Customer Lifetime-Value Equation

What exactly are your customers worth to you? Calculating their lifetime value (LTV) can help you determine, among other things, the effectiveness of your marketing strategies and your chances of improved profitability down the road.

LTV is measured using the revenue stream generated by a customer after the initial order, minus all of the costs associated with obtaining and fulfilling those orders. The actual formula used can vary slightly from company to company, but it generally looks something like this:

1. Take your subsequent gross revenue and add shipping income.
2. Subtract returns; shipping expense; cost of goods sold; advertising costs; and costs to take and fill an order.
3. Divide the total by the number of new buyers.
4. Divide again by the discount rate (see below).

The discount rate includes the interest rate, a risk factor, inflation and cost of capital (your accountant or finance director may be able to help you here). You need the discount rate to compute LTV, because you’ll have to add or compare profits received in different years. That is, consider the present value of money, because funds received in the future won’t be worth as much as money received today. So you must discount it if you want to compare or add it to current dollars.

Why Measure LTV?

LTV evaluates the effectiveness of your marketing activities. Customer value will be different for those responding to catalogs, space ads and package inserts. Customers acquired through rental lists can vary by the type of list source: catalog, subscription, or compiled or specific list segment. In addition, catalog lists vary by season and promotions offered. And customers within those sources will vary by products purchased, whether they’re business or residential buyers, and by gender, age or other demographic.

First, let’s define the difference between a buyer and a customer. A buyer has purchased once; a customer is someone who has purchased more than once. The goal is to turn buyers into customers since, as a cataloger, you depend on repeat purchases for profits. Obviously, you need buyers before you can have customers. When someone buys only once, the result most often is a financial loss—it’s difficult to make money on one-time buyers.