60 Seconds On: Calculating Customer Lifetime Value
Customer lifetime value or LTV is a number that represents the monetary value a customer provide your business over time. Knowing this number is crucial if you want to make smart business decisions.
For example – If acquiring a new customer costs you $6, is that good or bad? The answer depends on how much $$$ you stand to gain from that customer.
Here’s a 60 second look at how to calculate customer lifetime value in order to grow a profitable business (and make changes when you find that getting your customers is costing you more than they’re worth):
Topics covered in this post:
The customer lifetime value Calculation:
Customer lifetime value = c*p*n*π*(1+a)
Advanced version (including compound interest rate):
Customer lifetime value = (c*p*n*π*(1+a))/(1 + i)^n
c = average revenue from 1 purchase.
‘c’ is the price it costs to buy one product from your company. If you sell more than one product, this is the average price of your products. If you offer a subscription-based service, ‘c’ represents the cost of the subscription for the customer for one period (monthly / quarterly/ yearly / whatever other period-type you choose to use for your subscription).
π = company profit per purchase
‘π’ is your profit from a single sale. To calculate ‘π’ you need to subtract how much it cost you to make your product from ‘c’, which is the revenue you receive when you sell it.
n = average number of time periods per customer
Before defining ‘n’, choose a meaningful time period for your business – week (if your offering is something that can and is likely be bought multiple times a week), month, quarter or year. Once you do that, you can calculate ‘n’, which the average amount of time periods you are able to retain a customer for, on average.
For instance – if your business is a gym, you can choose to define a year, as the time period to look at. In this case ‘n’ would be the average number of years a person remains a member of your gym.
p = average number of purchases per customer per time period
‘p’ is the average amount of times the same person purchased your product(s) / service during this time period (include the first purchase in your calculation).
Going back to the gym example, a person pays you a monthly subscription to the gym, so ‘p’ would be 12 since the time period we chose to define for the gym example was one year and there are 12 month in a year.
a = average customer referral rate per period
Some customers (hopefully most of them) are more valuable than the profit you make on their purchases. These are people who refer their friends, fans, follower, strangers they meet on the street, to purchase from you as well.
These kinds of people are influentials and they are the ones who help your business grow organically. So while this is not a ‘must’ variable for your lifetime value formula, it is an important one.
‘a’ defines the average amount of other people who buy from you that each customer refers to you.
For instance, let’s say that your gym has 3 customers. One of them refers 1 friend during the year and the two other members don’t refer anyone during the year, then ‘a’, which is the average referral rate for a period, would be 1/3.
*You will notice that in the lifetime value formula itself, I don’t use ‘a’ but rather (1+a) – this is because ‘a’ does not include the customer himself, (1+a) reflects that the customer lifetime value is the sum of both the customer himself, plus the average amount of other customers he refers in a given period.
Advanced formula variables:
(1 + i)^n = Compound interest rate where ‘n’, as defined above, is the number of time periods and ‘i’ is the interest rate per time period
For more advanced LTV calculations, you’ll want to take into account the discount rate over the average customer lifetime.
Basically, if we look at the gym example again – if a price of a gym membership is $20 a month then each customer would pay you $240 each year. However, the $240 you’d get at the end of this year, or at the end of next year, is not equal to $240. If the yearly interest rate was 5%, then the $240 you’d get at the end of this year, is actually worth $228.57 today (240/(1+0.05)). In order to calculate the current value of the the $240 you stand to gain from each customer for the average of 3 years that he keeps his membership, you’ll need to divide $240 by 1 plus the yearly interest rate three times.
After you’ve calculated your customer lifetime value, you can do a number of things:
- Since you now know how much value you can make per customer, you also know your cut-off point for the price of customer acquisition. If a the lifetime value of a customer is $300, you know that if you spend less than that to acquire a new customer, you’re making a profit
- If you find that acquiring a new customer is more expensive than the LTV, you need to do some optimization. One the one hand you can lower the cost per acquisition by optimizing your campaigns / sales efforts, and on the other hand – you can optimize the variable in your customer lifetime value formula in order to increase your average customer lifetime value.
4 Ways to increase your customer lifetime value:
- Identifying the types of customers who tend to buy more / churn less and focusing your acquisition efforts in getting more of them since their lifetime value is higher
- Put a higher price tag on your products (=having a higher ‘c’ and ‘π’)
- Improve your customer retention efforts so that ‘n’and/or ‘p’ would be higher
- Incentivize your existing customers to refer friends (=increase ‘a’) and/or focus your acquisition efforts more on influencial people (they would naturally produce higher ‘a’)
Further reading: Check out the Kissmetrics blog for an infographic that details three other possible LTV calculations.
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