Customer lifetime value

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.” ^[4] Customer lifetime value differs from customer Profitability gold CP (the différence entre 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. ^[2]

Customer lifetime value:

The present value of the future cash flow is attributed to the customer during his / her entire relationship with the company. ^[2]

Present value is the discounted sum of future cash flows: each future cash flow is multiplied by a carefully selected number. The multiplication factor accounts for 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. 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 in the future. ^[2]

CLV applies to the concept of present value to cash flow. Because of the present value of any stream of future cash flows, CLV will represent the single lump sum value today of the customer relationship. Even more simply, CLV is the dollar value of the customer relationship to the firm. It is an upper limit on what the firm would be willing to pay for the customer relationship. If we view a customer relationship as an asset of the firm, CLV would present the dollar value of that asset. ^[2]

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 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 in marketing resources.

Customer Lifetime Value metrics are used primarily 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 principles CLV May be extended to transactions-focused categories Such As consumer packaged goods purchase by Incorporating stochastic models of individual or aggregate behavior . ^[5] In case of retention, it has a decisive impact on CLV. ^[6]

Construction

The following formulas are consistent, the following formula can be used to calculate the lifetime value of a customer relationship:

Customer lifetime value ($) = Margin ($) * (Retention Rate (%) ÷ ([1 + Discount Rate (%)] – Retention Rate (%)) ^[2]

The model for customer cash flows treats the firm’s customer relations as a leaky bucket. Each period, a fraction (1 less the retention rate) of the firm’s customers is lost for good. ^[2]

(1) constant margin (per cent), (2) constant retention probability per period, and (3) discount rate. Furthermore, the model assumes 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. ^[2]

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. ^[2]

Under the assumptions of the model, CLV is a multiple of the margin. The multiplicative factor represents the present value of the expected length 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 client 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. ^[2]

Methodology

Simple trade example

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

The numerator represents the average monthly profit by the customer, and the dividend by the churn rate sums the geometric series representing the chance the customer will still be around in future months. ^{[ quote needed ]}

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

A retention example

CLV (customer lifetime value)

1. forecasting of remaining customer lifetime (most often in years)
2. forecasting of future revenues (most often year-by-year)
3. estimates of costs for delivery those products
4. the present value of these future amounts ^[7]

Forecasting accuracy and difficulty in tracking CLV calculation process.

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

• Churn rate , the percentage of customers who have a relationship with a company. One minus the churn is the retention rate . Most models can be written using either a churn rate or a 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 income 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.
• Margin contribution
• 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, incentive incentives, etc.
• Period , the unit of time in which a customer relationship is divided for analysis. A year is the most commonly used period. Customer lifetime is a multi-period calculation, usually stretching 3-7 years into the future. In practice, analysis beyond this point is considered as speculative to be reliable. The number of periods used in the calculation is sometimes referred to as the horizon model .

Thus, one of the ways to calculate CLV, where is a year, is as follows: ^[8]

{\ 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 {\ displaystyle {\ text {GC}}} is annual gross contribution per customer, {\ displaystyle {\ text {M}}} These are the (relevant) retention rates for those who have been retained in the previous year. {\ displaystyle n} is the horizon (in years), {\ displaystyle r} is the annual retention rate, {\ displaystyle d}is the annual discount rate. In addition to retention costs, firms are likely to invest in cross-selling activities which are designed to increase the annual profit of a customer over time. ^[9]

Simplified models

It is often helpful to estimate customer satisfaction with a simple model to make initial assessments of customer segments and targeting. If{\ displaystyle {\ text {GC}}} can be expressed as a simple model assuming an infinite economic life (ie, {\ displaystyle {\ text {N}} \ rightarrow \ infty}): ^[10]

{\ displaystyle {\ text {CLV}} = {\ text {GC}} \ cdot \ left ({\ frac {1} {1 + dr}} \ 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 intuitive HAS 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 shoulds be willing notary C. to ACQUIRE Each customer, Especially in direct response marketing .

Lifetime value is typically used to judge the appropriateness of the costs of acquiring 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.

Additionally, CLV is used to calculate customer equity .

Advantages of CLV:

• asset management
• Monitoring the impact of management strategies and marketing investments on the value of customer assets, eg: 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
• encourage marketers to focus on the long-term value of customers instead of investing in low-cost customers with low total revenue value
• implementation of sensitivity analysis in order to determinate getting impact by spending extra money you Each customer ^[11]
• optimal allocation of limited resources for ongoing marketing activities in order to achieve a maximum return
• Customer Specific Communication Strategy ^[12]
• a natural decision criterion for use in the automation of customer relationship management systems ^[13]
• measurement of customer loyalty (proportion of purchase, probability of purchase and repurchase, purchase frequency and sequence etc.) ^[14]

The Disadvantages of CLV do not stem from CLV modeling, 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 future is recognized at the future value of money. HOWEVER, NPV calculations require additional sophistication Including Maintenance of a discount rate , qui MOST organisms leads to INSTEAD calculate CLV using the nominal (non-discounted) figures. Nominal CLV predictions are biased slightly higher, scaling higher the farther in the future are expected from customers.

Net profit vs. revenue

A common error is for a CLV prediction to calculate the total revenue or even the gross margin associated with a customer. However, this can cause CLV to be multiple of their actual value, and instead be calculated at full profitfrom the customer.

Segment inaccuracy

Opponents often cite the inaccuracy of a CLV prediction to argue that they should not be used to drive significant business decisions. For example, major drivers to the value of a customer, and

Comparison with intuition

More, predictors such as a particular demographics of a customer group can be expected to be an experienced marketer, but are often omitted from CLV predictions and thus cause inaccuracies in certain customer segments.

Over-rated customers at the expense of potential customers

The biggest problem is that they are actually used for marketing purposes (ie, that will change customer behavior). Low value customers can be turned into high value customers by effective marketing. Many CLV models use incorrect values ​​in the form of a larger number of middle-value customers. Additionally, these high-value customers may be saturated, and may be the most expensive group to serve, and may be the most important group to reach by communication. The use of survey data is a viable way to collect information on potential customers. ^[15]

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 (eg, let’s say it is effective and you increase your retention rates), your average CLV will increase.

See also

• Customer profitability , the profit makes the firm of serving a customer
• Gompertz Distribution , Applied Applied to the Distribution of Adult Lifespan by Demographers and Actuaries
• Customer value maximization , What is CVM and How to increase Customer Value?

References