The simple way to calculate customer lifetime value
How do you calculate customer lifetime value (LTV)? What if I told you there is no “right” way to calculate it, only your way of calculating it. I have been helping brands with retention for years, and no brand is calculating or looking at lifetime value the same way.
The only important thing is that you define what customer lifetime value is for your brand and measure it consistently so you can see and measure improvement. Improving customer retention is like going to the gym. You need to be consistent and the gains are gradual. If you don’t document your progress (take pictures of your abs each week) you won’t notice the changes.
Customer Lifetime Value Formulas Are Confusing
If you are like most people you started your search with something like “How do I calculate customer lifetime value?” and then you were met with formulas and calculations like the one below.
If you are like me though, these formulas are confusing and definitely intimidating. If you have a university or college math degree go ahead and give those formulas a try, but for everyone else, I have an easier way to get your LTV.
The Simple Way to Calculate LTV for Ecommerce
The simplest way to calculate customer lifetime value is to break it into three easier-to-understand parts. Simply put, the lifetime value of a customer is broken into three pieces:
How much someone spends per order (AOV)
How often they are making a purchase (Purchase frequency)
How long they stay a customer (average lifespan)
Before we go into the full LTV formula let’s first go over how you will find the three pieces you need.
Average order value (AOV)
Average Order Value = Total Revenue / Number of Orders
This one is pretty self-explanatory: it's the measure of how much the average order is worth to your store. If AOV increases it means that customers are more valuable each time they make a purchase. This in turn increases your customer lifetime value.
Purchase frequency (PF)
Purchase Frequency = Number of Orders / Unique Customers
Purchase frequency is going to tell you how many times the average person will purchase from you in a given period of time. I personally recommend looking at 1 year (365 days). It’s long enough to be relevant, yet short enough that most of you will have enough data to support it. As long as you use the same time period for both orders and customers you are good.
I would argue that purchase frequency is the most important retention metric you can be paying attention to. Getting a customer to purchase one more time per year or even half a purchase a year usually has a bigger impact than the smaller gains you can make in AOV of 20% - 30%.
Average Lifespan (t)
This is by far the hardest variable of the customer lifetime value formula to get. It is an estimate of how long a customer will remain a customer with you before they go “dormant.”
Way too simply put, this means if an average of 2 years pass between a customer’s first purchase and last, you would have a t-value of 2. But how do you figure out the average lifespan of a customer? The answer… you can’t for most brands.
You need mountains of customer data spanning years to discover an accurate customer lifespan number. If you have that, contact me and I will give you a more scientific approach. Most DTC brands aren’t old enough to have that amount of data. I like to assume a lifespan of 1-3 years for simplicity based on the recommendation of Avinash Kaushik.
Average Lifespan = 1 Year Conservatively or 3 Years Liberally
Bringing it all together (LTV)
Now that we have the three variables, we can calculate customer lifetime value (LTV).
LTV = (AOV x PF) x t
Not nearly as intimidating when we break it down into the three basic parts. However, discovering t is so hard that I actually recommend you remove it from your equation so that you are just left with what I call, customer value.
Customer Value for Ecommerce Instead of Lifetime Value
Too many brands let uncertainty around average lifespan stop them from tracking LTV. The truth is, tracking anything is better than waiting to have enough data to decide on an accurate t-value. That is why I recommend that brands who are just getting started with retention measure and track customer value rather customer lifetime value.
Customer Value = AOV x PF
Simply, customer value is just the removal of an average lifespan. This won’t show you the longevity of your customers but it does give you an idea of what customers are worth, and gives you a place to start benchmarking. Retention really comes down to encouraging a customer to come back for repeat purchases and even without measuring (t) you are able to see if your efforts are moving the needle.
Customer Lifetime Value Variants
The formulas above are the simplest variations of customer lifetime value, but you are able to get much more granular. Here are a few variants to the standard LTV equation that will help you make more informed retention decisions.
LTV Including Your Profit Margin
All of the previous equations are looking at revenue and not profit. I don’t know about you but I care more about my brand’s profitability than its ability to drive top line growth. You can make a small tweak to see the profit realized per customer rather than straight dollars.
Customer Value (profit) = (AOV x PF) x Profit Margin
I recommend using your operating profit margin. This takes into account more than just the difference between your cost of goods and what you sell them for to include acquisition costs, employees, and other overhead costs. It will give you a much healthier view of what you are actually profiting per customer.
Segmented LTV
Customer lifetime value is great for getting a store-level understanding, however, the true power of LTV shines through when you segment your customer base to get more specific.
Here are three ways you can segment your customers to get a closer look:
Acquisition Channel - This allows you to see which channels you are spending on are leading to the best long-term value. You can then allocate more dollars to the channels that are performing.
Products Purchased - This allows you to see if certain products are resonating better. Does a certain product make customers more likely to purchase again? Segmenting by product is an overlooked way of understanding shopping behavior.
Engagement - Actions that a customer takes can drastically change their LTV. How much more is a member of your loyalty program worth, what about a member of your mailing list? You can use this information to encourage engagement in profitable campaigns and programs.
Get Started with LTV Today
You don’t need to have fancy calculations to get started with retention marketing. You just need a way to start keeping score today. That way you can benchmark where you are at and see the improvements you make.