With Facebook CPAs skyrocketing, Customer Lifetime Value (CLV) and how it is the key to building a successful eCommerce company has become the talk of town.

Yet, most of the stuff that a Google search finds is incorrect or at least incomplete. And if it isn't, it’s not really actionable and only scratches the surface.

To operationalize CLV in an eCommerce company, there are a lot of nuances that need to be considered and understood.

This article contains everything I learned about CLV over the last ten years, running marketing for eCommerce businesses, and will equip you with what you need to know to not only survive, but thrive in this new reality.

You will learn:

• The mindset shift required to effectively use CLV
• How to actually calculate your customer lifetime value (most people do it wrong).
• Why CLV is actually not the most important KPI for most brands.
• How to calculate the right CLV to CAC (Customer Acquisition Costs) ratio for your business.
• Why looking at the average CLV is a waste of time when optimizing.
• What reports to look at instead to find pockets of high CLV customers.

Sounds good?

Let’s get started.

From transactions to relationships

The underlying premise of using CLV as a core metric is quite simple.

Instead of analyzing profitability for every transaction in isolation, you look at your entire relationship with your customers and analyze profitability across that relationship.

This works well as most eCommerce companies spend more than 90% of their budget on acquiring a new customer and therefore marketing costs usually only occur at the beginning of the relationship.

The costs to acquire a customer are simply called customer acquisition costs (CAC) and are calculated by dividing the marketing spend by the number of new customers. This is usually done on a monthly basis to track the development of your acquisition efficiency over time.

So if you acquire a customer for €50 and his first order generates €20 of value, you lose €30. 

Bad deal.

But if that same customer, without you investing any more money, places another three orders with a €20 value that €30 loss turns into €30 profit. 

Good deal.

So the costs and the value are just captured at different points in time. 

Specifically brands that sell a product with a high probability of repeat purchases like low value consumables might not be able or even want to generate enough value in the first order to break even on acquisition costs. 

They count on customers coming back frequently to break even and turn a profit.

By shifting from a transactional view, so evaluating every purchase individually, to a relationship view, evaluating all purchases from the same customer together, they can maximize overall long-term profit and continue to acquire new customers that on a transactional analysis appear to be unprofitable.

One of the underlying assumptions of this approach is that the vast majority of your marketing is invested in acquiring your customers. 

If this is not the case or you simply can’t measure the relationship (like on Amazon for example) you should stay away from this approach and continue to evaluate your efforts on a transactional basis.

How to calculate Customer Lifetime Value

The CLV expresses how much a customer is worth to you and, like the name suggests, consists of three main components. 

Customer, Lifetime & Value.

The customer part is pretty clear. That leaves with two. Let’s look at them individually.

What is the value of your customers?

The value of a customer should always be equal to the Cumulative Contribution Margin 2 (CM2) you generate from him. 

If you see someone that is showing you a CLV figure that is based on revenue, just run.

The CM2 is the Net Revenue (so excl. Returns and Taxes) minus the Cost of Goods Sold, Logistics, Fulfillment & Transaction Costs. So all variable costs required to fulfill the order.

Why is marketing not included? Like I said, in most eCommerce businesses the majority of marketing is spent to acquire new customers and therefore only seen as a cost for the first order and not all orders. 

Understanding the lifetime of your customer

This is already where the trouble begins. What is the lifetime of your customers?

Honest answer: It is tough to say.

But it also does not matter too much in most cases.

Different products have different natural life cycles. What you will find though is that in most cases, ecommerce businesses have a concave value (aka. CM2) growth.

Meaning that most of the value is generated early in the relationship and with every month that passes, the incremental CM2 that is generated per customer decreases.

So, while there is a way to calculate an average lifetime of your customers, it’s actually not that important for multiple reasons as we will talk about later.

What is crucial is for you to understand what the value curve looks like for your business to understand how much value you can extract within a given time frame when you reach CAC break even.

Finding the right CLV/CAC ratio to maximize growth

CLV and CAC together cover all revenue and variable costs, but they are captured at different points in time. 

