October 24, 2018
The definition and importance of customer lifetime value (LTV)
If you’ve been in business for any length of time, then you’ve probably heard or used the term Customer Lifetime Value (LTV) — but are you sure you know what it means? This guide will clearly define the importance of customer lifetime value, and how you can use it to grow your business effectively.
Today, generalization is the opposite of what customers desire and expect.
It’s unrealistic to assume that all customers want to be treated equally with the same level of service and the same product offerings. Different customers generate different levels of revenue for a business — that’s a simple fact.
Customer LTV can help you understand these different types of customers, the level of value they bring to your business, and the way they want to be marketed to, sold to, and serviced.
In other words, using and understanding data to measure LTV is what can really set you apart from the crowd. And when you truly understand how LTV can benefit your business, that’s when you’ll see opportunities for your new and existing customers in a whole new light.
What’s the Definition of Customer Lifetime Value (LTV)?
LTV is a measure of a customer’s actual or likely value to your business. The three most common versions of lifetime value are:
- Total spend (total spend to-date)
- Predicted value (future potential spend)
- Predicted Lifetime Spend (spend in the past and predicted future)
For each of these measures, they can also be time-bound and expressed as total sales or sales minus acquisition and product cost.
What’s the Importance of Customer Lifetime Value?
LTV can be measured to indicate the health and success of your business as a whole. Use it to gain value and insight into a broad range of focus areas, including:
Researching and identifying high-value customers will provide critical customer insight into who you should be catering to and how. On the flip side, understanding low-value customers also provides insight into potential improvements to business focus and resource allocation.
Understanding the product preferences of your best/highest value customers provides direction to future design and service offerings. Unlike other profit strategies, which can be time-consuming and only work in the short term, this strategy will yield benefit to your business in the long term.
Targeting prospects that look like your best customers will yield lower Costs Per Acquisition (CPAs). Once you recognize the characteristics of your most successful (read: valuable) segment of customers, finding and attracting them to your business will be much easier. Plus, the longer you can retain a customer, the lower your overall CPA.
Gaining a new customer is much more expensive than retaining an existing one, which reinforces the importance of customer lifetime value. Use the LTV to understand how to grow the lifetime value of your existing customer base. This strategy will ensure repeat purchases, reactivation of customers already in your reach, and ultimately, more revenue for your business.
Recognizing your most profitable customers based on LTV can show you how to minimize wasted resources and spend. You can then adjust your marketing and service costs to focus only on your most profitable segments, building a group of highly-engaged brand evangelists.
“A long-term customer is of more value than a single-deal customer.”
– Larry Myler at Forbes
3 Strategies for Measuring Customer Lifetime Value
You can measure customer LTV using three different calculations. You need to understand how each option is calculated and what to consider when using either metric before you can choose the method that works best for your business.
1. Total Spend
How is total spend calculated?
Calculate total spend by subtracting the total value of all of a customer’s refunds from the value of all of their orders:
Total Orders – Returns = Total Spend
What are the benefits of calculating total spend?
- Total spend is simple and fast to calculate.
- Total spend will give you a measure of fact — it is the most real and tangible of all the omnichannel customer metrics.
- Total spend is easily compared against other information (such as time lapsed since last purchase) to better understand inactive, high-value customers.
What are the limitations of calculating total spend?
- Total spend is backward facing. It’s measured by looking at past purchases and behaviors, so it doesn’t tell you much about future value.
2. Predicted Value
How is predicted value calculated?
There are two ways to predict future spend:
1. Aggregate historical prediction
This metric is calculated by multiplying the average spend per year by the average customer lifetime.
Use this highly simplified method by identifying the average tenure and spend per year for all customers. Armed with these two data points, you can then predict how much each existing customer is likely to spend.
For example: If customers spend $40 per year and stay with you for 4 years, then you can predict a two-year-old customer is likely to spend another $80 with you.
2. Individual customer prediction
Apply a machine learning model to predict each individual customers’ probability of re-purchase. Multiply this probability of re-purchase by their average re-purchase price and adjust for seasonality and growth.
This highly analytical predictive approach is capable of producing very accurate predictions at an individual customer level. This model is most commonly used with more than three years of historical data, so you can hold out the most recent 12 months of data to assess the accuracy of the prediction.
What are the benefits of calculating predicted value?
- Predicted LTV considers the future and doesn’t assume that historical high-value customers will continue to contribute.
- Knowing a customer’s likelihood to spend helps you focus on those customers who are most likely to yield a positive ROI.
- Predicted LTV can be recalculated as and when more data becomes available — and more data means improved accuracy.
What are the limitations of calculating predicted value?
- Predicted value requires a more sophisticated data infrastructure and IT resource.
- Predicted value can be inaccurate in a business undergoing significant change, because past behavior may not be a reliable indicator for future behavior.
- The accuracy of the predicted value is dependent on the available data. Limited data can result in lower accuracy.
3. Predicted Lifetime Spend
How is predicted lifetime spend calculated?
Predicted lifetime spend is calculated using the total spend and predicted value methods described above:
Past total spend + predicted spend = predicted lifetime spend
Calculate everything they have spent in the past and predict their future spend (using an aggregated model) to understand the total lifetime value of your customers.
What are the benefits of calculating predicted lifetime spend?
- Predicted lifetime spend will give you a very complete view of customer value, because you’re calculating everything from the past, along with the prediction for the future.
- Predicted lifetime spend gives you greater knowledge and understanding of future expectations, which means greater and more intuitive planning can be done.
- This holistic view allows for focus on the long-term health of your customers.
What are the limitations of calculating predicted lifetime spend?
- Predictive modeling for the “future” component requires sophisticated infrastructure and resource.
- Again, the accuracy of future predictions is based on the data available – so limited data can have limited accuracy.
To successfully implement LTV, we recommend that you take 4 steps:
- Assess your company’s technical capability to generate these calculations.
- Identify the teams and use-cases for the calculations.
- Implement an agile test-and-learn approach.
- Where successful, automate the process and make it accessible in your day-to-day workflow.
Knowing the importance of customer lifetime value is a vital for any successful business. It can give you insight into the types of customers who use your product the most, the types of features and service offerings you should invest in for the future, and where you can reduce your marketing spend to maximize your budget.
Now you know that the importance of customer lifetime value can’t be overstated. To calculate customer lifetime value effectively, you need to invest in the right technology, resources, and expertise — and transforming the way customer data is used in your business isn’t always easy.
So how do you start? By building a data-loving culture in your business. Click here to download our Data Culture Report and learn how to set your business up for data-loving success today.