Understanding your customer lifetime value

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As startups and small businesses grow, understanding metrics and data will give them insights to stay ahead of their competition or in some cases, just stay afloat. 

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Oftentimes, business owners are overwhelmed with the amount of financial metrics they hear about and their advisors aren't putting the right metrics in front of them.

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One of our favorite financial metrics that all businesses should try to track is "Customer Lifetime Value". The customer lifetime value metric shows how much a customer will be worth to a business over the period of their relationship.  

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Understanding this number will allow you to set your sales and marketing budget, improve operations, and cut out unnecessary spending in other areas. 

How to calculate customer lifetime value

Different advisors will calculate this metric slightly differently, so it’s important to remain consistent in your measurements over various periods.

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To calculate customer lifetime value (CLV), look at the gross profit margin (GPM) on the profit and loss statement (P&L). GPM is calculated as Revenue less Cost of Goods Sold. Cost of Goods Sold may also be listed as Cost of Sales.  An inventory-based company may use "Cost of Good Sold" while a service-based company may call it "Cost of Sales." 

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Some advisors may recommend using the net profit margin vs gross profit margin.  Given the variations in general and administrative expenses, we prefer the gross profit margin to more accurately look at the profitability of a customer.

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Gross Profit Margin: By using information from the company’s profit and loss statement (on an accrual basis, if possible):

Gross profit margin per customer: After you have calculated the company’s GPM, you'll take the GPM and divide it by the number of unique customers the business has. 

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For example, if one customer buys from the business five times, that customer will be counted as one customer and not five customers.

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Determine the “GPM per customer” by taking the gross profit divided by the number of unique customers 

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Gross Profit / # Unique Customers = GPM per Customer

Determining the average customer's "lifetime" or how long they stay with the business (i.e., 3 years) can be more of an art than a science for a small business with limited data.  If your business has only been around for a few years, we recommend reviewing industry statistics to help approximate the lifetime value of the customer.    

Customer lifetime value: Calculated by taking the gross profit per customer and multiplying it by the average customer lifetime.

Real-world example

A cold brew company just started making a new nitro blend and they have a gross profit margin (GPM) of $500,000, and they have a total of 1000 customers for this product line. 

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The gross profit per customer is $500,000 GPM / 1000 customers = $500.

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This niche coffee company has done research to determine that their average customer stays with them for 10 years, given how addicting their nitro blend is.

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Thus, their customer lifetime value from this product line is $5,000 ($500 * 10 years). 

Why is customer lifetime value important?

If you understand your customer lifetime value, you can make strategic decisions that others in your industry may be overlooking. 

Marketing

The CLV will give the business an idea of how much to spend to acquire a new customer on marketing, advertising, and sales.  In the example above, the coffee company may be targeting a 2:1 ratio, meaning they’d pay up to $2500 to acquire just one customer. In fact, studies have shown that Starbucks will spend nearly $20,000 to acquire just one customer, given the high CLV of a Starbucks customer.

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There are some aggressive schools of thought in the marketing world that businesses can spend up to one year worth of client margin to buy that ten year loyal customer. All business owners will need to think about how much they're willing to spend to acquire a customer that will provide them with a certain amount of gross profit over the defined customer lifetime. 

Resolving customer experience issues

Customer lifetime value can also help identify business cycle issues. For example, if a business starts to see their CLV decline from year 1 to year 2, they may have a fulfillment or experience issue internally that they must solve before expanding further. 

Customer retention vs customer acquisition

Customer or client retention varies from industry to industry.  However, research shows that keeping a customer can be 5 to 20 times less expensive than the cost of acquiring a new customer.

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If the customer lifetime value can be increased by just 10%, a business is going to see better results as compared to having to spend additional money to attract new customers over and over again.  

Putting it all together

Once a business understands its customer lifetime value,  it can use it on a month-to-month or quarter-to-quarter basis to fully understand the business at this deeper level, and then focus on what can be changed over time to improve results.  

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Every business begins this CLV journey at a different stage, so we routinely urge our clients to just start tracking, whether it is at the beginning of a new period or in the middle of their busiest season. The data will give you new insights and help you and your team make more informed decisions for years to come.

Reduce your bottom line with Ramp

Ramp is transforming finance, and we’re just getting started. Our mission is to offer significant savings in time and money, allowing businesses to flourish. Organizations turn to Ramp for one reason: enhanced business efficiency. Ramp aims to accelerate their journey towards achieving their goals.

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Ramp's effectiveness is evident in our customers' growth. Businesses are making wiser choices backed by real-time, AI-powered insights, and allocating their teams to more strategic tasks by streamlining mundane, manual processes.

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The information provided in this article does not constitute accounting, legal or financial advice and is for general informational purposes only. Please contact an accountant, attorney, or financial advisor to obtain advice with respect to your business.