Determining Customer Lifetime Value - Identifying Your Customers - Customer Analytics For Dummies (2015)

Customer Analytics For Dummies (2015)

Part II

Identifying Your Customers

Chapter 6

Determining Customer Lifetime Value

In This Chapter

arrow Learning the importance of customer lifetime value (CLV)

arrow Determining the CLV

arrow Applying CLV to the profitability of your business

If you’ve ever signed up for a credit card that had a low introductory interest rate, or enjoyed a low cable subscription in the first year of signing up, then you’ve experienced marketing strategies informed by a company’s analysis of customer lifetime value (CLV).

The CLV is the total profit that an individual customer generates for your business over his or her lifetime. The customer lifetime is the time period that starts when a customer first uses your business (in person or online) and ends when he buys his last service or product from you. The CLV covers the entire relationship you have with that specific customer, or segment of customers.

In Chapter 4, I discuss the importance of segmenting customers. One of the primary reasons for segmenting customers is that not all customers generate the same revenue or profits for an organization. Certain segments are more profitable than others. Now, the next step is to understand how segments of customers differ in the duration of their relationship with your business. The CLV is intimately linked to customer loyalty (see Chapter 12). Some customer segments are more prone to loyalty and are therefore more likely to cultivate a long-term relationship with your business, thus generating more revenue over their lifetime. Identifying the CLV of different segments enables you to balance the acquisition costs of a new customer with expected long-term revenue. This knowledge also helps you fine-tune your marketing strategy to acquire more high-CLV customers.

Why Your CLV Is Important

The CLV metric serves many purposes. The most obvious is that it gives you a good idea of how much total profit you can expect from a customer. It isn’t a hard science, but solid calculations based on data yield a reasonably accurate estimate to work with. Knowing the total lifetime profit (or loss) created by a specific client can also help you determine which goods or services justify higher marketing costs or sales compensation. Moreover, calculating the CLV of different customer segments helps orient your marketing strategy.

Aside from gaining a holistic view of the client, CLV is a good tool for forecasting future sales and profits, using resources efficiently, and controlling costs. Cable companies are a good example of effectively utilizing the concept of CLV. The reason cable companies offer such low upfront fees is that they’ve calculated the lifetime value of their customers and therefore know they can afford to initially lose a certain amount of money in order to acquire long-term customers.

As another example, the financial services firm Charles Schwab has the lifetime revenue of individual customers ready for managers and employees when resolving problems customers encountered with their service. Employees have the ability to credit customers with free trades, and in some cases, even help offset the losses based on the lifetime value of a customer. It doesn’t make sense to haggle over $100 with a customer who has spent $10,000 over 10 years with the firm. This philosophy has helped make Charles Schwab a financial firm with one of the highest customer loyalty levels.

Using CLV to acquire customers

Knowing how long the average customer who initially benefits from low fees does business with them, organizations can determine how much money they can lose to acquire new customers. Consider these examples:

· Eastman Kodak which used to take a loss on selling its cameras because it knew it could make the loss up with the sales of film.

· Razor blades are relatively cheap and, in some cases free, when you purchase them with a new shaver. It’s the years (and therefore, the additional money) customers spend buying the refill blades that allows for the initial low prices.

· If your printer breaks, it doesn’t make sense to repair it. You can buy a new color printer for under $50 now. The reason is that the printer companies are willing to sell you a printer at a loss in order to get the years of ink-toner purchases.

· Remember the old record/CD clubs like Columbia House? They’d charge a penny for ten CDs, because they knew they’d lock you in to purchasing ten overpriced ones even if you didn’t want them over the next year.

All of these are examples of companies calculating the lifetime value of their customers and basing their customer acquisition strategy on that piece of information.

A daring customer acquisition strategy like those used by cable companies could be a financial catastrophe without appropriate data to back it and predict customer behavior. Although the CLV concept has been around for years, few companies have the technology to track each customer, know the usage on an individual basis, and implement this metric in order to quantify behavior. In the next section, I explain how to effectively calculate and use the CLV.

Applying CLV in Business

The CLV can be used to evaluate the amount of money that can reasonably be devoted to customer acquisition. In order for your business to be profitable and financially sustainable, it is essential that the CLV outweigh the customer acquisition costs. Otherwise, your business is bound to lose considerable amounts of money. If it costs $1,000 to acquire a new customer through marketing, sales, and production costs, but the customer generates only $75 over the typical lifetime, then that’s a losing strategy.

