WHY
Customer Lifetime Value (LTV) is a critical metric that every business should measure for each product or service they offer. LTV represents the total revenue a customer is expected to generate throughout their entire relationship with your company.
As a simple example, let’s say that ABC Gym charges $30 per month for membership, and the average member stays for 12 months. This means the Customer Lifetime Value (CLTV) of a customer is $360.
Knowing your customer LTV is essential because it provides valuable insights into the long-term profitability of your customer base and helps shape your marketing strategy.
Here are some key reasons why measuring LTV is crucial:
- Better Resource Allocation: Understanding LTV enables you to allocate your marketing and sales resources more efficiently. By identifying which products or services yield the highest LTV, you can focus your efforts on attracting and retaining the most valuable customers, resulting in a more cost-effective marketing strategy.
- Improved Customer Segmentation: LTV helps you segment your customer base effectively. You can categorize customers based on their LTV, allowing you to tailor your marketing efforts and offers to different customer segments. This personalized approach can lead to higher conversion rates and customer satisfaction.
- Enhanced Product Development: Measuring LTV per product or service can guide your product development efforts. You can invest more in products or services with a high LTV and optimize or discontinue those with a low LTV, ensuring your resources are directed towards offerings that generate the most revenue.
- Long-Term Profitability: Companies that focus on maximizing LTV often achieve greater long-term profitability. According to a study by Harvard Business Review, increasing customer retention rates by 5% can increase profits by 25% to 95% over the long term, highlighting the significance of LTV in building a sustainable business model.
Now that you understand the importance of measuring LTV let’s proceed to the practical steps for calculating it.
WHAT
To calculate customer lifetime value for a single customer, you’ll need the following metrics:
Average Purchase Value (APV): This metric represents how much, on average, a customer spends each time they make a purchase.
- Formula: APV = Total Revenue from the Customer / Number of Purchases
- Example: If a customer has spent a total of $500 across 10 purchases, APV = $500 / 10 = $50.
Average Purchase Frequency (APF): This metric tells you how often, on average, a customer makes a purchase from your business.
- Formula: APF = Number of Purchases / Time Period (usually measured in months or years)
- Example: If a customer made 10 purchases in 2 years, APF = 10 / 2 = 5 purchases per year.
Now that you understand the metrics you’ll need, the formula for calculating LTV is:
LTV = APV x APF
Example: LTV = $50 (APV) x 5 (APF) = $250
The example above is how you’d calculate LTV for a single customer. This is useful when you want to understand the lifetime value of an individual customer. It’s particularly helpful when making decisions about personalized marketing or loyalty programs.
However, if you want to calculate your average customer LTV for more than one customer at a time, you’ll need two additional metrics:
Churn Rate: Churn rate represents the percentage of customers who stop doing business with your company over a specific period of time.
- Formula: Churn Rate = (Number of Customers at the Beginning of the Period – Number of Customers at the End of the Period) / Number of Customers at the Beginning of the Period
- Example: If you had 100 customers at the start of the year and only 80 at the end, the churn rate is (100 – 80) / 100 = 20%.
Average Revenue Per User (ARPU): ARPU measures the average revenue generated by each customer over a specific period.
- Formula: ARPU = Total Revenue Generated / Number of Customers
- Example: If your business earned $10,000 from 100 customers in a month, ARPU = $10,000 / 100 = $100.
Utilizing churn rate is important when you want to account for customer attrition and get a more accurate picture of your business’s sustainability. It’s particularly useful for making decisions about customer retention strategies.
Now, the formula you’ll use to calculate average customer LTV with churn rate and ARPU is:
LTV = (ARPU x APF) / Churn Rate
Example: LTV = ($100 (ARPU) x 5 (APF)) / 0.20 (Churn Rate) = $250
The relationship between churn and customer LTV is that as churn rate decreases (meaning fewer customers leave your business), the LTV tends to increase because customers stay with your business longer, resulting in more revenue generated over their lifetime. It’s essential to monitor and manage churn rate to maximize customer lifetime value and the overall health of your business.
