Understanding the "LTV" or Life Time Value

JUSTINE JACQUOT

Approx. reading : about 8 min

What IS (lifetime value) ?

THE LIFETIME VALUE of a customer, as its name indicates, is an estimate of the average revenue that a customer will generate to the company during their lifespan as a customer, which means from the moment he first purchases something up to the end of the commercial relationship.

This metric concerning the customer, can help determine many strategic economic decisions for your company.

In particular, It allows you to determine;

-Marketing budget

-Resources

-Profitability

-And other things that you should consider such as pricing strategy or customer support configuration

It is a key metric in subscription based business models that complements MRR (Monthly Recurring Revenue).

How to calculate customer's LTV ?

First of all, you must choose a period of analysis consistent with your activity. Annual, over 18 months, over 24 months etc. It is up to you to determine it. In this article, we will consider an annual period to simplify readability.

Then, several steps and indicators are required to calculate LTV in a reliable and useful way. To calculate LTV properly, you must first have the following information about your company at hand:

You should be able to find all this information in your data system and recollect it to set up the best base possible.

The different steps to CALCULATE LTV :

Step N°1 : Determine customer retention rate

The retention rate is the opposite of the rate of attrition (or churn rate).

It is the number of customers who are still customers after a given period of time. It will allow you to calculate the customer’s lifetime.

Calculating the customer’s retention rate is simple: you only have to divide the number of customers still active by the end of a given period by the total number of customers that you had over said period.

Example: out of 95 clients, 85 stayed. Your retention rate is therefore 85/95, or 0,8947 (89.47%).

Step N°2 : Determine customer lifespan

Customer lifespan is the time the relationship between the customers and the company lasts. How long (months, years, etc) do your clients pay for your services before canceling, on average?

Again, the calculation is very simple:

The formula : 1/(1-retention rate)

In our example; 1/(1-0,8947) = 9,5

Customer’s lifespan is therefore on average around 9 years and 5 months. In the context of a retention close to 100% it is preferable to consider a lifetime of more than 10 years.

Step N°3 : The average gross margin

This ratio tells you if your business is likely to make a profit or not.

Its calculation requires the collaboration of the accounting and finance team because you will need data that are not only statistical:

The formula to be used:

Gross margin = (Total Revenue – Cost of Sales) ÷ (Total Revenue)

Example : (1 000 000 – 650 000) / 1 000 000 = 0.35 (35 %)

The cost of sales is the addition of the sales and marketing expenses over a given period.

Step N°4 : The average purchase value

The average purchase value is how much money your customers spend on average every time they place an order, products and services included. You can however choose to consider only certain services or products in your analysis. That depends on your needs. However, that will have an impact on the calculation of your customer’s LTV. Be specific on this point.

Average Purchase Value formula

Average Purchase Value= Revenues/Number of orders

If your annual revenues are 60 000€ and the number of orders is 97, the average order value is 618€.

In the context of subscriptions, you should consider each invoice as an order

For example:

A monthly paid subscription = 12 orders per year
A annually paid subscription = 1 order per year

Step N°5 : purchase Frequency

Purchase frequency gives you a valuable indication of the number of orders carried out by your customers.

The formula to use to calculate purchase frequency:

Purchase frequency= Total number of orders/Total number of customers.

In the context of subscription based businesses, you should consider that the frequency of orders corresponds to each new subscription (and not to the periodic billing deadlines)

For example:

Each one of these occurrences corresponds to a new order.

However, unlike the average order/purchase, the monthly invoices should not be considered as frequency of purchase/orders as this could distort the calculation of your customer LTV.

The number of customers to take into account is the addition of customers still active by the end of a given period.

Step N°6 : Customer Acquisition Cost (CAC)

The CAC or Customer Acquisition Costs measures how much an organization spends so that a prospect client becomes a paying customer. The expenses to be taken into account are numerous and varied depending on your business sector of activity.

The formula to calculate it:

Customer Acquisition Cost: Costs of sales and marketing/Total number of new customers acquired thanks to these expenses.

In a general way, you need to make at least the addition of the following expenses.

The marketing and advertisement expenses related to the customer’s acquisition campaigns (not including advertisement for the corporate image for example)
The sales expenses related to the customer’s acquisition, such as the wages of sale representatives, prospecting and CRM tools over a given period etc

You can segment these expenses at any time to keep only some of them and exclude others. This depends on your needs but it will ultimately impact the calculation of the customer LTV.

When it comes to the customers acquired, it is sometimes difficult to know whether this or that expense helped you get this or that client. This is not very important for the calculation of customer’s LTV because this metric is a mass indicator and helps you project yourself rather than analyze the performance of this or that marketing expense.

However, it may be useful to segment and refine the calculation of customer LTV and compare it with the calculation of the general customer LTV in order to monitor the performance of an expense when compared to the average.

After all this research and calculations, you have the necessary tools to calculate customer LTV.

You can calculate your customer LTV with the following formula:

LTV= (Average purchase value x Gross margin x Purchase frequency x Customer lifespan) – CAC

The value is expressed in a currency (EUR, USD, etc…) and not in a percentage.

It is important to keep in mind that different types of customers can have different LTVs, especially when you have different pricing levels for your various offerings. In this case, it makes more sense to calculate the LTV for different customers based on the pricing segment into which they fall.

