Customer lifetime value (LTV) estimates the average revenue a customer will earn for a company over the entire length of the relationship. It's an important metric that plays a critical role in optimizing revenue and profit because it's a crucial part of calculating the unit economics of a business. It should be considered when estimating budgets, forecasting cash flow, determining valuation, and increasing profitability.
Want to know more about LTV? Then keep reading to get an in-depth understanding of how it can help your business.
What is LTV?
The average lifetime value of a customer is a metric that helps the business measure the amount of revenue it can reasonably expect from a customer throughout the business relationship.
Customer lifetime value spans beyond purchase by purchase basis. It is the sum of all your company's values from a customer throughout your relationship. CLV is one of the benefits of repeat business. The longer your relationship with a customer, the higher the lifetime value.
CLTV is an important metric because it gives you an insight into the profit you are likely to earn from a customer relationship. Thus you will know how much you are willing to invest in nurturing such a relationship.
CLTV can also be used to determine how long a business will take to earn the amount of money spent on customer acquisition, such as investments in marketing and sales efforts.
Customer lifetime value aids critical decision-making. It can help you recognize high-value customers so that you give them more attention. Your customer service and success team can use this metric to increase customer loyalty and reduce churn rate.
How to calculate LTV
You can calculate the lifetime value of your entire customers or certain customer segments.
There are different models of calculating customer lifetime value; historical customer lifetime value and predictive customer lifespan value. You can get different results depending on your approach to measuring your customer lifetime value. Your business model and available resources or information will influence your choice.
Historical customer lifetime value
The historical customer lifetime value approach tries to calculate customer lifetime value by summing the gross profit you've made from purchases your customers have made in the past. To get this, you only require data on past customer purchases. If you want to calculate your CLV with this approach, you can either use
Average Revenue per User (ARPU) method or Cohort analysis.
Although historical CLV is regarded as an easier model compared to Predictive CLV, it has some disadvantages. The historical model does not consider changes in customer behavior and interest, which may affect the final result. You can only use the historical CLV model if all your customers have the same product/service preference and they stayed with you for the same period.
Predictive customer lifetime value
Predictive customer lifetime value model models customer behavior and forecasts future buying behavior of new and existing customers with machine learning or probability.
Using machine learning, regression is used to fit in past data and forecast the CLV. Using a probabilistic approach, a probability distribution fits into the data. Then the monetary value for each transaction and the future count of transactions will be estimated.
Although this approach is more technical, it achieves better results.
Customer Lifetime value formula
Customer Lifetime Value = Customer Value × Average Customer Lifespan
To get your CLV with this formula, you must first calculate your customer value.
CV = Average purchase value × Average number of purchases
Secondly, calculate your average customer lifespan ( ACL). After doing that, you can now multiply your CV and ACL to get CLV.
Before applying this formula to a real example, we need to understand several sub-calculations involved.
Average purchase value ( APV )
Average purchase value is also referred to as average order value. It is the amount a customer spends on each purchase. You can get this by dividing your company's revenue over a specified period ( e.g., 12 months) by the number of orders you processed throughout that same period.
Average purchase frequency rate ( APFR)
How often does a customer purchases from your company? To calculate APFR, you have to divide the number of purchases you made within a certain period by the number of distinct customers who made purchases within that specified period.
Customer Value ( CV)
Customer value is the value of each customer to your company within the specified period. To get customer value, you have to multiply the average purchase value by the average purchase frequency rate.
CV = APV × APFR
Average Customer lifespan ( ACL)
To get ACL, you will average the number of years a customer has continued to buy from your business.
Customer lifetime value example
A skincare retailer wanted to determine customer lifetime value, CLV of 5 customers within a year. Each customer spends an average of $50 on every purchase and frequents the shop four times annually. A customer spends at least eight years with the company.
Customer lifetime value ( CLV) = Customer Value × Average Customer Lifespan
First, we need to get a CV.
CV = Average purchase value × average purchases frequency rate
= Average value of customers = 50× 4 =$ 200
Average Customer lifespan( ACL) = Sum of customer lifespans ÷ Number of customers
8×5/5 = 8
CLV = 200× 8 = $1600
Extra tip: To determine the profitability of each customer, you can incorporate gross margin into your CLV formula.
