How to Calculate Customer Lifetime Value with Big Data: A Step-by-Step Guide

We all recognize and agree that calculating Customer Lifetime Value (CLV) is probably the most powerful metric for measuring the true value of your customers. Yet, the idea of collecting and synthesizing big data to calculate CLV seems to be the most daunting and challenging task for almost any company. We decided to compile a handful of reasons as to why we think your business should start analyzing the data and measuring this metric today.

In short, Customer Lifetime value can help a business: 

  • Determine whether a consumer is going to be profitable or not – and, for how long
  • Predict the monetary value associated with a customer relationship  
  • Gain valuable insights into their consumers and identify its loyal vs. average customer base
  • Effectively use big data to maximize customer engagement and develop successful and targeted marketing strategies
  • Learn about a consumer’s personal behavior to develop personalized initiatives to boost future profits and retention
  • Stay ahead of competition

Beyond the benefits, though, the first question here is what analytic tool or formula do you need to compute and measure the lifetime value of a customer? How do you go about defining these inputs and assumptions to develop a viable CLV model? 

While there are many methods for calculating Customer Lifetime Value, it is essential to use a framework that encompass the four key components needed to develop a comprehensive CLV model: 

  • Gross Profit  
  • Customer Acquisition Cost
  • Retention Rate
  • Discount Rate  

Mix these ingredients together and we get the resulting Customer Lifetime Value formula:

(GP – CAC) * (RR / (1 + DR – RR)

Identifying Your Customer Acquisition Cost (CAC)

One of the biggest mistakes that companies make today is essentially just calculating the expected gross profit of a customer and using that as the lifetime value of a customer without incorporating the Customer Acquisition Cost (CAC). Simply defined, CAC is the cost related to acquiring a potential customer. In other words, the marketing and sales dollars you spend persuading a customer to buy your product or service. This cost usually includes advertising, promotion and campaign spend.

“The importance of Customer Acquisition Cost stretches beyond just defining the success of a marketing campaign.”

However, the importance of Customer Acquisition Cost stretches beyond just defining the success of a marketing campaign. It enables a company to decide which investment to make to get the maximum engagement and ultimately the highest ROI. According to marketing researchers, the cost to acquire a new customer is six to seven times more than to retain an existing customer. Determining your CAC can help a company spend their targeted marketing dollars toward retaining and growing the existing customer base, while measuring the effectiveness of a promotion or campaign.

Calculating Your Retention Rate (RR)

Another key ingredient needed to measure CLV is Retention Rate – the rate at which a company retains its current customer base. How long are your customers really sticking around? It describes the average lifespan of a customer’s relationship thereby allowing a business to compute the net profit of that customer. A study by Bain & Company reported that increasing your retention rate by just 5% could potentially increase a company’s profit by 25% to 90%. Knowing your retention rate can help you develop retention strategies to improve your CLV and ultimately increase future revenue.

“Knowing your retention rate can help you develop retention strategies to improve your CLV and ultimately increase future revenue.”

To calculate Retention Rate you take the total number of customers at the end of a period (E), the total number of customers acquired during that period (N), and the total number of customers at the start of the period (S). In other words, you use the following formula:

{(E – N)/S}*100

Bringing It All Together  

Now that you understand the different components that are pre-requisites to calculating CLV, the next step is bringing all the ingredients together and applying the formula. Ensure that you use the appropriate discount rate – that helps you determine the present value of the future expected customer profits. Usually this rate falls between 8 and 15%. 

“CLV doesn’t add much value if you don’t segment your customer base to get different analysis points.”

The formula may be straightforward, and though it will produce a useable metric, it doesn’t add much value if you don’t segment your customer base to get different analysis points.  

Here are a few best practices that you should keep in mind as you measure CLV for your business. 

Umbel Best Practices 

First and foremost, segment, segment, segment your customer base! This cannot be emphasized enough. Customer lifetime value should never just be one number. Not all customers are the same and they definitely shouldn’t be measured equally. Segmenting by behavior or by frequency of purchase, site visits, or average vs. loyal customer are a few ways to start the user segmentation process. Here at Umbel, we help our clients segment and convert their audience data into valuable insights to maximize customer lifetime value.   

Second, CLV is not a one-time calculation. Managing and monitoring your CLV model should be a continuous on-going process. It is important to re-assess this metric to be a sustainable and profitable business in the long run, including evaluating your CAC to ensure that the CLV ratio is higher than the CAC. 

Third, Customer Lifetime Value is an analytical framework and tool that can help a business strategize initiatives and campaigns to increase gross profit and improve retention rates. The CLV metric itself is not the strategy, but rather should be used to develop targeted marketing strategies.

Lastly, don’t just take the average gross profit and assume that number to be the lifetime value of your customer. Most businesses forget to include CAC when calculating CLV and incorrectly measure the net profit attributed to a particular customer.

If you’re interested in learning more about identifying the CLV of your audience, contact us for a demo