HOW TO PROPERLY USE YOUR “CUSTOMER’S LTV” INDICATOR IN YOUR BUSINESS ON A DAILY BASIS

Each new customer generates additional revenues at different frequencies (daily, monthly, annually etc) throughout their “lifespan”. Thus, the customer LTV indicator is a key variable to determine the budget for sales and marketing campaigns for customer acquisition and for the prediction of revenues.

First case in which you can use customer LTV: To determine the acquisition marketing budget.

It is crucial for any company and especially for those in the field of SaaS subscription, that the Customer Acquisition Cost (CAC) is always lower than the customer LTV (Lifetime value of a new customer).

This is why knowing customer LTV would allow your marketing and sales teams to compare their estimated acquisition expenses with the average customer’s LTV of the company. Thanks to this, they will be able to determine the right acquisition strategies by considering only those likely to represent a fast and optimal return on investment

Second case in which you can use customer LTV: To position the price of offers

Several factors come into play to determine the right price. Customer LTV is one of these factors because it allows you to identify how long it will take to make a customer profitable according to the price that it would be proposed to him.

Example: A company decided to modify one of its prices and finds out that the new value of “customer LTV” is lower than the current CAC.

This means that the implementation of this new price is thus not appropriate.

This is also a good tool to know if some services or products offered in upsell have a proper price or not. Customer LTV is also used to implement promotional operations, coupons or discounts. Customer LTV provides valuable information about profitability.

Third case : To arbitrate the allocation of resources between the acquisition and the retention of the customers.

Another key sector in which customer LTV can be applied is to determine how much resources to allocate to convince new customers, to retain existing customers or to offer upsell solutions.

When you have 1000 to spend in a segment of clients, it is useful to know if you should invest it in acquiring more clients in this segment or invest it in selling additional solutions (upsell) to existing clients in this segment.

Customers LTV allows you to determine a return on investment hypothesis and thus also choose in a clear way.

Fourth case: To segmentate the customers portfolio according to customer’s LTV to identify who are the most profitable and promising customers

Once you can sementate your customers according to their customer LTV, you can easily choose if you should allocate more resources for customer acquisition or on the contrary for the retention of some of your existing customers.

It is also possible to use customer LTV to identify your best customers in your global customer portafolio. This could lead you to a better commercial approach. For example, customers with a high customer LTV should receive more attention and especially be the object of more regular monitoring all along their customer lifespan so that when their contract deadline is approaching your customers are treated better than the average and therefore they stay with you.

Now that you have understood how to calculate customer LTV and also how to optimize its use, we will see how you can increase customer LTV.

How to increase customer ltv (customer lifetime value)

Each point of customer LTV won is a potential additional point of revenue. If your company is able to increase customer LTV while reducing the rate of cancellations (CHURN), this will automatically improve the profitability of your company in the long term.

We recommend you to have a proper strategy aiming to increase LTV while you fight against attrition (The famous CHURN).

Among all the possible initiatives to increase customer LTV, we will give you two that are the easiest ones to put in place and the ones with the best return on investment.

Strategy N°1: Play with the modularity of offers

You can increase your customer LTV quickly and easily thanks to your base of customers. If for each existing customer you can sell an additional 100 dollars/euros a year, your LTV will obviously increase. This will also have an effect on the purchase frequency, on the average purchase and on the retention duration. An effective way to increase customer LTV is to create additional options that can be sold to the customers in order to increase their customer LTV.

Strategy N°2: Play with price flexibility

If, in addition to modularity, you incite your customers to subscribe for a longer time in exchange for personalized or decreasing rates, you are automatically extending the retention period and therefore the lifespan.

For example: if the current average lifespan of a customer is 6 months, you can create packages with prices that will start decreasing from the 7th month of subscription, or assign an account manager during the last two last months of the customer’s lifespan and double your efforts to increase the probability of renewal (and upsell at the same time).

In conclusion

In short, customer LTV is the total revenue opportunity generated over the lifespan of a customer. The higher the LTV, the less your company needs to be exceptional in other areas such as retention, fighting cancellations or in sale leads conversation rates.

LTV is a key metric for subscription-based or usage-based business models.

Without this metric, you will not be able to arbitrate acquisition and retention. You will not be able to optimize acquisition budgets because you will not be able to anticipate your ROI of future customers acquisitions.

It is important to remember that :

Customer LTV is an indicator that is complex to calculate. You need reliable and suitable tools to determine and calculate it accurately. LTV is a metric that is based on the revenue generated. This means that the basis of your LTV is in your invoicing and in the subscription of your subscribers. Without an appropriate IT system, it becomes complex to calculate this metric reliably and above all to keep its reliability over time.

LTV helps you understand how to extend the customer’s lifespan. This is therefore a statistical indicator but also a strategic one. It is not possible to base your calculation on unreliable elements that are not linked to invoicing.

Dotsha is the monetization and billing platform for subscription and usage-based businesses. As such, we master and automate the complete Offer, Quote, Order, Invoice, Payments chain for you in collaboration with your CRM and your accounting department. All the data necessary for a reliable LTV is available in Dotsha. Contact us to find out more about us and arrange a demonstration.

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