Skip to content

    How to Calculate Customer Lifetime Value (LTV/CLV)

    by Oren Greenberg on

    Any serious marketing or product analysis is incomplete and ultimately futile without understanding the lifetime value (LTV), or Customer Lifetime Value (CLV) of a business. Customer lifetime value defines the total profit a business makes from any given customer over time. It does not focus on unit economics or single transaction but on the lifetime relationship that you build with your customers.  

    It aims to measure, benchmark, and forecast the revenue that a customer generates during his or her lifetime engagement with your business. It is a complex enough task to measure the immediate value of a conversion accurately, let alone over the entire lifecycle of a user. In this post, I am going to run you through all the variables that effect LTV and how to effectively measure it, no matter what your business model is.

    Why is CLV/TLV important

    Understanding CLV will allow you to put a number on the economic value of each customer so that you can take informed decisions on how much investment towards acquisition and retention make business sense. Armed with an accurately calculated CLV, you will be able to forecast how much revenue and repeat business you can expect from particular consumer personas based on their acquisition source, demography, past transaction history, and more.

    On an average, it costs about five to seven times more to acquire a customer than it does to retain one. One of the greatest challenges start-ups face is ensuring the average Customer Acquisition Costs (CAC) keeps reasonably lower their LTV. It's a challenge because many businesses focus on the immediate transactional customer value and in the process, ignore the experiences that lead to a conversion - thereby missing out on retention and a chance to repeat these transactions.

    Renowned Boston-based VC David Skok says that LTV on an average should be about three times your CAC for a viable business which relies on a recurring revenue model. The cost of acquisition should be recovered within 12 months of acquiring a user. The purpose of increasing your customer lifetime value, as David points out, is to create a favourable balance in your business model that enables you to offset the cost of acquisition. 

    Over 66% of marketing professionals either do not know or have a skewed sense of how much their customers are worth in terms of lifetime revenue and lose out on as much as 17% of their sales opportunity.

    Definitions

    Let's start by defining all the variables that you will need to efficiently calculate LTV. There are a lot of them, so make sure you jot them down somewhere.

    • Cycle: The incremental time that you commonly use in your business (usually week, month or year). It does not matter what you use as long as the choice you make it remains consistent for all calculations.
      Example: You calculate total online food orders in 1-week increments. Your cycle is 1 week. 

    • Sales per cycle: This is the total revenue you have earned per cycle from each customer.
      Example: A customer orders food online worth £50 pounds a week. 

    • Repeat Sales: The number of times a customer purchased from you during a cycle.
      Example: A customer ordered food 3 times in the last cycle. Your repeat sales = 3.       

    • Average Cost of Sale: The average cost your business incurred to complete each transaction. This is the total cost of providing the service you offer.
      Example: The packaging cost + the cost of acquiring the user on your mobile food ordering app + delivery charges + any other cost variable you can connect to the sale directly. For the current example, every order of value £25, the cost is £12       

    • Retention Time: The number of cycles you expect the customer to keep purchasing from you. Note that the frequency of purchase may decrease over time (for non-subscription based models). Make sure you use the same cycle as you have done before. Sometimes also called Customer Lifespan.
      Example: A customer who ordered up to 5 times for the last 3 cycles is likely to be retained for 50+ weeks.       

    • Average Sale Value: The average revenue per transaction that you made from a customer during a cycle. This is a simple average; total sale revenue divided by the number of transactions.
      Example: The customer who spent £50 on online food delivery, ordered 3 times. Average sale per week = £50/3 = £16.6

    • Profit Margin per customer: This is the average profit you make on each customer and is calculated using a simple formula: [(Average Sale Value – Average Cost of Sale) / Average Sale Value] x 100
      Example: Profit margin for the above customer example is: [( £25– £12) / £25] x 100 - 52% 

    • Discount Rate: This is the interest rate applied in discounted cash flow analysis to learn the current value of future cash flows. Usually, this ranges between 8% and 15%. 

    • Average Customer Value per Cycle: This is the total sale value for all customers in a cycle. Calculated by: (Total of Average Sale Value of all customers)/Number of total customers.
      Example:
      Customer 1 Average Sale value: £18.90
      Customer 2 Average Sale value: £11.25
      Customer 3 Average Sale value: £17.33
      Average Customer Value per Cycle = (18.90+11.25+17.33)/3 = £15.82 

    What you need to calculate LTV

    Calculating LTV can quickly become a mathematical nightmare if you do not have all your variables and data identified and clearly sorted beforehand. Get your analytics experts and fish out reports well in advance. Depending on the complexity of your business model, here's what you will need:

    • For Average Revenue per User: We will need the total revenue and number of cycles since the customer was acquired.

