Topic: Customer lifetime value

In marketing, customer lifetime value (CLV or often CLTV), lifetime customer value (LCV),
or life-time value (LTV) is a prognostication of the net profit

contributed to the whole future relationship with a customer. The prediction model can have
varying levels of sophistication and accuracy, ranging from a crude heuristic to the use of
complex predictive analytics techniques.

Customer lifetime value can also be defined as the monetary value of a customer relationship,
based on the present value of the projected future cash flows from the customer relationship.
Customer lifetime value is an important concept in that it encourages firms to shift their focus
from quarterly profits to the long-term health of their customer relationships. Customer
lifetime value is an important metric because it represents an upper limit on spending to
acquire new customers. For this reason it is an important element in calculating payback of
advertising spent in marketing mix modeling.

One of the first accounts of the term customer lifetime value is in the 1988 book Database
Marketing, which includes detailed worked examples. Early adopters of customer lifetime
value models in the 1990s include Edge Consulting and BrandScience.

Purpose
The purpose of the customer lifetime value metric is to assess the financial value of each
customer. Don Peppers and Martha Rogers are quoted as saying, “some customers are more
equal than others.” Customer lifetime value differs from customer profitability or CP (the
difference between the revenues and the costs associated with the customer relationship
during a specified period) in that CP measures the past and CLV looks forward. As such,
CLV can be more useful in shaping managers’ decisions but is much more difficult to
quantify. While quantifying CP is a matter of carefully reporting and summarizing the results
of past activity, quantifying CLV involves forecasting future activity.

Customer lifetime value:

The present value of the future cash flows attributed to the customer during his/her entire
relationship with the company.Present value is the discounted sum of future cash flows: each
future cash flow is multiplied by a carefully selected number less than one, before being
added together. The multiplication factor accounts for the way the value of money is
discounted over time. The time-based value of money captures the intuition that everyone
would prefer to get paid sooner rather than later but would prefer to pay later rather than
sooner. The multiplication factors depend on the discount rate chosen (10% per year as an
example) and the length of time before each cash flow occurs. For example, money received
ten years from now must be discounted more than money received five years in the
future.CLV applies the concept of present value to cash flows attributed to the customer
relationship. Because the present value of any stream of future cash flows is designed to
measure the single lump sum value today of the future stream of cash flows, CLV will
represent the single lump sum value today of the customer relationship. Even more simply,
CLV is the monetary value of the customer relationship to the firm. It is an upper limit on
what the firm would be willing to pay to acquire the customer relationship as well as an upper
limit on the amount the firm would be willing to pay to avoid losing the customer
relationship. If we view a customer relationship as an asset of the firm, CLV would present
the monetary value of that asset.One of the major uses of CLV is customer segmentation,
which starts with the understanding that not all customers are equally important. CLV-based
segmentation model allows the company to predict the most profitable group of customers,
understand those customers' common characteristics, and focus more on them rather than on
less profitable customers. CLV-based segmentation can be combined with a Share of Wallet
(SOW) model to identify "high CLV but low SOW" customers with the assumption that the
company's profit could be maximized by investing marketing resources in those customers.

Customer Lifetime Value metrics are used mainly in relationship-focused businesses,

especially those with customer contracts. Examples include banking and insurance services,
telecommunications and most of the business-to-business sector. However, the CLV
principles may be extended to transactions-focused categories such as consumer packaged
goods by incorporating stochastic purchase models of individual or aggregate behavior. In
either case, retention has a decisive impact on CLV, since low retention rates result in
Customer Lifetime Value barely increasing over time.

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 Rate

Discount Rate

Retention Rate

{\displaystyle {\text{Customer Lifetime Value}}={\text{Margin}}\cdot {\frac

{\text{Retention Rate}}{1+{\text{Discount Rate}}-{\text{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:

forecasting of remaining customer lifetime (most often in years)

forecasting of future revenues (most often year-by-year), based on estimation about future
products purchased and price paid

estimation of costs for delivering those products

calculation of the net present value of these future amountsForecasting 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:

CLV

GC

n
r

M
⋅

(
1

0.5

{\displaystyle {\text{CLV}}={\text{GC}}\cdot \sum _{i=1}^{n}{\frac {r^{i}}{(1+d)^{i}}}-

{\text{M}}\cdot \sum _{i=1}^{n}{\frac {r^{i-1}}{(1+d)^{i-0.5}}}}

,where

GC
{\displaystyle {\text{GC}}}

is yearly gross contribution per customer,

{\displaystyle {\text{M}}}

is the (relevant) retention costs per customer per year (this formula assumes the retention
activities are paid for each mid year and they only affect those who were retained in the
previous year),

