What is lifetime value?
Lifetime Value or LTV is an estimate of the average revenue that a customer will generate throughout their lifespan as a customer. This ‘worth’ of a customer can help determine many economic decisions for a company including marketing budget, resources, profitability and forecasting. It is a key metric in subscription based business models, along with MRR (Monthly Recurring Revenue).
How to calculate LTV
Lifetime Value can be calculated in many ways. In the case of a subscription model, a simple method is to take the average monthly amount expected from each customer and divide it by your churn rate (the rate at which you lose customers each month). For example, if you charge $500 per month and your churn rate is 5% then your LTV for a new customer is (500/0.05) or $10,000.
In this case, your customer’s expected ‘lifetime’ is 20 months.
For companies that use a non-subscription model, it is the total income you expect to gain from a new customer including any add-ons and/or upsells that you expect from the customer. This is calculated by multiplying the Average Order Value by number of Expected Purchases and Time of Engagement. Therefore, the LTV of a customer can grow or shrink over time based on your offerings and ability to grow the account.
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 is LTV used?
Lifetime Value is a key variable in revenue forecasting, as each additional customer brings additional revenue per month and throughout their projected ‘lifetime’.
LTV can also be used to determine the marketing budget of a company. Adding LTV segments to your customer personas will help you get a better view of the importance of each customer. Specifically, the Customer Acquisition Cost (CAC), the cost of acquiring one new customer, for each segment should always be lower than the Lifetime Value of a new customer.
For example, if a company is considering lowering the price point for one of its product segments, but estimates that the new Lifetime Value of a customer of that segment will be lower than the current CAC for that segment, then creating that price point is an unsustainable business decision.
Another key area where LTV can be applied is resource allocation for current customers. Once you are able to segment your customers according to their LTV, you can allocate more resources towards both the acquisition and maintenance of certain customers. Customers with a high LTV should receive more resources depending on what stage of the customer lifecycle they are in, especially if they are nearing the end of the cycle with potential for renewal.
How to increase lifetime value
Increasing the LTV of new customers by reducing churn will increase the long-term profitability of your company. It is recommended that you have a retention strategy tailored towards different LTV segments in order to reduce churn. If the current expected lifecycle of a customer is six months, you could create packages that are seven months long, or allocate an account manager during the last two months of the lifecycle and step up efforts to increase the likelihood of renewal.
For companies with non-subscription based pricing, one effective method of increasing LTV is to create add-ons that can be up sold to customers in order to increase their LTV.
LTV in CRO
In conversion optimization, you can use LTV to determine the value of your goals. This is done by breaking down the Lifetime Value of a customer and assigning values to each micro and macro conversion in the funnel.
Doing this instead of assigning values based on the first conversion will allow you to get a more accurate view of the value of each conversion metric towards the LTV of your customer. This method also allows you to break down your CAC according to each stage in the funnel, making it easier to create an accurate marketing budget.