Most e-commerce store owners are familiar with the more common KPIs - revenue, gross/net profits & profit margins. While all of these are important to know and understand, customer lifetime value (CLV) is a very important metric to understand for e-commerce businesses of all sizes. While there are more comprehensive, algorithmically focused formulas for CLV, this post will focus on the basics that every new or scaling store owner can use.
If you’re new to e-commerce or if you have some experience but haven’t spent the time to understand CLV and how it can help you scale, then read below.
What is Customer Lifetime Value?
It’s exactly as the name describes - a calculation of the financial value of a customer to your business. Unlike other KPIs which often are a myopic in view, this metric gives you a longer term view of the health of your business and the value of various types of customers to your business.
Why is Customer Lifetime Value Important?
Imagine you own a pizza parlour. One customer comes in every week to buy a slice of pizza on their way home from work. The 2nd customer buys a large pizza every six-months for an event. Which customer would likely be the most valuable to you? Most would say the first customer, which is correct. Even though a single slice likely generates less revenue than a single large pizza, having a repeat purchase from someone weekly vs. every 6 months demonstrates someone who is more loyal and you would want to focus on differently.
How Do You Calculate Customer Lifetime Value?
This calculation requires only 3 components. Average order value, purchase frequency and customer value. You’ll want to get this value over a predetermined time frame - often one year. (Note for new store owners: If you’re a new store owner and don’t have historical data, this is a great forecasting exercise for you. Make your absolute best estimate at each of these numbers but be sure to lean more on the conservative side to ensure if your plan doesn’t go as predicted (I know you’re thinking “when have my plans EVER not gone exactly as I predicted”), it doesn’t completely disrupt your business.) If you have a Shopify store, you’ll be able to get some of these calculations in their reports section.
Here are the calculations.
Average order value (AOV)
This average simply gives the amount each customer spends.
Formula #1: Average Order Value = Total Sales / Order Count
Example:
Sales: $1,000
Order Count: 50
$1000 / 50 = $20 Average Order Value
Purchase Frequency (PF)
This calculation determines the average # of times your customer makes a purchase during your predetermined time frame.
Formula #2: Purchase Frequency = Order Count / Total Unique Customers
Example:
Order Count: 50
Total Unique Customers: 20
50 / 20 = 2.5 Purchase frequency
Customer value
Customer value provides the monetary value each customer provides by simply multiplying your average order value x purchase frequency
Formula #3: Customer Value = Average Order Value x Purchase Frequency
Example:
Average Order Value: $20
Purchase Frequency: 2.5
20 * 2.5 = $50 Customer value
Customer lifetime value
Once you have your customer value, simply multiply that by the average lifespan of your customers - in other words, how long do they stay a customer of yours? If you’re a new business, use two years as a conservative rough estimate.
Formula #4: Customer Lifetime Value = Customer value x Avg. customer lifespan
Example:
Customer Value: $50
Avg. Customer Lifespan: 2 years
50 * 2 = $100 Customer Lifetime Value
After completing these formulas, this will calculate your basic CLV and will give you an outline of how valuable each customer is to you. While this information is useful, it also is extremely general and broad, and doesn’t effectively help you determine your best from your average customers.
That’s where segmentation comes in, and what we’ll discuss in part 2.