Things to Consider
There are a few additional points to consider when working with Customer Lifetime Value (LTV):
Segmentation: You can calculate LTV for different customer segments or cohorts. Not all customers are the same, and some may have significantly higher LTV than others. Segmenting your customer base allows you to tailor your marketing and retention strategies more effectively.
- Imagine you have a group of customers, and they’re not all the same. Some may be frequent shoppers, while others only buy occasionally. Segmenting means dividing these customers into smaller groups or “segments” based on similarities, like their buying habits or demographics. This helps you understand which types of customers are the most valuable to your business.
Discounting: In some cases, it’s essential to account for the time value of money by discounting future cash flows. This means that a dollar earned in the future is worth less than a dollar earned today. Discounting can provide a more accurate representation of the present value of future customer revenues.
- Think of money like a cake. If you get a slice of cake today, it’s more enjoyable than waiting to get that slice in the future. Discounting means considering that money you’ll receive from customers in the future is worth a little less than money you get today. This way, you can figure out the real value of future customer earnings.
Customer Acquisition Cost (CAC): To determine whether your customer acquisition efforts are profitable, you can compare the LTV of a customer with the cost it took to acquire them (CAC). If your CAC is significantly higher than the LTV, it may indicate that you need to adjust your acquisition strategies.
- CAC is like counting how much money you spend to bring in new customers. It includes things like advertising, marketing, and sales expenses. You want to make sure that the money you spend to get new customers doesn’t cost more than the money those customers bring in.
Referrals and Word-of-Mouth: LTV calculations often focus on direct revenue generated by a customer. Still, it’s essential to consider the potential impact of referrals and word-of-mouth marketing. Satisfied customers can bring in new customers, increasing the overall value they bring to your business.
- Sometimes, happy customers tell their friends about your business, and those friends become customers too. This is like a bonus because it doesn’t cost you anything to acquire these new customers. LTV calculations might not always consider this, but it’s a nice extra benefit.
LTV to CAC Ratio: This ratio compares the Customer Lifetime Value (LTV) to the Customer Acquisition Cost (CAC). A ratio higher than 1 indicates that your customers are bringing in more revenue than it costs to acquire them, which is a positive sign for your business.
- Imagine you’re playing a game where you invest money to make more money. The LTV to CAC ratio is like keeping score. If you’re spending $10 to get a customer, but that customer brings in $30 over time, your score is good (LTV to CAC ratio is 3:1). It tells you if your investments in acquiring customers are paying off.
Updating LTV Calculations: LTV is not a static metric. It should be periodically reviewed and updated based on changes in customer behavior, pricing, or other factors that affect revenue and retention rates.
- Think of LTV like a weather forecast. It’s not always accurate forever. It might change if your customers start buying more or less, or if you change your prices. You need to keep checking and updating your LTV calculations to make sure they’re still accurate.
Predictive Analytics: You can use predictive analytics to estimate LTV for new or potential customers. This can help you make informed decisions about resource allocation and marketing strategies.
- Imagine you have a crystal ball that can predict the future. Predictive analytics is like using data and math to guess how much money a new customer might bring in based on what you know about similar customers in the past. It helps you make smart decisions about marketing and investments.
Consideration of Customer Churn: As mentioned earlier, churn rate has a significant impact on LTV. Reducing churn through customer retention efforts can lead to more valuable long-term relationships with your customers.
- Churn is like losing drops of water from a bucket. If you’re losing customers, it’s like losing money. Reducing churn means plugging those leaks so your bucket stays full. It’s important because it helps keep your LTV higher.
Industry Benchmarks: It can be helpful to compare your LTV metrics to industry benchmarks to see how your business performs relative to competitors. This can provide insights into whether your customer relationships are stronger or weaker than average in your industry.
- Think of industry benchmarks like comparing your test scores to the class average. It tells you if your business is doing better or worse than others in your industry. If your LTV is higher than the average for businesses like yours, it’s a good sign.
Additional Resources:
For more information on Customer LTV, check out the following articles:
How to Calculate Customer Lifetime Value