- First: why is Customer Lifetime Value important
- How do you calculate customer lifetime value?
- First, let’s keep calculating LTV simple
- Then we can add referrals to the mix
- Now let’s get to the complicated part: you don’t just sell one product
- Here is our Customer Lifetime Value Calculator
- Measuring customer lifetime value shows the value of segmentation
- The time problem is it lifetime or year?
- The simple way to calculate LTV
- Related Questions
Most companies, as in 99% of them, do not know who their most valuable customers are. In my experience, it is all companies, from massive multinationals to the startup trying to raise funds.
Every once in a while, there is a company or an MSP owner who knows exactly what their clv customer’s lifetime value is and it is a striking point of clarity that guides all strategic thinking, creates better products, enables better processes, and makes selling much, much, easier.
The metric we use for customer value is Customer Lifetime Value or Lifetime Value or simply LTV.
The definition of customer lifetime value is what a customer is worth to you over time. It is the total of the money they will spend with you and the referrals they will provide minus the cost to deliver (though not normally the cost to acquire). To understand how well your marketing is working you subtract the Customer Acquisition Cost (CAC) from the Lifetime Value.
First: why is Customer Lifetime Value important
First, Customer Liftetime Value (CLV) and Lifetime Value (LTV) are the same thing… we use LTV, many use CLV.
Whatever acronym you use, here is why you care:
That the squeaky wheel gets the grease is not only a cliche but also true. But greasing the squeaky wheel is not always the best business decision.
Knowing your Customer’s Lifetime Value, allows you to prioritize your actions based on how they will impact your business rather than the volume of their complaints.
Consider our Thrivers groups as an example. When we started, we had a couple that were free. We were figuring out the business model and did not know our value.
After a few months, we launched our paid program but kept our free groups alive.
Here is where the value equation becomes so important: the free groups asked for a lot of stuff, they were our most demanding customers. Since they asked for so much, we had a tendency to deliver to them.
We wanted them to be happy.
The problem was that the time we spent on solving problems for the free groups led to delays in solving problems for the paid groups. The paid groups had fewer issues and fewer requests, but it took us longer to handle their problems.
And that is backward.
This is not just a paid versus free issue
In business, we constantly make trade-offs with time, money, clients, strategy, and where to focus.
One key to growing a business is to put that focus on the areas that make the most money. By serving the needs of the highest value customer you accomplish three things:
- You keep your highest value customers happy, so they keep paying you.
- You hone your product/service to your highest-value opportunities.
- You can align your marketing to the needs of the highest value prospects.
Remember that value is the importance of the transformation you offer in the mind of your customer. Price is the amount the customer is willing to pay you. Their willingness to pay is a function of the value and how much they trust you.
So, the better you know your high-value customers and can talk to high-value prospects, the more trust you create and the higher the price you can charge.
How do you calculate customer lifetime value?
Explaining how to calculate Lifetime Value is easy, however, calculating it presents some challenges.
The basic LTV calculation is:
The sum of money you receive from the customer over their “life” as a customer plus the value they bring to you minus the cost to deliver.
The challenge comes in figuring out how much money you will receive, how long they live as a customer, the value they bring to you, and the cost to deliver.
So, you know, little things.
First, let’s keep calculating LTV simple
Imagine you have one product that you sell to a client one time. Your simple product is a one-time purchase of $5,000.
You know that producing that product (or delivering the service), costs you $2,000.
So your simple LTV is $5,000 – $2,000 = $3,000.
Then we can add referrals to the mix
Start with the case above and then imagine that your customers only buy once but some make a lot of referrals to you.
Since your product is a one-off, you don’t work with your customers anymore. But, it might be nice to send them a gift basket for the referrals. Now, who gets the basket and what size? Should everybody get a gift basket?
Consider three customers:
Customer A just buys the product and disappears. Their Value to you = $3,000.
Customer B makes two referrals. Their value to you is the original $3,000 + the value of the referrals. They made two so their value is $9,000. You might send them a bottle of wine.
Customer C makes a referral every month and has done that for 10 months already. Their value = 3,000 + 10×3,000 + the expected value of referrals in the future. So, their value is $33,000 + the expected value of referrals in the future. Send them the biggest Harry and David gift basket you can find.
This example brings up two issues in calculating LTV double counting and expected future value.
In the example above I attributed the entire value of the future customer to the referral. This means that you will double count the value because you will also attribute that value to the customer that paid you.
There are many complex algorithms you can use to sort this out. Ignore them. They don’t matter. Just double-count.
This calculation is not about precision, it is about helping you decide who is more valuable to you. Is Customer C more valuable than Customer B? Absolutely.
Does it matter that there is also a Customer D out there who is also worth $3,000 because Customer C referred them? No. Let it go.
Problem two is expected value in the future, how do you figure that out?
Simply it is a guess and however you do it, as long as you put some logic behind it, is probably fine.
Your experience will help guide you.
But here are some analytic tools that might help:
If you think that Customer C could continue to refer customers to you forever at 1 per month that means that they will be referring $36,000 of business to you each year.
The value of cash flow that goes on forever or at least a long time (otherwise known as in perpetuity) is the annual value divided by the annual discount rate.
Now, I am not going to explain the discount rate here (but if you insist, go here), and I don’t want you to worry about it. We will assume that the discount rate is 10%. Maybe it is higher, maybe it is lower, but for LTV purposes precision is a waste of time and 10% gives us a nifty round number that makes calculation easier.
