Customer Lifetime Value – Understanding, Measuring & Growing It
Part of the new Understanding KPIs series
Part of working on neatly means pulling in a lot of data and making sure that we understand the metrics that we pull in from the various integrations we work with.
This has led to a lot of Googling definitions, and scribbled calculations on notepads! Couple that with the planning that we had to put behind the insights feature and we’d picked up a lot of knowledge on metrics.
With all of this knowledge that the team has gathered, we thought, why not share it? Which kicks off the first post in our new series! In each post, we’ll delve into the nitty gritty of a KPI, helping you to understand exactly what it is, how to measure it and tips on how to improve it for your business.
So without further ado…
Customer Lifetime Value: Understanding, Measuring & Growing It
Customer Lifetime Value is the one of the darling KPIs of the SaaS world, but is relevant to all kinds of businesses. It’s also one of the most confusing calculations out there.
Every article and analyst that you turn to will offer you a variation on the calculation, which makes it increasingly confusing when trying to figure out which calculation works best for you.
Which is where I come in! I’ve gathered the calculations together from some of the top experts in the industry and compiled the top 4 results below to work through.
But first let’s start by making sure we understanding exactly what Customer Lifetime Value (LTV) is and why it’s important to measure it.
Defining Customer Lifetime Value
The basic definition of LTV is that it represents the dollar value of a customer relationship.
A slightly more detailed version of that definition can be found on Wikipedia:
“a prediction of the net profit attributed to the entire future relationship with a customer”
This KPI tells you how much a customer is worth to your business, pretty straightforward so far, right?
So what makes this KPI so important to measure?
One of the key reasons to measure LTV is to shift your business’ focus from short term quick profits, to building long term relationships with your customers.
It’s all about retention and by focusing on retention it eases the pressure when it comes to growing your business. It’s a lot easier to grow when you know you have a group of loyal customers with whom you have solid long term relationships, rather than frantically trying to push more and more new customers through the door every day.
LTV also helps you to define a target Cost per Acquisition. If you know that the average customers brings the business $100 then you know that your CPA should be at a maximum $33. (It’s recommended that your LTV:CPA ratio is about 3:1).
This then goes on to help determine how long it takes to get back the money you’ve spent on that customer – your payback period.
So far so good? You can see why it’s one of the metrics to keep an eye on. It focuses you on customer relationships and helps you to identify how profitable you will be long term – what’s not to like?
Now for the tricky bit – calculations.
How to measure Customer Lifetime Value
As I’ve mentioned, there are numerous versions of the Customer Lifetime Value formula. For those of us who rely on a calculator, some of these calculations are enough to send you into a sweaty, nail-biting pit of panic, just take a look:
Ugh, I’m getting palpitations just looking at it.
Lucky for us there are other calculations that are a whole lot simpler. I’ve identified 4 that should help you.
Across these four versions there are a few metrics that are seen in each of them, so make sure to have them to hand:
- Average Order Value
- Retention Rate
- Repeat Purchase Rate
Got them? Off we go…
Let’s start with the most basic calculations, with offerings from Hubspot and Sweet Tooth Rewards.
You’ll notice that these formulas are pretty much the same. There’s some variation in the terms used but:
Purchase frequency = No. of repeat sales
Average Lifespan = Average Retention time
Sweet Tooth Rewards have added in some brackets, but using the rules of BODMAS means Hubspot’s would be calculated in the same way.
The beauty of these formulas is that it uses metrics you’ve probably got easy access to. Most ecommerce platforms provide these metrics for you and while the lifespan metric might be harder for you to find, it’s recommended that you use between 1-3 years for an ecommerce retailer.
Customer Lifetime Value is an important KPI to be tracking, so at the very least you can use this basic formula to make sure you have an understanding of it.
Next up: Ometria
Ometria also have a basic and detailed version of CLV.
Their basic formula is this:
Again, pretty much the same metrics as our previous two calculations, but this time with the addition of Average Gross Margin. Average Gross Margin is:
(Revenue – Cost of Goods)/Revenue
This basically gives you your average gross margin per lifespan, and give you deeper understanding of your Customer Lifetime Value.
However, while all of these calculations give you a fair understanding of how much profit you’re making from a customer, it ignores things such as discounts.
Which is why we need to use the detailed version and the one which Kissmetrics puts forward as the Traditional Equation:
You can see that they’ve taken into account any discounts or free stuff customers could get by adding in that rate of discount metric.
As Kissmetrics explains, this metric is the interest rate used in discounted cash flow analysis and usually falls between 8 – 10%.
So which one should you use?
Really, there’s no right or wrong answer. You should use whichever formula you feel most comfortable with and have the most metrics readily available for.
If rate of discount is not a metric that you have access to, don’t fret and just revert back to using Hubspot or Sweet Tooth Rewards’ formula.
Or if all else fails, find a tool that does it for you! There are many tools out there for SaaS, and while not many Ecommerce platforms readily provide it, there are options out there (including the aforementioned Kissmetrics).
A key thing to remember is this:
The whole point of this KPI is to make your life easier, if using the simpler formula means you don’t spend too much time on it getting stressed out, then use the simpler formula.
One last thing…
Once you’ve nailed down your formula, you can start segmenting and that’s where LTV really comes into it’s own. You can break down which channels are delivering your best value customers.
Using an example partially inspired by Avinash Kaushik, let’s say your PPC campaign has the best conversion rate of all the channels sending you customers. However, when you break down the LTV, it turns out that Search Marketing actually drives customers with a better lifetime value.
As a result you might decide to put a little less budget into PPC and a little more into SEO to try and increase the number of those valuable customers.
How to Improve your Customer Lifetime Value?
Believe it or not, that’s the difficult bit over with, now for the fun part, how to use it.
Using data from your Cost Per Acquisition, Profit Margins and more, you’ll know what your target LTV is. All you need to do now is reach it.
If you’re not sure how to improve Customer Lifetime Value, here’s a hint: take a look at those metrics you’re using to calculate it.
If you can increase just one of those metrics, you’ll increase your LTV.
Improve Average Order Value
There are many ways to increase your average order value, but here’s a few:
- Increase your free shipping threshold
- If your current AOV is $25 and your target is $30, up your free shipping threshold to $30 will get you there. Customers are more likely to throw that extra item in the basket if it means getting free delivery!
- Create discounts that relate to how much you spend
- Again, offering 10% off when you spend over $XX is a simple way of getting customers to increase their basket size
- Offer bundles
- If there’s a few products that customers often purchase together or that could be useful together, create a bundle. Customers will love you for the discounted items and you’ll get an increase in AOV.
Improve Repeat Purchase Rate
This metric is inherent to LTV, it’s all about customer loyalty. Part of that is just having a great product, great customer service and being able to listen. Focus on getting that down, and your retention will increase.
So that’s Customer Lifetime Value!
We’ve covered a lot there, so let’s recap:
- LTV is all about how much your customers are worth to your business
- It helps you focus on the most important part of your business – your customers!
- There are many calculations out there, some simple, some complicated. Stick with one that makes sense for you
- Improve LTV by focusing on your customers – provide a great product, great customer service and great value for money and you’ll see this KPI skyrocket!
Is Customer Lifetime Value a KPI that your business uses? Let us know how it impacts you and your team!