To develop a marketing budget, you need to reflect on how much and where you will invest your money:

· Explore allowable acquisition cost: How much can you afford to spend to get a customer who will continue to return for repeat business?

· Explore investment acquisition cost: How much is it going to cost to acquire new customers?

remember Certain customer segments are more loyal and generate more profits than others over their lifetime. Focusing the customer acquisition strategy on those more profitable segments helps ensure that the customers you invest money to acquire are going to stay with you and keep generating revenue.

Calculating Lifetime Value

Calculating customer lifetime value can involve some complex math with many variables and equations that can be quite intimidating. There is even very expensive software to compute complicated CLVs for all different types of customers and products. Fortunately, you don’t have to be a mathematician or computer scientist to compute a basic, helpful CLV estimate.

The analysts at KISSmetrics present a simple way to calculate the CLV using an infographic on its website, and I summarize a similar approach here. Remember that the more data you can gather about your customers’ buying habits, the more accurate your results will be. However, the method is quite easy and you can get a good estimate of your CLV with relatively little data. It’s a three-part process:

1. Estimate revenue.

2. Calculate the CLV.

3. Identify profitable customers.

Estimating revenue

I recommend this process to estimate a typical customer’s revenue:

1. Calculate how much money a typical customer (or a typical customer from a specific segment) generates per purchase.

One way to do that is to average the revenues from several customers (within a segment or from your market as a whole).

For example, the typical revenue from a customer’s purchase in a sandwich shop can be around $8. Figure 6-1 shows fictional purchase data from six different customers, as well as the average.


Figure 6-1: Customer purchase data.

remember The larger the customer sample, the more precise the results are. The CLV can’t be more precise than the data it is calculated from. Therefore, look at “hard” data such as historical or current sales, to obtain accurate averages.

2. Estimate the frequency of the customer’s purchases.

The appropriate time frame, called the purchase cycle, depends on the industry. A sandwich shop may find that the most relevant time frame is one week, and that each customer purchases about three times per week (like some of my colleagues), as illustrated in Figure 6-2. For purchasing desktop and laptop computers, it’s likely two to four years, and for rental cars and airline tickets it may be a few times per year, depending on the customer segment.


Figure 6-2: Frequency of customer purchases.

3. Calculate the revenue per customer over a certain time period.

Multiply the revenue per purchase by purchase frequency:

Revenue per purchase x Frequency of purchase = Revenue over a certain time period

In the sandwich shop example, the result would be expressed in dollars per week:

$8/purchase × 3 purchases/week = $24/week

Figure 6-3 shows the breakdown of this average for the same six customers.


Figure 6-3: Average revenue per week per customer.

Calculating the CLV

The simplest way to compute the customer lifetime value is to evaluate how long the average customer does business with your company and to calculate how much revenue is generated during that period:

· Revenue per purchase

· x Frequency of purchase

· x Customer lifetime


In the sandwich shop example, assuming that the revenue per purchase is $8, the frequency of purchase is three times per week, and the customer lifetime is 20 years, the CLV is:

$8/purchase x 3 purchases/week x 52 weeks/year x 20 years = $24,960

However, to make the result more precise, other factors should be taken into account if the data is available. Using the revenue generated from a customer will almost always overestimate the customer’s true lifetime value because it doesn’t factor in the costs of things like employees, building and/or equipment lease, and advertising. In fact, without factoring in costs, CLV is usually referred to as customer lifetime revenue (CLR).

It therefore makes sense to factor in the profit margin, which is the percentage of the revenue left over after subtracting all the company’s expenses. A more realistic CLV can then be calculated using the following equation:

· Revenue per purchase

· x Frequency of purchase

· x Customer lifetime

· x Profit margin


In this example, with a 21% profit margin, the CLV becomes $5,242. Profit margins vary significantly by industry and product type. For example, General Electric’s lighting business has profit margins of less than 5% and its industrial business has margins around 15%. Computer software typically has margins above 70%.

remember Do the best you can to compute a realistic margin based on your business and products because it has a substantial effect on computing an accurate lifetime value calculation.

Two values can be used to refine your CLV calculation:

· Retention Rate: The customer retention rate is the percentage of the customers who repurchase over a specific period of time.

