There are terms which are so often bandied around in Marketing discussions that they end up losing meaning and purpose. Arguably LTV is one of those concepts that has over the years become synonymous for as many things as there are marketing schools of thought. It is time to explore again this age-old concept, identify its limitations and make it fit for the current times.
What is Lifetime Value?
The official definition, if there is such a thing, is that LTV is “a prognostication of the net profit contributed to the whole future relationship with a customer”. Quite simply, as the name indicates, it is the value of a customer over their lifetime.
A basic yet often used way of calculating the LTV consists of multiplying the value of a customer by their average lifespan. For example, an average customer is worth £50/year and remains a customer for 5 years, therefore making the LTV £250.
In some eCommerce systems, LTV is calculated as an average of an “up to now” metric. In other words, looking at how much each customer has spent so far as an individual and taking the average of this number. This will often yield a different result because of the timescale looked at and illustrates how even the simplified calculation can be subject to interpretation.
The more traditional and slightly more advanced version of the formula is LTV=M*R/(1-D-R) where M is the yearly margin generated by a customer, R is the Retention rate and D the discount rate (discounting the value of future money, typically 10% per year). In the above example, if we have 80% retention rate, the formula is 50*0.8/(1+0.1-0.8) = £133
There are more granular ways of calculating the LTV and one important aspect can be to do so for different segments or cells. Not all customers are created equal and LTV will have different meaning and applications whether looked at by the CFO or the CMO.
What is LTV typically used for in CRM?
LTV is most usually used as a way of justifying and setting an upper limit for acquisition costs. It is at first sight a reasonably sensible metric to look at; if the acquisition cost is higher than the amount a customer could ever generate, it makes sense not to spend money acquiring them.
The metric can also be used to determine what customer equity is theoretically left. For any active customer in your CRM database, the difference between the revenue generated so far and the LTV is the equity or monetary potential left in the relationship.
Calculating the LTV for various cells or sub-segments of your database is a good start to having a metric that is more actionable by marketing.
What are the challenges with LTV?
Problem 1: The first issue with how LTV is typically used in CRM is that it somewhat denies the very idea that marketing works (i.e. that marketing can affect and change customer behaviour). One way of focusing the marketing effort is indeed to spend money on the segment with high LTV potential. Nonetheless, if we believe marketing is effective, shouldn’t we also try to turn Low-value customers into high-value customers?
Problem 2: As just mentioned, I often see brands focusing on the customers segment with higher LTV. Of course, these are loyal customers and they should be looked after accordingly but they might not be a sensible target for incremental revenue. (i.e., they are already doing well, and they are the most likely to be near the “spending ceiling”. After all, there is only so much coffee or insurance one can buy). Moreover, CRM campaigns aimed at engaged and high value customers tend to create an attribution bias, also setting the wrong benchmark and expectations about what a successful campaign is.
Problem 3: Although LTV is looking at the future revenue a customer should generate during the relationship with the brand, it is a metric that squarely looks at the past. It is looking at past margin, past costs, past retention rate, etc… As per point 1, if we assume marketing works, shouldn’t those metrics evolve and improve over time?
Problem 4: It is a pretty cold metric that is reducing a customer to its wallet. “What else is there?” I might hear the more pragmatic marketers retort… At the risk of opening another can of worms, we do live in a social/viral world that is extremely different from the one that saw the birth of the LTV metric. Put simply, LTV makes no allowances for brand advocates and influencers. Of course, it might not be the role of this particular metric to take advocacy into account but being aware it is ignored is important when implementing a CRM strategy on the back of it! With loyalty and customer experience sitting at the top of most brand’s marketing agenda, it seems like a particularly significant omission.
Problem 5: However it is calculated, and whatever the number of segments it is tuned to, LTV is a metric of averages. When you acquire a customer, it is not an average customer; it is an individual with a number of attributes that are unique and specific to him or her. Not all customers are created equal, their potential is unique to them and so is the experience that will allow them to fulfil this potential.
So where do you start?
It is easy to point out what the issues and limitations of a metric like LTV are, but harder to address them. To avoid LTV becoming an answer that cannot be questioned, I would recommend thinking about the questions that cannot typically be answered:
- Why is this customer’s LTV high?
- What steps does a customer need to go through to join the high LTV segment?
- What customers have the potential to become high LTV customers?
- How do I provide each customer with the experience they need to achieve higher LTV?
This is no mean feat, but it is what Planning-inc’s Future Value modelling can focus your marketing effort on. Email futurevalue@planning-inc.co.uk to schedule a discovery session to see how Future Value might work for your business.
