You’ve heard of Customer Lifetime Value (LTV). You know that it’s important and that companies who can increase overall LTV can significantly increase their bottom line.
You’ve probably even heard the stats, like that the top 1 percent of ecommerce customers are worth a whopping 18 times more than the average customer. You know that approximately 80 percent of your future revenue will come from 20 percent of your most loyal customers, and that increasing customer retention rates by 5 percent can result in an astonishing 25-95 percent increase in revenue.
You’ve also heard that LTV is critical for calculating metrics such as desirable customer acquisition cost; but how does one calculate Customer Lifetime Value?.
In this post, we’re going to break down:
- What Customer Lifetime Value actually is
- Why it matters so much to your ecommerce store
- A simple way to calculate your LTV
- Ways to improve and increase your LTV
By the time we’re done, you’ll be able to attend ecommerce cocktail parties (or perhaps even conferences) and sound like a seasoned vet as you discuss LTV.
What Is Customer Lifetime Value?
On the surface, LTV is a rather simple concept. Like the name says, it’s how much an average customer will spend with your business over the lifetime as a customer.
It’s the average cumulative total of all of their purchases for the duration of time that they’re purchasing from you.
Let’s say you have two customers named Eric and Erin.
Eric always wants to shop around to find the best deal. He’s not particularly loyal to any one brand, and is willing to purchase from just about anyone as long as he feels like he’s getting a good deal. Price matters more than relationship to him. Eric occasionally purchases from your site, but only when you’re offering the lowest price on a particular product.
Erin, on the other hand, likes to find brands she loves and then stick with them for the long haul. You happen to be Erin’s favorite ecommerce store for purchasing household goods, and she buys almost everything from you.
Out of the two, who will have the higher lifetime value as a customer? Obviously, it’s Erin. But, and this is critical, your average LTV is not based on Erin alone. It’s based on the average cumulative total of all the purchases of all your customers, including loyalists like Erin and those who shop around, like Eric.
This starts to get to the heart of why this metric matters so much. If you have fifty customers like Eric and four customers like Erin, your LTV is going to be low, which then negatively affects a host of other aspects of your business. Let’s break this down a little more.
Why Is Customer Lifetime Value So Important To eCommerce?
LTV is far more important than most ecommerce store owners realize. Here’s why:
LTV Determines Whether You Can Scale
Generally speaking, your Customer Lifetime Value should be at least three times greater than your Customer Acquisition Cost (CAC).
In other words, if you’re spending $100 on marketing to acquire a new customer, that customer should have an LTV of at least $300. If it’s not somewhere in that 3:1 ballpark, your profit margin won’t be high enough to scale your business.
Remember, your LTV has to essentially cover all the expenses associated with each customer. This includes marketing, shipping, customer service, the specific technology you employ, and much more.
Without a 3:1 LTV to CAC ratio, scaling is going to be really difficult. You’ll be operating with razor thin margins and constantly have to be fighting for new customers, which is always a precarious position. One down month can throw off your entire business.
LTV Helps You Evaluate Your Retention Strategy
If you have a low LTV, it means you either need a new customer retention strategy or need to significantly revamp your existing one.
If your retention strategy isn’t effective, it means you must constantly acquire new customers to maintain revenue. Your ad spend is going to be much higher and your ROI on that ad spend will be low. If there ever was a lose-lose situation, this is it. Additionally, without loyal customers, you become vulnerable to ups and downs in the market.
When the economy takes a downturn, customers who aren’t loyal to your brand will go to the seller with the lowest price.
LTV Allows You To Determine The ROI Of Your Marketing Efforts
There’s a relatively simple way to determine how well your marketing efforts are working: compare your Customer Lifetime Value to your Customer Acquisition Cost. The lower the ratio, the lower the ROI you’re getting on your marketing efforts.
For example, if you have to spend $200 to acquire a customer, and your LTV is $200, your marketing efforts are almost a complete wash. You’re not really adding anything to your bottom line, and you’re setting yourself up to eventually run out of money.
No one can operate at a 0% profit margin for long (unless you’re independently wealthy and running your store for kicks, in which case you probably can stop reading now). As Kevin Donnelly notes:
“Customer Lifetime Value (CLV) is one of the most important factors in determining your business’ present and future success. It’s an often-overlooked metric that can accurately predict how much your customers are really worth. By measuring the net profit that you’ll take in over the course of your entire relationship with a customer, you’ll be able to narrow down exactly how valuable they are to your business.”