Revenue, COGS and logistics & fulfillment Costs are captured as CLV on an ongoing basis everytime a order is placed.

Customer Acquisition Costs (CAC) are the marketing costs invested to acquire a customer and are captured when a customer is placing his first order. That’s because most eCommerce companies invest most of their marketing money on acquiring customers.

Therefore when your CLV is bigger than your CAC, you are generating a profit from every single customer you acquire.

So you might think that maximizing the CLV/CAC ratio is the core to maximize profitability in a relationship-based approach.

Wrong.

Let’s look at the following example.

You currently acquire 1000 customers per month with a CAC of 20 and a CLV of 100, giving you a CLV/CAC ratio of 5.

That’s 80.000 in profit -> 1000 * (100-20)

But by being so profitable, you could leave money on the table. 

You don’t want to optimize relative but absolute margin. Money in the bank.

Let’s build on this example.

Since you are so profitable, you start spending more on marketing. This increases the number of new customers you can acquire but also increases your CAC as efficiency tends to decrease as you scale spend.

Let’s assume that the growth in customers and growth in CAC are perfectly correlated. So if you want to acquire 10% more customers, your average CAC for all customers will also increase by 10%.

With that being the case, you could generate the most profit by increasing your CAC to 50 allowing us to generate 2500 customers per month.

Now your CLV to CAC ratio is only 2 (100/50) and your profit per customer is down to 50. A decrease of 37.5%.

But the total amount of profit you were able to generate in up to 125.000 (2500*(100-50)). 

That’s a 56% improvement and the benefit of using CLV to optimize for absolute profit.

You move the time horizon you optimize for from a single transaction to a more long-term view which allows you to increase absolute profitability.

So in theory, a CLV/CAC ratio of 2 would maximize profits.

This is not a general rule but specific to the outlined margin structure and CAC to marketing spend relationship.

Finding this sweetspot and with it your ideal CAC target is crucial as it's usually a core operational KPI your acquisition efforts are built around (more on that later).

However, reality is unfortunately a bit more complicated and there are a few other things that you need to consider.

Especially if you have a business that generates a significant percentage of its CLV after the first purchase of the customer.

CLV/CAC Ratio Pitfalls

Even if your CLV/CAC is in the theoretically best spot, you still might run into problems.

Liquidity problems to be exact.

That’s an issue that is frequently overlooked but crucial when trying to find the perfect CLV/CAC ratio for your business.

You are investing marketing money at the beginning (aka CAC), but are only generating profit over a longer period of time (aka CLV).

Your customers are therefore an asset that you are monetizing. Almost like inventory.

So initially, there can be a liquidity gap and therefore to find the perfect CLV/CAC ratio, there are a few things you need to consider. 

Lifecycle Length

How stretched out your value curve is will have strong implications on your liquidity.

You might think that a long customer lifetime is a good thing. Well, all other things being the same, a shorter lifetime is always preferable.

The chart below shows you two potential life cycle lengths and CLV distribution.

In both options,you generate a CLV of 100 but Option 1 generates the CLV with 3 months where Option 2 needs 12 months to get there.

The red area underneath the CAC line is what I call the Liquidity Gap. It’s the portion of your CAC that you have not recouped yet and can’t reinvest yet.

Therefore, the sooner you can extract the value from my customers, the better your cash position will be and the quicker you can reinvest it into more new customers.

Value Distribution in the Lifecycle

But even when two companies have the same lifecycle length one might run into liquidity problems while the other thrives.

It’s not just about the length of your lifecycle, but also how value is distributed within that lifecycle.

In the chart below in both cases a CLV of 100 is reached after 12 months. But the green line generates a lot more of that CLV early on in the lifecycle and therefore its liquidity gap is way smaller.

Again, the more value is generated early on in my relationship the better for my liquidity.

Your Marketing Budget & Growth Rate

The next question then becomes how much you invest into marketing per month and how quickly you want to grow this amount.

Again, the higher both of these numbers are, the larger the amount of customers you will have that have not broken even yet and therefore the higher your total liquidity gap will be.

