Customer Lifetime Value (CLV)

Customer Lifetime Value

Core CRM idea - customer should not be viewed as a set of independent transactions, but as a lifetime income stream

Lifetime value (LTV), which is also known as customer lifetime value (CLV), is a measure of a customers, or customer segments, profit generation for a company

Def: Lifetime value is the present day value of all net margins earned from a relationship with a customer, customer segment or cohort*.

The focus on net margins rather than gross margins is because a customer that appears to be valuable on the basis of the gross margins generated might seem less profitable once cost-to-serve the customer is taken into account

Customer Lifetime Value

Def: A customers LTV is the net present value of the expected future stream of financial contributions from the customer. Every customer of an enterprise today will be responsible for some specific series of events in the future, each of which will have a financial impact on the enterprisethe purchase of a product, payment for a service, remittance of a subscription fee, a product exchange or upgrade, a warranty claim (NPV), today, of each of these future value-creating events can be derived by applying a discount rate to it to factor in the time value of money as well as the likelihood of the event LTV is sum of the NPVs of all such future events attributed to a particular customers actions. While calculating LTV, firms must consider *current and **potential values

Customer Lifetime Value

From a customers stream of positive contributions, including product and service purchases, an enterprise must deduct the expenses associated with that customer, including the cost of maintaining a relationship. If costs associated with a customer outweigh the customers positive contributions altogether LTV is below zero. The most reliable predictor of a customers future behavior could be that customers past behavior. Many variables cannot be easily quantified - assistance a customer might give an enterprise in designing a new product, or the value derived from the customers referral of another customer, or the customers willingness to advocate for the product or company on a social networking Web site LTV is a quantity that no enterprise can ever calculate precisely, no matter how sophisticated its predictive analytics programs and statistical models are.

Calculating CLV
LTV can be estimated at the level of the individual customer, customer segment or cohort.

To compute LTV, all historic net margins are compounded up to todays value and all future net margins are discounted back to todays value. Estimates of LTV look to the future (potential value) because.

Revenues grow over time

Cost to serve lower for existing customers

Referrals generated

Higher prices paid by existing customers

One industry in which potential value can be an important differentiator is

the airline business*.

Calculating CLV

Revenues grow over time - customers buy more with time. - customers become more relaxed about using your product. - a satisfied customer may look to buy additional categories of product from a preferred manufacturer. E.g., An insurance company that has a loyal car insurance customer is likely to experience some success cross-selling other personal lines, for example home, property and travel insurance.

Cost-to-serve is lower for existing customers

- both supplier and customer understand each other. For e.g., customers do not make demands on the company that it cannot satisfy. Similarly companies do not communicate offers that have little or no value to customers.

Calculating CLV

Referrals generated - by existing, satisfied customers through their unpaid advocacy. - Word-of-mouth is recognized as powerfully persuasive because it is regarded as being independent and unpaid. - Taking into account the customer influence factor in modeling lifetime value is even more critical in some industries where a small number of customers exert a disproportionate share of influence on others buying decisions, such as in the pharma industry. - Identifying and trying to quantify the value of such key opinion leaders (KOLs) is a high priority for pharma companies

Higher prices are paid by existing customers - than those paid by new customers. - This is partly because they are not offered the discounts that are often employed to win new customers, and - partly because they are less sensitive to price offers from other potential suppliers because they are satisfied with their experience

Benefits of calculating CLV

Help an enterprise determine how much it can afford to spend to acquire a new customer Decide just how much it would be worth to retain an existing customer Enterprise can target its customer acquisition efforts in order to concentrate on attracting higher-value customers More economically correct way to evaluate investments on the customer compared to simply counting immediate sales

Easy

Hard

Calculating CLV Things you need to know while calculating

For existing customers
What is the probability that the customer
will buy products and services from the company in the future, period-by-period?

For new customers

(Additional) What is the cost of acquiring
the customer?

What will the gross margins on those

purchases be, period-by-period?

What will the cost of serving the customer

be, period-by-period?

To bring future margins back to todays value

What discount rate should be applied to
future net margins?

Probably the most straightforward way to estimate a customers potential value is to look at the range of LTVs for similar customers and then to make the arbitrary assumption that in an ideal world it should at least be possible to turn lower- LTV customers into higher-LTV customers.

Calculating CLV
A common practice is to use the weighted average cost of capital (WACC) as the discount factor.

impact that discount rate has on customer value

Calculating CLV
In year 0, the company spent $10 million in marketing campaigns to generate new customers The result was 100 000 new customers added to the customer base at an acquisition cost of $100 per customer. In year 1 the company lost 40 per cent of these new customers, but the remaining 60 per cent each generated $50 contribution to profit It takes nearly five years to recover the investment of acquiring this cohort profit per customer rises over time Customer retention rate rises over time

CLV computation for cohort of customers

Several strategies available to the organization now

Improve customer retention rate in the early years of the relationship. This will produce a larger number of customers to generate higher profits in the later years. Increase the profit earned per customer by: a. reducing cost-to-serve b. cross-selling or up-selling additional products and services. Become better at customer acquisition by: a. using more cost effective recruitment channels b. better qualification of prospects. Customers who defect early on perhaps should not have been recruited in the first place. Royal bank of Canada case*

Dont leave this discussion of LTV by believing that if you improve customer retention business performance will automatically improve. It depends entirely on which customers are retained and how you manage those relationships.