The most accurate and comprehensive Lifetime Value (LTV) formula incorporates Gross Margin: *LTV = (Gross Margin % ARPA) / Revenue Churn Rate**.
Here's a breakdown of the components:
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Gross Margin %: The percentage of revenue remaining after subtracting the cost of goods sold (COGS). Calculated as:
((Revenue - COGS) / Revenue) * 100. This represents the profitability of each customer. -
ARPA (Average Revenue Per Account/User): The average revenue generated per customer/account over a specific period (usually monthly).
-
Revenue Churn Rate: The percentage of revenue lost from churned customers over a specific period (usually monthly).
Why use Gross Margin in the LTV formula?
Using gross margin instead of just revenue provides a more realistic understanding of the actual value each customer brings to your business. It accounts for the costs associated with serving that customer, revealing true profitability.
Simplified LTV Formulas (Less Accurate):
While the formula above is more accurate, simpler LTV formulas exist:
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LTV = Customer Value / Churn Rate (Where Customer Value = Average Purchase Value * Average Number of Purchases)
-
*LTV = Average Customer Lifespan Average Revenue Per Customer**
Example:
Let's say a SaaS company has the following metrics:
- Gross Margin: 70%
- ARPA: $100
- Revenue Churn Rate: 5%
Using the comprehensive formula:
LTV = (0.70 * $100) / 0.05 = $1400
This indicates that, on average, each customer is worth $1400 in profit over their lifetime with the company.
Important Considerations:
- Time Period: Ensure all metrics (ARPA, Churn Rate) use the same time period (e.g., monthly, annually).
- Cohort Analysis: Ideally, LTV should be calculated using cohort analysis, grouping customers by acquisition date to track their behavior over time. This provides a more accurate and insightful view of customer value.
- Segmentation: Different customer segments may have significantly different LTVs. Calculate LTV for each relevant segment.
By using the formula incorporating Gross Margin and carefully considering the factors above, you can gain a much more accurate understanding of your customer LTV and make better business decisions.
