What Is Customer Lifetime Value (LTV) And How to Calculate It?
in Monetization and Pricing
February 13, 2023
You just got a new subscriber who picked a Standard Plan for $50. The first payment comes through, and you start wondering how many more you should expect before that particular customer unsubscribes. For how long can you keep that person as a customer? Or maybe they'll stay forever?
Whether you're offering software in a SaaS model or selling other goods, knowing how much revenue you can expect from an average customer can be very valuable. Of course, the metric we're talking about is the customer lifetime value (LTV), sometimes abbreviated to CLV.
So, how to calculate customer lifetime value, and why should you even do it? This article will answer some more questions about the LTV metric.
Customer Lifetime Value Definition
Customer lifetime value is a metric with which you can calculate the average revenue from a customer throughout the entire relationship. Simply put, it's a way to measure how valuable an average customer is to your company.
The metric gives companies a better perspective on the role of costs and critical processes, such as customer acquisition and retention. It can be helpful when it comes to crucial decisions as it helps with forecasting and identifying potential risks.
However, before we move on, it's necessary to point out that:
1. The LTV/CTV metric should be something other than your key influence in the decision-making process. If you rely too much on the expectations based on LTV, you put yourself at considerable risk due to factors that need to be considered, such as a possibility of an unexpected rise in churn rate.
2. There are a few ways to calculate LTV. Depending on your business type, you should adjust the formula according to your requirements. But more on that in just a sec.
How to calculate customer lifetime value?
The formula for a standard SaaS business can be straightforward. For example, let's say we offer three subscription packages at $10, $50, and $100 in monthly payments.
To calculate LTV, we need the following:
x - the average price that customers pay each month (considering discounts).
y - the average length of a relationship (in months).
x*y = LTV
For example, we might have a large percentage of users in the $10 category, making the average monthly value per customer around $20. Then, we calculate that our users subscribe for about eight months on average.
If we multiply both numbers, the result will be our LTV. In this case, the customer's lifetime value would be $160.
If a business isn't operating in a subscription-based, monthly model, the formula gets a little trickier because we have to find out the following:
x - the average value of one purchase.
y - the average number of purchases by one client each year.
z - the average length of the relationship with a client in years.
In this scenario, the formula would be: (x*y)z = LTV
Of course, calculating LTV is a simple process that only gives us a little. The real value starts with analysis and concluding what the numbers show us. For example, we can analyze customer behavior, break down customers into segments, and see further what works and doesn't. And we're talking about the actual LTV and all the numbers that lead us to calculate it.
In addition, we can add expenses to the equation to better understand the role and efficiency of marketing and overhead.
So, while we're here, let's discuss the benefits of calculating and analyzing LTV.
Benefits of calculating LTV
Awareness is the first and perhaps most significant benefit of calculating metrics such as LTV. Once we start paying attention to the numbers, we're ready to analyze all the "hows" and "whys" behind them. Here are some crucial areas and aspects we can improve, thanks to calculating LTV.
If you know what's coming, you can prepare for it.
Measuring LTV over an extended period gives us a clear perspective on what's to come in terms of revenue. If we similarly analyze costs, we get a decent set of tools to improve decision-making.
Of course, it should be used with caution. It only gives us some of the answers and shouldn't be the only metric we're taking into account. In addition to that, we have to remember that we live in a world of VUCA, which means:
And that adds an even bigger risk factor to any decision. We talk more about the subject in the article: How to manage pricing in times of recession and inflation
A better understanding of customer acquisition costs (CAC)
Customer acquisition costs are one of those metrics that pretty much every business measures. How many of them do it correctly is a topic for another discussion, but it's fair to say that the metric is widely known. Business owners and managers understand its importance. That's great, but it gets much better when we add CAC and LTV.
If we start analyzing the value of customers and the cost of their acquisition, we can come up with some fascinating conclusions that can make us rethink our entire strategy. For example, we can learn that we spend a significant amount of our budget to acquire low LTV customers, while our big spenders come from different, less expensive sources.
On top of that, we shouldn’t forget about the CAC/LTV ratio and industry benchmarks that matter. This simple formula gives us a clear understanding of whether our sales and marketing efforts actually pay off.
For example, a 1:1 ratio or lower would mean that you’re in the red and you’re simply losing money the more you spend on customer acquisition. A 3:1 ratio or higher usually means that you’re doing quite well regarding sales and marketing ROI. However, when your is 7:1 or even higher, you should start thinking about increasing the budget because it’s possible that you’re underspending and, thus, restraining your growth.
We can get on an even deeper level once we start including factors such as seasonality, the role of plan downgrades and upgrades, discounts, and even demographic data.
In the end, you become much more familiar with your customer base, which brings us to the next crucial advantage.
Getting to know your customers on a much deeper level
Calculating and analyzing the elements of the LTV equation brings us closer to understanding who our customers are, what makes them buy in the first place, and what keeps them with you for longer. But, of course, it's not a replacement for proper customer feedback.
More importantly, it's a tool that allows us to track the performance and see how impactful the changes we implement are. On top of that, it forces us to ask questions that we might have never thought of any other way.
For example, there are clear patterns that make customers buy more or upgrade their subscription packages. With that information, we can look for ways to encourage even more such actions and make those decisions more appealing to those that still hesitate.
How to work on your LTV?
After you're done calculating and analyzing, you should set a few key goals that lead you to get the metric higher. There are many paths to improve LTV, and they should always be picked according to your customer's needs and product characteristics.
For example, a short average relationship time may signal that you should work better on customer onboarding. Your customers may feel overwhelmed by the product and require better assistance during the first months of the relationship. A more comprehensive collection of blog post tutorials or instruction videos could do the job.
So, before you decide on the strategy, it's good to survey or ask some of your customers about their experience. In the end, their opinion matters the most.
Here are some possible paths to improve your LTV:
The last one can be crucial if we implement the value-based pricing strategy.
Understanding and providing value during the entire relationship with a client
Analyzing customer behavior can be a great motivator and a starting point for understanding our product's value. And with that, we can rethink the pricing strategy in the value-based approach, which maximizes profits in the long run.
Value-based pricing strategy can be a real game-changer because it's focused on the product's actual value to the customer at all times, whether at the beginning of the relationship or after several years.
To sum up, the LTV metric can be valuable and influential, but in most cases, it's the first step to much bigger and better things. However, it's the first step that's often the most difficult.
So if you need any help, we're here for you. You can arrange a free consultation with us here.