Customer Lifetime Value: How to Calculate It and Why It Matters for Small Business Owners

You know that your company’s viability depends on your customers returning again and again. If everyone just purchased your product or service once, not only would you be spending every moment of your waking life chasing down new consumers but you’d also be churning through your cash reserves spending on customer acquisition. This is why customer lifetime value matters so much.

The “lifetime” value of a customer gives you insight into how much a customer will spend over the course of their relationship with you—whether it’s a couple of months or a couple of years. Understanding how to calculate customer lifetime value will enable you to make essential changes to your business model and identify issues that’ll make sure you’re financially solvent.

We’ll show you the customer lifetime value calculation with an example, plus get into the details of how you should think about customer lifetime value to make your business more successful.

What Is Customer Lifetime Value?

The customer lifetime value calculation shows you how much revenue a customer will generate over their relationship with your business. This isn’t literally the customer’s lifetime—it’s the duration over which they’ll be an active consumer with your company. There’s a direct relationship between the length of a customer’s length with a business and their value; the longer they continue to purchase from your business, the higher their customer lifetime value.

The lifetime value of a customer is represented by several different acronyms: LTV and CLV are the most common among them. You might also see CLTV or TCV (total customer value). For the purpose of this post, we’ll go with “LTV,” but know they’re all referencing the same important metric.

How to Calculate Customer Lifetime Value

You’ll find several different customer lifetime value formulas. Some are simpler than others, some are more “traditional” and complex. No matter how you choose to calculate customer lifetime value, you’re driving toward the same understanding: How much value is this entire relationship going to deliver me?

When you’re calculating LTV, you’ll choose a time period and customer segment to focus on. (Note that the segment could be all of your customers over the entire lifespan of your company—up to you.) Before you’re able to calculate to the lifetime value of a customer, you’ll need to know the following:

• Average customer “lifespan” (T): The average amount of time a customer continues buying from your company. Get this number by looking at all the customers in the segment you’re examining, finding within their data how long they remain customers, and take the mean.
  

• Average purchase value (APV): The value each of individual purchase. Get this number by dividing the total revenue of the segment you’re examining in a time period by the number of transactions over the same period. A year is a good place to start to get helpful data.
  

• Average purchase frequency (F): The rate at which customers purchase during the time period. Get this number by dividing the total number of purchases during the period you’ve selected by the number of unique customers who bought during the period. (Meaning if someone bought twice, count them once.)

Customer Lifetime Value Formula

Again, there are several different ways to not only calculate LTV but also represent the same calculation. We’ll go with this formula, using the variables for the definitions explained above:

LTV = (APV – F) x T

In English?

Your customer lifetime value calculation will involve first calculating your business’s average purchase value (APV), then subtracting the average purchase frequency from the APV number. That’ll give you your basic “customer value” metric. Then, you’ll calculate your average customer lifespan and multiply it by the customer value you’ve just calculated.

Customer Lifetime Value Example

Let’s do an example with an ecommerce company selling pillows. We’re looking at a time period of a year, and our segment is every customer who’s bought a personalized pillow. Here are some business financials:

• Total revenue from personalized pillows over the last year: $18,000
• Price per pillow: $50
• Number of transactions: 300
• Number of customers: 240
• Average customer lifespan: 1.5 years

What is the customer lifetime value here? Let’s start with calculating customer value:

APV – F

($18,000/300) – (300/240)

$60 – 1.25

= $58.75

Next, customer value times customer lifespan:

(APV – F) x T

$58.75 x 1.5

= $88.125

Which means that, over the last year, a personalized pillow customer’s LTV for this company is just more than $88. If you look at the data about the retail cost per pillow ($50) and the percentage of customers who ordered more than once (20%), plus the average relationship with customers (1.5 years), you can start to understand where these calculations come from.

Why LTV Matters, and How Customer Acquisition Cost (CAC) Factors In

You’re going to spend money to acquire your customers. Whether you choose to seek out your customers through digital ads, direct mail, experiential marketing events, samplings, freemium trials, or anything else, all of this costs you money. (And you need to know how much you’re spending on a customer-per-customer basis—your customer acquisition cost or CAC.)

