What is customer lifetime value?
Customer lifetime value (CLTV) is the predicted economic value of a customer over the course of their relationship with a brand. Also known as lifetime value (LTV) or lifetime customer value (LCV), this measurement helps businesses make decisions about how much to spend on customer acquisition and retention. It can also set a course for product development and customer service initiatives.
How to calculate lifetime value
While there are a number of ways to calculate LTV, required inputs include customer revenue, gross margin, net retention percentage / purchase frequency, and customer lifespan. Keep in mind that LTV will be more approximate than exact because estimating long-term value is based only on today’s known variables.
To calculate LTV, identify:
- ASP: Average sales price or spend per customer. Divide total annual revenue by the number of purchases during the same time period.
- Gross margin: The ratio of total revenue per customer to the cost of goods sold. To calculate, subtract the cost of goods sold throughout the year from the annual revenue, then divide by annual revenue.
- Net retention percentage or purchase frequency: Average expansion rate or purchase frequency per customer. For SaaS, net retention percentage captures the amount of revenue change within the install base. For consumer or goods business models, purchase frequency will work, just divide the number of purchases by the number of unique customers who made purchases during the time period.
- Tenure: The average amount of time a customer continues to purchase.
Plug those values into the following formula for LTV:
((ASP X Gross Margin) x Net Retention % / Purchase Frequency) x Tenure = LTV
For example, an online apparel company’s average customer spends $275 each time they visit the site and they visit 3 times a year. Customers typically purchase from the site for a total of 5 years. Gross profit margin is 60%. The LTV calculation would be:
((275 X 60%) x 3) x 5 = $2,475 LTV
Why is LTV important?
Understanding and managing customer LTV is key to business growth. It provides insight into customer behaviors, like spending and loyalty. It also helps teams understand how much should be invested to acquire and retain customers, and how that differs based on customer segments. Lastly, LTV can unify teams across the enterprise around a single focus of improving each customer’s lifetime value.
Benefits of LTV
Understanding LTV empowers informed decision-making that can positively impact profit, brand engagement, and customer service initiatives.
Customer acquisition costs more than customer retention. Knowing the future value of customers compared to the average amount spent on acquiring them helps understand capacity for growth and profitability.
A high LTV-to-customer acquisition cost (CAC) can indicate that acquisition is cost-effective. This ratio also helps evaluate which channels, segments, and regions may be the most lucrative.
Understand brand loyalty
Working to improve customer loyalty is important to profitability. The probability of selling to an existing customer is higher than selling to a prospect. Existing customers also are more likely to try new offerings and spend more than new customers. Thus, customers with high LTV scores also can be the biggest brand evangelists who bring new business with them.
Improve profit margins
LTV is the average expected earned revenue per customer. The higher the LTV, the higher the profit. Using this metric to invest in efforts that retain customers and reduce churn can increase profitability.
Gain or retain more leads
It’s critical to attract new clients to the pipeline, and LTV helps to understand the value a new client is likely to bring to an organization. Armed with this information makes for easier, better acquisition and cross-selling decisions.