LTV: How to calculate lifetime value
Customer lifetime value helps you measure the net profit your customers generate over the duration of their relationship with your business.
Customer lifetime value, often called CLV or LTV, is defined as the monetary value of a customer to a business, and is an important metric to understand how profitable a company can be or how much it can potentially spend to acquire new customers.
Why is customer lifetime value so important?
Customer lifetime value tells you how much business value each individual customer generates. As a result, CLV is used to understand if your customer relationships are profitable. Product, marketing, advertising, and sales teams often use CLV to find out how much money they can spend on acquiring, engaging, and retaining customers while still being profitable. But before you get to calculating CLV, there are a few other things you must know:
Average Purchase Value
This is the average value of a customer transaction. For example, for an eCommerce company this could be the average value of each cart, while for a subscription service this could be the cost of the subscription.
Average Gross Margin
This tells you what part of each customer purchase is profit and what part is cost. Average gross margin can be calculated with the following formula:
Gross Margin = (Total Revenue – Cost of Sales) ÷ (Total Revenue)
This is the average number of transactions a customer makes over a given time period (usually a year). Purchase frequency can be calculated by dividing the average number of purchases by the average number of customers. For example, for a monthly subscription service, the number of purchases made over a year is 12.
This is the length of a typical customer relationship. To make calculations easier, this is generally measured in multiples of the same period as the purchase frequency. For example, a business that retains its customers well may have a customer lifespan of 5 years, while one that isn’t good at retaining its customers may have a lifespan of 6 months, or 0.5 years. Improving customer lifespan is often a very effective way to improve your CLV.
Note, customer lifespan calculations vary for different types of businesses. For a SaaS product that relies on fixed contracts, the lifespan ends when a customer fails to renew their contract. For a consumer app, however, the product team will have to figure out when they consider a customer to have churned (for example, after 2 weeks of no recorded activity).
Customer Acquisition Cost
Customer acquisition cost, often called CAC, is the average amount you spend on acquiring a customer, and includes everything from marketing and advertising to sign up incentives,( for example, a $10 Amazon gift card). This article can help you understand the intricacies and nuances of calculating CAC.
How to Calculate the Lifetime Value of a Customer
Once you have the above information, it is easy to calculate the lifetime value of a customer. Just multiply your average purchase value by your average gross margin, purchase frequency, and customer lifespan. Finally, subtract your cost of acquisition.
CLV = (Average Purchase Value × Gross Margin × Purchase Frequency × Customer Lifespan) – CAC
For example, if your product is a $10 a month subscription service with an average gross margin of 70% and you spend $20 to acquire a customer with a lifespan of 60 months (or 5 years), your customer lifetime value calculation would look like this:
CLV= ($10/month × 0.7 × 12 months/year × 5 years) – $20 = $400
There are multiple ways of calculating customer lifetime value, but the above method is one of the most popular and comprehensive ones. However, CLV can vary based on a variety of factors, like product SKUs/plans (free vs. paid), user types (consumer vs .business), and degree of user engagement (power users vs. casual users).
Calculating CLV with more accuracy
More advanced CLV analyses can be done by breaking down your CLV further, and can help you find the right user cohorts or product SKUs to focus on, understand how much to spend on acquisition, and more.
Calculate CLV by cohort
Cohort analytics helps you break down your user base into groups of users based on common characteristics or experiences, allowing you to better identify their behavior across the user lifecycle. Breaking down your CLV by cohort can help you understand which users or product offerings to target.
For example, you can create cohorts of users on each plan you offer, and compare their CLV to find out which users are most profitable. Amazon did just that and found that Amazon Prime members had a much larger CLV, and hence deserved more focus.
Calculate net present value (NPV) of your CLV by using a discount rate
CLV calculations begin with the assumption that your customers generate an average amount of revenue—and therefore profit—each month or year for a certain amount of time. But the revenue and profits you receive in the future is less valuable than they would be if received today.
Discounting future revenue and profits ties your CLV to the current cost of your investment, as well as your opportunity cost. The discount rate varies from company to company, but once you have a fixed discount rate, you can calculate a net present value (NPV) of your CLV by separately discounting profits for each period, or by using an online NPV calculator (or even Excel).
What can CLV teach me about my business?
Customer lifetime value can shed light on a lot of key business drivers and opportunities, allowing you to make more informed decisions Some examples are:
- Understanding overall customer profitability so you can forecast what an optimal CAC should look like.
- Figuring out user profitability over time so you can prioritize time to value.
- Attributing CLV for each acquisition channel to get more ROI on paid channels.
- Breaking down CLV by product or plan to promote the most profitable offering.
Though there are many ways to break down and apply CLV, viewing it only as a tool for acquiring as many customers as possible as cheaply as possible is a recipe for failure. It’s true that deeply analyzing your CLV can help you prioritize segmentation, retention, and monetization to improve future customer profitability. But, as Harvard Business Review states, CLV should be used to see customers as value-creating partners rather than as value-extraction targets.
Remember, CLV is just a piece of the puzzle, but combined with more advanced analyses, it is a powerful way to understand your customers and their impact on your business.