As a simple example, if 800 out of 1,000 customers are still customers after a year, the retention rate is 80%. If you have the data, look at multiple years to generate a more accurate rate of retention.

· Discount Rate: The discount rate is an economic notion that is used to calculate the present value of future revenues.

The basic idea is that having money today is worth more than having that same amount of money at some distant point in the future. Would you rather have $10,000 today or $10,000 in ten years?

The same principle applies to company profits. Future profits are discounted to account for their current value.

If the lifetime of a customer is short (weeks, months, or a year or so), then the discount rate won’t have as much of an effect as if the lifetime lasts years or decades.

The CLV equation becomes more accurate if retention rate and discount rate are taken into account:

· Revenue per purchase

· x Frequency of purchase

· x Customer lifetime

· x Profit margin

· x ( retention rate) / (1 + discount rate - retention rate)


If the retention rate is 75% and the discount rate is 10%, you obtain a CLV of $11,233 for the previous example. While the retention rate is always lower than 100% and therefore reduces the CLV, taking the value of future money into account using the rate of discount results in a higher yet more realistic CLV.

As with most of the customer analytics discussed in this book, the precision of the CLV depends on the quality of the data available and the number of variables that can be evaluated. However, even imperfect results can be used to compare different customer segments and identify the most profitable customers.

Identifying profitable customers

Calculating the lifetime value of different customer segments enables you to identify the segments that are worth the investment of large acquisition costs.

To find the most profitable customers, calculate the CLV for your different customer segments and compare with the average CLV. Differences in lifetime value between segments can be rather large and should help focus your customer acquisition strategy. It may be more expensive to gain the good customers’ loyalty, but in the long run, they will generate more revenue.

If, for example, the sandwich shop’s frequent customers generate about $3,000 more than the infrequent customers over their lifetime, then an investment of say $500 spent marketing to acquire these more frequent customers would pay off.

Marketing to Profitable Customers

Identifying the most profitable customer segments can be done in a sound, data-driven manner using the CLV. However, even increasing the number of your “good” customers may not be worth an expensive marketing campaign or costly incentives. To find out whether your efforts will pay off in the future, calculate your marketing campaign (or customer acquisition efforts) return on investment (ROI).

tip The CLV can be used to evaluate the success of a marketing campaign. Looking back at the money spent for customer acquisition during a certain time period and dividing by the number of customers acquired during that time, you obtain the average amount of money spent to acquire each individual new customer. You can then calculate the ROI of your marketing campaign to evaluate whether it was a financial success or failure.

To calculate the ROI of your marketing campaign to acquire new customers, use the following equation:

ROI = (CLV - Marketing cost per customer acquired) / Marketing cost per customer acquired

For example, if the sandwich shop spends $5000 on advertising and finds that it obtains 50 new customers, the cost to acquire a new customer is $100. The ROI of the advertising campaign will depend on the type of customer (frequent or infrequent) that's gained.

For example, using the CLV of $5,242 for the frequent customers from the previous example, the ROI of this campaign is:

($5,242 − $100) / $100 = $51

For every $1 spent on advertising, $51 is gained over the frequent customer lifetime.

However, if the advertising campaign attracts infrequent customers who may only purchase $6 once a month over 5 years, generating lifetime revenue of $360 and a CLV of $75.60 (after factoring in the profit margin of 21%). The ROI is then:

($75.60 − $100) / $100 = $−0.24

In other words, if the advertising campaign attracts infrequent customers, over a 5 year period, the campaign will result in a loss of 24 cents for every dollar spent. Not a good investment at all.

A negative ROI means that the marketing campaign was a money loser. CLV thus provides crucial information about just how much should be spent on a marketing campaign or how much you can afford to lose by offering incentives.

remember Just like acquiring new customers by creating attractive incentives and marketing specifically to them, increasing your existing customers’ CLV by boosting their satisfaction helps your business grow:

· A higher satisfaction rate increases the frequency of purchases, the amount of revenue generated each time, and your customer lifetime. All those factors contribute to a higher CLV.

· Satisfied and loyal customers are more likely to recommend your products or services to their friends and colleagues (see Chapter 12), thus enlarging your customer base.

· The cost of acquisition of new customers is often much higher than what needs to be spent to retain existing customers and increase their purchases.

· Customers who are highly satisfied provide free word-of-mouth marketing!