If you are a SaaS business, it is important for your business to understand the importance of Customer Lifetime Value (CLTV):
- To acquire, retain, and increase its customer base
- To understand the profitable business segments
- To adopt strategies for improving the CLTV of the business
The growth of the Internet and mobile devices has expanded the types of innovative services that are offered in a contractual setting. Companies have increasingly turned to subscription-based models for offering services including software.
In subscription-based enterprises like SaaS, a customer pays a fee to the firm in order to have access to the firm’s products or services for a specific period of time. Therefore, to succeed, a SaaS business needs a proper understanding of the strategic, financial, and operational implications of a subscription-based model.
This is possible with the help of performance measurement reports. That’s because such financial reports demonstrate information that helps a subscription-based business to monitor its own performance. Such information helps a business in taking key decisions like the type of customers to be retained, seeking effective advertising channels, determining the value of the customer base, and the customer acquisition cost.
A key SaaS metric that helps in addressing all the above-mentioned issues is the Customer Lifetime Value (LTV). LTV can be enormously informative when calculated correctly.
Therefore, in this article, we are going to discuss the customer lifetime value meaning, how to calculate LTV, and why is CLTV important specifically for a SaaS business.
Customer Lifetime Value Meaning
Customer Lifetime Value (LTV or CLTV) is the total value consumers bring to a business throughout their lifetime. It is a key financial metric that indicates the total revenue a business can reasonably expect from a single customer account throughout the business relationship.
CLTV is the value of future cash flows or profits attributed to a single customer or a group of customers discounted using the firm’s average cost of capital. Thus, CLTV is a forward-looking metric that is responsible for driving customer profitability.
This financial performance metric drives the customer profitability, specifically when a firm has to determine the:
- Type of customers it needs to acquire. This means that a firm has to determine the maximum amount of expenses that it must incur to acquire a customer.
- What customers to nurture. In this case, managers should focus on customers with high CLV, and
- Quantity of resources to allocate. This means that the firm needs to determine the marketing resources that it should allocate so as to maximize CLV.
The above points showcase that the sum of the CLV across a firm’s entire customer base (called Customer Equity) is important for a subscription-based business to calculate. It gets impacted by the firm’s ability to acquire, retain, and increase its customer base.
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In financial terms, CLTV is the net present value of a customer. It is the difference between the total amount of revenues from a customer and the business’ expenses for such a customer during the whole duration of the business relationship.
Accordingly, the CLTV of a business comprises both quantitative and qualitative components. The quantitative components include sales volume, customer acquisition costs, direct costs, and activity-based costs. Note that the value of these components is represented in the value of a customer by calculating the present value of the sum of each of the components.
Whereas, the qualitative components include cross-selling or upselling potential, referral potential, information potential, and opinion leader potential. The value of these components is represented in the value of a customer by determining the future value of each of these components.
Customer Lifetime Value Example
It is not challenging to calculate the CLTV of a subscription-based business. The real challenge lies in determining the influence of CLTV drivers on the calculation of CLTV. It is important for a subscription-based enterprise to look into the relationship among each of these drivers. That’s because the variables CLTV are interdependent.
Let’s consider the Starbucks example to understand the concept of the customer lifetime value. Considering the estimated sales figures of Starbucks from 2004, the LTV of an average Starbucks customer is estimated. The sales data from Starbucks does not reflect current marketing trends and is only provided to illustrate the steps necessary to calculate LTV.
Suppose, Starbucks has 5 customers with the following details:
|Attributes||Customer 1||Customer 2||Customer 3||Customer 4||Customer 5||Average|
|Customer Expenditure per Visit||$ 3.50||$ 8.50||$ 5||$ 6.50||$ 6||$ 5.90 (s)|
|Number of Visits per Week||$ 4||$ 3||$ 5||$ 6||$ 3||$ 4.2 (c)|
|Average Customer Value per Week||$ 14||$ 25.50||$ 25||$ 39||$ 18||$ 24.30 (a)|
The process to calculate CLTV is as follows:
- Calculate an Average of All the Variables
The first step is to calculate an average of all the variables. Accordingly, the first variable is the Average Customer Lifespan. This is nothing but the time period for which someone remains a customer with the business entity. In the case of Starbucks, the average customer lifespan is 20 years. It is represented by ‘t’.
The next variable is the Customer Retention Rate. This rate refers to the percentage of customers, who, over a given period of time, repurchase, when compared to an equal and preceding period of time. The Customer Retention Rate for Starbucks is 75%. It is represented by ‘r’.
Next is the Profit Margin per Customer. For Starbucks, it was 21.3%. It is represented by ‘p’.
Then is the Rate of Discount which is nothing but the interest rate used in discounted cash flow analysis to determine the present value of future cash flows. Typically, this number falls between 8% and 15%. For Starbucks, it is 10%. It is represented by ‘i’.
