Many of the world’s most successful companies pride themselves on being customer centric. Thought leaders such as Peter Fader are helping companies to focus in on their most important customers by understanding the Customer Lifetime Value. See his books Customer Centricity: Focus on the Right Customers for Strategic Advantage and the new Customer Centricity Playbook. He teaches how to calculate Customer Lifetime Value (LTV or CLV) and also how to focus on the customers with the highest LTV.
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Investors in subscription businesses also obsess over Customer Lifetime Value and the ratio of the Customer Lifetime Value to Customer Acquisition Costs, LTV/CAC. Generally, this ratio needs to be greater than 3 in order to have a viable business. Ideally, this ratio should be closer to 6.
LTV/CAC = 3 to 6
Much of Ibbaka’s pricing strategy work involves designing pricing strategies to optimize this ratio which can be done in several different ways. A common way of calculating LTV is from David Skok’s “for Entrepreneurs” blog. The best article is SaaS Metrics 2.0 - Detailed Definitions.
LTV = (ARPA x Gross Margin)/Revenue Churn Rate
LTV is Customer Lifetime Value
ARPA is Average Revenue per Account
It is important to use the same time unit for each of these metrics, whether this be month, quarter or year.
Price and pricing model can impact all of these variables. Higher prices give a higher ARPA and a higher gross margin but, in certain cases, this can also increase the revenue churn rate. In designing your pricing, you want to find the sweet spot that is optimizing for maximum LTV over your customer base (sometimes referred to as customer equity). This will normally require the use of a Monte Carlo model to explore different assumptions and how they interact (Ibbaka can help you to build these models).
The simplest way to increase customer equity is often to increase prices. So why do we hesitate before doing so? There are three common risks:
Higher prices may lead to higher churn
Higher prices may increase customer acquisition costs
Higher prices may reduce the addressable market and lead to a smaller number of customers
The main reason companies fear these is that they have not spent enough time thinking about the customer’s perspective. Your customer is not interested in seeing their LTV increase. They care about how much value you are providing to them. We call this Value to Customer or V2C.
Just as you calculate the LTV of each customer, you should be calculating and communicating the V2C you offer to your customers. The V2C must be larger than the LTV. In most markets, it must be a multiple of LTV and the earlier the market and the more risk, the higher this number has to be. As a rule of thumb …
V2C/LTV > 3 in established markets
V2C/LTV > 10 in new markets
How does one calculate V2C?
The simplest approach is to calculate the Return on Investment. Note that it is important to calculate the ROI over the full lifetime of the customer, which is calculated as follows.
Customer Lifetime = 1/Customer Churn Rate
This is different from the usual ROI calculation, which is normally measured over a fixed number of years independent of the churn rate.
The Investment, the I in ROI, is the LTV plus internal costs.
This leaves the most difficult part of the work calculating the Return. The grunt work in value-based pricing is understanding what drives the return on investment for the customer and comparing this with the alternatives. This is unique to each offer and will be discussed in many future posts on this blog. ROI is generally expressed as a percentage but in this case, we are interested in the actual dollar returns so that we can compare them to the LTV and get a ratio.
Companies that focus on maximizing customer equity and LTV while forgetting about V2C are building on a shaky foundation. If V2C is lower than LTV, or if the ratio even approaches 1 to 1, then there is no sustainable business. The only way to grow customer equity long-term is to grow the value you are creating for your customer. This is why Ibbaka works to help our customers move around the value cycle and ensure that both LTV and V2C are growing in balance.