Unit Economics: How to Calculate LTV for Online Marketplace
Unit eсonomics is a set of different metrics that allow you to take your business to the next level or correctly evaluate a startup idea. It is a kind of special “calculator” that allows you to manage business parameters. Unit economics is especially important in eCommerce and particularly when running a marketplace since some parameters are most convenient to count and track in the digital space.
To be successful and start making money, startup owners need at least to be able to analyze their audience, market and economic metrics. In this article, we will look at how to calculate LTV for eCommerce, what related metrics exist, and how to interpret them correctly.
You may be also interested in how to calculate churn rate.
What is an LTV for eCommerce?
LTV—Lifetime Value—is a gross profit that a user brings to a business over the entire time they work with this business. It is a metric which is indispensable in marketing, customer acquisition, and customer retention work, especially when it comes to eCommerce.
You have to make sure that customers are valuable and the resources for their attraction does not exceed the profit of the whole cycle of customer relationships, otherwise you will simply go bankrupt. For example, you sell perfume. Attracting each new customer costs you $50. In this case, the analysis shows that you need to make a strategy so that the revenue from the client should be 3-4 times more, that is about $200.
Why Is Customer Lifetime Value Important?
Each marketplace business and marketing strategy are built on revenues exceeding expenses, and the LTV ratio is an indicator of current status. Let’s go through the main benefits of analyzing this metric.
- Identifying the most loyal customers. Clients with the highest LTV coefficient can be called loyal clients. Most often these are clients who have the biggest average check or they can have a smaller check, but make purchases more often and bring business more profit due to the quantity. Entrepreneurs need to pay special attention to these metrics and focus on increasing their loyalty and retention.
- Optimize customer retention efforts. LTV is one of the most significant figures. For example, if CAC—cost for attracting a customer—is higher than LTV, you need to focus on increasing the customer cycle time or finding more effective engagement channels. This also applies to comparing other metrics.
- Understanding behavioral factors. You are able to adjust communication with the client on the website depending on the value of the LTV factor and understand what exactly makes them want to buy your product.
What is the difference between LTV and CLV?
The terms LTV and CLV are very close in meaning. They are often used synonymously. However, experts distinguish a slight difference between them. CLV or CLTV is calculated per one particular customer, while LTV is a measure of the average figure for CLV of a certain group of customers. In this article we will use these terms as synonyms with the first meaning.
Key metrics to know before you can calculate LTV
This block is a crib for you. There is a list of the terms which are related to our topic and will be used in the next block:
- CAC—Customer Acquisition Cost—the average cost of attracting a user;
- ARPU—Average revenue per unit—an indicator of the profitability of a product based on the amount of money that is generated from each of its users or subscribers;
- Lifetime—customer interaction time with a company;
- Customer churn—a company’s loss in subscribers for a given period of time;
- Gross profit—represents the income or profit remaining after the production costs have been subtracted from revenue;
- Revenue—the amount of income generated from the sale of a company’s goods and services;
How to calculate LTV eCommerce?
There are a lot of methods to analyze and count LTV which you can find on the Internet. But most of them are irrelevant. Let’s define the most common formulas which are applicable to marketplaces.
Why is a simple formula for LTV not a reliable approach?
The most wide-spread formulas are these two:
- LTV = Lifetime * ARPU
- LTV = ARPU / Customer churn
ARPU metric is based on revenue. You might remember that LTV is a gross profit from customers, but these two formulas are based on revenue which is not equally the same as gross profit. When we are talking about the digital sphere, their product is close to zero cost by physical resources. In this case revenue and profit are very similar. Yet, for many other businesses it is not true since gross profit and revenue will differ significantly. So, these formulas can give you very approximate results which may be very far from the real state of your business. The LTV counting should be based on gross profit. There is a complicated analysis but it is reliable and true.
Cohort Analysis as a perfect way to monitor LTV
Cohort analysis may seem as a difficult system but we will try to explain it in a simple way.
Let’s start with how to work with gross profit and how to calculate it correctly. Remember that gross profit is the result of deducting all variable costs that are directly related to the product or service sold from revenue.
Simple rules for determining what expenses must be deducted from revenue to make a gross profit are:
- If expenses grow in proportion to sales, they should be deducted. These are variable expenses.
- If certain expenses do not grow proportionally with sales, they do not need to be deducted. Most likely, these are fixed costs.
Thus, for a company that deals with a marketplace, variable costs will be considered the cost of new modules, annual updates, commissions, the amount of which depends on profits. But the salaries of employees, for example, managers will not be deducted because it is a fixed expenditure.
A concept of cohort analysis
Now when the gross profit calculation is clear, we can turn to the cohort analysis. A target audience is a mixture of different people: those who began using your service just now, yesterday, last month, and last year. Data of these heterogeneous people is difficult to track, monitor, and analyze.
The concept of cohort analysis is to highlight several users groups—cohorts—by certain features, and to monitor the behavior of those groups over time. The picture below illustrates how many percent of people of a certain cohort used services of a company. Percentage in the picture is an LTV for a certain day.
Typically, cohorts are defined based on the time when people of a certain cohort started to use your product or store. By identifying these users groups, you track them during all periods of time and measure essential metrics for each individual cohort. Thus, by comparing the cohorts’ performance of two consecutive months, you can objectively compare how good were product versions corresponding to those time periods, what stage needed to be improved, and marketing efficiency in general.
For deeper analytics, the highlighted cohorts can be divided into littler groups according to different characteristics like language, location, traffic source, and other suitable points which make sense for your business. Chances are your main metrics will differ for various segments, just as product changes will affect various customer groups differently.
Each user goes through several stages from first contact with a company to repeat sales. These stages are individual for each business, but to show how cohort analysis works, we can conditionally distinguish three stages: first contact, first purchase, repeat purchase. There is also a branch here where the customer can stop any relationship with a company at one of the stages. The duration of each of these stages can be tracked on each group, you can calculate the average value, determine what affects the acceleration of transition processes from stage to stage, and track the CAC metric more closely. According to these data, it will be possible to predict the growth or decline in sales.
For ease of representation of LTV analysis, you can use a common Google or Excel table, special online services or specialists who can help to analyse metrics.
How to increase LTV?
- Customer Services—the happier your customers are, the more money they will spend with you. Companies that are actively customer-focused earn more. For example, you can improve this sphere by offering a special discount for repeat customers, bonuses, and gifts for participating in a loyalty program.
- Customer Retention—acquiring a new customer can be a costly affair. You need to retain those users who are already paying you. This is guaranteed to lead to an increase in profit per customer and therefore an increase in LTV. For example, to retain customers, you can offer them additional products by working with up- and cross-sales or you can re-promote the product after the expiration of the usage period.
- Sales Orientation—now when your customers understand how much you value them, it is time to take a closer look at your sales. Increasing sales per order is achieved by working closely with customers right at the time of purchase. You can introduce warranties and gifts for certain purchases.
Although there are many possible formulas for calculating LTV, the most reliable way is cohort analysis. So, in this article, we looked at how to calculate LTV for eCommerce. This calculation is applicable to different types of businesses, including marketplaces. LTV Metrics helps entrepreneurs and startups to assess customer engagement and loyalty, to see how well marketing funnels are working, and to predict the further growth and development of a company.