Step 1: Determine the revenue generated by the customer in a specific period
To calculate LTV, you first need to know how much revenue a customer generates for your business in a specific period. This can be a yearly, quarterly, or monthly period. You can easily pull this information from your customer management system.
Step 2: Subtract the gross margin
The next step is to subtract the gross margin from the revenue generated. Gross margin is the revenue left after the costs of goods sold (COGS) have been subtracted from revenue. For example, if the revenue generated by a customer is $100,000 per year, and the gross margin is 70%, then the gross margin is $70,000.
Step 3: Divide by the estimated churn rate
Churn rate is the percentage of customers that cancel or stop using your product or service. You can estimate the churn rate by looking at past customer behavior or industry benchmarks. Once you know your estimated churn rate for a customer, divide the gross margin by the estimated churn rate. For example, if the estimated churn rate for the customer is 16% per year, divide the gross margin ($70,000) by the churn rate (16%), which results in nearly $437,500.
Step 4: Calculate LTV
Finally, to find the lifetime value of your customer, you now multiply the customer's LTV by their expected time spent as a customer. This means you multiply the annual LTV by the cross-sectional customer lifetime (in years). For example, if you expect a customer to use your product or service for five years, the LTV would be $2,175,000 ($437,500 x 5).
Calculating LTV enables businesses to decide how much they can spend on obtaining new customers. By boosting customer retention, therefore reducing churn rates, organizations can create more significant revenue streams and potential sustainable profits more efficiently. Taking the time to learn the LTV for your customers allows your organization to create an effective strategy that is both fulfilling and generates successes that benefit everyone involved with the company.