Being in the business for well over 10 years I am always surprised how many eCommerce clients cannot answer the question "what is the lifetime value of your customers?" Usually in my initial prospecting calls with somewhere within the second half of the call I ask this question. At least 50% of the time I hear the answer: "no." It does seem like most eCommerce companies understand the value, but don't always have the analytics expertise to calculate this. Of course, you also have the eCommerce companies in their infancy that just don't have the customer data to support estimating anywhere near an accurate lifetime value.
What does "customer lifetime value (LTV)" mean? Essentially it's the total value a customer will contribute to your company over their lifetime.
Why is it important to know the lifetime value of your customers? First, it tells you how much you can spend to acquire a customer without losing money. Second, it gives you a baseline to start from while you make changes to increase the value of each customer. There are a lot of companies out there that never make it because they don't know their customers lifetime value. They are paying $75 to acquire every new customer, but the average customer might only drive $50 in revenue. Understanding this is crucial to growing a successful eCommerce company over time.
There are two primary methods to calculate this. One is based on historical data (in which you need a lot), and one is based on predictive modeling. Which way you need to use will depend on how many customers you've had as well as how long you've been in business. More than likely for at least the first 2-3 years you'll be using predictive modeling, but as your actual data set grows you can integrate more historical data until eventually, you get to a point where it's entirely based on your own metrics.
If you're using historical modeling, you have the opportunity to segment even further, maybe by acquisition channel or demographic data. Now you can find which of your customer sets have a higher lifetime value than others. This allows you to focus on acquiring customers that are more valuable regarding long-term revenue they bring in. Marketing to the "right" customers will help improve your customer acquisition metrics. There's a great infographic I found from RJ Metrics illustrating this (see below blog)
As you continually do things like marketing to the right customers, adding new products to your website, improving your cross-selling approach you can continue to increase the lifetime value of your customers giving you more profit and more you can spend to acquire new customers.
Now just because you know the answer to this question doesn't solve everything. One of the significant challenges for eCommerce companies, especially those in the first 1-3 years of their business is that they don't have enough existing customers to offset the loss to acquire a new customer. Here's what I mean by that. If the lifetime value of your customer is $100 over a 2 year period and to get to $100 in revenue that customer has to place 4 orders and it costs to $50 to acquire that customer; initially you lose money. Yes over a two years period you'll still make a $50 profit from that customer, but you might lose $25 for the first 6-12 months.
Look at Amazon and Jet. They lost tens to hundreds of millions growing their customer base initially while continually increasing the customer lifetime value until they can eventually be profitable. Now this indeed takes a lot of investment capital, and there aren't many companies in this position, but it's an excellent example of what it takes to grow in the eCommerce space now.
Early on in the years of pay per click on Google, Yahoo, and Bing, it was relatively easy to make a "profit" from a first order. As the market became more competitive rarely now do we see this from eCommerce companies on non-brand search keywords. Same goes for Facebook ads. Facebook advertising has doubled in cost each year as it's gone from having unsold inventory to completely selling all ad spots. Understanding and improving your lifetime value is continually increasing in importance to the success and growth of your eCommerce business.
If you've been in business for 3, 4, 5 years or more you might have enough repeat customers that you can cover your loss to acquire new customers and your eCommerce business is still profitable. Many eCommerce companies and startups don't have that luxury though, and they are operating at a loss until they can start getting those repeat orders in. Depending on how long that cycle is for your customers to make a second or even a third purchase, this can be challenging. As an eCommerce company, we're all trying to get to that point, where repeat customers drive the profit and capital to continue losing money on a first purchase to acquire new customers.
Stay tuned for our white paper where we'll show you exactly how to calculate the lifetime value through both historical and predictive modeling.