How Profitability is Measured in Lifetime Value: Beyond the Basic Calculation

TLDR

Calculating Lifetime Value can sometimes be confusing given how profitability can be measured at different margin levels.

We explain the difference between CM1, CM2, and CM3 calculations, why platforms like Recharge and Skio can't provide true Lifetime Value, and how to choose the right profitability measurement for your business decisions.

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Full article

Ask ten, different subscription businesses how they calculate Lifetime Value and you'll get ten different answers.

Some use gross revenue, others deduct product costs, and many include completely different expense categories.

The core issue is that Lifetime Value profitability can be measured at various levels, each serving different strategic purposes. Understanding these levels and when to use each one is crucial for making sound business decisions about customer acquisition, retention investments and growth strategies.

What's Actually Included in Lifetime Value

Before diving into profitability levels, let's clarify what Lifetime Value represents.

Customer Lifetime Value measures the total profit generated by a customer over their entire relationship with your business. Critically, Lifetime Value calculations don't include Customer Acquisition Cost, as that's measured separately and compared through ratios like Lifetime Value:CAC.

This separation is important because Lifetime Value represents the value created once you have a customer, while CAC represents the investment required to acquire them. Mixing these creates confusion about which activities actually drive customer value versus acquisition efficiency.

Most Lifetime Value calculations include:

• Total customer revenue over their lifetime

• Direct costs associated with serving that customer

• Allocated costs based on the margin level you choose

• A time horizon (often capped at 36 months for practical forecasting)

The key decision is determining which costs to include when calculating profitability, which brings us to the margin level framework.

Understanding Margin Levels: CM1, CM2, and CM3

Different businesses need different profitability perspectives depending on their decision-making requirements.

The contribution margin framework provides three distinct levels:

CM1 (Contribution Margin 1): Product-Level Profitability CM1 deducts only the direct cost of goods sold from revenue. For a meal kit company, this includes ingredients and packaging. For a software business, this might include hosting costs per user and payment processing fees.

CM1 is useful for understanding product profitability and making decisions about pricing, product mix, and direct cost optimisation. It shows the gross contribution each customer makes before any overhead allocation.

CM2 (Contribution Margin 2): Variable Cost ProfitabilityCM2 deducts variable costs that scale with customer volume but aren't directly tied to individual products. This includes shipping costs, customer service expenses, and variable portions of technology costs.

CM2 helps with decisions about scaling operations, pricing strategies that account for service delivery costs, and understanding the true marginal profitability of additional customers.

CM3 (Contribution Margin 3): Full Cost Profitability CM3 includes allocated fixed costs like marketing overhead, general administrative expenses, and fixed technology infrastructure. This represents the fully loaded profitability of customer relationships.

CM3 is essential for strategic planning, investment decisions, and understanding whether your business model is fundamentally profitable at scale.

Choosing the Right Margin Level for LTV

The margin level you choose for LTV calculations should align with your decision-making needs.

NB this is largely taken from corporate-level brands; these levels of LTV aren't commonplace in smaller brands.

Use CM1 Lifetime Value when:

• Making product pricing decisions

• Evaluating product line profitability

• Assessing direct cost reduction opportunities

• Comparing customer segments with different product preferences

Use CM2 Lifetime Value when:

• Planning customer acquisition investments

• Making operational scaling decisions

• Evaluating channel partner economics

• Setting Lifetime Value:CAC targets for growth planning

Use CM3 Lifetime Value when:

• Making strategic investment decisions

• Evaluating overall business unit profitability

• Planning long-term resource allocation

• Assessing acquisition or investment opportunities

Many established enterprises use CM2 for day-to-day decisions and CM3 for strategic planning, as this provides both operational clarity and comprehensive profitability understanding.

How to Calculate Lifetime Value Properly

Regardless of which margin level you choose, the basic Lifetime Value calculation follows the same structure:

Lifetime Value = (Average Monthly Revenue Per Customer × Gross Margin %) × Average Customer Lifespan

However, more sophisticated calculations account for churn rates and discount future cash flows:

Lifetime Value = (Monthly Revenue × Chosen Margin %) / Monthly Churn Rate

For businesses with significant growth or seasonal patterns, cohort-based calculations provide more accuracy:

Lifetime Value = Sum of (Monthly Cohort Revenue × Margin % × Retention Rate) for each month of customer lifetime

The key is consistency.

Whatever margin level and calculation method you choose, apply it consistently across all customer segments, time periods, and business decisions.

Why Platform Metrics Aren't True Lifetime Value

Subscription platforms like Recharge and Skio provide valuable customer metrics, but they can't provide true lifetime value because they lack access to your cost structure.

Recharge sensibly labels their metric "Lifetime Revenue" to avoid confusion, while Skio calls it "Lifetime Value" despite not having cost data.

These platforms can calculate customer revenue patterns and retention curves, but they can't account for product costs, operational expenses, or margin calculations.

Platform metrics are useful for understanding customer behaviour patterns and revenue trends, but they shouldn't be used for profitability decisions or Lifetime Value:CAC planning.

You need to overlay your actual cost structure to get meaningful Lifetime Value calculations.

Think of platform metrics as helpful inputs to your Lifetime Value calculations rather than complete answers. They provide the revenue and retention data you need, but the profitability analysis requires your internal cost information.

Making Lifetime Value Actionable

The goal of proper Lifetime Value calculation isn't precision for its own sake - it's making better business decisions. Different stakeholders need different Lifetime Value perspectives:

• Marketing teams typically work with CM2 Lifetime Value for acquisition planning, as it includes the variable costs of serving customers but excludes fixed overhead that doesn't change with acquisition decisions.

  
  

• Product teams often use CM1 Lifetime Value to understand which features and products drive the most value, focusing on direct cost relationships.

  
  

• Finance and strategy teams rely on CM3 Lifetime Value for comprehensive profitability analysis and long-term planning decisions.

The most sophisticated subscription businesses calculate Lifetime Value at multiple margin levels and use each for its appropriate purpose. This provides comprehensive insights while avoiding the confusion that comes from inconsistent calculations.

Understanding these distinctions transforms Lifetime Value from a single number into a strategic framework that drives better decision-making across your entire subscription business.

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