Finally, Avg. Gross Margin per Customer Lifespan is calculated. To calculate this, Starbucks’ profit margin of 21.3% represented by ‘p’ and the average customer spend are considered. The following formula is used to calculate the average customer spend:
LTV = 52(a) × t = 52($24.30) × (20) = $25,272
Thus, if the average customer spends $25,272 during their time as a customer (“t”), Starbucks has gross margin per customer lifespan of $5382.94 ($25,272/5 (No of Customers)).
- Calculate Average LTV
Starbucks can use the following equations to calculate its LTV.
LTV = 52(a) × t = 52($24.30) × (20) = $25,272
LTV = t(52 × s × c × p) = 20(52 × 5.90 × 4.2 × 0.213) = $5,489
LTV = m r1+i-r = 5382.94 0.751 + 0.1 – 0.75 = $11,535
Average LTV = $14,099
Once the LTV of an average customer is calculated by Starbucks, the maximum acquisition cost of a new customer is estimated. Using the average of various LTV equation results, Starbucks must spend less than $14,099 to acquire new customers. If Starbucks spends more than $14,099 per acquisition over the course of an average customer lifespan (20 years), there’s a chance that it could lose money.
How To Calculate Customer Lifetime Value?
Many models have been proposed for CLTV calculation. A subscription-based business needs to undertake a more sophisticated analysis in order to determine the customer LTV. Such an analysis includes considering the impact of the key drivers of CLTV which are lifetime, margin, and yield.
This means that a subscription-based enterprise must examine the relationship between the metric and its drivers to manage its customer LTV.
The following equation demonstrates this relationship and the Customer Lifetime Value Formula:
Lifetime Value = Average Value of Sale x Number of Transactions x Retention Time Period
Customer Lifetime Value (CLTV) = Lifetime ✕ Margin
Note that the customer lifetime value calculation takes into consideration the customer acquisition costs, operating expenses, and costs to produce goods or render services that the business is offering.
Now, let’s understand each of the components of the Customer Lifetime Value formula.
- Average Purchase Value
The Average Purchase Value refers to the average value of a sale for a subscription-based enterprise. It is calculated by dividing the firm’s total revenue over a period of time by the total purchases that its customers make over the same period of time.
Average Purchase Value = Total Revenue of a Business/Number of Orders
- Average Purchase Frequency Rate
Average Purchase Frequency Rate refers to the number of purchase transactions that the customers of a subscription-based enterprise make over a specific period. It is calculated by dividing the total purchases made over a period of time by the individual customers that made those purchases during such a time period.
Average Purchase Frequency Rate = Number of Purchases/Number of Customers
- Customer Value
The value of a customer is nothing but the revenue that an individual customer generates for a business over its lifetime with such a business. It is calculated by multiplying the average value of the purchase by the number of times the purchase is made by the customer.
Customer Value = Average Purchase Value x Average Purchase Frequency Rate
- Average Customer Lifespan
The Average Customer Lifespan refers to the average number of years for which a customer continues to purchase the business’ goods and services.
Average Customer Lifespan = Sum of Customer Lifespans/Number of Customers
- Lifetime Value
The LTV of a customer is calculated when the value of the customer to the business is multiplied by its average lifespan. This financial performance metric helps a business entity to determine the revenue that it can expect to earn from a customer over the life of its relationship with the firm.
Customer Lifetime Value (CLTV) = Customer Value ✕ Average Customer Lifespan
However, the basic structural model or the traditional method to calculate CLTV is the Net Present Value model. In this model, a subscription-based enterprise has to assume that it has the estimates of the average contribution margin per customer per period (M).
Accordingly, the CLTV formula is:
Customer Lifetime Value (CLTV) =t=0T M(1+d)t * rt
r = constant rate of retention of customers per period
d = constant discount rate
t = time period
T = total number of time periods considered
Note that as per the above formula, CLTV demonstrates the net contribution margin that a SaaS business or a subscription-based business achieves per customer once acquired. This formula represents the sum of the revenues gained from frim’s customers over the lifetime of transactions after deducting the total cost of attracting, selling, and servicing customers, taking into account the time value of money.
Note that the CLTV models should estimate the value of a customer over the entire customer’s lifetime. However, in practice, most researchers use a finite time horizon of three or four years.
Why is Customer Lifetime Value Important?
It is important for a subscription-based enterprise to calculate the CLTV because it provides a customer-centric perspective to the business. Such a perspective helps an enterprise some key marketing and sales decisions like customer acquisition, retention, cross-selling, upselling, and support.
- Know Customer Acquisition Cost
The first and the foremost strategic decision that a subscription-based enterprise is able to take is how much it needs to spend to acquire a customer.
