If there was a vending machine that instantly delivered a crisp $20 bill for every $10 bill you fed it, how many times would you feed the machine your money? Answer: “As many times as physically possible.” And you would never run out of cash to put back into the machine. That’s called profitability, and essentially that’s the same formula a business uses to remain viable—make more money delivering a product than it costs to provide the product.
The dimension that complicates the business formula is time. Usually, a significant investment comes before the payoff. Usually, the attribution of overhead requires knowing how many sales the overhead should be divided by. Usually, the business pays its marketing campaign costs in a lump sum receiving the promise of leads and conversions but not yet knowing the yield. The profitability reveals itself after the fact in a Profit and Loss statement.
But here’s one advantage to time: the older a business is, the more opportunity it has to glean the benefit of the Lifetime Value of a customer. The cost to originally acquire a customer can be steep, but if they buy again, buy more, buy more often, sample more of your products, and even refer people to you, they become less costly, more loyal, and easier to serve.
Increasing customer retention rates by 5% can increase profits from 25% to 95%. (Bain & Company) Furthermore, the likelihood of selling to an existing customer is 60-70%, while the probability of selling to a new prospect is only 5-20%. (Marketing Metrics)
Knowing the lifetime value of the customer means that you might put $10 into the vending machine now to receive only $3 immediately, but $3 more each month for 12 months on average. Adjusted for the time value of money, that recurring revenue can still be better than the magic vending machine.
What is Lifetime Value?
The Lifetime Value (LTV) of a customer represents the total revenue a business can reasonably expect from a single customer ever. It considers that customer's revenue and compares that number to the company's predicted customer lifespan. Businesses use this metric to understand how much revenue they can expect a single customer to generate over the course of their business relationship.
Lifetime Value Calculation
The Lifetime Value of a customer is calculated by multiplying the average purchase value, the average purchase frequency rate, and the average customer lifespan. It gives a dollar value to the relationship with each customer and is a critical metric that informs a company's decision about how much money to invest in acquiring new customers and retaining existing ones.
Average purchase $ x average frequency x time before churn = LTV
In some industries, this is easier to calculate than in others.
In this case, the Lifetime Value (LTV) of a customer can be calculated relatively straightforwardly.
Here’s a hypothetical subscription-based example:
- Average Monthly Revenue Per User (ARPU): This is the average amount of money that each subscriber pays per month. Let's say, for example, that most subscribers are on a plan that costs $13.99 per month.
- Average Customer Lifespan: This is the average length of time a subscriber stays with a subscription service before canceling. Let's assume this is about 25 months.
- Customer Acquisition Cost (CAC): This is the average amount of money a business spends to acquire a new subscriber. This includes marketing and advertising expenses, sales team salaries, and more. Let's say this is about $25 per subscriber.
Using these figures, we can calculate the LTV as follows:
LTV = (ARPU * Average Customer Lifespan) - CAC
LTV = ($13.99 * 25) - $25
LTV = $324.75
This means that, on average, each subscriber is worth about $324.75 in net revenue to the company over the course of their subscription.
Knowing this figure can help the business make informed decisions about how much they can afford to spend on acquiring new customers, retaining existing ones, and developing new content or features.
But complex businesses also need to calculate an LTV.
Let's consider a large multinational CPG brand that has a wide range of products across different categories such as beauty, grooming, health care, fabric & home care, and baby, feminine & family care. Calculating the LTV for a company this diverse can be quite complex for the following reasons:
- Multiple Product Lines: With a wide variety of products, each with its own pricing, usage rate, and customer base, customers buy different products at different frequencies.
- Different Types of Customers: Serving a diverse customer base with different buying behaviors, some customers might be loyal to one product but not others. Some might buy in bulk, while others buy products as needed.
- Indirect Relationship with Customers: By selling most products through intermediaries like retailers and e-commerce platforms, not direct-to-consumer (DTC), this makes it harder to track individual customer purchases and calculate LTV accurately.
Despite these challenges, a CPG could estimate LTV by creating customer segments based on product usage, purchase frequency, and other factors. For example, they might calculate the LTV for "young families" who regularly purchase typical household products at similar times.
Here's a simplified example:
- Average Revenue Per Segment (ARPS): This is the average amount of money that a "young family" spends on CPG products per year. Let's say this is $500.
- Average Customer Lifespan: This is the average length of time a "young family" stays in this segment before their purchasing behavior changes significantly (e.g., the kids grow up and they stop buying diapers). Let's say this is 5 years.
- Customer Acquisition Cost (CAC): This is the average amount of money a CPG spends to acquire a new customer in the "young family" segment. This includes marketing and advertising expenses targeted at this segment. Let's say this is $100.
Using these figures, we can calculate the LTV as follows:
LTV = (ARPS * Average Customer Lifespan) - CAC
LTV = ($500 * 5) - $100
LTV = $2400
This means that, on average, each "young family" customer segment is worth about $2400 in net revenue to the CPG over the course of their time in this segment.
Knowing this figure can help the company make informed decisions about how much they can afford to spend on acquiring new customers in this segment, retaining existing ones, and developing or promoting products that appeal to this segment.
The Importance of Knowing LTV
Without understanding the lifetime value of a customer and the time it takes to realize the lifetime value, it would be impossible to understand whether your cost to acquire the customer is a great deal or a miserable one. LTV determines the long-term financial value of any given customer, which can aid in shaping marketing strategy, budgeting decisions, and customer service objectives. Understanding LTV can also help businesses segment their customers into groups based on profitability. This knowledge allows companies to tailor their marketing efforts and resource allocation towards maintaining relationships with high LTV customers and improving relationships with lower LTV customers.
Each marketing tactic can change your average LTV
The LTV of a customer can change significantly based on the effectiveness of different advertising campaigns. For instance, a campaign that successfully targets a demographic with a high average purchase value and high purchase frequency can increase the LTV of customers from that demographic. Conversely, a campaign that doesn't resonate with its target audience may lead to lower purchase frequencies, reducing the LTV of those customers. Therefore, understanding LTV can help businesses optimize their advertising campaigns and improve their overall marketing strategy.
In a data-driven marketing funnel, LTV plays a crucial role in informing decisions at each stage of the funnel. By understanding the LTV of different customer segments, businesses can tailor their marketing efforts at the acquisition, conversion, and retention stages of the funnel to maximize profitability. For instance, a high LTV customer segment may warrant more resources at the acquisition stage, while improving the product or service experience may be more important for a lower LTV segment at the retention stage.