So let’s say that you have a CAC of €50 and the CLV of your customers is €100 but only €30 of the value is generated with the first order, you have still made an initial loss of €20.

So when you invest €25k into marketing that will be an initial loss of €10.000 - 25k/50*20

If you were to 4x your marketing budget to €100k that loss will also quadruple to €40k.

Not only the starting marketing budget is important but also how quickly you want to grow it as these losses get stacked on top of each other until each cohort of customers (more on that later) reaches break even.

Your Starting Cash Balance

Following the previous point and the fact that we are talking about liquidity in general, your starting cash position is crucial and will dictate how aggressively you can invest into acquiring customers that you will only monetize later.

If you only have €100k in the bank, but you lose €20 with every initial purchase of a customer, the most customers you could possibly acquire is 5.000 - 100.000/20

While there are many ways to finance working capital needs of eCommerce companies, new alternative financing options are only now emerging for these companies to finance customers.

Therefore, to scale more aggressively, eCommerce companies where the majority of CLV is generated after the first purchase have thus far often needed venture capital financing to maximize acquisition in a short period of time.

Cash Conversion Cycle

Like I mentioned, in our CLV the value and its related costs are captured on an ongoing basis. While this is true for fulfillment and payment costs, it is not for your COGS. These usually need to be paid to your supplier and manufacturer upfront before you can sell your products. 

The difference in when you are generating value from your inventory and when you have to pay for it is called the Cash Conversion Cycle (CCC). Another liquidity pitfall that is easily overlooked.

Since finding the ideal CLV/CAC ratio for your business is mostly a liquidity question, the CCC also needs to be considered in this context and optimizing it by for example negotiating better payment terms will alter the ideal ratio.

Fixed Costs

CLV and CAC only contain variable revenue and costs but obviously you also have fixed costs like salaries and rent.

Again, finding the right CLV/CAC is mostly a liquidity question and therefore fixed costs need to be considered when trying to find the ideal ratio.

Certainty & Risk-Appetite

CLV is a constantly changing number. The longer the lifecycle is during which value is generated, the longer the time frame where things could go wrong.

A production could go wrong, suppliers might miss their shipping deadline, marketing campaigns might not have the forecasted effect.

To avoid any one of these things derailing your entire business, you should set your CLV/CAC ratio and growth targets at a place that keeps a safety net of liquidity. The closer you run to zero, the quicker you will grow, but also the larger the risk exposure you have will be.

How much risk exposure you want is a very personal decision and one that should be made consciously.

Bringing it all together in a simple model

Puh, quite a few things to consider right?

There is no CLV/CAC ratio that is the ideal for every business. You have to consider all these factors and can’t just optimize for profitability but have to consider liquidity.

Luckily all these variables can be modeled out in a spreadsheet.

And yes, we I have created a template for you to do just that. 

Here you can find a link to a public spreadsheet that contains all the variables mentioned above and allows you to play through different scenarios.

You will be shocked by how small changes can turn your business upside down completely.

Watch this video to make sure that you know how the sheet works and to understand the impact and relationship of the different variables that we talked about.

If you don’t have all of the input variables, our tool Klar provides them (among many others). Reach out and we’ll get you onboarded. 

Operationalizing CLV In Your Company

Optimizing your business based on the ideal CLV/CAC ratio considering your short-term liquidity can unlock massive growth potential for your business.

But operationalizing this in your company can take some time and it requires a change in the way your organization thinks.

Understand Your CLV

This one should go without saying. You need to know exactly how your CLV develops in the months after first purchase.

Don’t just look at a weighted average across all your customers but understand if there are any trends in CLV development.

Do customers that have bought recently have a different CLV from past customers? Why would that be? This thread by OG Andrew Chen might have the answer.

Another trend could be seasonal. Customers acquired in summer might have a lower quality than those acquired in winter. If so, your model needs to reflect that.

The best report to understand what your CLV curve looks like and to uncover seasonal trends is the cohort report like the one built into Klar.

