For a growing company, it’s vitally important to keep a close eye on customer lifetime value, particularly in relation to the cost of customer acquisition. This handy metric can help you understand the total amount that customers are worth to your business, providing you with insight into the effectiveness of your customer acquisition and customer retention strategies. Want to know more? First off, let’s define customer lifetime value.
Define customer lifetime value
Customer lifetime value (LTV) is the average amount of money that customers spend on your business over the entire course of their relationship with you. For example, if a customer buys around £100 of goods or services from your company every year for around five years, their customer lifetime value would be £500, minus the costs incurred in acquiring the customer. If we imagine that £10 was spent on the advertising that led to the customer acquisition, that’s a net customer lifetime value of £490.
Why is customer lifetime value important?
Because it costs so much less to retain an existing customer than it does to bring in a new one, customer lifetime value is an enormously important metric to explore. Put simply, the more you can increase your business’s average customer lifetime value, the more likely you’ll be to experience growth in the business. Let’s look at a very simple example to explain the importance of LTV in practical terms.
Imagine a company spends £10 on acquiring a new customer, but – unlike in the previous example – their average customer only spends £20 per year for a total of five years. That means that their net customer lifetime value would be £90. Or in other words, they’d need to acquire over five customers to bring in the same amount of revenue that was previously being brought in by just one customer.
So, it’s easy to see why customer lifetime value is so important for businesses. The cost of acquiring customers eats into your profits and reduces your potential for long-term, company-wide growth.
How to calculate customer lifetime value
There are several different methods you can use to do a customer lifetime value calculation. In short, you can either look at historic LTV (calculation based on actual purchases) or predictive LTV (calculation based on a prediction of what customers will spend). With historic LTV, all you need to do is add up the total value of all of your transactions and multiply by the average gross margin.
Although this is a valid approach, historic LTV doesn’t account for variation in customer behaviour. As a result, predictive LTV may actually be a little more accurate. With the predictive model, you’ll need to take a slightly more complex approach as a number of different data points are required to make the calculation. Put simply, you’ll need to know the following values before you can begin learning how to calculate customer lifetime value:
Average Order Value (AOV) = Total Sales Revenue / Total Number of Orders
Gross Margin (GM) = (Total Sales Revenue – Cost of Goods Sold) / Total Sales Revenue
Churn Rate (CR) = (Number of Customers at End of Period – Number of Customers at Start of Period) / Number of Customers at Start of Period
Customer Lifetime Period (1/CR) = 1 / Churn Rate
Purchase Frequency (F) = Total Number of Orders / Total Number of Unique Customers
You can express the calculation using the following customer lifetime value formula:
LTV = AOV x F x GM x (1/CR)
Customer lifetime value formula example
To understand how to calculate customer lifetime value in a little more depth, let’s look at an example:
Imagine Company A has a total sales revenue of $100,000 and a total number of orders of 2,000. Therefore, the Average Order Value would come out to $50 (100,000 / 2,000).
In addition, they have 400 unique customers. Using this information, you can establish that the Purchase Frequency is 5 (2,000 / 400).
Company A’s Cost of Goods Sold amounts to $30,000, which means that the Gross Margin is 0.7, or 70% (100,000 – 30,000 / 100,000).
Finally, given that Company A’s Churn Rate is 10.5%, their Customer Lifetime Period would amount to 9.52 (1 / 0.105).
Putting all that together, we can work out the customer lifetime value formula like so:
LTV = 50 x 5 x 0.7 x 1.52 = $266 (per customer)
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