What is customer LTV, how is it calculated and why is it important

Imagine you’re a business owner looking to sell your products on one or more online marketplaces. Maybe you’ve tried selling your products on social media, but you’re not getting the traction you need. Or, maybe you’ve tried hosting a webinar for your niche audience, but it didn’t yield the results you expected.

If this sounds like you, you’re in luck because you’ve found the perfect solution. A study by HubSpot reveals that 71% of customers will leave a purchase between 3 and 6 months after their order was fulfilled. This is known as customer Lifetime Value (LTV).

So if we can learn one thing from this, it’s that customers are fickle. They’ll either love you or they’ll leave you. But before we dive into how to calculate customer LTV and what it means, let’s discuss the basics of what makes up this number.

Customer Lifetime Value (LTV)

Put yourself in your customer’s shoes for a moment. What is your experience with the company you’re doing business with (assuming it’s a company)?

If you’re considering purchasing a product or service from this company, what is your first thought? What are your expectations?

The lifetime value of a customer is the amount of money a business can expect to earn from that customer over the course of their relationship.

When a business builds a relationship with a customer and understands their needs, this business can tailor their products and services to meet these needs. As a business owner, the question you should be asking yourself is this: How much do I need to charge to make my customers come back for more?

The Four Types of Customers

As discussed in the previous section, the lifetime value of a customer is determined by the amount of money a business can expect to earn from that customer over the course of their relationship. This section will define the four types of customers and how each one’s value changes over time.

Before we begin, it’s important to note that customer LTV is different from customer acquisition cost (CAC). We’ll discuss this more in a moment, but for now, know that customers can leave a business at any time and that their LTV can change at any time as well. If you’re curious, you can review customer statistics at any time from your Google My Business dashboard.

The first type of customer is the free trial user.

With these users, your only goal is to get them to sign up for your product or service. In the majority of cases, you’ll be offering free trials because you want to find out how much value your product or service provides to actual users. This type of customer costs you nothing because there’s no commitment from their part. You don’t have to provide any value to them beyond getting them to try your product or service. Just make sure that you’re mindful of the fact that they’ll never be a true ROI (return on investment) because there’s no product or service to show for it in the first place.

The second type of customer is the customer who buys now, but returns later.

These customers come back at some point and either purchase something from you or take out a subscription. In either case, you’ve now created a new relationship with this customer. This customer is different from the free trial user because there’s now an expectation that you’ll provide some value to them. They’ve spent money with you, but you haven’t necessarily made a commitment to provide value in return. Make sure that you’re mindful of this difference in expectations when calculating their LTV.

The third type of customer is the customer who makes random purchases.

You’ll notice that these customers don’t really buy much. They might purchase a keychain or mug from you. These are essentially one-time customers who have now established a casual relationship with your business. They might come back once or twice for more casual shopping, but you’ll never know if this is going to become a consistent pattern. Never, ever get frustrated with these types of customers because, in the end, they’re not costing you anything.

The last type of customer is the long-term customer.

These are your typical high-spend customers. They’ve been a part of your business for some time and now you’re responsible for paying back that investment. Your goal is to develop long-term, stable customers who are willing to spend money over time on your products or services. These are the customers you need to focus on if you want to see future growth.

So now that you have an idea of how customer LTV works, it’s time to get back to the original question: How is this number calculated?

How to Calculate Customer LTV

The best place to start is with your billing system. From here, you can input all of the transactions from your business, including but not limited to orders, shipments and invoices.

As a general rule of thumb, you’ll want to add up all of the money spent on customers from the point of view of the person processing the payment. This includes but is not limited to credit cards, direct deposits and ACH (bank) transfers. Do not include money spent on business-related expenses, such as advertising or hosting fees because these are not attributable to a specific customer. 

Now that you have your transactions in order, it’s time to start aggregating revenue and expenses. You’ll want to add up all of the sales you’ve had over time and then subtract all of the costs that you’ve had to bear over that same time period. This number should equal your business’ net income (revenue minus expenses).

Take a look at our example above. We have a business with $10,000 in annual revenue and $5,000 in expenses. Our net income is therefore $5,000. We’ll use this number for our example.

Example

To calculate customer LTV, you’ll want to use a tool like InvoiceBee or AccountPlus. With these types of programs, you can pull in all of your transactions and get a clear picture of how much each customer is costing you. Plus, you can set up automated reminders to follow-up with customers and keep track of what they’ve purchased.

Depending on how sophisticated you want to get with your LTV calculations, you can use formulas, variables and math to get the results you want. Some businesses prefer to use a tool like InvoiceBee because they want to make sure that their LTV is being calculated correctly. They can check this number frequently and if anything doesn’t add up, they can contact their accountant for help. This level of detail gives them peace of mind.

Why Is Customer Lifetime Value Important?

If you want to maximize your ROI (return on investment), you need to focus on the right metrics. One important number to look at if you’re invested in customer retention is customer lifetime value because it provides you with a clear picture of the lifetime value of a customer. When a business understands how much money they’re losing due to customer turnover and what that number is costing them in terms of revenue and profit, they can take action to better retain their customers. 

Just remember that customers don’t always represent profit. Sometimes, they’re a cost-center. For example, if you own a coffee shop and you buy a grand total of $2,000 worth of coffee inventory each month, you’ll be spending $2,000 each month just on coffee beans. This is an expense that isn’t attributable to a revenue source. Therefore, you can’t directly calculate this number from Coffee Shop’s perspective. However, you can estimate it by looking at what you spend on coffee beans each month and what you sell each month. If you multiply coffee beans sold x the average revenue per cup, this is how much Coffee Shop is costing you in terms of revenue.

This just shows you how important it is to take a holistic view of your metrics when trying to understand your business’ performance. Sometimes, looking at individual metrics can lead you to believe that a business is doing well when, in reality, they’re losing money hand over fist. By analyzing a number of metrics together, you can get a clear picture of the overall health of your business.