This is possible only if the business knows how much money it can generate from a customer. In the case of the SaaS business, firms spend more to acquire customers relative to what they spend on retaining the existing customers.
Thus, if a SaaS business wants to generate profits, its cost of acquiring a customer should be significantly lower than the revenue generated from the customers during the period when they remain subscribed to the firm’s service.
If this is not the case, then the SaaS business will find a great challenge in generating profits in the long run.
- Understand Customer Behavior
Customer Lifetime Value helps a subscription-based business segment its customer data into different categories. Such categories can be established based on the customer’s ‘lifetime’ values.
In other words, a subscription-based enterprise can identify customers who are expected to abandon the subscription early. Accordingly, such a business can take proactive decisions.
Besides this, a subscription-based business can offer special discount rates to the customers in order to encourage customer retention in specific segments.
Another major benefit of customer segmentation is that a subscription-based enterprise can use similar successful models to acquire similar and high-value customers.
Why Do We Calculate Customer Lifetime Value?
CLTV is a profitability metric that helps a subscription-based enterprise like a SaaS business to target its marketing efforts to the most lucrative market segments. It can make use of various customer profitability metrics in order to make marketing decisions at both a strategic and a tactical level. These applications include:
Thus, a SaaS business must calculate Customer Lifetime Value for the following reasons:
1. Promotional Campaign Spending
A SaaS business can use LTV models to understand the impact of different variables on the CLTV in a more systematic manner. These models can help a SaaS business to decide how much it needs to spend on its promotional campaigns.
Further, such a metric also helps a subscription-based business to decide how to allocate promotional budgets between acquisition and retention spending.
2. Customer Acquisition or Retention Decisions
It is important to note that the CLTV models also help a SaaS business in making customer acquisition or retention decisions. Subscription-based businesses have been using this metric to undertake decisions with regard to various marketing problems.
Once such businesses determine the CLTV, they are able to adopt appropriate marketing strategies and specify the resulting acquisition or retentions costs, rates, and trade-offs. Note that very few businesses consider both acquisition and retentions costs in the same model. But fundamentally, a business should not spend more than the lifetime value of a customer in order to acquire a customer.
Now the criterion for determining the optimal balance is the firm’s customer equity. Note that the balance is optimal when customer equity is at its maximum amount.
Therefore, to measure customer equity, a business must first measure each customer’s expected contribution toward offsetting the company’s fixed costs over the expected life of that customer.
Then, it should discount the expected contributions to a net present value at the firm’s target rate of return for marketing investments. Finally, it must add the discounted, expected contributions of all current customers to balance acquisition and retention.
Typically, behavioral segmentation is defined in terms of usage volume such as heavy users, medium users, and light users. However, customer profitability can serve as another important basis for behavioral segmentation. This is because earning profits is the primary objective of a business.
As a result, a SaaS business can determine CLTV to track the difference in profitability among various segments. Thus, a business can cluster the customer base of segments with similar values for the CLTV.
A SaaS business can segment customers based on three perspectives on customer value. These include current value, potential value, and customer loyalty. These aspects help a subscription-based business to identify customer segmentations with more balanced viewpoints.
The current value of such perspectives provides a business with financial viewpoints with respect to each of the segments. Whereas, the potential value of LTV perspectives indicates a cross-selling opportunity for the business. Finally, customer loyalty estimates the durability of the previous two values.
4. Mergers and Acquisitions
The investment banking community makes use of CLTV to obtain insights that help them in making strategic decisions like identifying profitable market segments, CAC, customer retention rate, etc.
Note that customers are one of the most important assets of any firm. If a firm determines the value of its customers, it gets insights into its overall value.
5. Service Discriminattion Towards Customers
In fact, it also helps a business to determine the optimal level of service to be rendered for each of the customer bases. This means companies can provide a differentiated level of service depending on the lifetime value of their customers. Many companies are already using this strategy.
Also, the profits from a customer may vary significantly from one period to the next. This means that the decisions a business makes on the basis of the customer profitability in 1 year might look unfortunate in the next year.
For instance, say a firm reduces the level of service to a customer who is unprofitable in the short term. This results in damaging the organization’s chances of retaining that customer’s long-term profitable business.
Contrary to this, suppose a retailer has a few customers who delivered a good profit last year for some reason. However, such customers have been otherwise persistently unprofitable for the retailer. Now, if the retailer increases the service levels to such customers, it will certainly increase costs for the retailer. Besides this, it may even exacerbate the longer-term problem of poor profitability.
6. Resource Allocation
A subscription-based business will be able to allocate marketing budgets across customers or market segments using different customer profitability metrics. It can make resource allocations that maximize the return on the marketing investment. Provided, the business has access to valid profitability measures.
