Why Does Customer Lifetime Value Matter?
Understanding the lifetime value of a customer is important for any business owner that wants to profitably expand operations and grow revenue. Here are a few of the business cases where understanding the lifetime value of a customer matters:
- Optimizing Customer Acquisition: By far the most obvious scenario where understanding customer lifetime value is important is marketing and sales. By knowing the value a customer brings to the business over their lifetime, marketing and sales managers can make informed decisions about how much to invest in acquiring new customers. Customer lifetime value provides a framework for evaluating the return on investment (ROI) for customer acquisition strategies. Marketing teams need this information to be able to justify the cost that a particular marketing or sales strategy might have.
- Driving Profitability and Growth: By leveraging customer lifetime value insights, businesses can optimize pricing strategies, improve upselling and cross-selling initiatives, and identify opportunities for business expansion. Customer lifetime value helps align business goals with customer-centric strategies, driving profitability and sustainable growth.
- Customer Retention Strategies: By actively tracking (and working to improve) customer lifetime value, businesses will find ways to identify any trends that may be negatively impacting customer retention early on. Prioritizing lifetime value also helps marketing teams understand customer behavior and buying patterns better.
How Do I Calculate Customer Lifetime Value?
There are several ways to calculate customer lifetime value, and we're going to help you pick the best one for your business here.
While these methods vary slightly, the ultimate question we're trying to answer remains the same. Depending on the business model you use one of these models may make more sense than another will. Ultimately you're trying to accurately answer the question "What is a customer worth to us?".
As a note, we normally look at customer lifetime value as a top line, or a middle-line figure. We're not normally looking at net profits to determine the lifetime value of a customer (although you would want to understand this too). This is because cost structures greatly influence net profit and this will be very confusing to the sales and marketing initiatives working to grow LTV.
Different businesses have different types of cost structures. Some are more heavily influenced by variable costs and others have only fixed costs. If we were looking strictly at net profit to understand this figure, then various types of expenses like capital expenditures would skew our understanding. Capital expenditures will reduce net profit, but can be large one-time expenses. Imagine you have a sales director who has been successful in growing customer lifetime value by pushing upsells. Imagine how unhappy they would be at bonus time if you told them that their bonus would actually be lower this year, because accounting decided to reinvest cashflow into a new corporate headquarters. This would make no sense when trying to understand how the lifetime value of acquiring any new customer is increasing or decreasing. Additionally, some corporate structures will incur taxes before net profit which will confuse the situation further (especially when we get into micro details like cash and non cash taxes).
Here are three good frameworks for looking at customer lifetime value:
- Customer Value x The Average Time A Customer Is With You: This model is often best for software companies. If their SaaS is sold at $99/month and their average customer stays with them for 9 months, then their customer lifetime value using this method would be $891. This method of calculating LTV works well for SaaS companies because the marginal cost of adding a new user is extremely small, and their profitability is often more about the length of time a customers spends with them versus the amount they charge (although this is certainly a factor).
- Gross Profit Per Customer x The Average Time A Customer Is With You: This model may make much more sense for companies operating with an agency model. As an example, if an advertising company were to charge $5,000/month to their customer, but would need to pay outside contractors $1,000/month in order to fulfill that service, then they'd look at their gross profit per customer as $4,000/month. Using gross profit in this scenario would be much more meaningful as it is much more reflective of the actual benefit a customer brings. If the average gross profit per customer was $4,000/month, and an average customer stays 5 months, then their customer lifetime value would be: $20,000 (in gross profit).
- Average Order Value (gross) x Average Number of Purchases Per Customer: This model will make the most sense for physical product-based businesses. As an example, lets say we sell shoes. We sell them for $200 and they cost us $40 to make. So our Gross profit would be $160 per pair. Maybe our average across all customers is 1.2 pairs per order (some people buy more than one pair, but most don't). So we could take $160 x 1.2, for $192 average gross order value. If the average customer purchases 3 times over their lifetime, then your customer lifetime value would be $576.
As you can see, calculating customer lifetime value can be made into a very subjective exercise. The reason for this is that businesses models can vary greatly. Ultimately these frameworks will be helpful for you to work through your business model and figure out what the value of adding a new customer is to your business.
As a side note, in M&A deals, the reasoning behind the method of calculating customer lifetime value you choose will be scrutinized by the buyer. They will want to see customer lifetime value as accurately as possible.
What Do We Do With Customer Lifetime Value?
Here, we'll briefly look at a number of ways understanding your customer lifetime value will help you with your business decision-making process:
- How much can we spend to acquire a new customer and still have a profitable relationship with that customer?
- What is the exact amount of money that we can expect each new customer to spend with our business over time?
- Which independent products are the most profitable for us to sell?
- Which products are having the biggest impact on sales?
- What are our churn rates?
Ultimately the more you know about your business, the better questions you can ask. Once you know your numbers and have figured out how to sell your products at a profit, you will understand the reality of what scaling operations will look like.
How Do I Increase My Customer Lifetime Value?
Here we'll briefly look at some ways that business owners can improve their customer lifetime value.
- Raising prices.
- Sales and marketing efforts aimed at getting customers to purchase additional items, or to return and purchase again.
- Ensuring standards for product quality are met and that customers have realistic expectations about what they are buying.
- Surveys, and communication with customers to learn more about why they chose to buy.
- Customer loyalty programs that incentivize customers to purchase (that are valuable, realistic, and attainable).
- Make returns easier. Many product businesses see an increase in both new customers as well as repeat business when they can establish trust with customers regarding their ability to make returns.
- Set good expectations with customers in a way that avoids you overpromising and underdelivering.
Some or all of these strategies may be able to help you raise your customer lifetime value. It's important to ensure that your ultimately selling a quality product because at the end of the day, no amount of pricing tactics can fix a poor value proposition.
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