Modern Internet marketing is ruled, governed, and driven by metrics. And one of the most important of them is “customer lifetime value”.
What Is Customer Lifetime Value?
According to a common description, customer lifetime value (aka LTV, CLTV, or CLV) is a prediction of the net profit attributed to the entire future relationship of a company with a customer. For our purposes here in this article, we’ll stick to CLTV as a proper abbreviation.
Now, that’s a lot of big words, I know. Hold on, I’ve got something else for you.
According to a not so common but brief and informative description, customer lifetime value is a metric that represents the amount of net profit a company makes from any given customer.
Basically, it’s how much money you will earn from a single client on average.
Despite being quite logical and pretty straightforward from the first sight, CLTV is a tricky metric that’s not always easy to calculate right, let alone analyze and make meaningful conclusion based on it.
However, it’s all possible, and this is what we’ll talk about today.
CLTV History
One the first accounts of the term “customer lifetime value” was in the marketing books in the late 80s. That was before the Internet and subscription-based online services.
However, the subscription model had been going on for quite some by then, especially in the telecommunications industry. This is probably due to the nature of their business – the clients of telecommunications companies aren’t like other customers.
What makes them different is that they don’t pay the full price for the services upfront. Instead, every day/week/month/call/view (depending on the plan) they make a so-called micro-payment – call it subscription if you wish.
The price paid by the client for one call/view or a month worth of subscription isn’t enough to sustain the provider company. Their greatest interest lies in making the clients stick to the company’s services and keep contributing those micro-payments until they’re dead for as long as possible.
Customer Retention
A few years later, they would call it “customer/user retention”, which is a metric that shows how many clients will still be using your product/service after a certain period after buying it (usually it’s 7, 14, and 30 days).
Retention Shown on an Example
On day A, 100 people started using a product/service. 7 days later, only 50 of them remained – others disliked the product/service or simply became uninterested in it. Another 7 days later 10 more people quit due to various reasons, which has left us with just 40 clients. Finally, a full month (30 days) has passed since the day A and during that time 5 more people quit. We’re left with only 35 clients out of those 100 who initially started using the product/service.
Therefore, 1-month retention rate is 35%.
Makes sense, right?
Churn Rate
Again, this term comes from the practice of telecommunications companies, and it’s closely related to the retention rate. Let’s see how it works on a simple example.
On day A, yet another group of 100 people started using a product/service. After a certain period of time (usually, it’s month), 30 of them abandoned the product/service and never came back.
Therefore, we have 30% churn rate. It shows how valuable and usable our product/service is in the long-term perspective. Decreasing the churn rate is one of the primary tasks of any marketing team.
Of course, in real life it’s much more difficult than that – marketers often calculate the churn rate for different cohorts of users for different months: e.g., first-month churn rate for cohort A is 30%, 2nd month churn rate is 10% and so on.
Now, let’s say the company’s management rolls out a new plan on how to make people stick with the product/service – make it more user-friendly, add features, give discounts, and whatnot. How will the company’s management understand if their plan succeeded in the long run?
This is where customer lifetime value comes in.
Customer LTV Explained
We need to measure the current amount of profits we get from a single client on average now and compare it to the one we’ll get later. That involves crunching A LOT of numbers.
CLTV Formula – Basic
In a very simplified form, the CLTV formula will look like this:
Customer Lifetime Value = Total Customer Revenue – Total Customer Costs
This formula does not take a whole lot of factors into consideration, such as retention rate, churn rate, cohorts, discount rate, etc. But it should work for now – let’s take a real-life example to demonstrate how it all can be applied.
Calculating – Example 1
First, we have a mobile app, which is paid and it costs $2.99. We, as the owners of the app, know that, on average, 10 people download the app every day. It costs us $50 of marketing and other expenses to acquire those 10 buyers daily.
Therefore, we need to calculate the total customer revenue per day
$2.99 * 10 = $299
Then, we just subtract our total customer costs from it and divide the value by 10 to get the CLTV per one customer.
($299 – $50)/10 = $24.99
Our CLTV is $24.99. Seems quite obvious, huh?
However, in real life no everything is so easy. Even in our example, adding some extra purchases to the product brings much more confusion.
Calculating – Example 2
The same 10 people download our $2.99 app daily. However, now our app has a few in-app purchases that enhance the user experience. Let’s say, only 1 in 10 people who have bought the app, will also buy an in-app purchase.
Obviously, the lifetime value of the in-app buying users will be higher than that of the regular ones.
Cohorts
In order to complicate things even more, we could add such parameter as “cohorts”.
Cohorts are groups of people grouped together using a certain criteria
– e.g., “users from the UK”, “people aged 25-35”, “people who bought my product while it was on sale” and so on.
Obviously, there’s no such thing as an “average customer”. Different customers act differently depending on their demographics, locations, income level, source of acquisition, and other factors. This is why you need to segment them.
Knowing these differences and leveraging this knowledge gives you an ultimate power as a marketer. In order to identify various cohorts, you need to run a cohort analysis.
Cohorts Example
For example, in our case it could be:
- people who downloaded the app on weekend
- users from the US and Canada
- people who haven’t purchased an in-app
Then, if you see that the metrics of people in these cohorts are different from others, you should work with these segments closely to find opportunities for your business and leverage them. For example:
- seeing that people who downloaded you app on weekend, don’t buy any in-apps, try to offer them a discount
- seeing that users from the US and Canada download your app more than users from other countries, why not raise the price?
- seeing that people who haven’t purchased an in-app, tend to leave the app during the first 14 days of usage, send them push-notifications as a reminder
CLTV Formula – Full
Now, we know what a simplified CLTV formula looks like. However, if you want to be precise (and in modern marketing, you’d better be), you will need to take every aspect into consideration.
In this case, the full CLTV formula will go as this.
Customer Lifetime Value ($) = Margin ($) * (Retention Rate (%) ÷ ([1 + Discount Rate (%)] – Retention Rate (%))
Now, we know what margin and retention rate are. What is a discount rate then?
Discount rate is a metric that shows the loss of money value over time. Let me explain it.
Obviously, $100 in 1990 isn’t the same $100 in 2017. Money loses over time – it’s a natural process caused by inflation. When you are in a big business, things like this start to matter.
Discount rate is especially effective when you are trying to calculate the lifetime value of subscription-based service customer.
For example, in a hypothetical situation – a user has subscribed to a service via a mobile app or a website.
In most cases, you won’t get money instantly – the billing will start at the end of the first subscription period (a month). Therefore, the user will pay you his/her first $2.99/mo only 30 days from now.
Obviously, by that point in the future, that sum of money will have lost some of its value and become $2.95, for instance.
The user is expected to spend not more than 10 months within the service before unsubscribing, thus no more payments. The further the payment from the present time, the bigger the discount rate. Ten months from now, $2.99 will be $2.70 and so on.
Discount rate is mainly based on the current inflation rate in the given country for the given currency.
Conclusion
In today’s “Customer Lifetime Value Explained: Using CLTV for Your Business” article, we’ve talked about how to calculate and apply customer lifetime value. The next article will focus on how to raise CLTV.
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If you have further questions on the subject, please write them in comments – I’ll be glad to answer.
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