To take into the account profit margin, use this formula;
Customer lifetime value = Customer value x Average customer lifespan x Gross margin
What is a good customer lifetime value?
There is no good or bad customer lifetime value. It depends on your business model and customer acquisition costs. These costs vary from business to business. What you consider a good customer lifetime value may be far from ideal for another company.
To understand the ideal CLV benchmark for your business, you have to compare it to your CAC. After analyzing these two factors and you figure out your CAC, you can determine if your current CLV is good enough or if you need to do better.
The cost of acquiring customers will depend on your marketing strategy and sales effort. Typically it is believed your CLV should be higher than your CLC. A good CLC: CLV should be around 3:1. That is, the customer lifetime value should be three times higher than the cost of acquiring the customer.
Research on companies CLV: CLC by fuel by the McKinsey team showed that not every company can achieve the typical 3:1 ratio. The researchers used 40 Saas companies as specimens. The samples found a mean of 3.4 and a median of 2.8. This shows that most Saas companies fell below the 3:1 benchmark.
Aside from the CLV: CLC, the study also found that high customer lifetime value has a relationship with company growth rate. Companies with CLV: CLC higher than 3:1 had a 42% average annual growth rate. Companies that had 3:1 or lower had a 28% average annual growth rate.
Benefits of measuring customer lifetime value
Below are a few reasons to track and measure customer lifetime value.
Higher CLV increases revenue.
When you spend less to acquire customers and earn more value, your revenue will grow. To make this happen, you have to take steps to increase customer lifespan.
Companies that invest in customer satisfaction and customer success can get an increased revenue compared to those not making serious efforts towards that end. According to a study by Hubspot, 55% who come with a higher growth rate believe customer service is an important investment. While only 28% of companies with low or stagnant growth rates believe it is important to invest in customer service.
Calculating CLV will give you an insight into high-value customers, and you will be able to devise means of increasing their lifespan. You can personalize your product or services towards their needs and grant them other benefits that can boost brand loyalty. Happier customers spending more money on your product/ services can make your revenue soar.
A typical example of companies that have used the LTV metric to get insight into high-value customers is Amazon. In 2013, customer intelligence research found that Amazon Prime shoppers are spending $1,340 on Amazon annually. The figure is double the spending of non-amazon prime shoppers. This metric allowed Amazon to focus its customer service more on prime members and increased its profitability over the years.
Higher CLV can help reduce customer acquisition cost
The cost of acquiring new customers can be five times higher than the cost of retaining them. According to market research, the probability of acquiring new customers is between 5%-20%. However, there is a 60% - 70% chance of selling your product or services to an existing customer. By measuring your LTV, you can identify high-value customers and focus on activities geared towards satisfying them.
A study found that companies can achieve a 25%-95% increase in profit with just a 5% increase in retention rate. As such, you can increase your profitability with higher LTV without spending more money to acquire new customers.
It helps you understand customer behavior
You can use customer lifetime value to create customer segments. You can recognise customers that are spending less and are likely to churn very soon. You can use this data to devise strategies that can boost the retention of these likely-to-churn customers. You can offer them discounts and several other benefits to reawaken their interest in your product/services and retain them.
It helps you recognize and target your ideal customers
The goal of LTV is to help you recognise customers who are spending more on your product/ services. LTV can help you streamline your sales and marketing efforts to target customers that are likely to spend more on your business. With this knowledge, you can recognize prospects that are likely to spend more and create a personalized customer acquisition strategy to target prospective high-value customers.
It helps you streamline your budget
Measuring LTV will not only give you insight into how much a customer is worth throughout its lifetime, but you will also recognize highly profitable, low profitable, and non-profitable customers. With the results of your LTV, you will know how much to allocate to retain each segment without running at a loss.
It helps you recognize issues in your customer retention strategy and fix them earlier
If you calculate your LTV and discover a lower customer retention rate, this will propel you to enquire into possible causes. This inquiry will help you develop better solutions geared towards more customer loyalty and retention. If the issue is also with pricing, you will be able to fix that without undermining your customer satisfaction.
How to improve customer lifetime value
There are many ways to improve customer retention and increase customer lifetime value. Some of the ideas you can adopt include;
Improve your onboarding process
Onboarding is an essential stage in the customer lifecycle after acquisition. Onboarding occurs in the first few days after a customer makes the first purchase. It is a stage where they are getting up close to your brand; they should get to know all your business offerings, why you do them, and why they should be loyal to your brand.