A subscription-based business is able to achieve this by matching customer profitability with the measure of customer responsiveness to marketing efforts. In other words, a subscription-based business should not simply allocate the resources to customers or market segments in direct proportion to profit. Rather, it should allocate the same according to both profit and responsiveness.
How To Imporve Customer Lifetime Value of a SaaS Business?
Businesses are increasingly leveraging CLTV principles to maximize expected profits from each of their customers during their tenure as customers.
As competition increases, more businesses implement loyalty programs, subscription services, auto-replenishment options, free shipping to keep customers coming back.
This means that SaaS businesses now determine CLTV depending upon their customer base. Furthermore, they use such data to develop strategies that maximize lifetime value.
The following are some of the ways in which a subscription-based business can improve its customer lifetime value.
1. Improving Customer Retention
Today’s digitally native, omnichannel, convenience-seeking, value-oriented customer has permanently changed retention rates. Industries that were once virtual monopolies and enjoyed high retention rates are experiencing customer loss.
For instance, customer retention in e-commerce is significantly low. This is because customers quickly move from one dot-com to another. The average retention rate at a typical e-commerce site is just 18 months.
As per a study, the customers favor and visit a variety of stores. In fact, it was found that 83% of the households regularly visit 4 to 9 stores in a given year just to make their grocery purchases. This showcases how frequently the loyal customers of a specific brand switch across all products and services.
This means businesses must respond if customers have choices and are not predisposed to being loyal. They need to actively manage customer retention in order to improve their enterprise value in the long run.
If this is unachievable, then businesses need to continually acquire new customers. This can be costly for businesses, specifically e-commerce, as an alternative. That’s because direct-to-consumer brands and digital saturation are driving up customer acquisition costs for everyone.
Remember that not all customers have the same level of retention or CLTV contribution towards a business. In fact, the top customers of a business contribute disproportionately to its enterprise value. They achieve this through a combination of better period-over-period retention, frequency, and margin than the average customer.
In such a case, the objective of a business should be to maximize the economic value of top customers. As far as other customers are concerned, the business can invest in them in order to build the next generation of high-value customers.
However, the challenge is that not all customers of a business will be top customers. The business does not have to worry about this as it is possible to maximize every customer’s CLTV contribution.
The key to maximizing enterprise value is to understand various levers that are both incremental to profit in the short term and improve customer lifetime value in the long term. Such levers may include promotions, programs, products, customer experiences, and others.
2. Increasing Purchase Frequency
Another way to improve customer lifetime value is to predict the time until the customer purchases again and the levers that persuade customers to return. Such levers may include promotions, products, programs, or experiences that get people to come back.
Such an analysis helps business levers that influence the next customer purchase. Further, it also helps the business to optimize levers like prices, promotions, offers, etc. that influence customers to purchase sooner.
Thus, a business can personalize offers, maximize the likelihood of customers returning, and ultimately increase customer lifetime value. Provided it understands the levers that matter to each customer.
This means that if a business knows that a particular customer is price-sensitive, it may offer a limited-time price discount to decrease her time until the next purchase. Likewise, a business can bundle products X and Y together as it understands that a specific customer might respond to bundled products and increase the probability of purchase.
Thus, understanding levers enables retailers and manufacturers to deploy different strategies by customer segments. This helps them to move their customers up the loyalty ladder, win back lapsed buyers, or acquire new customers.
Note that quantifying factors that improve retention and purchase frequency are important for a business to personalize its customer experiences. Such personalization ultimately drives greater economic value from customers.
Also, applying CLTV principles ensures that retailers and manufacturers understand the tradeoffs of different types of customer engagement tactics. That is, they understand that some promotions or programs might drive only short-term profits. Whereas, others will drive both short-term profits and long-term customer lifetime value.
3. Promote Products With Short Purchase Cycles, High Repeat Rates, and Relatively Higher Margins
It is important to note that there might be less risk of losing a customer between buying periods if the purchase cycle is shorter than for a category with a naturally long purchase cycle. This is because, in the case of categories with a naturally long purchase cycle, the customers can shift to competitors.
4. Cross-Promote Products To High-Potential CLTV Customers
There are cases where high-potential CLV customers convert highly on some products but fail to convert as much on other products contributing more profitability. Therefore, a business must consider cross-promoting these products to maximize CLTV.
Note that a business may not capture a 100% share of profitability by adopting such a strategy. But, it is certainly worth for the business to promote a high-margin category or service to high-potential CLTV customers. This is because the sale can still be incremental to both short-term profitability and long-term enterprise value.
If this is not the case, then a business may also consider a high-potential CLTV customer buying significantly in one segment, but not other products known to have a high-basket affinity. In this case, a business can maximize the CLTV by cross-promoting such products to the high-potential CLTV customer.