact. We argue that profit margins should be considered when estimating CLV, but first, what other factors contribute to customer lifetime value?
How to Calculate Customer Lifetime Value
CLV = Average Value of Sale × Number of Transactions × Retention Time Period
Typically expressed as total revenue, it can be argued that this equation needs another component — profit margin.
CLV = Average Value of Sale × Number of Transactions × Retention Time Period × Profit Margin
Why Express Customer Lifetime Value as Profit?
There are many factors that contribute to a company’s bottom line. The revenue obviously represents the top line figure which is then subsequently strained by the costs of doing business. Unfortunately, no cost structure is ever safe from the effects of macroeconomics.
Prices of raw materials, utilities, and labor are all subject to change. Why then would you calculate the lifetime value of customers without taking profit margin into consideration?
This also represents the actual financial gain that can be expected from a customer in the long term. Customer lifetime value can also signal how viable current spending on customer acquisition is. If, for example, the cost to acquire a customer was $ 100 and you calculated CLV as $ 200, in terms of revenue, you might feel secure in your business model.
Recalculating CLV after reading this article you discover your profit margin cut this number down to only $ 80. So, you’ve been spending $ 100 to acquire a customer, but only estimate you will make back $ 80 over the life of the average customer. This is the sign of a business model doomed to fail.
In the visual below, we recommend expressing customer lifetime value in terms of real earnings and includes tips to increase your customer lifetime value.