How to calculate LTV (plus definition and formula)
By Indeed Editorial Team
Published 4 May 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Customer lifetime value is a metric that measures how long it takes a company to recoup the investment required to obtain a new customer. It helps determine how losing customers might impact a business, how much it costs to acquire new customers and how price changes impact total revenue. If you work in finance or business development, learning about customer lifetime value can help you make more informed decisions when acquiring and retaining valuable customers. In this article, we discuss what customer lifetime value is, outline how to calculate LTV and note ways you can increase it.
What is customer LTV?
Customer lifetime value (LTV) is a metric that determines the total revenue a business can expect to receive from a single customer throughout the customer lifecycle. A customer establishes a relationship with a business once they subscribe to a product or service and sustain it through repeat purchases. Customer LTV considers an individual customer's revenue value and compares it to the predicted customer lifespan. Businesses use LTV to identify the most valuable customer segments and directly influence the customer sales journey.
An increase in LTV means the company is performing well as the consumer continues to purchase from them. Alternatively, a decline in LTV indicates that the company is spending more to acquire customers and losing profit. Sometimes these profit losses are short-term, as businesses make up the deficits through revenue sharing and by developing new products and features.
How to calculate LTV
If you want to understand more about your customers, it can be valuable to know how to calculate LTV. There are several ways of how to calculate the LTV of a customer. These methods require you to determine how much revenue each customer generates and how long they're expected to stay with the company. Once you have this information, the basic formula for calculating LTV is:
Customer lifetime value = customer value x average customer lifespan, where customer value = average purchase value x average number of purchases
Here's a step-by-step guide on how to calculate LTV using an example:
1. Consider the sample size
It's important that you have a large enough sample size to generate a meaningful customer LTV. Using a low number of customers reduces the statistical power of the metric and its reliability. Also, when there are fewer customers, each one has a greater impact on the LTV calculation, which can cause more drastic changes to occur with the loss of just one customer. Businesses that have a large number of customers and revenue rarely experience huge variations from month to month.
Example: Coffee Kingdom is a start-up business with only a few loyal customers. To generate a reliable LTV, the company waits a few months until it has an established base of ten customers and a more accurate understanding of its profit margins.
2. Calculate the average purchase value
Measure the average purchase value of each customer. This calculation is necessary to determine the average customer's value that features in the LTV equation. To find this value, divide the business's total revenue for a specific time period by the number of purchases. The formula is as follows:
Average purchase value = total revenue / number of purchases
Example: Coffee Kingdom generated £800 between January and April. During this time, the business oversaw 50 purchases. The company divides this quarterly revenue by the total number of purchases for that period, giving them the number 16. This means the average purchase value of each customer is £16.
3. Calculate the average purchase frequency rate
The frequency rate helps determine how many visits the average customer makes to the company within the set timeframe. You can work this out by dividing the number of purchases by the number of unique customers.
Example: As established, Coffee Kingdom has ten loyal customers. Since the business oversaw 50 purchases between January and April, it performs the calculation:
50 / 10 = 5
This means that the average customer visits the business five times. This means that five is the average purchase frequency rate.
4. Determine the average customer's value
Use the two previous calculations to determine the customer value of the business. Calculate the customer value by multiplying the average purchase value by the number of times they make a purchase. The formula is:
Customer value = average purchase value x average number of purchases
Example: Coffee Kingdom multiplies their average purchase value of 16 by the average number of purchases made by each customer, which is five, to determine the average customer's value. Their average customer value is £80.
5. Calculate the average customer's lifetime span
The average customer lifespan is the average number of days between the first order date and last order date of all your customers. This helps determine the company churn rate, which establishes the rate at which customers stop doing business with the company. You can convert the average number of days into years by dividing the result by 365.
Example: Coffee Kingdom started with 15 customers at the beginning of January and has 10 by April. The company calculates its churn rate using the following formula:
Churn rate = lost customers / total customers at the start of the time period
5 / 25 = 0.2
This means the company has a churn rate of 0.2 or 20%. To determine the customer lifetime span, Coffee Kingdom divides 1 by the customer churn rate, giving them the number five. This means that the average lifespan of a customer is five weeks.
6. Determine the customer's lifetime value
Determine the customer's lifetime value by multiplying the customer value by the average customer's lifespan. Be sure to multiply the customer value by 52 if you based your calculations on weekly habits or 12 if you based them on monthly habits.
Example: Coffee Kingdom does the following calculation to determine their average customer's lifetime value:
80 x 5 = £400
This means that the average customer brings in £400 for the business on a quarterly basis.
Why is customer LTV important?
Customer LTV is important because it determines a company's total revenue relative to the cost of acquiring customers (CAC). This ratio helps businesses accurately predict their profitability and determine the overall health of a product or service. It's essential for both established companies and start-ups, as it ensures you choose a successful business model that minimises customer spending while capitalising on customer retention.
LTV provides a complete overview of company figures compared to other metrics, such as the average revenue per user (ARPU). This metric doesn't consider how long customers are going to pay the amount or if they're likely to upgrade their subscription in the future. Customer LTV bridges the gap between the ARPU metric and customer retention to provide a more rounded picture of the company's health.
How to increase LTV
There are several ways you can increase customer LTV. Understanding how to increase LTV helps businesses improve their retention rates and generate more revenue. Some ways to increase it include:
1. Optimise the onboarding process
Customer onboarding is the process that consumers go through before they start using your product. Use the onboarding process to teach customers about the brand, why it matters and why their purchase is worthwhile. Collect data based on a customer's previous purchases to offer personal deals or similar items to the customer. Doing so shows the customer that the brand takes an interest in their needs and is willing to support them from the offset.
2. Expand product line
Adding new products is a good way to capitalise on existing relationships by offering customers more value. Ensure that these products relate to the original so that you can promote synergy amongst your product line. Alternatively, consider creating a new product line to attract a completely new market segment.
3. Improve customer services
Conduct research to find ways of improving your customer service. These might include omnichannel customer support programmes, seeking customer feedback and having a proper return or refund policy in place. Be sure to publicly capture and share examples of good customer service to make potential customers feel positive about interacting with the brand.
4. Build trust
It's essential to build trust to establish long-term customer relationships. Convince customers that your brand can offer them the best products or services for their needs at the best price and demonstrate this through brand offerings and deals. You can also build trust by interacting with customers online and cultivating personal connections. Engage with customers online by asking for their feedback, liking their posts about the brand and providing them with exclusive behind-the-scenes content.
5. Cross-sell and upsell
A cross-sell is the sale of an additional product that's related to the primary purchase that a customer makes. Alternatively, upselling is the practice of encouraging consumers to buy a higher-priced product than the one they initially intended. Cross-selling and upselling help businesses increase the amount of revenue they generate from each customer while offering them a more personalised service in the process.
Please note that none of the companies, institutions or organisations mentioned in this article are affiliated with Indeed.
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