Marketers and businesses make a fuss over too many metrics and KPIs.
If you are focusing too much on Google Analytics or Adobe Analytics or keeping an eye on every follower/like count growth on your Facebook or Instagram, you are not there yet to lead a marketing department.
Ouch!
Having said that, I am not undermining the importance of tracking your WOW or MOM growth of users or traffic on site.
As for me, aside from the metrics and KPIs mentioned earlier, I focus primarily on CLV and CAC.
Don’t worry. I will not leave you confused with those acronyms.
What is Customer Lifetime Value (CLV, LTV)?
People are the biggest asset to a business- both employees and customers.
As a marketing leader, I keep a close eye on the total revenue the business expects to earn from the day a prospect becomes a customer, until the day the customer stops purchasing from the business.
So, the customer lifetime value (LTV) or lifetime value is defined as “the present value of the future cash flows attributed to the customer during his/her entire relationship with the company.”
Customer lifetime value also goes by CLTV or lifetime customer value (LCV).
Why is Customer Lifetime Value important?
Knowing the CLV helps a business determine the maximum dollar amount to spend on acquiring a customer, aka, CAC (customer acquisition cost).
We will get into the numbers soon.
That is why customer lifetime value is important in estimating ROAS (return on advertising spend).
A Mckinsey report suggested that running promotions for a segmented audience can help grow sales for retail brands by as much as 5%.
Customer lifetime value is just the metric that would help you segment your customers based on value.
For instance, a business can focus more on retaining high-value customers. Or, it can work on using look-alike modeling to acquire new customers.
Being customer-centric is the key to growth in the competitive market today. If you want to grow your business, you cannot ignore this.
This metric is a goldmine to retain high-value customers, generate more revenue per customer (especially less-value customers), and improve the customer experience.
More on improving CLV later…
How to calculate Customer Lifetime Value?
Before we serve the sumptuous CLV recipe, let’s dissect its ingredients
- Average Order Value (AOV)
- Purchase Frequency (F)
- Gross Margin (GM)
- Churn Rate (CR)
Let’s discuss these before we discuss the formula for customer lifetime value.
Average Order Value (AOV)
This is the average dollar amount spent each time a customer buys from your business- website, mobile app. You get the idea.
AOV = Total Revenue / Total Number of Orders
Let’s say a pizza store’s annual revenue was $1 million, and it received 50,000 orders.
In this case, AOV = 1,000,000/50,000 = $20
Purchase Frequency (F)
This represents the number of times a customer buys from your business in a given time period. This KPI helps understand customer engagement.
F = Total Number of Orders / Total Number of Unique Customers
Taking the same example of a pizza store. Total Number of Annual Orders: 50,000. Total Number of Unique Customers (annual): 25,000
Hence, F= 50,000 / 25,000 = 2
Therefore, our mythical pizza store has a Purchase Frequency of 2.00
Gross Margin (GM) or Gross Profit Margin
Gross margin is calculated by subtracting the cost of goods sold (COGS) from the net sales revenue of a business.
Gross Margin= Net Sales−COGS
COGS= Starting inventory + purchases – ending inventory
The gross margin represents the portion of each dollar of revenue that the company retains as gross profit.
Let’s assume a company’s quarterly GM is 40%. This means that it retains $0.40 from each dollar of the revenue generated.
Gross margin helps a business assess the profitability of its manufacturing activities, while net profit margin helps it assess its overall profitability. Here is another way of calculating the gross profit margin.
GM = (Sales Revenue – COGS)/Sales Revenue
Let’s use an example: Starting Inventory: $100,000, Purchases: $200,000, Ending Invetory: $60,000
COGS = 100,000 + 200,000 – 60,000 = 240,000
Let’s assume a total sales revenue of $600,000
Then GM = (600,000 – 240,000)/600,000 = 0.6 or 60%
Churn Rate (CR)
This is also known as the rate of attrition or customer churn. Churn is defined as the rate at which customers stop doing business with a company.
For a successful company, Growth rate > Churn Rate
CR = number of churned customers / total number of customers
Churn lowers the LTV because when users leave, the revenue that could have been earned decreases. Churn increases the CAC.
In simplest terms, Customer Life Time Period = 1/Churn Rate
In our previous example, let’s assume that 3,000 churned (or stopped doing business with the store).