    • For Custom CLV: Average Sale, Number of Repeat Sales, Expected Retention Time, and Profit Margin.

    • For Sale Per Cycle: Total Sales and Number of Repeat Sales

    • For calculating Profit Margin: Average Sale, Average Cost of Sale

    • For calculating Simple LTV: Average Customer Value per cycle, usually averaged across 5 customers, but you can set it as any value, and average customer lifespan.

    • For Custom LTV: Average Customer Lifespan, customer costs per transaction averaged across 5 customers, the number of transactions per week averaged over 5 customers and profit margin per customer.

    • For Traditional LTV: Average gross profit margin per customer lifespan, your customer retention rate, and rate of discount.

    • For forecasting LTV: Recurring revenue per customer, recurring costs, the gross amount the customer contributes to your overall revenue for the cycle, net margin, acquisition cost, and the expected number of purchases in the next three cycles.

    How to calculate LTV

    Let's look at the simplest form of LTV that can be calculated; it is nothing other than the Average Revenue per Customer in the following fashion. For ease of calculation, we'll calculate sample LTV for a one year cycle. 

    Note: since we took one week as the cycle period for all the above variables, we will need to convert a year in terms of weeks - a year has 52 weeks.

    The LTV, in this case, is the total revenue divided by the number of weeks since the customer first joined and then multiplied by 52 to get a one-year LTV. 

    Simple LTV = (Total Revenue/Customer Lifespan)x52

    Traditional LTV

    This is one of the oldest methods to calculate LTV which has stood the test of time. The calculation is simple but effective because it takes into account both Customer Retention Rate and the average number of transactions over 5 (or however you set it) customers.

    LTV = Average Customer Lifespan x (52 x Revenue per transaction averaged over 5 Customers x Number of Transactions per week averaged across 5 customers x Profit Margin per Customer).

    Churn Rates, Negative Churn Rates and Customer Lifespan

    Things are getting murkier! Up till now, we have been carefully avoiding the annual percentage at which your customers stop transacting. Essentially, it is the drop-off rate in your business funnel.

    Why is it so important? Because if you take even a small cohort of just 100 customers and apply a constant churn rate, what you will see is an exponential decay in the size of this cohort over time. That is just how it is, customers leave.

    Mathematically, this decay can be represented by the simple formula:

    Customer Lifespan = 1/Churn Rate, 

    Where Churn Rate = Number of churned customers / Total number of customers.

    What happens if revenue from retained customers is greater than the revenue lost from churned customers? What we have here is called Negative Churn Rate. You will need a new formula to calculate LTV for a business with negative churn rate.

    LTV based on Churn Rate is an incredibly powerful metric which when done well, can arm with you an invaluable piece of information. Being a negative number, the way Churn Rate usually effects Customer Retention Rate is as follows:

    Retention Rate = 1 - Churn Rate

    LTV with negative churn = (Average Revenue per Customer x gross Percentage Margin) x {[1/(1-k)] + [(growth rate for customers that have not churned x k) / (1-k)^2]}

    Where K is the constant in formula defined by:

    Constant k = (1-churn) x (1-discount rate)

    Identifying your high-value customers

    Customers who are the most profitable, who are the most loyal and who are the easiest to attract and retain. In other words - customers with low Churn Rate, low cost of acquisition and high lifetime value. These are the customers you want to hold on to. 

    To know your High-Value Customers (HVC), calculate LTV for each of your customers and then rank them. Customers with the highest LTV are our most valued ones.

    Knowing LTV of your customers can help you help you decide which customer segments to focus on in terms of how aggressively you acquire these customer types, how much effort should go into sales, even how to reward your sales team for converting customers belong to the HVC persona.

    What to do after calculating LTV

    Segment and Analyse

    Start by segmenting your customers based on LTV. Make micro-segments based on the frequency of transactions, revenue per transaction and total number of transactions done by each customer. Further, classify your customers according to their demography. Micro segmenting is going to enable you to have individual marketing and retention strategies for each group. Segmenting customers based on their LTV lets you determine what should be your maximum cost of acquisition for each group.

    Talk to your HVCs

    Start a customer discovery exercise targeting your HVCs. Try to understand why they love your product and brand. What are their backgrounds? What kind of purchase motivation do they have? Try to discover patterns in their purchase behaviour. What are some of the common traits that define an HVC? The best way to discover these details is to talk to your most loyal customers

    Over to you! Now that you have a thorough understanding how LTV calculations work, it is time to apply it to your business. As you have seen, it is no easy task. The process is time-consuming and can quickly become rather complicated. Ensure you do not rush through the process. You might want to consider hiring a good marketing agency to do the work for you. 

    Related Articles