How do businesses make long term financial and growth-related decisions? How do they know when to aggressively expand and when to pull back the reins?
Well, one major factor involved in making these types of decisions is known as the Lifetime Value of a customer, otherwise known by its acronym, LTV.
The LTV of a customer is simply a prediction of the net profit attributed to the entire future relationship with a customer. Luckily, Lifetime Value of a customer can be calculated fairly easily by nearly anyone. The LTV of a customer becomes even more important when working in any subscription-based business, such as a Software-as-a-Service company.
Customer churn rate and LTV are intricately related. That is to say, you can't figure out your LTV without first calculating your customer churn rate.
Keep reading to see how you can use your customer churn rate to calculate the LTV of your own customers!
Why Calculate My LTV?
Knowing your LTV is essential to the health and future growth of any subscription-based business. It is one of the primary metrics (along with customer acquisition cost) from which you can glean the insight needed to make major decisions in terms of moving forward with, or holding back on your business model.
Subscription-based services do experience some unique growing pains as they acquire a customer which upfront licensing based business do not, but this isn’t necessarily a bad thing.
Most subscription based services actually lose money every time they acquire a customer.
This is because the initial cost of the product is much lower than it would be in an upfront licensing arrangement, as the charges recur on a regular basis.
The goal for all subscription-based services is to lower their churn rate to the point where the vast majority of their customers are with them long enough for the initial costs of customer acquisition are recouped -- every dollar after this point is pure profit.
Understanding how customer churn rate and LTV are related is the crucial first step in being able to manage these growing pains.
Establishing Your LTV
The very first step in establishing your LTV would be to calculate the average lifetime of your customers. This is as easy as…
Lifetime = 1/Churn
It’s important to keep in mind that the time scale over which you calculate your customer churn rate will affect the outcome of this equation. For example, if you calculate your churn rate in terms of months then this equation will produce your lifetime in terms of months.
Now that you’ve got your average customer lifetime, calculating LTV is easy…
LTV = (Avg. Monthly Subscription Payment x Gross Margin %) / Churn Rate
So, say your business has an average monthly subscription payment of $19.95 and sells at a gross margin of 50% and has a monthly churn rate of 3%. This would give you a LTV of $332.5 per customer over the course of 33 months.
Mastering how to calculate the LTV of your customers is essential to planning a scalable business model for any software-as-a-service, or other subscription based business. To help you out I’ve included a Google document where you can just punch in the figures mentioned above and it will spit out a LTV for your customers.
I hope this article was helpful to you! If you’d like to continue the discussion, or if you have any questions please leave a comment below!