Actionable Marketing Advice

An introduction to Lifetime value models

Using lifetime value models to set campaign investment levels

We think Lifetime value (LTV) models are a powerful tool to help businesses demonstrate the future value they can generate from marketing activities. It’s a much better approach to evaluate investment based on long-term returns from marketing activities rather than the short-term success of a single sale. As the inimitable Avinash Kaushik has said, setting marketing budgets without using LTV is like saying a relationship will be successful based on a one night stand.

Although the benefits of using lifetime value models are strong, in our experience, lifetime value is a technique that’s not used as much as you might expect or it should be. It seems it’s mainly a “big company thing”, more often used in sectors like financial services, retail or where direct marketing marketing has been practiced.

We think LTV models can and should be used in businesses of different sizes  for many applications like retail, utilities, travel or web services like software services or publishing where there will be recurring revenue. They are also important to creating business plans and forecasts for startup businesses to help estimate future revenue.

Perhaps they’re not used unless you are “shown the ropes” by colleagues who know about them or you cover them on a course. We built them in as activities on the IDM Digital Marketing Diploma for many years for that reason. To help businesses model LTV from marketing investments we’ve just published this LTV model spreadsheet. This post explains the background of using them.

Recommended Guide: Lifetime value models

Download our LTV spreadsheet model.

What is lifetime value (LTV)?

A classic textbook definition is:

“Lifetime value is the total net benefit that a customer or group of customers provide a company over their total relationship with a company”.

Lifetime value can be calculated historically where it has value in understanding the value generated by specific customer groups or where customers are acquired from different sources. We’ll cover these in a future post. However, we feel the main application of Lifetime value modelling is in campaign planning and budgeting and that is where we will concentrate there.

Using lifetime value models to set the allowable cost of acquisition

A key feature of using LTV is that the value contributed by customers over time is calculated in terms of its present day value. This is THE key benefit of lifetime value model calculations since it enables you to work out how much you can afford to invest to acquire customers or develop services that will increase LTV.

Lifetime value analysis enables companies to set realistic investment levels in marketing budgets for customer acquisition programmes. As you’ll know, every new campaign should have a clear target cost for allowable customer acquisition (CPA). But how do you know how to set it? You can set it at the average order value for the first sale, but this doesn’t take future orders or revenue into account and will limit your budget.

LTV models help set allowable CPA at a level which takes the future value of a customer into account based on the percentage of new customers who make repeat sales and optionally recommend your service to others.

The way this is estimated is through creating a spreadsheet model based on these inputs:

  • The percentage of customers who order again or renew in each each year
  • The amount spent per year by each customer
  • Direct and indirect costs per year (but excluding marketing costs)
  • A discount factor which takes into account future revenues in present day terms given inflation

As with any model, these are estimates, so the technique works best in markets where these values are stable.

Lifetime value model calculations

Although the name alone looks scary and some of the formulas like those in the infographic at the end of this post don’t help, LTV calculations are relatively straightforward if you’re comfortable with a spreadsheet or a template is available.

To help here, we’ve created a simple Lifetime value calculation spreadsheet for Expert members:

Further reading

To learn more see this example of a lifetime calculation for Starbucks from Kissmetrics. It gives another way of considering LTV, but it is more complex than that in the spreadsheet above.

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  • Bryan Dibben

    Thank you Dave for an informative article. :)

    Within my current role we sell wedding catering services to couples getting married.

    We looked at the life time value of our wedding customers. At first glance it appeared the life time value was relatively low. The reason for this was the low level of repeat purchase of wedding catering services and/or related services. After all, you only get married once, (or twice) in a life time.

    However, it was also important for us to take into consideration other benefits when analysing the life time value. For example, the likelihood of word of mouth was quite high within our existing wedding customers. A good proportion of our new business came through recommendations from old customers.

    In other words although previous customers were unlikely to repeat purchase there were other benefits we could elicit through our marketing. (These non financial benefits may get left out of some life time value models).

    The result of our analysis meant the majority of our marketing was targeted towards new customers and a small amount to maintain relationships with previous customers.

    • http://www.smartinsights.com/ Dave Chaffey

      Thank you Bryan for your comment – it’s taken me a week, but we like to reply to every comment :)
      Thanks for sharing – that’s an interesting one – you would think it is negligible there, but highlights the need to take recommendations into account.
      More sophisticated LTV models do feature the recommendation factor – definitely worth factoring in in many cases and taking action to encourage the behaviour. I’ve noticed when training at The IDM that they have various recommendation tactics which their competitors don’t seem to use.
      Dave

  • Nick Hilditch

    Dave
    It was a revelation to me when you taught LTV on the IDM DipDigM and in your essential book. There are (IMHO) two challenges to overcome: it is far more complex to implement in real life tha the model suggests, especially through an extended channel chain; secondly it is not yet widely known or understood – when eventually it is, perhaps finance people will stop thinking we are just the ‘pink fluffy jumper’ or colouring-in department.

    • http://www.smartinsights.com/ Dave Chaffey

      Thanks Nick – that’s what I hope – to open eyes. It’s rarely mentioned compared to the social media commentary. Kudos to Kissmetrics for prompting me to do a post.

      Yes, harder in reality, but that’s a good reason to work with the finance folks to work together on refining the models to get some mutual respect.

      “Colouring-in department” – I like that!

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