Here a video that explains how a cohort report works and how you can read it:

Identify different CLV segments

Once you have an intimate understanding of your CLV and its development, you need to dig two levels deeper to understand if there are different groups of customers that have significantly different total lifetime value or differences in the value length and distribution.

How to do it will be part of one of my next deep dives. If you don’t want to miss that, be sure to sign up for our newsletter.

Define Your Risk-Appetite & Set Up Liquidity Planning

Once you understand your CLV, the next step is having an honest conversation with yourself and how much risk exposure you want to have.

No plan is perfect and there are always things that can go wrong. Set up a proper liquidity plan (you can use our CLV/CAC model as inspiration) and make sure that you have enough cash reserves to compensate for smaller bumps in the road and for you to sleep at night.

I plan to build a detailed template, based on the simplified model above, in the future. If that is something that would be of value to you, let me know on LinkedIn or Twitter. If I get many requests I will prioritize it.

Set The Right KPI For Daily Operations

CLV is the engine of your business. 

But how can you make decisions daily based on something you only know the results of in many months, maybe even years from now.

Short answer: You can’t.

Therefore, you need a more immediate KPI you can optimize again.

This KPI should be your CAC as you can fairly accurately calculate it on a daily or at least weekly basis.

Your CAC target should be determined by your liquidity plan.

However, instead of determining a fixed CAC in the model, we would rather define CAC based on the Payback Period. So after how many days you want your CLV to become larger than your CAC.

Setting a payback window target instead of a fixed CAC targets reduces misaligned incentives and also gives your team more flexibility to explore new offers and treat different CLV segments (see above) appropriately.

Educate Your People

Now that you understand your CLV, built a liquidity plan and set your CAC payback period target, it is time to educate your team on this new approach.

This is absolutely crucial as you rely on them to make the correct decisions while in the trenches. 

However, they can only do so if they understand this methodology in detail and the relationship between its different variables.

Unfortunately, this step gets skipped or not treated with the necessary importance way too often. Because you spend many days thinking through it, this new way of thinking has become second nature to you.

Your team does not have this advantage.

So don’t rush this step. A good way to start is sharing this article with them and then sit down together and have an open discussion on any questions that were left unanswered.

Please send these questions to me so that I can incorporate answers to them in this article :)

Revisit Your Assumptions

This entire new approach is built on a varios assumptions. 

To make sure that you are staying on track you regularly need to verify that the assumptions you made are true.

If you are starting to see deviations, you need to make adjustments.

Here are the things that you should be checking every month:

CLV Development

Check the development of your CLV and your payback period every month.

Your go-to report again will again be your Cohort Report.

If your CLV varies significantly from your expected value, you need to adjust your liquidation plan and your CAC target accordingly. This can be easily done in Klar.

Change in CLV can be driven by external factors like changes to ad platforms and internal changes like a newly introduced offer.

CAC to New Customer Correlation 

Your liquidity plan is built on an assumption where your CAC will change as you increase marketing spend. 

You would usually assume that your CAC gets worse as you start to spend more but how much worse is tough to say.

That largely depends on how broad the appeal of your product is and the quality and execution of your acquisition team.

Once you start scaling spend you will get a better feel for this relationship and need to adjust your model.

Cash Position 

If there are any material changes in your cash position you need to update your model which in turn will likely trigger an adjustment in your CAC target and marketing budget.

The later such adjustments are made the larger their impact will be.

Think of CLV like a moving freight train. The later you break, the harder you will need to break to stop in time.

Final Thoughts

Implementing this relationship-based CLV approach will maximize the return on the capital that is available to you.

Make sure that you follow the approach outlined above when operationalizing it in your business. Especially the part on educating your team and regularly revisiting your assumptions.

Small differences in assumptions multiplied by thousands or tens of thousands of customers can have a big impact. 

So make sure that your CLV calculations are 1000%.

If there is anything that you feel like was left unanswered, please send me a email or a message on LinkedIn.

I am already working on two additional long-form content pieces that are building on top of this one:

1. How to identify high CLV customers
2. How to increase CLV of customers

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