How to Calculate the Lifetime Value of Ecommerce Customers

    by Ted Ammon

    Date

    October 18, 2013 at 10:00 AM

    calculating_LTVEvery kid wonders “when will I ever use this?” while slogging through their algebra homework in high school. If you were one of those kids, today’s the day. Hallelujah (or the opposite of hallelujah), it’s time to put those math skills to work. You’re going to need them when calculating the lifetime value of your ecommerce customers. 

    Should Have Paid Attention in Algebra Class

    The lifetime value (or LTV) of your customers is probably one of the easiest of your metrics to calculate, but many overlook its importance. With inbound marketing automation in place, most of the information is gathered for you and delivered with a nice little bow. It’s what you do with that information that sets you apart from your competitors. 

    So, why is the LTV so important? Many people throw around the term "ROI" or Return On Investment without actually knowing what it means. ROI is an oversimplified concept that's actually asking for a ratio of how much you get back versus how much you invested. The key concept missing from most marketers' perspectives on ROI is that, although we know intuitively that the goal is to develop lasting relationships with consumers, it's not a metric that most ecommerce marketers track and therefore isn't a metric that they can work on improving. If you're trying to calculate your "ROI" but just modeling the individual sales you get from your investment instead of looking at the value of customers you acquire and nurture, you're missing out on the big picture.

    When calculated correctly, you’ll know how much your customers spend, how often they spend it, and what programs and perks inspire those buyers to become regular customers. In other words, you can use the metrics to make your customers happy. Calculated correctly, knowing what kinds of customers have the highest LTV can help you determine where your company should invest in growth. Also, tracking this metric and the influencing variables helps you figure out how to affect those variables and improve this key metric.

    How to Calculate Ecommerce LTV

    While this metric may be the simplest to calculate, it’s also one that may involve more variables than you're used to. There are multiple ways that companies use to calculate LTV, but on the most basic level you should focus on a formula with variables you know how to influence so that this metric is actionable for you.

    Your basic formula is the following:

    (Average Order Value) x (Number of Repeat Sales) x (Average Retention Time)

    The infographic from KISSmetrics regarding the LTV of a Starbucks customer breaks down every step of the formula. The first step shows how to average your first variable, the average sale. The next is the number of visits per week, or the number of repeat sales. When these averages are plugged into the formula and a time supplied, we can see the lifetime value of that customer for the particular time given. In the case of the infographic, the time value supplied is one week.

    The infographic also shows the massive importance of measuring and optimizing for LTV. Have you ever wondered why there are so many Starbucks locations? Or why they have free wi-fi and comfy couches? It's because the Starbucks marketers know that they're not trying to sell a $5.90 cup of coffee -- they're trying to acquire and maintain a $15k customer. That simple math trick changes a lot about how you approach your marketing.

    Back to business: Let’s apply this first step to one of the hottest subscription services out there: Birchbox. A Birchbox subscription is ten dollars per month for women, and twenty dollars per month for men. In return for the ten dollars, customers receive a box of goodies from various companies hoping to find lifelong customers. We’ll apply this to the formula in this way:

    ($10) x (12 months) x (3 years) = $360

    Each female subscriber has a value of $120 per year, according to Birchbox. If the average customer is around for 3 years, that gives them an average LTV of $360!

    This, of course, is only the basic service Birchbox offers. Would a free month of service convince more people to subscribe? If so, would losing that $10 per customer be worth the additional revenue generated by the increased subscriptions? Would investing in identifying people who are at-risk of canceling and nurturing them increase this? Or would providing more opportunities for people to upgrade be able to increase the average order value?

    That’s exactly what the LTV is meant to help you figure out -- where the points of leverage are for you to improve your business.

    Let’s Get Complicated

    So far, your math is pretty easy. What if you’re trying to calculate the LTV of customers who don’t pay a set amount each month? This is the situation most B2C ecommerce merchants find themselves in. So even though they might know, intuitively, that they want to get existing customers to buy more, they may not be approaching it methodically if they're not measuring the right metrics.

    Let’s say your ecommerce site provides home healthcare products. For simplicity's sake, we’ll use three separate buyers as our example to calculate the average sale, like this:

    Buyer A cares for his grandfather, who has diabetes. Every month, he orders needles and test strips. On occasion, he purchases a new glucose meter. His monthly purchases average $60.

    Buyer B purchases her own diabetes testing supplies. She places larger orders for test strips every other month, so her average order is $25.

    Buyer C provides healthcare supplies to several of her family members. Each month, she orders test strips, needles, insulin pumps, supply cases, and diabetic socks. Her monthly order averages $150.

    To calculate the average monthly sale, simple math is used. 

    ($60) + ($25) + ($150) = $235/3 = $78

    We take that average monthly sale and multiply it by the number of repeat sales and then by the amount of time we expect to retain the customer.

    ($78) x (12 months) x (5 years)

    With this formula, the LTV is calculated as $4,680, or $936 per year. Of course, any healthcare supply ecommerce site that expects to stick around a while would have much higher numbers than this, but I may have already mentioned I’m terrible at math. I certainly don’t want to make things harder than they already are.

    Make the Investment

    I had no idea how my algebra lessons would apply to real life. Learning to calculate the lifetime value actually brought me a little bit of joy, even through the dread of crunching numbers. This is important information for your ecommerce business, and definitely worth facing the calculator for a little while. Once you determine what you must do to inspire loyalty through the lifetime value of your customers, don’t hesitate. Your investment into your customers’ happiness will determine the success of your company. 

    photo credit: kenteegardin via photopin cc

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