To understand whether the costs of product promotion, customer engagement and retention pay off, experts study many indicators, one of them is LTV. In this article, we explain why companies calculate LTV, how to calculate it and what data is needed for this.
What is LTV
LTV (Lifetime Value) is a metric that shows how much profit a customer brings in over the entire period of their interaction with the company.
This metric is calculated for the following purposes:
- Defining the target audience: LTV as a metric helps a marketer determine which customer segments bring the company the most profit and which of them should be targeted for primary promotion efforts.
- Optimization of advertising campaigns: a marketer can more effectively set up targeting and budget allocation.
- Develop loyalty programs: You can motivate customers to make repeat purchases and retain them. For example, if the customer’s LTV is high, you can offer them exclusive discounts, bonuses, or loyalty programs to strengthen the relationship.
- Measuring the effectiveness (payback) of advertising activities: LTV as a marketing metric helps evaluate the effectiveness of advertising campaigns, even if they do not generate immediate profit. For example, if advertising has led to the acquisition of customers with a high lifetime value, the advertising can be considered successful, even if it did not generate direct profit in the first month.
Here’s how it works in different industries:
- Online clothing store: The lifetime value of a customer can include the value of all their purchases, as well as the value of their referrals to your company to other customers.
- Online education platform: A student’s LTV may consist of the cost of all the courses they’ve taken, plus the cost of their premium content subscription.
LTV: calculating the indicator using a simple formula
The easiest way to calculate this metric is to use the following formula:
LTV = ACV × ACL
ACV (Average Customer Value) — the average value of a customer. The metric reflects the average amount that a customer spends on goods or services over a certain period. To calculate this metric, you need to know the total revenue for the period and the number of customers for the same period. The formula looks like this: ACV = (Total revenue from customers for the period) / (Number of customers for the period).
ACL (Average Customer Lifetime) — the average customer lifespan. This metric shows how long customers stay with you and how much profit they bring over the entire period of cooperation. The ACL value is taken from internal reports, a CRM system or an end-to-end analytics service .
So, to get LTV, you need to multiply the two indicators described above, calculated for the same period.
You can show how to calculate the LTV of a customer using a simple formula using an example. Let’s say you have a company – an online clothing store. On average, a customer makes purchases worth 3,000 rubles per month (ACV). The average customer lifespan is 12 months (ACL).
LTV = RUB 3,000 x 12 months = RUB 36,000.
It turns out that on average, a client brings your company 36,000 rubles over the entire period of interaction.
It is important to remember that this formula is just a basic calculation. In reality, LTV can be more complex and take into account many additional factors, such as the cost of recommendations and customer loyalty. The more metrics are taken into account in the calculation, the more complex the formula, but the more accurate the resulting value.
How to calculate LTV using other formulas
Below we describe three popular formulas for calculating the metric, which differ from the one described in the previous section.
Formula for the long term
In some situations, a simpler approach that takes into account total revenue and the total number of customers over a long period becomes more relevant. How do you calculate LTV in this case? The formula is the same as the ACV formula:
LTV = Total Revenue / Number of Customers
Total revenue in this formula can also be replaced with net profit.
We can show how to calculate the LTV of a customer for a long-term period using an example. Let’s imagine that you have an online store with 1000 customers for 5 years of work. During this time, you received a total income of 10,000,000 rubles.
LTV = RUB 10,000,000 / 1000 clients = RUB 10,000.
It turns out that, on average, each customer brings your company 10,000 rubles over the entire period of interaction.
Please note that if the period for which you take data is lower than the customer lifetime value, then this formula will simply calculate the revenue from the customer for the period, but not the lifetime value.
This formula gives a rougher idea of LTV than the simplest formula using ACV and ACL. It will take into account all buyers, including new ones, who will continue to buy from you and have not yet spent all their money. Therefore, LTV using this calculation method will be lower than the real one.
Formula taking into account the margin
For a more accurate assessment of the profit that a client brings in terms of LTV, it is necessary to take into account the margin, i.e. the difference between the cost of the product and its cost price:
LTV = ACV x ACL x GM
GM (Gross Margin) is the gross margin, i.e. the difference between the revenue from the sale of a product or service and its cost. GM shows how much money you have left after deducting expenses – the cost of raw materials, direct costs (for example, employee salaries), and indirect costs (for example, advertising costs).
Before we move on to LTV, let’s show you how to calculate gross margin:
GM = (Revenue – Cost) / Revenue × 100%
Revenue and cost mean revenue and cost for the specific period for which you are calculating the LTV indicator.
You can see how LTV is calculated using an example. Imagine that you have an online store with ACV = 3,000 rubles, ACL = 12 months and GM = 20%.
LTV = RUB 3,000 × 12 months × 20% = RUB 7,200.
It turns out that, on average, each client brings your company 7,200 rubles of net profit over the entire period of interaction.
The margin formula takes into account the actual costs of producing or providing goods and services, making the customer lifetime value calculation more accurate.
Formula taking into account the frequency of purchases and the average check
This is another formula that takes into account purchase frequency, customer engagement time, and gross profit:
LTV = AGM x PF x AOV x ACL
AGM (Average Gross Margin) — average gross profit. The metric shows the average value of profit that remains with the company after “cleaning” revenue from cost price. To calculate it, you need to find the average margin (GM) for several periods, for example:
AGM = (GM for June + GM for July + GM for August) / 3 (months) × 100%
PF (Purchase Frequency) — purchase frequency. Shows how many sales on average are made per customer during the period. The formula for calculating PF looks like this:
PF = Number of sales / Number of unique customers
Data for PF are taken for one period, and the longer it is, the better – preferably at least a year.
AOV (Average Order Value) is the average customer check. It is calculated using the formula:
AOV = Total Revenue / Number of Orders
AOV should be calculated over the same period as PF.
The chain of this LTV calculation formula is completed by the ACL metric, which we have already discussed above. It should be calculated in the same units as PF and AOV. That is, if the frequency of purchases and the average check were calculated per year, then the ACL should also be in years, not months.
You can see how to calculate the LTV of a client using this method using an example. Imagine that you are the owner of an online store selling sportswear. To calculate the LTV indicator for 1 year, let’s assume that it has the following data:
- Gross profit (AGM) – 40% of the selling price;
- The typical customer purchases sportswear on average 3 times a year (PF);
- the average customer order value (AOV) is 2000 rubles;
- ACL is equal to 1 year because we calculate LTV per year.
LTV = AGM × PF × AOV × ACL = 40% × 3 × 2000 × 1 = 2400 rub.
The result obtained means the following: on average, each client brings you 2400 rubles in the first year of interaction with your company.