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What does customer lifetime value (LTV) mean?
For businesses that have income based on recurring payments, or repetitive orders, they’ll need to work out what their customer lifetime value is. This figure represents how much a customer spends over the course of being associated with the business.
Let’s use online food shopping as an example. A person may regularly purchase their weekly food shop from a particular website, on average spending $75. In our example, this person purchases their food shop weekly for 6 months, before deciding to go elsewhere.
Their customer lifetime value would be $75 for every week they purchase from this website.
Why is customer lifetime value (LTV) important?
Calculating the average lifetime value of your customer is important as it allows you to assess how much you can afford to spend on marketing, sales and other resources.
For example, if your customer lifetime value was $100, this $100 would need to cover the costs of manufacturing (if applicable), staff/wages, marketing, and any other business expenses associated with the sale of one product, along with a margin for profit.
If you calculate that your customer lifetime value is lower than the expense to advertise, manage and supply the product/service, this means that you’ll need to take measures either to reduce the expense, or to increase the longevity of your customers.
This can be done by sending a survey to all customers who leave asking the reason behind their departure. Once you understand the reasons behind their departure, you can implement new processes or features to reduce the churn. For example, if the reason why a lot of customers leave is due to poor customer support, then this will be an area for improvement you can implement into your business plan.
What metrics support customer lifetime value?
Just calculating your customer lifetime value on its own, doesn’t provide much value as an overview of the profitability of a product/service, or your business.
As we’ve established, your customer lifetime value needs to be higher than all the expenses that occur in the purchase, otherwise your business will be at a loss each time it makes a sale.
A metric that is useful, and ties in with your customer lifetime value is your customer acquisition cost. Your customer acquisition cost is how much you’ve spent to acquire a new customer. It is calculated by taking your sales and marketing costs and dividing it by the total new customers you acquired. Although it won’t impact your customer lifetime value, it gives you a better understanding of how this money is being spent in terms of marketing.
A second metric is your attrition rate, which refers to the total amount of people (whether it be accounts, subscribers, members, customers) that have left in a given period. Understanding why a person has left, gives you the opportunity to improve your product or service so future customers will stay with you for longer. This in turn will improve your customer lifetime value.
Third, your retention rate, which is the opposite to your attrition rate. Your retention rate shows you how many customers stayed with you in a given period, rather than left. Your retention rate can teach you why a customer has decided to stay with you. It might be because of a feature that is really insignificant to the purpose of the product, but has a huge impact on the customer. Understanding these reasons will help you optimize your sales funnel and marketing strategy, as what features you (the owner) might think are important, might not be the same as the customer. You can utilize this knowledge.
How to calculate LTV?
To calculate your customer lifetime value you need to take the average order value, multiply it by the number of sales they’ll make in a given time period, then lastly multiply it by overall retention time.
For example, our online food shop has an average order value of $75 which is made 4 times every month. The customer stays for a total of 6 months, until leaving.
Therefore, we take $75, multiply it by 4 which gives us $300, lastly we multiply this by the retention time of 6 months – $1,800.
$75 x 4 x 6 months = $1,800 customer lifetime value
Average order value x Number of repeat sales x retention time = LTV
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