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.

All catalogers calculate as measures of their business things such as percent response, dollars per catalog or per thousand catalogs, and the average order. But only a few calculate and use LTV. Instead of focusing on the response rate or dollars per catalog alone, also consider the down-stream results. You could easily be spending either too much or not enough to obtain new buyers.

Two Types of LTV

As mentioned, LTV is the value of a customer over time. There are two types of LTV rates: absolute and relative. To obtain the first, you’d have to wait “a lifetime” for each customer. But the second type takes a relative point in time, such as three, six or 12 months, and uses it for comparison purposes.

Years ago, when first conceptualizing LTV, we wondered how anyone knew how long our lives were going to be or how long our customers were going to be customers. But now we understand we don’t really need to know these things to calculate the LTV. Catalogers really just want to calculate the lifetime value for a relative time frame and then be able to appropriately apply that value in their businesses.

Most companies that do such analysis examine or compare the values at regular intervals, usually monthly or quarterly. It’s not unusual to observe lists that perform only marginally in the initial mailing, but end up with stronger LTVs than lists that did better initially. It’s also not unusual to see negative values the first several months.

The LTV of some lists will continue to grow indefinitely, while others start to decrease after a period of time and could become negative again. The variations often can be the result of a company’s mailing or promotional strategies, especially if they mail too often or to old names. Sometimes the costs simply out-pace the subsequent revenue streams.

The Data Are Key

The actual calculation of LTV usually is done at the individual customer level and summarized to the original source-code level. It can just as easily be summarized to other variables such as age, gender or products purchased.

We prefer taking all the orders and revenue accumulated from each customer and subtracting the first order and revenue value. This usually involves a significant amount of data, and in theory, the more data the better, right?

In practice, massive amounts of data can be a problem. Of course, none of our legacy order-fulfillment systems have perfect data-collection features. Unknowns often are quite high in some seasons, books or years. Web orders aren’t always tracked back to their true original sources. Source codes aren’t always captured accurately by order-takers. Frequently, computer fulfillment operating systems have been changed or upgraded, and the data may be in multiple formats. Although LTV calculations are easy to conceptualize, they can be hard to do. The key is the data.

Even if your data are in shambles, you still can calculate an average LTV for a book, offer or promotion. This is better than not doing it at all, but it’s not the best way to determine your acquisition budget or the best use of available funds.

You can improve your overall LTV by selecting programs and lists that have higher LTVs. You also can implement programs and procedures to improve your customers’ LTV rates. For example, an increase can come from treating customers better in some way, such as sending them letters, birthday cards and/or newsletters. Give them gold cards and gold-card treatment. Of course, all these things cost money, so don’t forget to factor those extra costs into your equations.

Most catalogers agree with the theory of LTV, but in practice only some are applying its principle to their businesses. For example, some catalogers insist on being at break-even or better for the first order. Others know they can absorb some loss, but they’re not sure how much, so they assign an arbitrary value, say $10, for each customer. They do this because they haven’t systematically determined the real value.

Most catalogers using LTV look to recover their investments in acquiring a customer within the first year; others use six months—even 18 or 24 months. Your time frame should depend on your financial structure and results. Normally, we look for a maximum 12-month payback period when investing in new buyers, but this will vary depending on the LTV and your financial situation.

In practice, LTV can be applied to your customer file as an average, but since there really is no average customer, it’s best applied at either the list/segment level, individual customer level or both.

Stephen R. Lett is president of Lett Direct, a catalog consulting firm specializing in circulation planning, forecasting and analysis. He can be reached at (317) 844-8228 or through the Web site: www.lettdirect.com. Susan DeVito works for Lett Direct and specializes in lifetime value analysis. She can be reached at (207) 839-3382.