Definition of Customer Lifetime Value

In marketing

Marketing

Marketing is the process used to determine what products or services may be of interest to customers, and the strategy to use in sales, communications and business development. It generates the strategy that underlies sales techniques, business communication, and business developments...

, customer lifetime value (CLV), lifetime customer value (LCV), or lifetime value (LTV) is the net present value

Net present value

In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...

 of the cash flows attributed to the relationship with a customer. The use of customer lifetime value as a marketing metric tends to place greater emphasis on customer service and long-term customer satisfaction, rather than on maximizing short-term sales. One of the first accounts of it is in the 1988 book Database Marketing, and includes detailed worked examples.

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. In reality, it is difficult to make accurate calculations of customer lifetime value. The specific calculation depends on the nature of the customer relationship. Customer relationships are often divided into two categories. In contractual or retention situations, customers who do not renew are considered "lost for good". Magazine subscriptions and car insurance are examples of customer retention situations. The other category is referred to as customer migration situations. In customer migration situations, a customer who does not buy (in a given period or from a given catalog) is still considered a customer of the firm because she may very well buy at some point in the future. In customer retention situations, the firm knows when the relationship is over. One of the challenges for firms in customer migration situations is that the firm may not know when the relationship is over (as far as the customer is concerned).

Calculation in customer retention cases

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

1. forecasting of remaining customer lifetime in years
2. forecasting of future revenues 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.

Most models to calculate CLV apply to the customer retention situation. These models make several simplifying assumptions and often involve the following inputs:

• Churn rate
  Churn rate
  Churn rate , in its broadest sense, is a measure of the number of individuals or items moving into or out of a collective over a specific period of time...
  
  , the percentage of customers who end their relationship with a company in a given period. One minus the churn rate is the retention rate. 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
  Cost of capital
  The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
  
   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
  Interest rate
  An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
  
   is sometimes used as a simple (but incorrect) proxy for discount rate
  Discount rate
  The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
  
  .
• Contribution margin
  Contribution margin
  In cost-volume-profit analysis, a form of management accounting, contribution margin is the marginal profit per unit sale. It is a useful quantity in carrying out various calculations, and can be used as a measure of operating leverage...
  
  .
• 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 :

,

where is yearly gross contribution per customer, 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), is the horizon (in years), is the yearly retention rate, is the yearly discount rate.

It is often helpful to estimate customer lifetime value with a simple model to make initial assessments of customer segments and targeting. Possibly the simplest way to estimate CLV is to assume constant and long-lasting values for contribution margin, retention rate, and discount rates, as follows :

Uses and Advantages of CLV

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

Customer equity

Customer equity is the total combined customer lifetime values of all of a company’s customers.-Overview:In deciding the value of a company, it is important to know of how much value its customer base is in terms of future revenues...

.

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
• determination of the optimal level of investments in marketing and sales activities
• 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
• measurement of customer loyalty (proportion of purchase, probability of purchase and repurchase, purchase frequency and sequence etc.)