Life Time Value
Life Time Value is a 40 year old technique developed and still used by catalogue/mail order and TV shopping companies. These companies realised that the true value of a customer is not the value of the first sale but the value of all the purchases the customer has made. Plus the value of all the purchases the customer is likely to make in the future - discounted to the present. This is called the lifetime value (LTV).If a customer completes a £5 purchase on a first visit to a site but then continues to spend £5 another 9 times over the following 12 months before becoming inactive. Then the life time value of that customer to the business is not £5 but £50 and this can make a dramatic difference to how much a company is willing to spend acquire that customer. Life Time Value is therefore an important metric to know but it is often difficult to calculate precisely - don’t let that be an excuse to not try.
Calculating Life Time Value
Try to go back as far as your data will allow – say you’re a relatively new company and you have sales data going back 3 years. Take the total value of sales in the last 3 years and divide by total number of customers in the same time period to give you the average revenue per customer.
Total Value of Sales / Total Number of Customers = LTV (unadjusted)
This is your unadjusted average customer life time value and is reasonable rough estimate.
Adjusting for New Customers
But there is a bit of problem in this formula. Customers that you have acquired recently will not have ordered as many times as a normal customer would. Therefore this figure you just calculated will off be under reported. Therefore we must make the following adjustment.
To come up with a more accurate figure you must remove the data from all the customers who, on average, have not yet finished their relationship with you. In other words remove all the data from recently acquired customers.
To do this you need to the average length of time a customer stays with you. If you are an established company you can obtain a reasonably accurate estimation by taking a random sample of 50 customers who have not ordered from you in at least 12 months and determine the average time period between first and last date they ordered from you. This will be a very good approximation of the average length of a customer relationship. Now, simply remove all the sales and customers you have gained during this period and repeat the formula above.
Adjusted Total Value of Sales / Adjusted Total Number of Customers = Adjusted LTV
This is your more accurate (adjusted) estimate of average customer life time value.
Calculating Life Time Profit
To determine how much you can spend to acquire each customer, you must determine the lifetime profit (LTP) you receive from an average customer. This can be done by multiplying by your average profit margin per sale. Lifetime profit means two things. Firstly, it represents the average amount of profit you are going to receive from each customer. .But more importantly it also means how much more you can spend to acquire each customer and still make a profit in the long run.
Do not be afraid to spend more than the profit on the first sale to acquire a customer, however. As long as you cash flow is healthy enough to support it, spend whatever you need to acquire that customer, as long as it is less than the average lifetime profit plus your current customer acquisition cost.
More Info
Determining the Lifetime Value of and Lifetime Profit From Your Customers with Excel Spreadsheet by Ryan P Allis
Calculating LifeTime Value (LTV) or Lifetime Customer Value (LCV) by Jim Novo