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LTV Enables You To Compare Yourself To Industry Averages
Customer Lifetime Value varies wildly across industries and depends on numerous factors.
For example, if you’re selling a frequently consumed item such as coffee, your LTV will probably be higher than someone selling high-quality leather wallets that only need to be replaced once every five years (unless the wallets are incredibly expensive).
Using LTV can help you determine where you rank among your competitors. If your LTV is significantly lower than the industry average, you clearly have some work to do if you want to beat your competition.
A Simple Model For Calculating LTV (Step-By-Step)
While there are certainly more complex ways of calculating LTV, you can use the following method to get a general ballpark figure.
- Step #1: Determine Your Average Order Value (AOV). Your AOV is calculated by taking your total revenue during a given time period and dividing it by your total number of orders. If your total revenue is $1,000 and your total orders are 10, your AOV is $100. Simple, right?
- Step #2: Calculate Your Average Purchase Frequency. This metric represents how frequently customers purchase from you. You calculate this by dividing your total number of orders during a given time period by the unique number of customers. If you’ve had 1,000 orders from 10 unique customers, your Average Purchase Frequency is 100.
- Step #3: Estimate Your Customer Value. You’re almost to lifetime value. Multiply your Average Order Value by your Average Purchase Frequency to get an estimate of your customer value. In this case, $100 x 100.
- Step #3: Estimate Your Average Customer Lifespan. Essentially, this represents how long a person remains one of your customers. It’s the average time a person remains an active customer before they go dormant. If you want to simplify things, you can follow the advice of analytics expert Avinash Kaushik who suggests a 1-3 year timespan. For ecommerce brands with a limited catalog, he recommends estimating on the shorter end; and for stores with changing or regularly growing catalogs, the longer end.
- Step #4: Calculate Your Estimated LTV. Multiply your Customer Value by the Customer Average Lifespan to get an estimate of your Customer Lifetime Value.
Average Order Value x Average Purchase Frequency = Customer Value
Customer Value x Average Customer Lifespan = Estimated Customer Lifetime Value
If you want to dive deeper into the numbers, you can segment your LTV by calculating Customer Value by channel. This allows you to see which channels have the highest LTV and which are struggling. Once you have a general estimate of you LTV, you can calculate approximately how much you should spend on Customer Acquisition. If you find yourself unable to acquire customers at or below the 3:1 ratio noted above, it’s a sign that you probably need to do some optimization work on your site and with your advertising.
How Do You Increase Customer Lifetime Value and Customer Loyalty?
This really isn’t that complicated. To increase LTV, you need to increase either your Average Order Value or your Average Purchase Frequency. A bump in either of these metrics will lead to a rise in your LTV. Start by reflecting on your own experience. What things cause you to purchase more? If you’re an Amazon customer, you probably don’t need to think too hard.
- Maintain a minimum threshold for free shipping. Amazon uses this method with their Pantry items. In order to even purchase some Pantry items, your order needs to exceed a certain dollar amount. This essentially forces a customer to increase their Average Order Value. You can implement something similar on your site by shipping items for free once the total order amount exceeds a predetermined amount.
- Promote complimentary relevant items. The moment you put something in your cart, Amazon starts recommending other relevant items. If you’re purchasing a set of weights, they’ll recommend protein powder, a weight bench, and a back support belt. They know that once you’ve put an item in your cart, you’re more likely to purchase other things. Implement a similar practice on your site by promoting items that will complement what customers are already purchasing.
- Establish the value of your product. To state the obvious, being able to sell more expensive items increases the Average Order Value. But in order to do this, you need to work hard to establish both the quality and high value of your product. Think of Rolex and Mercedes. All their marketing reinforces the idea that their products are of the highest quality and for those who want to experience luxury. You can deploy a similar strategy on your site. Through the images, copy, and reviews, you can demonstrate that even though your product may cost more, it’s worth it.
- Create package deals. It’s hard to resist package deals. Any time you can bundle together items and then reduce the cost (within reason), you’re going to drive up your Average Order Value. Why? Because this appeals to both the loyalists and the bargain hunters. The loyalists will view package deals as yet one more reason to love you. The bargain hunters will be happy because they got a great deal.