In this case, if you know that the $36,000 will go on in perpetuity, then you divide that amount by .10, which is the same as multiplying it by 10 and you end up with $360,000.
TL; DR: if you think that the referrals will go on forever, multiply the annual amount by 10 to get the expected value.
In this case customer C’s LTV goes up to $33,000 + $360,000 = $393,000.
As I said, send them the nice basket.
Or maybe a Tesla.
The “in perpetuity” assumption may be a little high. So that is where experience and guessing come into play. If you know that your top referrers bring you 20 additional clients and Customer C has already brought in 10, then you can reasonably guess they will bring in another 10.
In this case their value is $33,000 + the value of ten more referrals = $30,000 so $63,000. Still worth a nice gift basket, but maybe not a new car.
Now let’s get to the complicated part: you don’t just sell one product
The above examples assume that you sell one product at a fixed cost. Very few businesses fall into that category (and if you do, consider an upsell!).
In real life, you must look at the value of your customer based on the products that you expect them to buy.
So, imagine you sell a product for $97. That product leads to a $300 a month subscription, which leads to a $2,500 a month subscription and additional services worth anywhere from $5,000 to $100,000 a year.
Now, how do you calculate your expected value?
The first way is to look at what people are currently buying and add some expectations around that.
With some experience and educated guessing you come up with:
- 50% of your $97 customers buy your $300 subscription and
- 20% of those who buy the $300 subscription buy the $2,500 subscription and
- 50% of those who buy the $2,500 subscription buy $10,000 a year in services.
- Those who buy the $300 subscription stay for a year.
- Those who buy the $2,500 subscription stay for two years.
This means that the expected value of someone who buys the $97 product is:
- $97 +
- 50% X (300 x12) = 1,800 +
- 50% X 20% x (2500 X 24) = 6,000
- 50% X 50% x 20% x $10,000 = 500
- = $8,397
However, the value of someone who buys your $300 subscription is
- 300 x12 = $3,600 +
- 20% x (2500 X 24) = 12,000
- 50% x 20% x $10,000 = 1,000
- = $16,600
And the value of someone who busy your $2,500 subscription is
- 2500 X 24 = 60,000
- 50% x $10,000 = 5,000
- = $65,000
And then you would add on to that the amount they are likely to bring to you in referrals bring all of this together to calculate the average lifetime value of a customer.
Here is our Customer Lifetime Value Calculator
Measuring customer lifetime value shows the value of segmentation
Customer Lifetime Value calculations demonstrate the value of figuring out which segment of your customers will buy which products. Average customer lifetime value is important, but the closer you can get to defining a segment, the better. you can tailor your marketing.
If you know which 50% will buy before they buy you can invest in supporting those customers – with maybe less effort in supporting those who won’t buy (or won’t buy yet).
Customer lifetime value marketing involves significant research and segmentation. The more you study your customers the more precisely you can identify who will buy what and segment them into groups. If you know that those who wear pink on Wednesdays are 80% more likely to buy your high-value product, you could build this into your model and act accordingly.
(Note: this does create a self-fulfilling prophecy problem, but we can worry about that another time.)
The time problem is it lifetime or year?
We have found that considering “lifetime value” can be way too complex and theoretical. So, we often look at value over a year.
Say you are running an advertising campaign for your $300 subscription. You know that on average they are worth 12×300 or $3600 to you. So, you might be willing to pay $1,000 to acquire them as a customer.
You just know that there is more potential value out there, but for this advertising decision, the one-year calculation is enough.
The simple way to calculate LTV
The above gives you a way of thinking about calculating LTV and I know it can get complicated. So, the way we typically do it is by using rules of thumb.
LTV is about decision-making, not precision. So, rules of thumb do fine. Sticking with our examples above you may decide:
- A $97 sale is typically worth about $5000
- A $300 subscription is worth about $3600 + some other stuff.
- For more detailed analyses a $300 subscription is worth about $8,000.
- Your $2,500 subscription is typically worth $60,000
This is usually enough to give you an idea for decision-making without making your life overly complex.
However, as you get to know your business and your customers it is worth adding more depth and complexity to your calculations – this will help you focus, align, and grow your business.
What is the customer lifetime value formula?
Total Revenue from a customer – total cost to deliver that revenue + value of referrals = Customer Lifetime Value
What is the difference between CLV and LTV?
There is no difference between CLV and LTV. Some people like writing CLV and some prefer LTV. They both refer to Customer LifeTime Value.
Why is Customer Lifetime Value Important to Businesses? Why Does It Matter?
Customer Lifetime Value matters for two reasons. First it tells you how much you can afford to spend to acquire a customer and second it helps you understand the value of segmentation. It might sound scary to spend $5000 to acquire a customer, but not if that customer is worth $100,000.
How can you increase customer lifetime value?
Here are three ways to increase customer lifetime value. One way is to increase the amount of time that customers spend with your company. This can be done by providing excellent customer service and creating loyalty programs that encourage customers to stick with your brand.
Another way to increase customer lifetime value is to increase the amount of money that customers spend with your company. This can be done by offering discounts and promotions, or by upselling and cross-selling products and services.
A third way to increase customer lifetime value is to increase the number of repeat customers. This can be done by creating a brand that customers love and by providing an excellent customer experience that encourages customers to come back.