How to Calculate the Lifetime Value of a Customer (LTV)
Fine Tune Your Marketing Strategy by Knowing the Lifetime Value of a Customer
Business owners and marketers are always looking to boost profits by finding the most cost effective ways to acquire new customers and improve existing customer relationships. Knowing how to calculate the lifetime value of a customer is crucial to the process of understanding how to maximize the return on investment in marketing, product development, and customer support.
What is Customer Lifetime Value (LTV)?
Simply put, LTV is a forecasting method used to estimate the projected revenue from a customer over the lifetime of their relationship with your business. Knowing the value of the repeat business helps you determine how much you should invest in customer retention and acquisition. Lifetime value is also referred to as customer lifetime value (CLV) or lifetime customer value (LCV).
Knowing the lifetime value of a customer, business owners can make important decisions on:
- Product Development - lifetime value metrics factor into decisions on how to incorporate customer feedback into product development. For example, deciding whether it is cost effective to make major product changes to satisfy the demands of a small segment of the customer base.
- Marketing - knowing the LTV of a customer can help determine whether acquiring new customers provides a sufficient return on investment (ROI). Obviously the marketing strategy is ineffective if the marketing costs to acquire a new customer exceeds the LTV.
- Customer Support - increasing customer satisfaction is statistically one of the best ways to retain "good" customers and increase LTV. According to the Harvard Business Review it is five to 25 times more expensive to acquire a new customer than it is to keep a current one.
How is Customer Lifetime Value Computed?
In the most simple form: LTV = Lifetime Customer Revenue – Lifetime Customer Costs
Using a simple example, if a customer purchases $1000 worth of products/services from your business over the lifetime of your relationship and the total cost of sales and service to the customer is $500 the LTV = $500.
Armed with this information, spending anything in excess of $500 on marketing to acquire a new customer would be a negative return on investment. Businesses typically earmark 10 percent of LTV (in this case $50) on acquisition costs, although startups or struggling businesses will often sacrifice profit margins on acquisition to build the customer base and/or improve cash flow. (After more than 10 years in business Netflix continues to sacrifice profits for subscriber growth.)
In the real world, the distribution of customer purchasing behavior is highly variable. As illustrated in the following example chart, some customers may be one-time or occasional buyers, versus the regular purchasers on the other end of the scale who have a higher LTV and generate the most profits.
We can therefore refine the LTV calculation using an average of the customer distribution. In the above chart example the sum of the LTV for all customers would be:
(10 x $500) + (20 x $1000) + (100 x $1500) + (20 x $2000) + (10 x $2500) = $240,000
Dividing by the total number of customers gives us an average LTV:
Avg LTV = $240,000 / 160 = $1500
Note that LTV calculations can be much more complex, for example, incorporating discounts or the likelihood of upselling loyal customers at a later date.
With the exception of ongoing service businesses such as cable companies and utilities, most businesses have a customer distribution similar to the above chart. Active, loyal customers tend to have higher LTVs and deliver more profits, whereas one-time or occasional customers, in addition to delivering lower profits, tend to be less satisfied and require a disproportionate amount of customer service.
How do Businesses Use Customer LTV?
Successful companies involve LTV on nearly every business decision and tend to focus their marketing and customer service efforts on the loyal, higher value customers (on the right side of the example chart). They may walk away from less profitable customer segments that are not cost-effective to reach and/or have little or no likelihood of being converted into higher value ones.
High LTV customers can be rewarded (and hopefully retained) in a number of ways, such as:
On the other hand, businesses in some industries such as mobile phone and internet service providers, banks, and insurance companies are sometimes known for taking the opposite tack and exploiting loyal customers who they know are unwilling to switch to a competitor, while customers who are willing to shop around generally get the best deals.
Customer Lifetime Value Case Study - Starbucks
Starbucks is well known for providing high-quality products and excellent service––customer satisfaction rates are as high as 90 percent according to some studies. According to Business Insider:
- The average lifespan of a Starbuck's customer is 20 years.
- The customer retention rate is 75 percent.
- The profit margin per customer is 21.3 percent.
This equates to an average LTV = $14,099 (In other words, if Starbucks spends more than $14,099 to acquire a new customer they are losing money.)