Let’s look at the main CLV formula is two ways – the first way in words and then as a CLV equation (see separate article on another one of my websites). As you will see, the main customer lifetime value formula is an extension of the simple CLV formula. The main changes are that the main CLV formula looks at each year of customer revenues and costs on an individual basis. This allows different numbers to be utilized each year. The main customer lifetime value formula also uses a discount rate to determine the present value of future revenues and costs.
The simple CLV formula is:
- Annual profit contribution per customer X
- Number of years that they remain a customer less
- The initial cost of customer acquisition
Whereas this CLV formula is:
- Annual profit contribution per customer (for each year under consideration) X
- The cumulative customer retention rate less
- The initial cost of customer acquisition
- With each yearly figure adjusted by an appropriate discount rate
Note: the second line formula – referring to churn rate – is actually calculating customer’s average lifetime period in years.
Main differences between the two CLV formulas
The main differences between the simple version and the full version of the CLV formulas are that the full customer lifetime value formula allows for:
- Changing customer revenues each year,
- Changing customer retention and up selling costs over time,
- Changing retention (and therefore churn rates) over time, and
- It applies a discount rate (to determine the present value).
An example for the main customer lifetime value formula
Let’s assume the following:
- Profit (customer revenues less costs) generated by the customer in year one = $1,000
- This increases to $1,500 in year two and then to a maximum of $2,000 for year three onwards
- The retention rate of customers is 75% (and therefore the churn rate is 25%)
- Cost to acquire the customer = $1,000
- A discount rate of 10% is considered appropriate
The calculation of CLV (BEFORE discounting) would be:
- Year 0 = – $1,000 acquisition costs
- Year 1 = $1,000 customer profit
- Year 2 = $1,500 customer profit X 75% retention = $1,125
- Year 3 = $2,000 customer profit X 56% (75% of 75%) retention = $1,125
- Year 4 = $2,000 customer profit X 42% (75% of 75% X 75%) retention = $844
- Year 5 = $2,000 customer profit X 32% (75% of 75% X 75% X 75%) retention = $633
- And so on
Using the free Excel template – the non-discounted CLV = $6,125
The calculation of CLV (WITH discounting) would be:
- Year 0 = – $1,000 acquisition costs divided by 1 (no discount)
- Year 1 = $1,000 customer profit divided by 1.1 (10% discount) = $909
- Year 2 = $1,500 customer profit X 75% retention divided by 1.21 (10% X 10% discount) = $930
- Year 3 = $2,000 customer profit X 56% (75% of 75%) retention divided by 1.32 (10% X 10% X 10% discount) = $845
- And so on
Using the free Excel template – the discounted CLV = $3,995
As you can see, the discounting factor has a significant impact on the final customer lifetime value.
