Customer lifetime value

Customer lifetime value (CLV or sometimes CLTV), lifetime customer value (LCV), or life-time value (LTV) is a marketing concept used to estimate the net profit a customer is likely to contribute over the entire course of their relationship with a company. The prediction model used to calculate CLV can vary in sophistication and accuracy, ranging from simple heuristics to complex predictive analytics techniques.

In essence, CLV represents the monetary value of a customer relationship, calculated based on the present value of future cash flows projected from that relationship. By focusing on the long-term value of customer relationships, rather than just short-term profits, firms are better able to allocate resources towards customer acquisition and retention strategies.

CLV is a crucial metric because it provides an upper limit on the amount a company can spend to acquire new customers. It is therefore an important element in calculating the payback of advertising spent in marketing mix modeling. The term "customer lifetime value" was first coined in the 1988 book "Database Marketing".

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Purpose

The goal of using the customer lifetime value (CLV) metric is to determine the financial value of each customer. CLV is different from customer profitability (CP), which measures the past, while CLV looks towards the future. CLV is more useful in making managerial decisions, but it is more challenging to quantify. While calculating CP involves reporting and summarizing past activities, calculating CLV requires predicting future activities.

CLV is the present value of the future cash flows associated with the customer's entire relationship with the company. Present value is the discounted sum of future cash flows, where each future cash flow is multiplied by a carefully chosen number less than one before being added together. The multiplication factor considers how the value of money decreases over time. The time-based value of money reflects the idea that people prefer to get paid sooner and pay later. The multiplication factors depend on the discount rate chosen and the time before each cash flow occurs.

CLV utilizes present value to estimate cash flows related to the customer relationship. The present value of any future stream of cash flows is intended to measure the current lump sum value of the future stream of cash flows. CLV represents the current lump sum value of the customer relationship to the company. Put simply, CLV is the monetary value of the customer relationship to the firm. It provides an upper limit on what the company would be willing to pay to acquire or retain a customer. CLV is also used to segment customers based on profitability, enabling the company to identify the most profitable customer groups and focus on them rather than less profitable ones.

CLV is primarily used in relationship-based businesses such as banking, insurance services, telecommunications, and B2B industries. However, the CLV concept can be applied to transaction-based sectors like consumer packaged goods by incorporating stochastic purchase models of individual or aggregate behavior. Retention has a significant impact on CLV because low retention rates result in minimal increases in customer lifetime value over time.

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Construction

When margins and retention rates are constant, the following formula can be used to calculate the lifetime value of a customer relationship:

Customer Lifetime Value=Margin⋅Retention Rate1+Discount Rate−Retention Rate

The model for customer cash flows treats the firm's customer relationships as something of a leaky bucket. Each period, a fraction (1 less the retention rate) of the firm's customers leave and are lost for good.

The CLV model has only three parameters: (1) constant margin (contribution after deducting variable costs including retention spending) per period, (2) constant retention probability per period, and (3) discount rate. Furthermore, the model assumes that in the event that the customer is not retained, they are lost for good. Finally, the model assumes that the first margin will be received (with probability equal to the retention rate) at the end of the first period.

The one other assumption of the model is that the firm uses an infinite horizon when it calculates the present value of future cash flows. Although no firm actually has an infinite horizon, the consequences of assuming one are discussed in the following.

Under the assumptions of the model, CLV is a multiple of the margin. The multiplicative factor represents the present value of the expected length (number of periods) of the customer relationship. When retention equals 0, the customer will never be retained, and the multiplicative factor is zero. When retention equals 1, the customer is always retained, and the firm receives the margin in perpetuity. The present value of the margin in perpetuity turns out to be the Margin divided by the Discount Rate. For retention values in between, the CLV formula tells us the appropriate multiplier.

Methodology

Simple commerce example

(Avg Monthly Revenue per Customer * Gross Margin per Customer) ÷ Monthly Churn Rate

The numerator represents the average monthly profit per customer, and dividing by the churn rate sums the geometric series representing the chance the customer will still be around in future months.^‍

For example: $100 avg monthly spend * 25% margin ÷ 5% monthly churn = $500 LTV

A retention example

CLV (customer lifetime value) calculation process consists of four steps:

1. forecasting of remaining customer lifetime (most often in years)
2. forecasting of future revenues (most often year-by-year), based on estimation about future products purchased and price paid
3. estimation of costs for delivering those products
4. calculation of the net present value of these future amounts

Forecasting accuracy and difficulty in tracking customers over time may affect CLV calculation process.

Retention models make several simplifying assumptions and often involve the following inputs:

• Churn rate, the percentage of customers who end their relationship with a company in a given period. Churn rate + retention rate = 100%. Most models can be written using either churn rate or retention rate. If the model uses only one churn rate, the assumption is that the churn rate is constant across the life of the customer relationship.
• Discount rate, the cost of capital used to discount future revenue from a customer. Discounting is an advanced topic that is frequently ignored in customer lifetime value calculations. The current interest rate is sometimes used as a simple (but incorrect) proxy for discount rate.
• Contribution margin
• Retention cost, the amount of money a company has to spend in a given period to retain an existing customer. Retention costs include customer support, billing, promotional incentives, etc.
• Period, the unit of time into which a customer relationship is divided for analysis. A year is the most commonly used period. Customer lifetime value is a multi-period calculation, usually stretching 3–7 years into the future. In practice, analysis beyond this point is viewed as too speculative to be reliable. The number of periods used in the calculation is sometimes referred to as the model horizon.

Thus, one of the ways to calculate CLV, where period is a year, is as follows:

Simplified models

It is often helpful to estimate customer lifetime value with a simple model to make initial assessments of customer segments and targeting. If GC is found to be relatively fixed across periods, CLV can be expressed as a simpler model assuming an infinite economic life (i.e., N→∞)

Advantages

Customer lifetime value has intuitive appeal as a marketing concept, because in theory it represents exactly how much each customer is worth in monetary terms, and therefore exactly how much a marketing department should be willing to spend to acquire each customer, especially in direct response marketing.

Other notable avantages of CLV are:

• management of customer relationship as an asset
• determination of the optimal level of investments in marketing and sales activities
• encourages marketers to focus on the long-term value of customers instead of investing resources in acquiring "cheap" customers with low total revenue value
• optimal allocation of limited resources for ongoing marketing activities in order to achieve a maximum return
• a good basis for selecting customers and for decision making regarding customer specific communication strategies
• a natural decision criterion to use in automation of customer relationship management systems

The disadvantages of CLV do not generally stem from CLV modeling itself, but from its incorrect application. These aspects will be covered in a following article.

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