{\displaystyle n}

is the horizon (in years),

r

{\displaystyle r}

is the yearly retention rate,

{\displaystyle d}

is the yearly discount rate. In addition to retention costs, firms are likely to invest in cross-
selling activities which are designed to increase the yearly profit of a customer over
time.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

{\displaystyle {\text{GC}}}
is found to be relatively fixed across periods, CLV can be expressed as a simpler model
assuming an infinite economic life (i.e.,

{\displaystyle {\text{N}}\rightarrow \infty }

):

CLV

GC

⋅
(

{\displaystyle {\text{CLV}}={\text{GC}}\cdot \left({\frac {r}{1+d-r}}\right)}

Note: No CLV methodology has been independently audited by the Marketing

Accountability Standards Board (MASB) according to MMAP (Marketing Metric Audit
Protocol).

Uses and 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.

Lifetime value is typically used to judge the appropriateness of the costs of acquisition of a
customer. For example, if a new customer costs $50 to acquire (COCA, or cost of customer
acquisition), and their lifetime value is $60, then the customer is judged to be profitable, and
acquisition of additional similar customers is acceptable.

Additionally, CLV is used to calculate customer equity.

Advantages of CLV:

management of customer relationship as an asset

monitoring the impact of management strategies and marketing investments on the value of
customer assets, e.g.: Marketing Mix Modeling simulators can use a multi-year CLV model
to show the true value (versus acquisition cost) of an additional customer, reduced churn rate,
product up-sell

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

implementation of sensitivity analysis in order to determinate getting impact by spending

extra money on each customer

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

measurement of customer loyalty (proportion of purchase, probability of purchase and

repurchase, purchase frequency and sequence etc.)The disadvantages of CLV do not
generally stem from CLV modeling per se, but from its incorrect application.

Misuses and downsides

NPV vs. nominal prediction

The most accurate CLV predictions are made using the net present value (NPV) of each
future net profit source, so that the revenue to be received from the customer in the future is
recognized at the future value of money. However, NPV calculations require additional
sophistication including maintenance of a discount rate, which leads most organizations to
instead calculate CLV using the nominal (non-discounted) figures. Nominal CLV predictions
are biased slightly high, scaling higher the farther into the future the revenues are expected
from customers.

Net profit vs. revenue

A common mistake is for a CLV prediction to calculate the total revenue or even gross
margin associated with a customer. However, this can cause CLV to be multiples of their
actual value, and instead need to be calculated as the full net profit expected from the
customer.

Often ecommerce reporting systems will report Lifetime Revenue (LTR), rather than
Lifetime Value based on net profit, due to the difficulty most ecommerce platforms have
generating an accurate profit figure (i.e. calculating accurate sold item costs, marketing costs
and delivery costs) on an order by order basis. Lifetime Revenue can still be a very valuable
and useful metric for ecommerce stores to report on in order to measure site performance.

Segment inaccuracy

Opponents often cite the inaccuracy of a CLV prediction to argue they should not be used to
drive significant business decisions. For example, major drivers to the value of a customer
such as the nature of the relationship are often not available as appropriately structured data
and thus not included in the formula.

Comparison with intuition

More predictors, such as specific demographics of a customer group, may have an effect that
is intuitively obvious to an experienced marketer but are often omitted from CLV predictions
and thus cause inaccuracies in certain customer segments.

Over-values current customers at the expense of potential customers

The biggest problem with how many CLV models are actually used is that they tend to deny
the very idea that marketing works (i.e., that marketing will change customer behavior). Low-
value customers can be turned into high-value customers by effective marketing. Many CLV
models use incorrect mathematics in that they do not take account of the value of a far greater
number of middle-value customers, over-prioritizing a smaller number of high value
customers. Additionally, these high-value customers may be saturated (i.e., not have the
ability to buy any more coffee or insurance), may be the most expensive group to serve, and
may be the most expensive group to reach by communication. The use of survey data is a
viable way to collect information on potential customers.

CLV is a dynamic concept, not a static model

A Customer Life Time Value is the output of a model, not an input. If you change the model
inputs (e.g., let's say marketing is effective and you increase your retention rates), your
average CLV will increase.

See also
Customer profitability, the profit the firm makes from serving a customer or customer group
over a specified period of time

Gompertz distribution, commonly applied to describe the distribution of adult lifespans by

demographers and actuaries
Customer value maximization, What is CVM and How to increase Customer Value?

Buy Till you Die, a class of statistical methods to estimate customer lifetime value

References
External links
MASB Official Website