In this case, Churn Rate = (22000-25000)/25000 = 0.12
Therefore, Customer Life Time Period = 1/0.12 = 8.33
What is the formula for customer lifetime value?
Plugging in these number into the customer lifetime value formula, we can easily calculate the CLV (LTV):
LTV = AOV x F X GM X Customer Life Time Period
= 20 x 2 x 0.6 x 8.33 = $199.92
How to Increase Lifetime Value of Customer (LTV)?
Put simply, a business can improve its customer lifetime value by increasing its AOV, increasing its GM (Gross Margins), increasing the purchase frequency (F), and reducing the churn.
Let’s dive deeper.
How to Improve Average Order Value (AOV)
Conversion optimization plays a key role in helping you improve the AOV on your website or app.
For example, you can add personalized product recommendations. Email marketing is a great way to support this strategy.
You can send personalized email campaigns using dynamic product recommendations.
I am a big proponent of observing consumer action on your site (or app).
Using heatmaps and other tools, you can observe how a prospect interacts with your website and products.
Get to know what they add to their shopping cart. And then use email campaigns to recommend products based on their actions.
Product bundling is another way to improve the AOV.
However, bundle products that make sense together.
You can recommend the bundle on the website, via email, or based on the shopping cart or browser history of the user.
We all like to earn points. The entire airline industry and credit cards are built on this premise of earning points to redeem them for rewards.
You can create a customer loyalty program, and allow your customers to redeem loyalty points for discounts and free goodies.
How to Improve Your Purchase Frequency (F)
You want your orders to make frequent purchases.
Again, personalized email marketing that uses historical customer data can help increase purchase frequency.
Your analytics team should dive deeper into the customer journey to assess which channels are they using more.
If John (a customer) has been using SMS to communicate with your company, does it make sense to focus more on emails for him!
You get the idea.
Customer Segmentation can save you time, resources, and money. A smart way to segment your customers is based on their current lifecycle stage. Conversion optimization (CRO) can be a blessing in this regard.
How to Improve Your Gross Margin (GM)
One of the easiest ways to maximize profit margins is by selling higher-margin products.
Simple in theory, not so much in real life!
However, by excluding products that are contributing to lower margins, you can build a better recommendation model.
You can also use a Price Optimizer to instantaneously find the right price for your products.
How to Reduce Churn?
The best way to reduce churn is to create a seamless, frictionless shopping experience.
Simple, yet so complex!
I always maintain that listening > Talking.
You need to listen and observe what your customers are doing with your business.
What are the points of friction?
What is causing them to either not buy a product, or abandon a shopping cart?
I will try to address this subject in detail in a separate blog post.
CLV: Why do so many businesses suck at this key marketing metric?
As businesses scale, data becomes fragmented and bucketed.
Multiple software, multiple departments, all make it difficult to collaborate when analyzing data.
It is important to understand that the calculation of customer lifetime attracts some challenges as well.
LTV for Each marketing Channel
Both B2C and B2B Marketing involve using different channels to attract, engage and retain customers.
Therefore, it makes sense to analyze the spending across different marketing channels in order to understand which campaigns are profitable and which ones are not.
For instance, you can compare LTV and CAC for paid social vs SEM (Google Ads, Bing Ads).
You can also analyze non-paid channels such as SEO and email marketing.
Factoring in GM (Gross Margin)
While the calculation of customer lifetime value typically requires you to use your overall gross margin, you should other expenses such as cost of goods, shipping & handling costs, payment processing fees, discounts, and refunds.
This will also depend on the nature of your business- B2B or ecommerce (B2C).
Average Customer Lifespan
This number can vary depending on your business and level of customer satisfaction.
Here are some industry averages.
A financial advisory company has a $25,000 annual average revenue per customer (ARPC), a $164,200 customer lifetime revenue, and $45,976 LTV.
A commercial insurance business generally falls in the $38,000 ARPC, $321,000 custom lifetime revenue, and $125,190 LTV.
Conclusion
It is important to track important marketing metrics such as the customer lifetime value (LTV) and customer acquisition cost (CAC) to measure your progress.
Hope this post will help you understand how to calculate the LTV using the customer lifetime value formula mentioned earlier.
Using CLV data, you can optimize (reduce) costs for lower CLV customers and increase the spending on acquiring and retaining customers with higher CLV.
This will also help you map the customer journey.