Once you’ve done your customer lifetime value calculation, you can get a number to understand the average of how much revenue each acquired customer will bring to your company. That number is foundational to helping you crack puzzles including:

• When you’ll be able to break even on your customer acquisition cost
• How you can improve your margins
• Where to direct your customer service resources
• Whether you’re spending on the right channels
• Where to focus on lowering your costs
• Which segments of your customers to develop your next offerings for (remember that 80% of your revenue generally comes from 20% of your customers)

If you don’t take away anything else, make sure you know the customer lifetime value to customer acquisition cost ratio (LTV:CAC). This’ll tell you the amount of lifetime value your customer will generate as compared to the cost to bring them into your acquisition funnel.

To calculate LTV: CAC, use this formula:

LTV ($)/CAC ($) = LTV (#):CAC (1)

Where CAC = your total marketing and sales expenses ($)/new customers acquired (#).

You always want the left side to be higher than the right, which means you’re generating more revenue from the customer than you’re spending to acquire them. If it’s 1:1, that means you’re breaking even (though likely not for long). Anything that’s weighted to the right should set off alarm bells that you need to get your CAC down and work on your retention.

What If You Don’t Pay Attention to LTV?

Well, nothing specifically. Your business won’t close tomorrow. But you’ll be missing a key insight into your business that’ll help you understand how to adjust your business strategy.

For instance, if you have a very low customer LTV:

• Your business model might be fundamentally unsustainable, and you’ll have no idea until it’s too late.
• You might not know that you’re spending too much on your CAC, essentially never getting any value out of your customers at all.
• You won’t have insights into the full scope of your customer margins, and all the ways you can manipulate them for full value.

Additionally, if you’re a small business seeking venture funding from investors, LTV is an important startup evaluation metric to know. As you might expect, it’s not only expensive to churn through customers, but your margins disappear quickly—and both of these things accelerate your burn rate. Businesses with high customer value can therefore be very attractive to investors.

Men’s health brand Keeps, which provides a hair-loss product that customers need to stay on for (quite literally) life or else they’ll lose the positive effects, has an unusually high LTV. But they’re a great example of a business that’s extremely attractive due to their potential customer revenue.

How to Think About Improving Your LTV

Improving customer lifetime value isn’t just about getting costs down. It’s about improving the quality of the customers you have, creating better relationships, and helping them find reasons to stick around. Much of that goes back to marketing, branding, and customer service.

If you’re looking to improve your LTV, consider asking yourself these four questions:

1. What can I do to retain my customers? Do you need to put a better recurring revenue model in place, for instance, and move away from one-off purchases? Do you have products with inherent long-term value that’ll keep customers coming back, off of which they’ll build lifestyles or infrastructures?

2. Do I actually understand my customers? If you’re seeing a very high customer churn, do you actually understand your customers and their needs? If people are moving away from your product or service as soon as or soon after they encounter you, do you actually know your market the way you think you do?

3. Do my customers understand me? Similarly, in a consumer environment in which transparency is highly valued, and consumers want to know whom they’re buying from and what they’re buying, you might want to assess whether or not you’re communicating your brand values correctly. If you can deepen your relationship with your customer, you’ll have an opportunity to retain them.

4. Am I focusing on the highest-value customer segments? You shouldn’t try to get rid of customer churn entirely—not everyone is going to stick around and be a repeat purchaser. That said, you’ll want to ask yourself whether or not you’re investing in delivering the best experience, service, and products to the customers who will ultimately deliver you the highest lifetime value. And figure out what you can change if not.

A Final, Non-Monetary Consideration for LTV

Generally, when you’re thinking about customer lifetime value as a marketer or business owner, your ultimate goal is to figure out how much money each customer can generate for you. With that information, you can hopefully take responsive action to generate revenue by either increasing LTV, lowering CAC and raising your margins. Maybe even both.

Here’s some other food for thought, though: MIT Sloan School’s Michael Schrage provides excellent perspective into looking at customer lifetime value as more than a number. In Harvard Business Review, Schrage advocates in investing in your customers—in other words, creating ways to make the customers you have more valuable.

Think about it. If your customers become evangelists for your products, they’ll organically bring in new consumers or users who’ll cost you nothing at all, boosting your reputation in the process. Or, if they trust you as a brand, they’ll provide you free feedback, aiding in your R&D of new products and telling you directly that there’s market whitespace you can fill.

With that in mind, the lifetime value of a customer isn’t just a number. It’s a way to be a better businessperson, and create long-term sustainability for your business with better products and services, and dedicated customers.

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from Fundera Ledger https://www.fundera.com/blog/customer-lifetime-value/