- Offer loyalty perks. There’s a reason that stores have used loyalty programs for decades. Whether it’s the Subway punch card that gets you a free sub after you buy five or the Walgreens point system which gives you redeemable points based on how much you spend, loyalty programs work. What sort of loyalty program can you create on your site? How can you reward faithful shoppers and entice them to come back again and again? Don’t be afraid to get creative with this.
- Create a smoother shopping experience. Friction is anything that gets in the way of a customer making a purchase. It can be too many fields on an order form, confusing navigation options, or surprise shipping costs. Eliminating friction through conversion rate optimization techniques can dramatically increase your average order value. Consider all that Amazon does to remove friction, from 1-click ordering to Prime shipping, to ordering simply by speaking to Alexa. They know that less friction equals more purchases.
Once you’ve determined how to increase your Average Order Value, you need to turn your attention to increasing the Average Purchase Frequency. Again, there are a number of relatively simple ways to do this.
- Utilize email campaigns. Sending regular emails to your customers accomplishes at least two things for your business. First, they simply remind customers of what you offer. The unfortunate reality is that many customers will order from you once and then forget about you the next time they need to make a purchase. Emails keep you at the front of their minds. Second, emails allow you to highlight special sales and offers, which can cement the loyalty of some customers and reignite the interest of dormant ones.
- Implement remarketing/retargeting. Using remarketing technology like the Facebook Pixel, you can ensure that your ads show up in front of your customers again and again. When a person visits your site, the pixel is placed in their browser. Then you can target Facebook ads directly at these visitors; so that as they’re scrolling through their newsfeed, your brand shows up constantly. When implemented properly, this strategy can lead to customers coming back again and again.
- Double down on customer service. Why is it that companies like Trader Joe’s and Zappos have such cult followings? It’s because they go over the top when it comes to customer service. As Help Scout noted about Trader Joe’s: An elderly man, 89 years of age, was snowed in at his Pennsylvanian home around the holidays, and his daughter was worried that he wasn’t going to have access to enough food due to the impending storm and bad weather in the area. After calling multiple stores in a desperate attempt to find anyone who would deliver to her father’s home, she finally got ahold of someone at Trader Joe’s, who told her that they also do not deliver…normally. Given the extreme circumstance, they told her that they would gladly deliver directly to his home, and even suggested additional delivery items that would fit perfectly with his special low-sodium diet. After the daughter placed the order for the food, the employee on the phone told her that she didn’t need to worry about the price; the food would be delivered free of charge. The employee then wished her a Merry Christmas. It’s this kind of customer service that brings customers back again and again. Did the Trader Joe’s employees have to make a delivery in a snowstorm? Of course not. But the company knows that customer service translates into higher LTV, and so they’re willing to do whatever it takes.
- Improve the overall customer experience. Just as with Average Order Value, improving the overall customer experience also leads into increase purchase frequency. This makes sense on an intuitive level. If a site is difficult to navigate, makes it hard to find the right products, or has a cumbersome checkout process, customers won’t return. On the other hand, if a customer has a smooth, frictionless shopping experience, they’re more likely to come back again and again. Utilizing conversion rate optimization to remove friction can result in big gains in terms of purchase frequency.
Conclusion: Loyalty = Revenue
Have you ever wondered why L.L. Bean offered a lifetime return policy on all their items? On the surface, this seems like a crazy idea. A person can purchase a shirt and return it in tatters twenty years later. The return will be accepted with no questions asked.
Why would the company do such a thing? Because they know that this kind of return program massively increases their customer loyalty. After all, if you can literally return anything at any time with no strings attached, there’s very little risk in buying. Additionally, it shows the generous spirit of L.L. Bean, which resonates on a deep level with customers.
Does this return policy cost the company a lot of money? Sure. But they’re willing to accept those costs because of the increased Customer Lifetime Value it generates. You certainly don’t need to go to those lengths to increase your overall LTV, but you would be wise to learn from L.L. Bean. It really is simply a numbers game for them.
They know that loyalty equals revenue, and they’re willing to take huge steps to increase that loyalty.
Are you willing to do the same?
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About the Author
Jon MacDonald is founder and President of The Good, a conversion rate optimization firm that has achieved results for some of the largest online brands including Adobe, Nike, Xerox, Verizon, Intel and more. Jon regularly contributes content on conversion optimization to publications like Entrepreneur and Inc. He knows how to get visitors to take action.