How do you calculate the Life Time Value of a customer

Most novice marketers have not even heard the term “Customer LTV“, let alone understand how to calculate it or work out what their LTV is. Yet it is one of the most important metrics you need to know when planning your marketing program and making day to day decisions on how to invest in marketing to drive your business. Without it, you are literally flying blind when you should really understand what your marketing investment yields in the business growth cycle.

In this article we are going to tell you what it is, how you can calculate it and how you can use it to make better investment decisions.

I will just use this opportunity to say that Metigy is currently working towards a major release that lets you plan and execute all your social marketing, based around setting and achieving defined objectives. In our data science plan, we will then extend this to calculate the key metrics for your brand, such as LTV, Payback period and CAC, all in real-time, and then calculate the impact of your actions against those metrics. If you don’t understand what i just said, no problem, read on and all will be revealed.

Anyway, that is the plan and for now we will just have to show you how to do it, so you can start thinking about LTV from now.

Concept 1: What is Customer LTV and how do you calculate it?

Customer Life Time Value (LTV) is the total value in sales/revenue you get as an average across all customers, for the entire time they are your customer.

If you are running a digital business or a startup, then you have hopefully heard this term, but it applies equally to every business that works to a revenue objective. When I first asked for a simple formula for this from Stephen Robinson, who is now on our Advisory Board and works with me to on Corporate Development objectives, Stephen shared with me this image which explains the LTV that Starbucks works to. I see this image everywhere now, so it has some credibility. The explanation is clear and simple, except for the fact that it presents three different ways you can calculate your LTV. Have a look at it and understand the principles, then I will explain which formula I recommend.

 

The right formula is a question of two things, how much data you have and what type of business model you are running.

If you have limited customer data to start with, then you are probably going to focus on the Simple LTV equation. Using this is better than making guesses on important marketing investments. In fact, if you are a high margin business like software where you don’t have a hard cost of sales or gross margin calculation, then this will work well for an indefinite period.

If you have more data, and in fact, if you are a business that has a real cost of sales and therefore can only work on a gross margin calculation for customer purchase value, then you will need to use the Traditional LTV equation.

So now you have a formula, it is time to calculate the LTV for your business. The infographic also provides detail on how to use the formula, so you just need some business intelligence data and a calculator, and you can take a great leap forward in your marketing planning.

Note: If you are a new business or don’t have this key data, then you will need to make some assumptions and then work hard to prove or adjust your assumptions as you confirm the data. Just focusing on this type of measurement is a good indicator that your business is more likely to succeed.

Concept 2: How do I use my new Insight?

OK, so now you know what an average customer is worth to you in real $’s. That is a pretty exciting concept if you have never worked that out before.

You now have a fantastic insight and three great opportunities.

The insight is obvious: Each new customer is worth $X to me, and you know what you can invest in a new customer and still come out ahead in the long-term.

Opportunity 1: Now that you know your LTV, what can you do in your business to improve your LTV. Can you work on retention to extend “t” as this will a have a massive impact on LTV? Can you work on average spend by offering additional value-add sales components or add-on purchases? Get creative on improving this LTV figure.

Opportunity 2: If we now focus on what it costs to acquire a customer, or what is often called CAC or Cost of Acquisition, we should see that it is firstly less than the LTV (or Houston, we have a problem) and the size of the gap as a percentage is a very good indicator of the long-term health of your business and the likely cashflow you will get from growing your customer base. We have a separate article coming on calculating CAC so look out for that. Improving this gap should get a lot of attention.

Opportunity 3: We now want to calculate the Payback period, and we have an article coming shortly on how to do this.

To clarify what this is in a simple form, if it takes you $100 to acquire a new customer and the average monthly spend for the average customer, which you will now know as “a” from your LTV calculation is $20, then your payback period is 5 months. To put this simply, and we will spend more time on this in a much more detailed post on this topic:

Every $100 you spend this month on marketing, will acquire you 1 new customer, which will be paid back in 5 months time and if you have an LTV of $1,000 then you have a $900 margin on each customer, with a positive cashflow each month from month 6-50.

Planning your business, and planning your marketing budget, should just have taken on a whole new importance.

Aside from helping you with these concepts and learning to be a great marketer, Metigy is also here to help you get that upfront cost of $100 as low as you can make it. The more we drive this down, the faster you can grow your business and sustain your cashflow.

Final note, if your metrics don’t look as good as the example, don’t worry. And I mean that. These metrics would be more typical of a maturing business that has got a lot of important elements already figured out. No matter how they look now, the key is that you have taken the first step towards getting great metrics, just by learning how to take this approach.

Happy growth marketing!