Using Lifetime Value to focus your marketing effort on your most profitable customers.
Lifetime Value (LTV) is a prediction of the net profit attributed to the entire future relationship with a customer.
LTV is a crucial metric for e-commerce, allowing a business to identify its most profitable customers. It also helps to understand which cohort of customers have higher lifetime value and how much you can afford to spend attracting the same type of customer in the future.
Forecasting how much a customer is worth in monetary terms lets you understand how much you can afford to spend to acquire each customer.
Your focus should be on long term value customers instead of investing resources in acquiring customers with low total revenue. Targeting highly profitable customers will help you achieve maximum returns on your marketing budget.
Forecasted LTV is a powerful feature when selecting customers; it helps you to make informed decisions when creating a customer-specific communications strategy, which is closely connected to customer churn analysis.
What's customer churn and how is it related to LTV?
Customer churn is the percentage of customers that stopped buying from your shop.
To better understand why the customer churn rate is so closely connected to identifying your most profitable customers, we can look at the example in the scheme below.
An example of two customers spending an equal amount of money over the same period of time but with very different churn probability.
Although these two customers have spent an equal amount of money ($60) over the same period and placed the same number of orders (3), it is reasonable to expect the first customer (blue) to be much more profitable over the long term than the second (green) customer.
This first customer has purchased frequently, spending an increasing amount of money on each transaction. Over time they're probably going to become a loyal buyer and therefore a highly profitable customer.
The second customer, on the other hand, has carried out multiple transactions in a short space of time, but has not been an active customer recently. They may be at risk of leaving. Or maybe this customer has already left.
How to define churn for an e-commerce business?
Taking action to prevent customers from leaving your business required to first identify the customers "at risk of leaving".
Customer churn in a contractual business setting, such as a mobile phone subscription, is commonly defined as 'the probability that a customer will voluntarily cancel the existing contract within the next X number of months’.
This is a classic binary classification problem as each customers will either churn– or will not churn.
However, churn can't always be so explicitly defined. In an e-commerce business, any purchase might be the last interaction with the company.
If a user does not complete a critical event on the platform within a window of time, then the customer could be considered to have churned from the platform.
The churn rate is a crucial metric for businesses because acquiring new customers is generally much more expensive than retaining existing ones.
It is often more efficient to convert your present customers into loyal buyers than chase new customers to achieve your sales target.
The forecasted lifetime value aims to help you visualize in a simple metric not only the present monetary value of your customers but also their potential future profitability based on their buying behavior.