This is a very critical stage, and you must make sure you make a good impression.
Great onboarding is likely to boost the chances of customer retention, while poor onboarding can lead to churn.
Making your onboarding a quick and easy process. You can provide guides, tutorials, videos, and other tips that can help customers get started and have a good experience. You can also use data provided by customers at the acquisition stage to curate personalized items, services, or deals. You should also probably do an email follow-up to ask whether their experience so far has been satisfactory or if they need help with anything.
Upsell and cross-sell your customers
You can increase your average order value and consequently increase your customer lifetime value by cross-selling and upselling to your customers.
To implement this, if you sell products after initial purchase when customers are about to check out of your website, you can offer complimentary products. This makes sense since the value you are getting from them will increase every time you upsell.
If your offering is subscription-based services, you can encourage customers to switch to annual billing or quarterly billing cycle for a discount to improve their lifetime value. This is also a wise strategy since it is guaranteed that a customer that switches to an annual subscription will generate 12 months of revenue compared to a monthly billing cycle that can be canceled prematurely at any time before the year runs out.
Improve your user experience
Make it easier for customers to buy from you. Customers that encounter difficulty while navigating your website or have a buggy mobile experience are less likely to return.
Brush up your user experience. Improve both technical and non-technical issues that may create difficulties for customers. Gather all steps customers have to take to complete their purchase in one place and not require customers to go from page to page to complete orders, make payment, confirm shipping details, and any other rigorous steps.
If you have to use pop-ups, it should be something reasonable and beneficial to customers. Don't be aggressive with your pop-ups. Your timed pop-ups shouldn't appear too early or too often. Go easy on advertising as well. Your customers can get annoyed if they are bombarded by a lot of ads on your website.
Improve your customer service
The importance of good customer service can not be overemphasized. Top-notch customer service can increase customer retention rate and decrease churn rate.
Sometimes it's not about your product but the way you treat your customers. Customers can switch to another brand that makes them feel valued even though you offer better service or product.
Improve your customer communication. Offer prompt customer support across all channels. Get a savvy social media manager to manage all your social channels. Ensure all inquiries and complaints are addressed promptly, respectfully, and reassuringly.
You can also leverage FAQ and resource pages to answer customers' questions at any time. You can create guides, ebooks and tutorials, and videos that elaborate on your products and services.
Build customer relationships beyond business
In the age of social media, customers are interested in a brand more than its products and services. They want to know the faces behind the brand. They want to connect to you on a different level. Customers appreciate businesses that show concern beyond just making money off them. Businesses that go out of their way to build this deeper customer relationship and communication are likely to earn their trust and loyalty.
You can curate a list of topics that may interest your audience that is not too sales-y. Your team can start conversations around these topics and listen to people's concerns. You can get experts in the field to address these issues and offer professional opinions. Making these extra efforts counts and can mean the world to your customers.
Build a customer loyalty program
Another strategic way to pave your way to the heart of your customers is to offer the most loyal customers rewards.
Create customer loyalty programs they can opt into and offer amazing benefits such as discounts, or exclusive deals.
You can offer rewards for different customer engagements with your brand; Bulk purchases, subscribing to your YouTube channel, following you on social media, engaging with your posts, writing reviews, and other actions that can boost engagement.
Listen to your customer's opinions
Listen to what customers have to say about your products and services and use it to improve. They are the consumers of your products. They understand what they want and how you can serve them better. Taking their opinion into consideration can help you satisfy them and increase lifetime value.
As such, create an avenue for customer feedback and opinions. You can ask them for feedback and suggestions through emails or opinion polls.
Taking your customer's advice means you care about their opinion and they feel included in the process. You will also understand their needs better instead of making assumptions. With this, you can improve your customer retention rates and build a loyal customer base.
Appreciate your customers
Say thank you! Yes, they are paying for a good or service, but they could have chosen other brands over you. Appreciate them for that. It makes them feel special and loved. There are several ways of doing that. You can add a thank you note to physical products. Such notes should reiterate how valuable the customer is to your brand.
If it's not possible to deliver a physical note, you can create an appreciation page that pops up after a successful order or subscription. Appreciating customers is likely to lead to more repeat purchases.