How to Calculate the Lifetime Value of a Customer (LTV)
Fine-tune your marketing strategy
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 (LTV) of a customer is crucial to understanding how to maximize the return on investment in marketing, product development, and customer support.
What Is Customer Lifetime Value?
Simply put, LTV measures 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).
Projecting the lifetime value of a customer provides business owners with important insights for decisions about:
- Product development: LTV metrics factor into decisions on how to incorporate customer feedback into product development. For example, you can decide 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). The marketing strategy is ineffective if the marketing costs to acquire a new customer exceed the LTV.
- Customer Support: Increasing customer satisfaction is statistically one of the best ways to retain your most valuable 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 Calculated?
In the simplest form, LTV equals Lifetime Customer Revenue minus Lifetime Customer Costs.
Using a simple example, if a customer purchases $1,000 worth of products or services from your business over the lifetime of your relationship, and the total cost of sales and service to the customer is $500, then the LTV is $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% of LTV ($50 in this case) on acquisition costs. However, startups or struggling businesses will often sacrifice profit margins on acquisition to build the customer base and improve cash flow. Netflix, for example, kept its prices low for years in order to expand its subscriber base, and it has continually grown revenues by around 30% per year.
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, while others are regular purchasers 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 $1,000) + (100 x $1,500) + (20 x $2,000) + (10 x $2,500) = $240,000
Dividing by the total number of customers gives us an average LTV:
Average LTV: $240,000 / 160 = $1,500
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 not only deliver lower profits, but also tend to be less satisfied and require a disproportionate amount of customer service.
How Do Businesses Use Customer LTV?
The likelihood of selling to your existing, loyal customers between 50% and 60%, compared to 5% to 20% for a new customer. Successful companies involve LTV in nearly every business decision and tend to focus their marketing and customer service efforts on the loyal, higher-value customers. They may walk away from less profitable customer segments that are not cost effective to reach or have little or no likelihood of converting into higher-value ones.
High LTV customers can be rewarded (and retained) in a number of ways, such as:
- Offering special discounts on multiple purchases
- Creating a loyalty program (punch or swipe cards are popular)
- Offering rewards for new customer referrals
- Providing special customer service
- Offering preferential credit terms
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. They can exploit loyal customers whom they know are unwilling to switch to a competitor while offering the best deals to customers who are shopping around.
Customer Lifetime Value Case Study—Starbucks
Starbucks is well known for providing high-quality products and excellent service and retaining customers. According to a case study by Visual Capitalist:
- The average lifespan of a Starbucks customer is 20 years.
- The customer retention rate is 75%.
- The profit margin per customer is 21.3%.
According to the case study, the average LTV of a Starbucks customer is $14,099 In other words, if Starbucks spends more than $14,099 to acquire a new customer they are losing money. The company can base its marketing decisions around this number, rather than blindly aiming to gain new customers at all costs.
The Bottom Line
The LTV is a critical metric for improving your business' marketing and boosting profit margins. Learn the lifetime value of your customers and use it to fine-tune your marketing strategy.