Maximizing LTV: Understanding, Importance, and Strategies
It is about What LTV is, Why you have to check it and How to calculate and Check it.
Nov 07, 2022
1. What is LTV?
LTV, as known as customer lifetime value, refers to the total earnings from a customer over the duration of their relationship with the business. It can be the answer to ‘how much revenue(or earnings) each new customer brings to the business before they leave’.
2. Why should you check LTV?
Tracking LTV is to keep relationships with customers. You can use retention rate1) as an indicator to check whether you keep relationships with customers well or not. LTV can be understood as the retention rate converted into money. No matter how good retention is, the business may not be sustainable if the amount customers pay is a drop of bucket. LTV is considered as an important metric in marketing. It is because for CRM, you cannot properly measure customers’ retention and their value only with indicators such as sales or unit price. Also, you should consider LTV as a target metric when making marketing actions to let your customers purchase more, longer, and more often.
1) Retention rate in Retentics refers to the repurchase rate of customers. It is different from retention in web log analysis which is to check how frequently and for how long users engage with your website after their first visit. For instance, if a customer made a purchase in January and made it again in February, it means he/she remains in February.
3. How to calculate and check LTV
There are many ways to calculate LTV. The easiest way is to divide cumulative sales by cumulative number of customers. However, this method lacks a lot of information. The goal of the LTV metric is to manage customers so that they keep using the service for a long time. There is no information about ‘time spent by a customer’ in the cumulative sales per customer. You need a visible number of it to decide how long you will make customers stay. Therefore, to reflect the length of time a customer stays, average retention period or number of purchases are used to calculate LTV. The best way is to check LTV with a cohort chart.
You can see how much your customers spend over time with a cohort chart. It is suitable for following customers’ purchase journey because the information on 'time spent by a customer' is visible.
In the image above, the cohort is defined as ‘new customers per month’ and shown in the first column (Month) and the second column(NC). For example, 1,547 new customers in June 2020 are defined as one cohort, and 3,979 new customers in July 2020 are defined as one cohort.
First, let's check the chart horizontally. 1,547 new customers in June paid an average of $94 per customer in the first month. In the second month, 44% of 1,547 customers remained, with a cumulative payment of $180 per customer from June to July. It means 680 people (44% of the 1,547 people) paid $86 (180 - 94) per person in July. Like this, the cumulative value that customers pay over time is clearly visible. You can also check that the LTV increases significantly from the 5th to the 6th month (LTV 5 to LTV 6) and from the 8th month to the 9th month (LTV 8 to LTV 9).
Now, let's look at the chart vertically. You can get the following values below, by averaging the retention rates of LTV 2 to LTV 9 which refers to the period of repurchase from the cohort of June 2020 to that of December 2020.
ㅤ | LTV2 | LTV3 | LTV4 | LTV5 | LTV6 | LTV7 | LTV8 | LTV9 |
Avg. Retention rate | 33.47% | 32.05% | 29.16% | 32.53% | 31.98% | 33.14% | 31.30% | 30.67% |
Excluding the second month, LTV 2, which is likely to have relatively high customer activity, the seventh month has the highest retention rate. In other words, many customers return to this service in the seventh month. It would be better if you know the exact customer purchase cycle, but you can still estimate the customers’ purchase cycle to determine the LTV ‘n’ which you need to keep track of in this way. Here’s the change in the LTV 7 for this business as shown below.
According to the chart above, LTV7 seems to be decreasing for customers acquired from July 2020 to May 2021. It means the value that customers are paying is decreasing over time. Fortunately, LTV 7 increases again from the cohort of June 2021.
4. How can LTV be used?
LTV should be constantly monitored like the number of visitors, conversion rate, purchases, sales, or retention rate. You need to find the typical purchase cycle of your customers and constantly check the LTV ‘n’ to check whether your business is growing or not. Growth of LTV means the growth of your business.
LTV can also be used to calculate customer acquisition cost (CAC). In the example above, LTV was calculated based on sales, but you can also calculate LTV based on contribution margin by using the profit rate. In this case, you can calculate the expected revenue that each customer will bring to your business over a specific period of time. You can determine how much you will spend on acquiring one customer. Assuming a profit margin of the example business above is 10%, the profit-based LTV 7 would be around $36. Then, if a customer remains in business for up to 7 months, the customer acquisition cost (CAC) should not exceed $36.
You can track LTV depending on how you define cohorts. You can define a cohort of customers acquired during a specific period with adding conditions such as purchased item, acquisition channel, etc. One of Retentics's clients acquires many customers through search ads which show the detailed pages of representative items. In order to calculate the ROI of these ads in terms of LTV, you can define a cohort with three conditions: duration, purchased item, and acquisition channel. Their purchase cycle is 3 months, so they measure the performance of the ads by checking LTV3 of new customers who acquired through search ads.
Summary
Retention rate is important because making existing customers repurchase is a lot more efficient than acquiring new ones. There are a lot of cases where repurchases of existing customers ensure business to keep its service when it is difficult to acquire new ones. LTV tracks the volume of this retention rate. Therefore, by tracking LTV and retention with a cohort analysis and taking appropriate actions, you can promote the sustainable growth of your business.
Written by: Julian Kim
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