Customer Lifetime Value (CLV) is a measure that allows managers to understand the overall value of their customer base and to assess the success rate of their management strategies.
We are going to describe how to calculate it and show the importance of it.
Defining Customer Lifetime Value
Customers are increasingly seen as assets that create value for companies.
Companies focus on three customer-focused strategies to raise these assets:
- Asset acquisition, attracting new customers to the company,
- Maximizing assets, maximizing the value the company extracts from each customer,
- Asset Retention, retaining existing customers for long time.
Customer Lifetime Value (CLV) is a criterion that allows managers to understand the overall value of their customer base and to assess the success rate of their management strategies.
Analyzing and calculating customer lifetime value allows managers to
anticipate the cost of attracting a customer and compare this with
the expected profit of that customer’s business throughout his lifetime.
Customer Lifetime Value depends on three different factors:
CLV is dependent on three different factors:
- Customer Acquisition Cost
- The annual profits that the customer produces for the company
- Number of years the customer is likely to buy from the company
#1 Customer Acquisition Cost
To acquire a customer, the company must spend some money.
Customer acquisition is usually done through marketing programs such as
advertising or sales promotion programs.
Managers using CLV analysis need to begin their own analysis by,
figuring out the cost of acquisition of any potential customer for the company.
#2 The annual profits that the customer produces for the company
Profits depend on the two parameters, one that the customer gives to the company,
and the other variable costs that the company will incur to serve the customer.
Every time a customer purchases from the company, the company earns money from this purchase.
Some customers make more money than others because
they buy products at full price rather than discounted price,
another reason is to buy more expensive products from the company.
Customers who buy more or in large volumes generate more annual revenue than those who buy less.
The annual profit is calculated by subtracting total variable cost of the products that
the customer purchases from the total revenue obtained.
In the analysis of Customer Lifetime Value, the Contribution Margin (Revenue-Variable Cost) is a good measure for measuring profits.
#3 Number of years the customer is likely to buy from the company
Different customers have a different lifetime.
Some customers are loyal to the brand to a great extent, and
when they are attracted, they will continue to buy from the company for many years.
Some other customers are not loyal to the brand and will buy the company for a short time.
Basic formula for calculating Customer Lifetime Value
In the simplest formula, you can calculate Customer Lifetime Value (CLV) as follows:
In this formula,
m is the contribution margin of the customer in one year (or another interval),
L is the expected purchasing life of a customer (measures in years if annul m is used) and
AC is Customer Acquisition Cost.
This formula defines three main forces, which stimulate Customer Lifetime Value.
This formula shows that the most valuable customers are:
- their acquisition is cheaper
- create more profits for the company in each period, and
- they are customer of company for more periods of time.
Numerical example calculating Customer Lifetime Value
A numerical example may help to understand this relationship.
Suppose the manager wants to estimate the lifetime value of a new customer, Alexander.
The manager estimates that the store has spent $20 dollars to attract Alexander, and
as long as Alexander is a customer, the store will earn $ 50 each year.
Based on past customer Churn Rate (I will explain it later),
the manager expects to keep Alexander for ten years.
Therefore, manager estimates that his customer’s lifetime value is $480 = $10 * 50 – $20.
It is the right time to talk about some of the hypotheses included in this formula,
the hypotheses that can be taken if necessary.
First, this formula assumes that the profit earned by a customer is the same for all periods.
This hypothesis is essentially done to simplify math operations,
but it is acceptable in many circumstances, for example,
when customers pay monthly installments.
Second, this formula does not take into account the time value of money,
since it implicitly assumes that the discount rate is zero.
If the relationship with the customer persists in the long periods of time,
this hypothesis is problematic, and in the following sections I will show how to remove these assumptions in future.
Comment your opinion for now. I will write down the rest soon.