Within your marketing efforts, you likely calculate the cost per acquisition (CPA) or the return on investment (ROI) to attract new customers. While these insights are valuable to understand how your promotional efforts are doing, there is another metric that looks at the long-term success of your business. Customer lifetime value (CLTV) highlights how valuable a customer is to your business over several years. It looks at the big picture relationship that consumers have with your brand.
There are multiple ways to calculate LTV depending on your business and resources. This guide will help you review the different methods and find the best one for your needs.
The Basic Approach to Customer Lifetime Value
The most basic way to calculate LTV is to take the total revenue across a specific period and divide it by the number of customers over that time. For example, if a coffee shop just celebrated its one year anniversary, it could use this calculation to determine what each customer is worth to the business. If the coffee shop made $200,000 in sales and had 2,000 customers, then the CLTV is $100 over a year.
From here, you can use the average order value (AOV) or the amount each customer spends at the coffee shop to understand how many times customers visit each year. If the AOV is $5, then the average customer visits the coffee shop 20 times per year — or about twice per month.
Keep in mind that this is a broad approach to your customer base. You likely have some customers who visit significantly more often and others who only buy from you once or twice per year. More advanced models will break out the purchase frequency for more accurate insights.
Add Cohort Analysis to Understand Different Customer Groups
The basic method paints customers with a broad brush, but a cohort analysis looks at customers within similar groups to break out different patterns. For example, you may establish a cohort of customers that all made their purchases in the same period or who have similar characteristics — or both.
For this method, let's use the example of a nail salon. If the AOV is $50 and customers visit the salon monthly, then customers will spend an average of $600 each year. However, within this group, there are different cohorts. There are customers who visit the salon weekly and spend $50 each time. Their CLTV would be closer to $2,500 over the course of a year. Similarly, some customers might only spend $15 on a basic manicure each month, bringing their CLTV to $180. With this dramatic range, you can see why some businesses look for more advanced models.
A cohort analysis looks at a specific group of customers over a certain period. Let's say the nail salon offers a Groupon promotion for 50% off in January. Those customers might spend $25 instead of $50 when they use the Groupon and then only visit every other month, spending about $40 each time. This means that over the course of the year, the value of the Groupon customers is around $265, or $25 + ($40*6).
With this information, the nail salon can determine how Groupon customers differ from other customers acquired through their marketing efforts. The salon can determine whether it wants to use Groupon again and can predict what kinds of sales will come from it.
Use the Retention Rate to Determine Long-Term Value
Once you break your customers out into cohorts, you can further analyze them using the retention rate. For this section, let's use the example of a gym that is trying to recruit new members to a monthly plan.
If a gym sells basic memberships for $10 per month, then most customers will spend $120 per year with the business. (This example is easier than the others because the customer lifetime value formula is growing more complicated.) To understand the true value of its customers, the gym will look at the average retention rate of each person who signs up. If the average customer maintains his or her gym membership for three years, then the CLTV is $360, or 3 x $10 x 12 months.
The gym can also use cohort analysis to determine how profitable a promotion will be depending on the retention rate. If customers who join in January because of a New Year's resolution campaign only stay an average of two months, then their CLTV is $20. If the gym conducted a January sale where customers could join for just $1, then that cohort only has a CLTV of $11. This means these customers are unprofitable if the gym spent more than $10 to market to them.
CTLV is important to provide context to your marketing efforts. While the gym might think it's profitable if it spends $15 on marketing to acquire each new customer, it needs to make sure the CLTV significantly exceeds its marketing costs. If the gym is marketing to low-quality customers that will quit, then it is wasting money.
Google Analytics Can Help With CLTV
If you feel overwhelmed by the various customer lifetime value model options and their calculations, know that there are tools to help. You can search for a lifetime value of customer calculator online where you plug in information and get results, or you can turn to Google Analytics for help.
Google Analytics has a lifetime value section where you can learn about customer behavior. Google will look at the first stages of customer interaction, such as page views, time on site, goals, etc. and determine the type of customer that site visitor will likely be. If you have an e-commerce business or use your website to schedule appointments, you might be able to set up Google Analytics to run this lifetime value analysis against customer purchase data.
The lifetime value analysis will break down your customer acquisition by marketing channel. It will also show a chart of the customer value over time. You can use this if you are investing in multiple marketing outlets and want to see which ones are driving the highest value customers to your brand.
That being said, Google Analytics might not offer all the features you would like, so continue looking for other CLTV tools that help you get a clear picture of your customer loyalty over time.
With the help of customer lifetime value calculation, you can improve your business in multiple ways. You can work to improve your operations so you lose fewer new customers, you can change your marketing to appeal to loyal customers, and you can better target potential customers who will stay with your business for a long time. Test different customer value models to find which ones work best for you.